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7/28/2019 OceanDrillingKey Nov Nov (1)
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Ocean Drilling, Inc.
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Competing Bids
France (in FRF)
96M USD (534.72M FRF)
24M USD Down Pmt (72MUSD (75%) Financed)
10 1/2% APR
8 Year Term
Equal Annual PrinciplePayments
Japan (in JPY)
90M USD (20,443.5M JPY)
18 M USD Down Pmt (72MUSD (80%) Financed)
8 3/4% APR
10-Year Term
Equal Annual Principle
Payments
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Differential Cash Flows
Down Payment
Depreciation Tax Shield
Below Market Loan Payments
Tax Effects of Loan Amortization
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USD
FRF or JPY
Now Future
Down Payment
Depreciation
Tax Shield
Below Market
Loan Payments
Tax Effects of
Loan Amortization
Cash Flow Diagram
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Down Payment
Occurs now at time 0, so there is no discounting
Occurs in FRF or JPY, but USD can be converted
to FRF or JPY at spot market rates France down payment = 24M USD
Japan down payment = 18M USD
Difference is 6M USD, to Japans advantage
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USD
FRF or JPY
Now Future
Down Payment
Depreciation
Tax Shield
Below Market
Loan Payments
Tax Effects of
Loan Amortization
Cash Flow Diagram
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USD Discount Rate
WACC used to evaluate project: reflects
risks of project operating cash flows
Cost of debt used to evaluate debt
financing: reflects risks of debt-related cash
flows
? Before-Tax Cost of Debt = 20%
? After-Tax Cost of Debt = 10%
Assume Marginal Tax Rate = 50%
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Depreciation Tax Shield - France
5-Year Depreciation: 15M, 21M, 20M,
20M, 20M
Total = 96M
Depreciation Tax Shield: 7.5M, 10.5M,
10M, 10M, 10M
NPV @ 20% = 28.17M
NPV @ 10% = 36.05M
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Depreciation Tax Shield - Japan
5-Year Depreciation: 13M, 20M, 19M,
19M, 19M
Total = 90M
Depreciation Tax Shield: 6.5M, 10M, 9.5M,
9.5M, 9.5M
NPV @ 20% = 26.26M
NPV @ 10% = 33.70M
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Depreciation Tax Shield
@ 20% discount rate, difference is 1.91M
USD, to Frances advantage
@ 10% discount rate, difference is 2.35M
USD, to Frances advantage
The more expensive the equipment, the
more valuable the depreciation tax shield
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USD
FRF or JPY
Now Future
Down Payment
Depreciation
Tax Shield
Below Market
Loan PaymentsTax Effects of
Loan Amortization
Cash Flow Diagram
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Loan Payments - FRF
Time Total Price Down Payment Loan Principle Beginning Interest After-Tax Net
Payments Balance Interest Cash Flow
0 535.68 133.92 401.76 0
1 -50.22 401.76 42.18 21.09 -71.31
2 -50.22 351.54 36.91 18.46 -68.68
3 -50.22 301.32 31.64 15.82 -66.04
4 -50.22 251.1 26.37 13.18 -63.40
5 -50.22 200.88 21.09 10.55 -60.77
6 -50.22 150.66 15.82 7.91 -58.13
7 -50.22 100.44 10.55 5.27 -55.49
8 -50.22 50.22 5.27 2.64 -52.86
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Loan Payments - JPY
Time Total Price Down Payment Loan Principle Beginning Interest After-Tax Net
Payments Balance Interest Cash Flow
0 20457 4091.4 16366 0
1 -1636.56 16365.60 1431.99 716.00 -2352.56
2 -1636.56 14729.04 1288.79 644.40 -2280.96
3 -1636.56 13092.48 1145.59 572.80 -2209.36
