Financial Risk Management - NYU Stern School of Businesspeople.stern.nyu.edu/igiddy/lafrontiers.pdf · 2000-06-21 · Financial Risk Management - NYU Stern School of Business

Giddy/NYU Financial Risk Management /1

Prof. Ian GiddyNew York University

Increasing Corporate Value Through

Financial Risk Management

NYU

Copyright ©2000 Ian H. Giddy Financial Risk Management 2

The Big Picture:Why Financial Restructuring?

l The Asian Bet l The Solution, Part I: Recapitalizationl The Solution, Part II: Debt Management

and Hedgingl The Solution, Part III: Corporate

Restructuring


The Asian Bet

l High growth disguised speculative financing structures

l Governments shielded companies and banks from capital market discipline

l Too much debtl Too much foreign-currency debt

l Closely held ownership relying on reinvested earnings


The Asian Bet

l High growth disguised speculative financing structures

l Governments shielded companies and banks from capital market discipline

l Too much debtl Too much foreign-currency debt

l Closely held ownership relying on reinvested earnings

The three excessesn Too much debtn Too much laborn Too much capacity

The three excessesn Too much debtn Too much laborn Too much capacity


How the Bet was Lost

l Vulnerable economies, newly liberalized, succumbed to currency crises

l Economic downturns followed

l Companies were unable to service even domestic debt, never mind foreign currency debt

l Still unreformed, many Asian companies remain misfinanced


It’s All About Value

l How can corporate and financial restructuring create value?

Operating

Cash

Flows

Debt

Equity

Assets Liabilities

Fix the business

Or fix the financing


Restructuring

What mix of debt is best suited to this business?

Fix the kind of debt or hybrid financing

What can be done to make the equity more valuable to investors?

Fix the kind of equity

Value the changes new control would produce

Fix management or control

Revalue firm under different leverage assumptions – lowest WACC

Fix the financing – improve D/E structure

Value the merged firm with synergies

Fix the business – strategic partner or merger

Value assets to be soldFix the business mix – divestitures

Use valuation model – present value of free cash flows

Figure out what the business is worth now


Getting the Financing RightStep 1: The Proportion of Equity & Debt

Debt

Equity

n Achieve lowest weighted average cost of capital

n May also affect the business side


Getting the Financing RightStep 2: The Kind of Equity & Debt

Debt

Equity

n Short term? Long term?

n Baht? Dollar? Yen?

n Short term? Long term?

n Baht? Dollar? Yen?

n Bonds? Asset-backed?

n Convertibles? Hybrids?

n Bonds? Asset-backed?

n Convertibles? Hybrids?

n Debt/Equity Swaps?n Private? Public?

n Strategic partner?n Domestic? ADRs?

n Debt/Equity Swaps?n Private? Public?

n Strategic partner?n Domestic? ADRs?

n Ownership & control?n Ownership & control?


Prof. Ian GiddyNew York University

Managing Leverage Risk


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 thereal business just by shuffling paper

- Modigliani-MillerCopyright ©2000 Ian H. Giddy Financial Risk Management 12

Most Value is Created on the Asset Side

l Only invest in assets (or keep assets) where ROE>required return on equity

l Value-Based Management for performance evaluation

?

Union Camp: Packaging Business


Does Capital Structure Matter? Yes!



Debt

Equity


COSTOF

CAPITAL

DEBTRATIO

Optimal debt ratio?





Debt

Equity


VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?





Debt

Equity


Value of Firm= PV(Cash Flows) + PV(Tax Shield) - Distress Costs


Changing Financial Mix

l Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt.

l Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).

l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.


Debt: Pros and Cons

Advantages of Borrowing Disadvantages of Borrowing

1. Tax Benefit:

Higher tax rates --> Higher tax benefit

1. Bankruptcy Cost:

Higher business risk --> Higher Cost

2. Added Discipline:

Greater the separation between managers

and stockholders --> Greater the benefit

2. Agency Cost:

Greater the separation between stock-

holders & lenders --> Higher Cost

3. Loss of Future Financing Flexibility:

Greater the uncertainty about future

financing needs --> Higher Cost


See Saw

Business Uncertainty

Financial Risk

Operating Leverage

Financial Leverage



Young and Old

Operating Leverage

Financial Leverage

Operating Leverage

Financial LeverageSize

Maturity


Disney

Weighted Average Cost of Capital and Debt Ratios

Debt Ratio

WA

CC

9.40%

9.60%9.80%

10.00%

10.20%10.40%

10.60%10.80%

11.00%11.20%11.40%

0

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%


Siderar

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046

10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565

0200400600800

10001200

0% 20% 40% 60% 80% 100%

Debt Percentage

Val

ue

($m

illio

ns)

