1. Corporate Financing Choices
Michigan/TMA
Corporate Financing Choices
Prof. Ian Giddy
New York University

2. Corporate Financing Choices
Do financing choices matter?
Debt or equity?
What kind of debt?
Certain kinds of market imperfections allow corporations to reduce costs by improving the financing mix

3. First Principles of Corporate Finance
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
Manage financial risk
This is the second component of corporate finance. Firms have to choose both the right financing mix and right type of financing for their needs.

4. Debt?
Equity?
What kind?

5. Is There an Optimal Capital Structure?
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E

6. Does Capital Structure Matter?
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
You cannot change the value of the
real business just by shuffling paper
- Modigliani-Miller

7. Most Value is Created on the Asset Side
Discounted Cash Flow (DCF) analysis for project evaluation
Value-Based Management for performance evaluation
Union Camp: Packaging Business ?

8. Is There an Optimal Capital Structure?
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
VALUE OFTHE FIRM
Optimal debt ratio?
DEBT
RATIO

9. How Much Debt?

10. Profits: Zero ~ Risks: High
How Much Debt?
A $19.95 company...an “ISP”
Profits: Zero ~ Risks: High

11. Ciba-Geigy

12. Case Study: Financing Ciba
1) What is Ciba's debt-to-equity ratio, and what might one advise the company about what it should be?
(2) How much of Ciba's debt is fixed-rate borrowing, and should this proportion change?
(3) How much of the company's debt should be long term?
(4) What is the composition, by currency, of Ciba's debt? What should it be?

13. Case Study: Financing Ciba
Could Ciba benefit from more debt?
Tax shield?
Could Ciba be hurt by more debt?
Risks of financial distress?
Costs of financial distress?
Reduce flexibility?

14. Ciba: How Much Debt?

15. Ciba: Are Revenues Stable?
Ciba Sales and Earnings
(in billions of Swiss francs)
100 10 1
Legend
Sales
Profits
0.1
1982
1984
1986
1988
1990
1992

16. Measuring Financial Leverage
Two variants of debt ratio
Debt to Capital Ratio = Debt / (Debt + Equity)
Debt to Equity Ratio = Debt / Equity
Ratios can be based only on long term debt or total debt.
Ratios can be based upon book value or market value.
When talk turns to debt ratios, we should first make sure that we are talking about the same measure, given all the different definitions around.

17. Measuring Cost of Capital
It will depend upon:
(a) the components of financing: Debt, Equity or Preferred stock
(b) the cost of each component
In summary, the cost of capital is the cost of each component weighted by its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))
The cost of capital is the weighted average of the cost of all the different sources of financing.
Preferred stock, which is not debt (because preferred dividends are not tax deductible) and not equity (because preferred dividends are fixed) is best treated as a third item on the cost of capital computation, with its own cost. The simplest measure of this cost is the preferred dividend yield. (Preferred dividend/Preferred stock price)

18. Why Does the Cost of Capital Matter?
Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital
If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
This is the conventional valuation model for a firm.

19. Optimum Capital Structure and Cost of Capital
If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
If the cash flows are the same, and the discount rate is lowered, the present value has to go up. (The key is that cash flows have to remain the same. If this is not true, then minimizing cost of capital may not maximize firm value)

20. Financing Choices
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
From
How much debt? to
What kind of debt?
You cannot change the value of the
real business just by shuffling paper
- Modigliani-Miller

21. Corporate Financing Choices: What Kind of Debt?
Fixed/floating
Currency of denomination
Maturity or availability
Domestic/Euro
Public/private
Asset-based
Credit enhanced
Swapped
Equity-linked

22. Short Term or Long Term?
In 1992, Ciba had fixed assets of SF13.9 billion and capital expenditures of SF1.9 billion.
Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets.
This suggests that if the proportion of debt financing as a whole is increased, much of it should be in the form of long-term debt.