4 -1636.56 11455.92 1002.39 501.20 -2137.76
5 -1636.56 9819.36 859.19 429.60 -2066.16
6 -1636.56 8182.80 716.00 358.00 -1994.56
7 -1636.56 6546.24 572.80 286.40 -1922.96
8 -1636.56 4909.68 429.60 214.80 -1851.36
9 -1636.56 3273.12 286.40 143.20 -1779.76
10 -1636.56 1636.56 143.20 71.60 -1708.16
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Expected Spot Rates
Forward Rates - Forward Parity
Interest Rates - International Fisher Effect
Expected Inflation Rates - Purchasing
Power Parity
Other
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Forward RatesTime FRF JPY
Spot 5.570/80 227.15/227.30
Midpoint 5.575 227.225
6-Month Midpoint 5.6775 219.9500
Premium/(Discount) -3.61% 6.62%
12-Month Midpoint 5.7800 212.4000
Premium/(Discount) -3.55% 6.98%
2-Year Midpoint 6.0300 197.2500
Premium/(Discount) -3.77% 7.60%
5-Year Midpoint No Quote 184.1500
Premium/(Discount) 4.68%
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Interest Rate-Based ForecastsUSD FRF JPY
Long-Term 0.161 0.179 0.109
Interest Rates
Factor 1.01550388 0.95521102
Spot 5.5750 227.2250
1 5.6615 217.0478
2 5.7493 207.3265
3 5.8385 198.0405
4 5.9291 189.17055 6.0211 180.6977
6 6.1145 172.6045
7 6.2093 164.8737
8 6.3057 157.4892
9 6.4035 150.4354
10 6.5028 143.6975
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Expected USD Loan Payments:
France LoanTime Net FRF Forecast Net USD
Cash Flow Spot Rate Cash Flow
0 72.00
1 -71.31 5.66 -12.60
2 -68.68 5.75 -11.95
3 -66.04 5.84 -11.31
4 -63.40 5.93 -10.695 -60.77 6.02 -10.09
6 -58.13 6.11 -9.51
7 -55.49 6.21 -8.94
8 -52.86 6.31 -8.38
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Expected USD Loan Payments:
Japan LoanTime Net JPY Forecast Net USDCash Flow Spot Rate Cash Flow
0 72.00
1 -2352.56 217.05 -10.84
2 -2280.96 207.33 -11.00
3 -2209.36 198.04 -11.16
4 -2137.76 189.17 -11.30
5 -2066.16 180.70 -11.436 -1994.56 172.60 -11.56
7 -1922.96 164.87 -11.66
8 -1851.36 157.49 -11.76
9 -1779.76 150.44 -11.83
10 -1708.16 143.70 -11.89
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Value of Discount FinancingTime Net USD Net USD
Cash Flow Cash Flow
FRF Loan JPY Loan
0 72.00 72.00
1 -12.60 -10.84
2 -11.95 -11.00
3 -11.31 -11.16
4 -10.69 -11.30
5 -10.09 -11.43
6 -9.51 -11.56
7 -8.94 -11.66
8 -8.38 -11.76
9 -11.8310 -11.89
Discount Rate 20% 20%
NPV 29.82 24.75
Discount Rate 10% 10%
NPV 14.75 2.26
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Discount Financing
@ 20% discount rate, difference is 5.07M USD, toFrances advantage
@ 10% discount rate, difference is 12.48M USD,to Frances advantage
The greater the difference between the market rateand the loan rate, the greater the value of the
discount financing: France = 7.4% (17.9%-10.5%); Japan = 2.15% (10.9% - 8.75%)
The higher the discount rate, the smaller the valueof the payments compared to the amount
borrowed
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USD
FRF or JPY
Now Future
Down Payment
Depreciation
Tax Shield
Below Market
Loan PaymentsTax Effects of
Loan Amortization
Cash Flow Diagram
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Loan Amortization
The USD value of the loan will decline by the
same amount each year on the balance sheet
The amount by which the loan declines will not beequal to the cash required to make the loan
payment: the FRF loan will require fewer USD
each year and the JPY loan will require more USD
each year
The gain (on the FRF loan) is taxable, and the loss
(on the JPY loan) provides a tax shield.