0.00%5.00%

10.00%

15.00%20.00%

25.00%30.00%

0% 20% 40% 60% 80% 100%

Debt Percentage

Co

st o

f C

apit

al


A Framework for Getting to the Optimal

Is the actual debt rat io greater than or lesser than the opt imal debt ratio?

Actual > OptimalOverlevered

Actual < OptimalUnder levered

Is the f i rm under bankruptcy threat? Is the f irm a takeover target?

Yes No

Reduce Debt quick ly1. Equity for Debt swap2. Sel l Assets; use cashto pay off debt3. Renegotiate with lenders

Does the f i rm have good projects?ROE > Cost of Equi tyROC > Cost of Capi tal

Yes

Take good projects wi thnew equity or with retainedearnings.

No

1. Pay off debt with retainedearnings.2. Reduce or el iminate div idends.3. Issue new equi ty and pay of f debt.

Yes No

Does the f i rm have good projects?ROE > Cost of Equi tyROC > Cost of Capi tal

Yes

Take good projects wi thdebt.

No

Do your stockholders l ikedividends?

YesPay Div idends No

Buy back stock

Increase leveragequickly1. Debt/Equi ty swaps2. Borrow money&buy shares.


Capital Structure: East vs West

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?

Intel Sammi


Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas


Perceived Benefits to Sammi From Acquisition of Atlas Steel

l Achieve $280mm savings by acquiring Atlas Steel and related companiesuCost of setting up own production facility

would have been $500 mmuSavings were channeled into restructuring

production facilities at existing plants

l Sammi’s share price rose 9% on news of strategic acquisitions


How Should the Acquisition Have Been Financed?

Assets added:$210 million


Debt added:$210 million(C$250m)

Debt added:$210 million(C$250m)


How Should the Acquisition Have Been Financed?



Debt added:$210 million

(C$250m)Loan: C$180m

Ret earn: C$70mPlus w.cap.:

Eurobond withwarrants US$50m

Debt added:$210 million

(C$250m)Loan: C$180m

Ret earn: C$70mPlus w.cap.:

Eurobond withwarrants US$50m



Problems faced by Sammi from the Acquisition

l Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages

l Future refinancing of debt caused earnings after interest costs to fall 17%

l Purchase price of $210.6 mm found to have been excessive

l The acquisition was ill-timed

l Existing and new plants suffered from low capacity utilization of around 65%


Sammi Steel in 1995

l Sammi Atlas pushed to raise productivity by 15%

l A leaner organization: Work force had shrunk by 19.4% since 1988

l 4 year freezes on salaries to limit labor costsl Unrelated and unprofitable businesses have

been sold offl New export zones identified in China and South-

East Asia

l Conversion of debt into equity to reduce interest costs by 6%;

l Result: dilution in EPS, unless offset by increased volume of sales


Analysis of Change in Value of Sammi Steel

( Billions of Korean Won) 1989 1994

Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027

( Billions of Korean Won) 1989 1994

Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027


March 1997

Sammi Steel is bankrupt!

ALTO


March 1997

Sammi Steel is bankrupt!

ALTOfinancefixit.comn Diagnosisn Preventionn and Cure

financefixit.comn Diagnosisn Preventionn and Cure


Financing Choices



FromHow much debt?toWhat kind of debt?andWhat kind of equity?

You can make a difference- Pepper-Giddy


Corporate Finance

CORPORATE FINANCEDECISONS


INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


Capital Structure: East vs West

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?