23. Currency of Denomination of Ciba's Debt? What Should It Be?
Geographic location of sales and capital assets.
Currency distribution of sales.
Nature of the company's businesses

24. Currency of Ciba’s Assets and Debt
Geographic distribution
Geographic distribution of of
Estimated
Estimated
Currency
Currency
currency
currency
Fixed
Fixed
distribution
distribution
distribution of
distribution of
assets
assets
Sales
Sales
of sales
of sales
Remarks on economic exposure
Remarks on economic exposure
debt
debt
Switzerland
Switzerland
41%
41%
2.4%
2.4%
Net short position because much of
Net short position because much of 9% 9%
production, but little of sales, here
production, but little of sales, here
43%
U.K.
U.K.  
5.4%
5.4%
Part of sales effectively U.S. dollar
Part of sales effectively U.S. dollar 7% 7%
denominated
denominated  
27%
27%
Other
Other
34.6%
34.6%
21%
21%
Europe
Europe
U.S. and
U.S. and
23%
23%
32%
32%
41.3%
41.3%
54%
54%
Canada
Canada
Latin
Latin 4% 4% 7% 7%
5.3%
5.3%
Most of sales effectively dollar
Most of sales effectively dollar 2% 2%
America
America
denominated
denominated
Asia
Asia 4% 4%
13%
13%
10.9%
10.9%
Part of sales effectively U.S. dollar
Part of sales effectively U.S. dollar 6% 6%
denominated
denominated
Rest of the
Rest of the 1% 1% 5% 5%
Most of sales effectively dollar
Most of sales effectively dollar 1% 1%
world
world
denominated
denominated

25. What Kind of Debt? Some Considerations
Fixed/floating:
How certain are the cash flows? Are operating profits linked to interest rates or inflation?
Currency:
Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination.
Maturity or availability:
Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing?

26. Guidelines for Financing
Liabilities to match assets: economic exposure of the firm determines base financing choices.
Decision on whether or not to fully match depends on company's view relative to the view implied by market prices.
When strategy is chosen, use the financing/hedging techniques that offer the lowest effective cost.

27. When Debt and Equity are Not Enough
Assets
Liabilities
Value
of future
cash flows
Claims on
the cash flows

28. When Debt and Equity are Not Enough
Assets
Liabilities
Debt
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

29. When Debt and Equity are Not Enough
What if...
Assets
Liabilities
Claims
are inadequate?
Debt
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Returns
are inadequate?
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

30. When Debt and Equity are Not Enough
Alternatives
Assets
Liabilities
Collateralized
Asset-securitized
Project financing
Debt
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Preferred
Warrants
Convertible
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

31. Asset Securitization: Sell Your Cake and Eat It Too
SPONSORING
COMPANY
ACCOUNTS
RECEIVABLE
CONTINUED
SERVICING
OF ASSETS
SALE OR
ASSIGNMENT
SPECIAL
PURPOSE
VEHICLE
ISSUES
ACCOUNTS
ASSET-BACKED
RECEIVABLE
CERTIFICATES

32. Cremonini Securitization
Sale of Receivables
Cremonini
Group
Purchaser
SPC
Subordinated
Lender
Purchase 98%
Lire 16%inter.
Receivables &
Contract
Rights
Goods &
Services
Purchase Price
& fee 98%
Receivables
Subordinated Note
Italian
Obligors
Issuer
Crystal Castle (SPC)
Spread
Account
Lire 2% interest
84%
FX and Interest
Rate Swap
Swiss Bank
Dollars
84%
Investors
Lire
Pledges:
SPC’s stock,
receivables,
contract rights
Senior
Euronotes
Guaranty of SPC’s
Lire Obligation
FSA
Guaranty of Euronotes

33. Managing Hybrid Securities
Principles of hybrid instruments
Market imperfections as motives for hybrids
Hybrids in the Eurobond market:
Asset-backed securities
Warrant bonds and convertibles
Index-linked bonds
Application: callable bonds

34. A Day in the Life of the Eurobond Market
Examine the deals
Why were each done in that particular form?
What determines the pricing?
Can you break the hybrids into their component parts?