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Loan Amortization: France
Time Loan Loan Principle Expected Loan Principle Foreign Exchange Tax Effect
Amortization Payment Spot Rates Payment Gain/Loss
USD FRF USD USD USD
0 0.00 0.00 5.5750
1 -9.00 -50.22 5.6615 -8.87 0.13 0.062 -9.00 -50.22 5.7493 -8.73 0.27 0.13
3 -9.00 -50.22 5.8385 -8.60 0.40 0.20
4 -9.00 -50.22 5.9291 -8.47 0.53 0.26
5 -9.00 -50.22 6.0211 -8.34 0.66 0.33
6 -9.00 -50.22 6.1145 -8.21 0.79 0.39
7 -9.00 -50.22 6.2093 -8.09 0.91 0.46
8 -9.00 -50.22 6.3057 -7.96 1.04 0.52
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Loan Amortization: Japan
Time Loan Loan Principle Expected Loan Principle Foreign Exchange Tax Effect
Amortization Payment Spot Rates Payment Gain/Loss
USD FRF USD USD USD
0 0.00 0.00 227.2250
1 -7.20 -1636.56 217.0478 -7.54 -0.34 -0.17
2 -7.20 -1636.56 207.3265 -7.89 -0.69 -0.353 -7.20 -1636.56 198.0405 -8.26 -1.06 -0.53
4 -7.20 -1636.56 189.1705 -8.65 -1.45 -0.73
5 -7.20 -1636.56 180.6977 -9.06 -1.86 -0.93
6 -7.20 -1636.56 172.6045 -9.48 -2.28 -1.14
7 -7.20 -1636.56 164.8737 -9.93 -2.73 -1.36
8 -7.20 -1636.56 157.4892 -10.39 -3.19 -1.60
9 -7.20 -1636.56 150.4354 -10.88 -3.68 -1.84
10 -7.20 -1636.56 143.6975 -11.39 -4.19 -2.09
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Tax Effect of Loan AmortizationTime Net USD Net USD
Cash Flow Cash Flow
FRF Loan JPY Loan
0
1 0.06 -0.17
2 0.13 -0.35
3 0.20 -0.53
4 0.26 -0.73
5 0.33 -0.93
6 0.39 -1.14
7 0.46 -1.36
8 0.52 -1.60
9 -1.8410 -2.09
Discount Rate 20% 20%
NPV 0.90 (3.24)
Discount Rate 10% 10%
NPV 1.40 (5.59)
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Tax Effect of Loan Amortization
@ 20% discount rate, difference is 4.14M
USD, to Japans advantage
@ 10% discount rate, difference is 6.99MUSD, to Japans advantage
The stronger the foreign currency, the more
valuable the tax effect of loan amortization
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Net Differential Value>0: Advantage to France
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20% or 10% Discount Rate?
There are two benefits to below-market financing: reducedafter-tax interest and increased debt capacity
If the company can realize both benefits, the after-tax cost
of debt (10%) is the appropriate discount rate If the company can not take advantage of the increased
debt capacity (as for Ocean Drilling), the before tax cost ofdebt (20%) is the appropriate discount rate
With the shipyard financing, Ocean Drillings ratio ofsenior debt to the sum of subordinated debt plusshareholders equity will be 1.28 ((240+72)/(50+194)).Their loan covenant requires it to be less than 1.25.
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Financial Summary
The terms of the Japanese loan look better
The Japanese loan is 3.16M USD better
than the French loan using the correct 20%(before-tax cost of debt) discount rate
The French loan is 1.84M USD better than
the Japanese loan using the more familiar10% (after-tax cost of debt) discount rate
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Practical Considerations
The difference between the loans is at best
3.5% (3.16M/90M) of the purchase price if
purchased in Japan (and only 1.9%(1.84M/96M) of the purchase price if
purchased in France)
Because these differences are based onuncertain estimates of future exchange
rates, they are not financially significant
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Hedging
The firm faces substantial operating risk;therefore, it should attempt to reduce financial risk
Forward Hedge: FRF forward rates are availablefor only 2 years (25% of the life of the loan) andJPY forward rates are available for only 5 years(50% of the life of the loan)
Money Market Hedge: Ocean Drilling does nothave the debt capacity to use a money markethedge
Swap: The appropriate hedging tool
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