Nokia TPI


Fixing the Capital Structure

Too little debtl Managers like to control

shareholders’ fundsl Underestimate the cost

of equityProducesl Less disciplinel Excessive cost of

capitall Takeover risk

Too much debtl Close control of equityl Easy moneyl Underestimate business

or financial risksProducesl Risk of financial distressl Excessive cost of

capitall Destroy operating valuel Takeover risk



TPI’s Refinancing

l Asia’s biggest debtorl Almost $4 billion in foreign currency

debt financing domestic revenues

l Protracted rescheduling results in $360 million debt/equity swap

l No change in management or effective control

l Still needs $1.2 billion new equity


Debt-Equity Swaps

l Cosmetic or real?l Choices for company under siegeuRaise new equity to pay off creditorsExample: IridiumuGive creditors equity in place of debtExample: Sammi


What Do Debt-Equity Swaps Do?

Overleverage creates financial distressOverleverage creates financial distress

Actual or potential defaultActual or potential default

Lenders take equity in lieu of repaymentLenders take equity in lieu of repayment

Lenders hold equity passivelyLenders hold equity passively Lenders replace managementLenders replace management Lenders sell equityLenders sell equity

Existing management buys timeExisting management buys time Change of controlmeans restructuring

Change of controlmeans restructuring

n Financial engineering

n Bottom line “rationalization”

n Divestitures & outsourcing

n Financial engineering

n Bottom line “rationalization”

n Divestitures & outsourcing


What Are The Alternatives?

l Key: Make the new securities attractive to:uExisting lendersuNew lendersuNew bond investorsuNew equity investors


The Financing Spectrum

Exp

ecte

d R

etu

rn

Risk

Senior Debtn Returns

independent of the value of the business

n Control through covenants

Senior Debtn Returns

independent of the value of the business

n Control through covenants

Equityn Residual returns

after contractual claims

n Control through voting rights

Equityn Residual returns

after contractual claims

n Control through voting rights


The Financing Spectrum

Exp

ecte

d R

etu

rn

Risk

Senior secured debtSenior secured debt

EquityEquity

Senior unsecured debtSenior unsecured debt

Subordinated debtSubordinated debt

Preferred equityPreferred equity

Convertible debtConvertible debt


What Are The Alternatives?

l Asset-backed or cash flow-backed debtl Senior debtl Subordinated debtl Subordinated debt with upside

participationl Subordinated debt with equity optionl Preferred equityl Restricted sharesl Common stock


Subordinated High Yield Debt

l “Junk bonds” – like equity, but allow increased financial leverage

l Tax advantage over equityl Big market in USA (institutional investors) and

increasing in Europel Leveraged loans favored by certain

commercial banksl Often used in connection with M&A and LBOsl Behave like equity – and often have equity

participation


Sub Debt -- Motivations

l Optimization of financial leveragel Regulatory-driven capital requirementsl Rated asset securitizations (senior-sub

structure in asset-backed securities)l Insider or supplier-credit subordination

(eg in project finance)l Work-outs and restructurings (existing

borrowers agree to seniority of new loans, to buy time)



Sub Debt’s Big Problem: High Interest!

Solutionsl Deep discount subordinated debtl Subordinated debt with equity warrants

l Convertible subordinated debtl Participating subordinated debt

l Puttable subordinated debt


Preferred Equity

l Legally a form of equityl Claim senior to ordinary equityl May have fixed dividend, or may be

“participating”l But cannot trigger liquidation if payment

missed

l Par value determines liquidation claim


Convertible Preferred

l Used by venture capital firmsl Permit investors to participate in growthl But give preference in liquidation if the

venture failsl And disguise share value (tax!)l A variant – PERCS* give issuer right to

convert into common stock

*Preferred equity redemption cumulative stock


Preferred Stock: Pros and Cons

Advantagesl No dilution of controll Dividends

conditional on availability of earnings

l Omission cannot force liquidation

Disadvantagesl Higher after-tax cost

than debtl Lower return on

equityl Limited investor

interest


The Difference

l “The Ministry of Finance received a preferred share while investors received a preferred share and a warrant allowing them to purchase the ministry's share at a 13.3% premium (equivalent to the cost of carry) during a three-year period. The preferred shares carry a 5.25% dividend and full voting rights”

l "When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."

l Alternatives: Thai Farmers Bank: SLIPS,Bankok Bank: CAPs


Transparency and Disclosure

l A 275-page prospectus, which provided a breadth and depth of information previously unseen in an Asian issue.

l "We went and looked back at US bank holding company offers - those that were US SEC Grade 3 compliant. We also went back and looked at a lot of the prospectuses for the recaps of US banks, like Mellon and Citibank. We looked at the level of disclosure they achieved and committed ourselves to exceeding that -- which SCB did."