35. A Day in the Life...

36. Equity-Linked Eurobonds
Eurobonds with warrants
Marui
Convertible Eurobonds
Battle Mountaingold
Index-linked Eurobonds
Bank of Montreal

37. Warrants Market Value Market Premium Theoretical Value V a l u e o f W
($)
Market
Value
Market Premium
Theoretical
Value
Price Per Share of Common Stock ($)

38. Convertibles Conversion Value Market Value Market Premium Straight
Bond Value V a l u e o f C n v r t i b B d
($) 0
Market
Value
Market Premium
Price Per Share of Common Stock

39. Nikkei-Linked
PRINCIPAL
REPAYMENT
19,000
28,000

40. Tracking Stock
QUANTUM CORPORATION to Issue Tracking Stock to Reflect Separate Performance of DLT & Storage Systems, Hard Disk Drive Groups
Milpitas, Calif., March 1, 1999
Quantum Corporation (NMS: QNTM), a leader in the rapidly growing information storage industry, today announced a broad strategy to accelerate its growth in the storage systems business, including tape automation, and strengthen its position in the hard disk drive (HDD) market, where it has been the leading volume supplier in the desktop segment for the past five years. As a supporting financial step in executing the strategy, the company is also proposing to replace its existing common stock with two classes of tracking stock. If approved by shareholders, the tracking stock is intended to reflect the separate performance of the company's two major businesses, hard disk drives, and DLT & storage systems. Quantum would become the first technology company based in Silicon Valley to employ tracking stock.
Storage Systems Strategy
The strategy Quantum is announcing today will accelerate its diversification process with several new initiatives in the storage systems business. First, Quantum plans to extend its automated tape library business further into enterprise-level storage area network applications, and offer the industry's first flexible combinations of disk and tape storage within a single system. Second, Quantum is preparing to enter the rapidly emerging market for storage appliances later this year. This new class of product is aimed at the workgroup level, and promises greatly improved ease-of-use and flexibility for end-users implementing storage solutions. Third, Quantum is developing system software to provide intelligence in future storage systems and storage devices. Activities in this area have enabled the company to take an early lead in demonstrating self-configuring disk drive appliances within the Jini™ network architecture being developed by Sun Microsystems.

41. Tracking Stock (Continued)
Chairman and CEO Michael A. Brown said that the storage systems strategy will allow Quantum to build on the industry's broadest range of storage devices and begin offering systems- and solutions-level storage products and services. In doing this, he said, the company expects to strengthen its position within the storage industry value chain.
"There is an explosion occurring in the demand for storage capacity," Brown said. "It's being fueled by the rapid growth of digital content–-data, video and audio–-along with the pervasiveness of networked computers, and the phenomenal rise of the Internet. As a result, the worldwide demand for storage is growing by 100 percent a year, making it the fastest growing segment of information technology. “
Tracking Stock Strategy
According to Brown, Quantum plans to issue tracking stock as the financial tool that will enable the company's strategy. Tracking stock recognizes that financial markets value differently the two businesses in which Quantum is engaged. "While Quantum remains a single corporation, tracking stock enables the financial markets to value more accurately the earnings potential of our two distinct businesses," Brown said. “We believe tracking stock is the best option of all the different ways of linking stock value directly to business unit performance. It gives us the financial advantages of separate valuations without the loss of shared strategy, technology, brand and company infrastructure."
If the plan is approved, shareholders would receive one-half share of the hard disk drive-based stock and one share of the DLT & storage systems-based stock for each share of Quantum common stock held. The two classes of tracking stock would comprise the company's common stock. Quantum would continue to be one company with one board of directors and one senior management.

