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

Prof. Ian Giddy

New York University

Corporate FinancingChoices

Michigan/TMAMichigan/TMA

Copyright ©1999 Ian H. Giddy Corporate Financing Choices # #

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


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

FINANCING ALTERNATIVES AVAILABLE TO MAJOR CORPORATIONS

DEBT

EQUITY

Subsidized funds

Privateplacement

Publicoffering

Revolvingfacility

Term loan

Real estate

Leasing

Assetbacked

Unsecured

Domestic

Eurobond

Fixed

Floating

Longterm

Shortterm

US CP

Euro CP

Bank debt

MTN

Dollar

Non-dollar

ARPFRN

VRN

StraightHybrid

Callable

Index-linked

Convertible

With warrants

Restricted

Full rights

Private sale

Public offering

Domestic

International

Equity options

Stripped

Unstripped

Projectfinance

Bankdebt

Debt?

Equity?

What kind?

Debt?

Equity?

What kind?


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


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


Is There an Optimal Capital Structure?


Value of the firm

=PV(Cash Flows)

Debt

Equity

Value of the firm

= D + E

VALUE OFTHE

FIRM

DEBT

RATIO

Optimal debt ratio?


How Much Debt?

A $19.95 company...an “ISP”

Profits: Zero ~ Risks: High

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, of Ciba's debt? What should it be?


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?


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 s table (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 i f 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 s table (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 i f 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


Measuring Financial Leverage

Two variants of debt ratioDebt 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.


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 = k

e (E/(D+E)) + k

d (D/(D+E))


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.


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.


Financing Choices


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


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


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.


Geographic location of sales and capital assets.

Currency distribution of sales. Nature of the company's businesses

Currency of Denomination of Ciba's Debt? 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%

43%

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

9%

U.K.

27%

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%

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

9%

U.K.

27%

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%


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?


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.


When Debt and Equity are Not Enough

Value

of future

cash flows

Value

of future

cash flows

Claims on

the cash flows

Claims on

the cash flows

Assets Liabilities



Value

of future

cash flows

Value

of future

cash flows

Contractual int. & principal

No upside

Senior claims

Control via restrictions


No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims

Voting control rights

Residual payments

Upside and downside

Residual claims


Equity



Value

of future

cash flows

Value

of future

cash flows


No upside

Senior claims



No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims


Residual payments

Upside and downside

Residual claims


Equity

What if...

Claims

are inadequate?

Returns

are inadequate?



Value

of future

cash flows

Value

of future

cash flows


No upside

Senior claims



No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims


Residual payments

Upside and downside

Residual claims


Equity

Alternatives

Collateralized Asset-securitized Project financing

Preferred Warrants Convertible


SPONSORINGCOMPANY

SPECIALPURPOSEVEHICLE

ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE

ISSUESASSET-BACKEDCERTIFICATES

SALE ORASSIGNMENT

CONTINUEDSERVICINGOF ASSETS

Asset Securitization: Sell Your Cake and Eat It Too


CremoniniGroup

ItalianObligors

PurchaserSPC

IssuerCrystal Castle (SPC)

Spread Account

SubordinatedLender

FX and InterestRate SwapSwiss Bank

Investors

FSA

Subordinated NoteLire 16%inter.

Receivables &Contract

Rights

Lire 2% interest

84%

LirePledges:SPC’s stock,receivables,

contract rights

Dollars 84%

SeniorEuronotes

Guaranty of Euronotes

Guaranty of SPC’sLire Obligation

Purchase Price& fee 98%

Purchase 98%

Sale of Receivables

Receivables

Goods &Services

Cremonini Securitization


Managing Hybrid Securities

Principles of hybrid instruments Market imperfections as motives for

hybrids Hybrids in the Eurobond market:

Asset-backed securitiesWarrant bonds and convertiblesIndex-linked bonds

Application: callable bonds


A Day in the Lifeof the Eurobond Market

Examine the dealsWhy were each done in that particular

form?What determines the pricing?

Can you break the hybrids into their component parts?


A Day in the Life...