MacroFactors

• Currency overvaluation• Capital restrictions

StructuralFactors

• Acctg & disclosure requirements• IAS compliance• Bankruptcy regime• Creditor rights• Govt-corporate nexus• Trading infrastructure

• Price-Value ratio, Sharpe ratio, EVA• D/E ratio• Currency & maturity mismatch• IAS conformity• Insider control• Objective research coverage• Trading liquidity

Firm-levelFactors

What Globally Mobile Investors Look At


Tracking Stock

l Tracking stock, sometimes known as letter stock or alphabet stock, is a class of stock designed to reflect the value and track the performance of a part of the issuer's assets, usually a separate business or group of businesses. Claimed advantages:upreservation of the efficiencies of a single

corporationuability of the market to more accurately value the

respective businesses of the issuer

l What does it really add?


Restricted Stock: Pros and Cons

Advantagesl Overcome foreign

control restrictionsl Insiders retain

controll If company well run,

value of control may be low

Disadvantagesl Nonvoting stock

trades at a discountl Dual-class recaps

hurt stock pricel May allow

management to avoid needed reforms



The New Equity Option

l Key: Make the new equity attractive to:l Portfolio investorsuDomesticuInternationaluReduce agency costs or we’ll “Just say no!”

l Strategic/direct investorsuDomesticuInternationaluCede control or we’ll go elsewhere


New Equity for Siderar

l What investors?uPortfolio investorsuFinancial investorsuCorporate investors

l What returns should they expect?= Risk-free rate+ Corporate risk+ Financial risk (leverage/debt mismatch)+ “Agency cost” premium+ Country risk

l What restructuring?


How Risky is Siderar?

Mean

The riskier the better!The riskier the better!


Common Stock as a Call Option

l The equity in a firm is a residual claim, i.e., equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc.) have been satisfied.

l If a firm is liquidated, the same principle applies, with equity investors receiving whatever is left over in the firm after all outstanding debts and other financial claims are paid off.

l The principle of limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than the value of the outstanding debt, and they cannot lose more than their investment in the firm.


Payoffs to Shareholders on Liquidation


The Conflict Between Bondholders and Stockholdersl Stockholders and bondholders have different

objective functions, and this can lead to conflicts between the two.u For instance, stockholders have an incentive to take riskier

projects than bondholders do, and to pay more out in dividends than bondholders would like them to.

l Since equity is a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity.u It is therefore conceivable that stockholders can take risky

projects with negative net present values, which while making them better off, may make the bondholders and the firm less valuable.


When The Creditors are Prowling

Trouble!

The financingis bad

The companyis bad

Businessmix is bad

Raise equity or

Change debt mix

Change controlor management

through M&A

Sell some businessesor assets

to pay down debt

Reason

RemedyProf. Ian Giddy

New York University

Designing Debtand Using Derivatives

NYU


Designing Debt: Match the Business

l Fixed/floating:uHow certain are the cash flows? Are operating profits

linked to interest rates or inflation?

l Currency:uConsider currency of the assets: currency of

denomination vs. currency of location vs. currency of determination.

l Maturity or availability:uAre the assets short term or long term? Should the

firm assume ease of refinancing, or buy an option on access to financing?



Identification and Definition of Financial Exposures

Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile.

Translation Exposure, Transaction Exposure, and

Economic Exposure

• Long-term versus short-term exposure

• Intracompany versus third party exposure

• Cross currency exposure

• Competitive exposures

Absolute Rate Risk, Convexity, Basis or

Correlation Risk

Currency Interest Rate

• Short-term liquidity portfolio

• Investment portfolio

• Capital markets borrowing

• Leasing portfolio

Price Risk, Basis or Correlation Risk

Commodity

• Procurement

• Inventory

• Sales elasticity


Measuring Market Exposure

l Defining corporate exposure:“How will my company’s value be affected by market price fluctuations?”

l Types of exposureuTransactionsuBalance sheet/portfoliouEconomic

l A risk management framework


Corporate Hedging Decisions:Frutas Amazonas

Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.