42. Tracking Stock (continued)
Tracking stock–-sometimes called "targeted stock" or "letter stock"–-is a financial instrument that has been used successfully by several Fortune 500 companies, including General Motors, Sprint and USX (U.S. Steel). While Quantum is the first Silicon Valley company to use tracking stock, as of this year a total of 15 companies have employed the technique, with some 395 billion currently outstanding or pending. All major institutional investors have tracking stock in their holdings.
Tracking stock is considered most appropriate when a company has distinct businesses that are valued differently, each business would have a large market capitalization individually, and there is a strategic benefit to keeping the businesses together in a single company. Brown noted that Quantum easily meets all three of these criteria, making it an ideal financial structure for the company.
Do you agree?
As a shareholder, how would you vote?
Would such a financing strategy apply to your company?

43. Economics of Financial Innovation
Certain kinds of market imperfections allow hybrids to flourish
But innovation are readily copied; so only certain kinds of firm can profit from innovations.
There is a product cycle and profitability cycle of innovations.

44. What Conditions Permit Hybrids to Thrive?
Government Rules and Regulations
Example: Japan Air Lines Yen-linked Eurobond
Tax Distortions
Example: Money Market Preferred
Constraint on Issuers or Investors
Example: Nikkei-Linked Eurobond
Segmentation-Driven Innovation
Example: Collateralized Mortgage Obligations (CMOs)

45. Structured Notes Bundling and unbundling basic instruments
Exploiting market imperfections (sometimes temporary)
Creating value added for investor and issuer by tailoring securities to their particular needs
Key: For the innovation to work, it must provide value added to both issuer and investor.

46. Case Study: Endesa Equity-Linked Notes
Client’s objectives
The “Guaranteed Minimum Return” product
How is this priced? Who else could benefit from it?
60%
Profit (Loss) with 100% Principal Protection
Profit (Loss) with 90% Principal Protection
50%
40%
Profit (Loss)
30%
20%
10% 80 85 90 95
100
105
110
115
120
125
130
135
140
145
150 0%
-10%
-20%
Index Level at maturity (Initial index level = 100)

47. Principles of Innovation Through Financial Engineering
Bundling and unbundling basic instruments
Exploiting market imperfections (sometimes temporary)
Creating value added for investor and issuer by tailoring securities to their particular needs
Key: For the innovation to work, it must provide value added to both issuer and investor.

48. Anatomy of a Deal

49. Anatomy of a Deal Issuer:
Looking for large amounts of floating-rate USD and DEM funding for its loan porfolio.
Wants low-cost funds: target CP-.10
Is not too concerned about specific timing of issue, amount or maturity
Is willing to consider hybrid structures.

50. Anatomy of a Deal Investor:
Has distinctive preference for high grade investments
Looking for investments that will improve portfolio returns relative to relevant indexes
Invests in both floating rate and fixed rate sterling and dollar securities
Can buy options to hedge portfolio but cannot sell options

51. Anatomy of a Deal Intermediary:
Has experience and technical and legal background in structure finance
Has active swap and option trading and positioning capabilities
Has clients looking for caps and other forms of interest rate protection.

52. The Deal
Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures
Structuring a MTN in such a way as to meet the investor’s needs and constraints
Line up all potential counterparties and negociate numbers acceptable to all sides
Upon issuer’s and investor’s approval, place the securities

53. The Deal / 2
For the issuer, swap and strip the issue into the form of funding that he requires
Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.