NEW INTER NA TIONAL BO ND ISSUES

Bo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r iceP r ice M a t ur ityM a t ur ity F eesF ees Boo k ru nn erBoo k ru nn er

C elworks Trust 1990-1¶ (b) US $250 9 1/4 99.80 1998 1 7/8-1 5/8 C redit Suisse

M arui Corp* US $500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nom ura

Holderbank ( a) US $150 9 3/4 101 1994 1 3/8-1 C SF B

Battle M ountaingold US $100 7 1/2 100 2006 2 1/2-1 1/2 M er rill Lynch

SN CF F Fr750 9 1/4 98.55 1997 1 7/8-1 1/4 C C F

Viennische Stadtsba nk (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L

Eurofim a (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank

Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IB J

Bank of M ontreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon C re dit

¶F inal te rm s. *With equity war rants. P rivate plac em ent. C onvertible. (a) Non-callable. ( b) C allable at par af ter 5 year s. I f c all notexe rcised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .

NEW INTER NA TIONAL BO ND ISSUES

Bo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r iceP r ice M a t ur ityM a t ur ity F eesF ees Boo k ru nn erBoo k ru nn er

C elworks Trust 1990-1¶ (b) US $250 9 1/4 99.80 1998 1 7/8-1 5/8 C redit Suisse

M arui Corp* US $500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nom ura

Holderbank ( a) US $150 9 3/4 101 1994 1 3/8-1 C SF B

Battle M ountaingold US $100 7 1/2 100 2006 2 1/2-1 1/2 M er rill Lynch

SN CF F Fr750 9 1/4 98.55 1997 1 7/8-1 1/4 C C F

Viennische Stadtsba nk (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L

Eurofim a (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank

Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IB J

Bank of M ontreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon C re dit

¶F inal te rm s. *With equity war rants. P rivate plac em ent. C onvertible. (a) Non-callable. ( b) C allable at par af ter 5 year s. I f c all notexe rcised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .


Equity-Linked Eurobonds

Eurobonds with warrantsMarui

Convertible EurobondsBattle Mountaingold

Index-linked EurobondsBank of Montreal


Warrants

TheoreticalValue

Market ValueMarket Premium

Value

of

Warrant

($)

0Price Per Share of Common Stock ($)


Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

Value

of

Convertible

Bond

($) 0

Price Per Share of Common Stock


Nikkei-Linked

28,00019,000

PRINCIPAL

REPAYMENT


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.


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.


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?


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.


What Conditions Permit Hybrids to Thrive?

Government Rules and RegulationsExample: Japan Air Lines Yen-linked Eurobond

Tax DistortionsExample: Money Market Preferred

Constraint on Issuers or InvestorsExample: Nikkei-Linked Eurobond

Segmentation-Driven InnovationExample: Collateralized Mortgage Obligations

(CMOs)


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.


Case Study: Endesa Equity-Linked Notes

Client’s objectives The “Guaranteed Minimum Return” product How is this priced? Who else could benefit

from it?

80 85 90 95 100

105

110

115

120

125

130

135

140

145

150

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Index Level at maturity (Initial index level = 100)

Profit (Loss) with 100% Principal ProtectionProfit (Loss) with 90% Principal Protection

Prof

it (L

oss)


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.


Anatomy of a Deal


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-.10Is not too concerned about specific timing

of issue, amount or maturityIs willing to consider hybrid structures.


Anatomy of a Deal

Investor:Has distinctive preference for high grade

investmentsLooking for investments that will improve

portfolio returns relative to relevant indexesInvests in both floating rate and fixed rate

sterling and dollar securitiesCan buy options to hedge portfolio but

cannot sell options


Anatomy of a Deal

Intermediary:Has experience and technical and legal

background in structure financeHas active swap and option trading and

positioning capabilitiesHas clients looking for caps and other

forms of interest rate protection.


The Deal

1 Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures

2 Structuring a MTN in such a way as to meet the investor’s needs and constraints

3 Line up all potential counterparties and negociate numbers acceptable to all sides

4 Upon issuer’s and investor’s approval, place the securities


The Deal / 2

5 For the issuer, swap and strip the issue into the form of funding that he requires

6 Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.


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


The Parties in the Deal

SCOTTISH

LIFE

CSFB

DEUTSCHE


The Deal in Detail

SCOTTISH

LIFE

CSFB

DEUTSCHE

Deutsche sells 3-year floating rate note paying LIBOR - 3/8%

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)

CLIENT

CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise


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.


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?)


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


www.giddy.org

Ian Giddy

NYU Stern School of Business

Tel 212-998-0332; 917-930-0291

Fax 212-995-4233; 630-604-7413

[email protected]

http://www.giddy.org

Documents

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