Corporate Hedging Decisions:Frutas Amazonas

l Continue funding in U.S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest

l Switch funding to pesetas, despite the slightly higher cost

l Borrow in dollars, but hedge the exchange risk in the forward market.


Frutas Amazonas

Eurodollar 3-monthloan rate

5 9/16%

Europeseta 3-month loan rate

7 15/16%

Spot exchangerate today

Pta128.210 perUSD

Forward exchangerate today

Pta129.005 perUSD

Forward discount,% per annum

-2.5


Frutas Amazonas

Type of Hedge Cost of HedgingForward 2.5%

Money Market Hedge(Borrow to matchassets)

2.375%

Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)

Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate


Market Risks: Definitions

Three Views of

Market Price Risk:lTransactions

lBalance Sheet/PortfoliolEconomic risk.

TransactionsExposure

TransactionsExposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Transactions Exposure

l Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain dateuExample: If Nokia invoices a NTT of Japan in

Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen.

uThis kind of exposure is readily hedgableusing forwards, futures or debt

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure



But Transactions Exposure Can be Misleading...

l Austin Computer purchases notebook computers in Taiwan for sale in the US.

l Austin must pay in NT$.

l Should it hedge its anticipated payments for 1996?

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Austin Computer

NT$

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Exchange Rate Risk: Translation

l Translation exposure arises when a company has assets and/or liabilities in a foreign currency, which must be translated at an unknown future exchange rate

l It affects the balance sheetuIt can be hedged using forwards, futures or

currency swapsuBut translation exposure can mislead!


Stora in Australia

Assetsl Cashl Accounts receivablel Inventoryl Property, plant and

equipment

Liabilitiesl Accounts payablel Bank debtl Bonds issuedl Equity (owned by

parent company in Sweden)

Net translation exposure = Value of foreign currency assets - Value of foreign currency liabilities.


Translation of Foreign Currency Exposure

l For US companies, governed by FASB No. 52 which specifies the current rate method

l First, each entity's balance sheet and income statement are measured in terms of their Functional Currency, which is the currency of the economic environment in which the entity primarily operates and maintains records

l Next, the functional-currency-denominated financial statements are translated into the parent's currency using the All-Current-Rate Method, which reports balance sheet items at the closing rate and income statement items at their average rates.


Photronics: Translation Exposure


Translation Exposure:Hedge Accounting Standards

l FAS 133, Accounting for Derivative Instruments and Hedging Activities, was released in the U.S. in June '98 with required implementation delayed in May '99 to calendar 2001 for most companies.

l IAS 39, Financial Instruments: Recognition and Measurement, was released in December '98 for implementation in January 2001 for most companies.


Hedge Accounting: FAS 133 and IAS 39

Core principals of the two are essentially the same:

l Derivatives deemed to be assets/liabilities and carried at fair value

l The use of special "hedge" accounting (deferral of gains/losses on valuation changes) is restricted


Economic Exposure

l Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes.uExample: Even though Intel invoices German

customers in marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen.

l The currency of determination is the currency in which most of the competition prices similar products.



Salmon for Chile

l Exporting salmon from Chile to Japan; finance inuPesos?uDollars?uYen?uKrone?

Ciba-Geigy


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, ofCiba's debt? What should it be?


Case Study: Financing Ciba

Could Ciba benefit from more debt?uTax shield?

Could Ciba be hurt by more debt?uRisks of financial distress?uCosts of financial distress?uReduce flexibility?


Ciba: How Much Debt?

Consideration General In Ciba's case

Tax shield Interest on debt is taxdeductible, so more leverageis better, other things beingequal.

Ciba is profitable, and hasbeen so since 1982, so itneeds as much of a taxshield as it can get.

Risk of financial distress Volatility of operating earningsincreases probability ofbankruptcy, which involvesout-of-pocket and other costs.

Ciba's earnings arediversified (health care,agricultural and industrialchemicals and materials) andrelatively stable (see chartbelow), unlike some large,capital-intensive firms. Thusit can tolerate more debt.

Intangible assets Firms with intangible assetssuch as reputation, patentsand human capital suffergreater losses when underfinancial stress.

Ciba relies heavily onresearch, reputation, andongoing customerrelationships, much of whichcould be lost if bankruptcythreatened.

Consideration General In Ciba's case

Tax shield Interest on debt is taxdeductible, so more leverageis better, other things beingequal.