54. The Issue Issuer: Deutsche Bank AG Amount: US$ 40 Million Coupon:
First three years: semi-annual
LIBOR + 3/8% p.a., paid semi-annually
Last 5 years: 8.35%
Price: 100
Maturity: February 10, 2000
Call: Issuer may redeem the notes in full at par on February 10, 1995
Fees: 30 bp
Arranger: Credit Swiss First Boston

55. The Parties in the Deal
DEUTSCHE
SCOTTISH
LIFE
CSFB

56. The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB
Deutsche sells 3-year floating rate note paying LIBOR - 3/8%
SCOTTISH
LIFE
CSFB

57. The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB
Deutsche sells 3-year floating rate note paying LIBOR - 3/8%
SCOTTISH
LIFE
For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years
CSFB

58. The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB
Deutsche sells 3-year floating rate note paying LIBOR - 3/8%
SCOTTISH
LIFE
For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years
For 1% p.a., Deutsche sells CSFB a swaption (the right to pay fixed 8.35% for 5 years in 3 years)
CSFB

59. The Deal in Detail DEUTSCHE SCOTTISH LIFE CSFB CLIENT
Deutsche sells 3-year floating rate note paying LIBOR - 3/8%
SCOTTISH
LIFE
For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years
For 1% p.a., Deutsche sells CSFB a swaption (the right to pay fixed 8.35% for 5 years in 3 years)
CSFB
CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise
CLIENT

60. What’s Really Going On? Note:
Issuer has agreed to pay an above-market rate on both the floating rate note and the fixed rate bond segment of the issue
FRN portion: .75 % above normal cost
Fixed portion: .50% above normal cost
Issuer has in effect purchased the right to pay a fixed rate of 8.35% on a five-year bond to be issued in three years time.

61. Motivations for Issuing Hybrid Bonds
Company has a view
There are constraints on what the company can issue
The company can arbitrage to save money
Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)

62. Designing Debt Cash Flows on Assets/ Projects Define Debt
Start with the
Cash Flows
Cyclicality &
Growth Patterns
Other Effects
on Assets/
Duration
Currency
Effect of Inflation
Projects
Uncertainty about Future
Fixed vs. Floating Rate
Straight versus
Special Features
Commodity Bonds
* More floating rate
Convertible
on Debt
Catastrophe Notes
Define Debt
Duration/
Currency
- if CF move with
- Convertible if
- Options to make
Characteristics
Maturity
Mix
inflation
cash flows low
cash flows on debt
- with greater uncertainty
now but high
match cash flows
on future
exp. growth
on assets
Design debt to have cash flows that match up to cash flows on the assets financed
Overlay tax
Deductibility of cash flows
Differences in tax rates
preferences
for tax purposes
across different locales
Zero Coupons
If tax advantages are large enough, you might override results of previous step
Consider
This provides the basic framework for designing the right kind of debt.
You begin by trying to match up financing type to asset type (in terms of duration, currency, growth patterns and special features). By doing so, you reduce your risk of bankruptcy, increase your capacity to borrow and consequently the tax benefits of debt.
Then, you modify the “perfect debt”
For tax factors, to ensure that you get the maximum tax benefit
To meet the needs and objectives of equity research analysts and ratings agencies
To fix any agency conflicts that might prevent lenders from lending
To prevent an undeservedly low rating from pushing up the cost of debt above what it should be. (If you are under rated, you should probably use short term debt until you feel your rating is justified)
Analyst Concerns
Ratings Agency
Regulatory Concerns
ratings agency
- Effect on EPS
- Effect on Ratios
- Measures used
Operating Leases
& analyst concerns
- Value relative to comparables
- Ratios relative to comparables
MIPs
Surplus Notes
Can securities be designed that can make these different entities happy?
Observability of Cash Flows
Type of Assets financed
Factor in agency
by Lenders
- Tangible and liquid assets
Existing Debt covenants
Convertibiles
conflicts between stock
- Less observable cash flows
create less agency problems
- Restrictions on Financing
Puttable Bonds
and bond holders
lead to more conflicts
Rating Sensitive
Notes
If agency problems are substantial, consider issuing convertible bonds
LYONs
Consider Information
Uncertainty about Future Cashflows
Credibility & Quality of the Firm
Asymmetries
- When there is more uncertainty, it
- Firms with credibility problems
may be better to use short term debt
will issue more short term debt

65. www.giddy.org Ian Giddy NYU Stern School of Business
Tel ;
Fax ;