Ciba is profitable, and hasbeen so since 1982, so itneeds as much of a taxshield as it can get.

Risk of financial distress Volatility of operating earningsincreases probability ofbankruptcy, which involvesout-of-pocket and other costs.

Ciba's earnings arediversified (health care,agricultural and industrialchemicals and materials) andrelatively stable (see chartbelow), unlike some large,capital-intensive firms. Thusit can tolerate more debt.

Intangible assets Firms with intangible assetssuch as reputation, patentsand human capital suffergreater losses when underfinancial stress.

Ciba relies heavily onresearch, reputation, andongoing customerrelationships, much of whichcould be lost if bankruptcythreatened.


Ciba: Are Revenues Stable?

Ciba Sales and Earnings(in billions of Swiss francs)

1982 1984 1986 1988 1990 1992

0.1

1

10

100

Legend

Sales Profits


Financing Choices



FromHow much debt?toWhat kind of debt?

You cannot change the value of thereal business just by shuffling paper

- Modigliani-MillerCopyright ©2000 Ian H. Giddy Financial Risk Management 92

Corporate Financing Choices:What Kind of Debt?

l Fixed/floatingl Currency of denomination

l Maturity or availabilityl Domestic/Euro

l Public/privatel Asset-basedl Credit enhanced

l Swappedl Equity-linked


Short Term or Long Term?

l In 1992, Ciba had fixed assets of SF13.9 billion and capital expenditures of SF1.9 billion.

l Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets.

l 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.



l Geographic location of sales and capital assets.

l Currency distribution of sales.

l Nature of the company's businesses

Currency of Denomination of Ciba'sDebt? What Should It Be?


Currency of Ciba’s Assets and Debt

Geographic distributionof

Currencydistribution

of sales Remarks on economic exposure

Estimatedcurrency

distribution ofdebt

Fixedassets Sales

Switzerland 41%

A43%

2.4% Net short position because much ofproduction, but little of sales, here

9%

U.K.

A27%

5.4% Part of sales effectively U.S. dollardenominated

7%

OtherEurope

34.6% 21%

U.S. andCanada

23% 32% 41.3% 54%

LatinAmerica

4% 7% 5.3% Most of sales effectively dollardenominated

2%

Asia 4% 13% 10.9% Part of sales effectively U.S. dollardenominated

6%

Rest of theworld

1% 5% Most of sales effectively dollardenominated

1%

Geographic distributionof

Currencydistribution

of sales Remarks on economic exposure

Estimatedcurrency

distribution ofdebt

Fixedassets Sales

Switzerland 41%

A

2.4% Net short position because much ofproduction, but little of sales, here

9%

U.K.

A27%

5.4% Part of sales effectively U.S. dollardenominated

7%

OtherEurope

34.6% 21%

U.S. andCanada

23% 32% 41.3% 54%

LatinAmerica

4% 7% 5.3% Most of sales effectively dollardenominated

2%

Asia 4% 13% 10.9% Part of sales effectively U.S. dollardenominated

6%

Rest of theworld

1% 5% Most of sales effectively dollardenominated

1%


Guidelines for Financing

l Liabilities to match assets: economic exposure of the firm determines base financing choices.

l Decision on whether or not to fully match depends on company's viewrelative to the view implied by market prices.

l When strategy is chosen, use the financing/hedging techniques that offer the lowest effective cost.


Designing Debt

Duration Currency Effect of InflationUncertainty about Future

Growth PatternsCyclicality &Other Effects

Define DebtCharacteristics

Duration/Maturity

CurrencyMix

Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Overlay taxpreferences

Deductibility of cash flowsfor tax purposes

Differences in tax ratesacross different locales

Consider ratings agency& analyst concerns

Analyst Concerns- Effect on EPS- Value relative to comparables

Ratings Agency- Effect on Ratios- Ratios relative to comparables

Regulatory Concerns- Measures used

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts

Type of Assets financed- Tangible and liquid assets create less agency problems

Existing Debt covenants- Restrictions on Financing

Consider Information Asymmetries

Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt

Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

Can securities be designed that can make these different entities happy?

If tax advantages are large enough, you might override results of previous step

Zero Coupons

Operating LeasesMIPsSurplus Notes

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

Commodity BondsCatastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed


Ban Pu

l How much debt in relation to equity should Ban Pu have?

l Should the debt be fixed or floating?

l How much of the company's debt should be long term?

l What should be the currency composition of its debt?

l Why a convertible?l How should its financing

change over the company’s life cycle?


Corporate Finance



INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


Young and Old

Operating Leverage

Financial Leverage

Operating Leverage


Maturity


Domestic and Global

Operating Leverage

Financial Leverage

Operating Leverage


Maturity


FAMILYOR STATEOWNERSHIP

Emerging Market Companies:Life-Cycle Financing

DOMESTICBANKDEBT

DOMESTICPUBLICBONDSAND PAPER

EURO,FOREIGN,AND GLOBALBONDS

MEDIUM-TERM NOTEAND CPPROGRAMS

DEBT

EQUITY

DOMESTICPUBLICEQUITY

LIMITEDFOREIGNEQUITY

GLOBALEQUITY



Corporate Financing Choices

l Do financing choices matter?

l Debt or equity?

l What kind of debt?

Certain kinds of market imperfections allow corporations to reduce costs by improving the financing mix


Banpu


Corporate Financing Choices:What Kind of Debt for Banpu?

l Fixed/floatingl Currency of denomination

l Maturity or availabilityl Domestic/Euro

l Straight/convertible


Banpu: Capital Structure

Summary financial data (Baht millions)

1992 1993 1994 1995E 1996J 1997E 1998EAssets Current 505 793 1226 1835 1719 1399 2251

Long term 2295 5372 7170 8931 11001 14201 17901Liabilities Current 894 2452 1692 1886 2338 2845 4441

LT: loans 90 738 2110 1900 3033 5000 7500LT: bonds 0 0 1200 3200 3200 3200 3200

Equity Shares (m) 31.5 47.3 47.4 47.4 47.4 47.4 47.4Price 515 514 514 600 692 750 800Value(S*P) 16214 24319 24370 28440 32801 35550 37920

Summary % LT assets 82% 87% 85% 83% 86% 91% 89%% LT debt 9% 23% 66% 73% 73% 74% 71%% Floating 100% 100% 76% 54% 63% 71% 79%% Debt 6% 12% 17% 20% 21% 24% 29%% Debt (conv.) 6% 12% 17% 14% 15% 19% 24%


Banpu: Capital Structure

Summary financial data (Baht millions)

1992 1993 1994 1995E 1996J 1997E 1998EAssets Current 505 793 1226 1835 1719 1399 2251

Long term 2295 5372 7170 8931 11001 14201 17901Liabilities Current 894 2452 1692 1886 2338 2845 4441

LT: loans 90 738 2110 1900 3033 5000 7500LT: bonds 0 0 1200 3200 3200 3200 3200

Equity Shares (m) 31.5 47.3 47.4 47.4 47.4 47.4 47.4Price 515 514 514 600 692 750 800Value(S*P) 16214 24319 24370 28440 32801 35550 37920

Summary % LT assets 82% 87% 85% 83% 86% 91% 89%% LT debt 9% 23% 66% 73% 73% 74% 71%% Floating 100% 100% 76% 54% 63% 71% 79%% Debt 6% 12% 17% 20% 21% 24% 29%% Debt (conv.) 6% 12% 17% 14% 15% 19% 24%


Conclusion

l Fixed/floating:uHow certain are the cash flows? Are operating profits

linked to interest rates or inflation?

l Currency:uConsider currency of the assets: currency of

denomination vs. currency of location vs. currency of determination.

l Maturity or availability:uAre the assets short term or long term? Should the

firm assume ease of refinancing, or buy an option on access to financing?


Conclusion: Corporate Restructuring?

l Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.

l Designed to increase the value of the firm Restructuring

Improve

capitalization

Change ownership

and control

Improve

debt composition


www.giddy.org

Ian GiddyNYU Stern School of BusinessTel 212-998-0332; Fax [email protected]://www.giddy.orgAlso see:giddyonline.comfinancefixit.comglobalsecuritization.com

Documents

Financial Risk Management - NYU Stern School of Businesspeople.stern.nyu.edu/igiddy/lafrontiers.pdf · 2000-06-21 · Financial Risk Management - NYU Stern School of Business