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Prof. Ian GiddyNew York University
Designing Debt
Copyright ©1998 Ian H. Giddy Designing Debt 2
First Principles
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.
Copyright ©1998 Ian H. Giddy Designing Debt 3
The Agenda
What determines the optimal mix of debt and equity for a company?
How does altering the mix of debt and equity affect the value of a company?
What is the right kind of debt for a company?
Copyright ©1998 Ian H. Giddy Designing Debt 4
Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©1998 Ian H. Giddy Designing Debt 8
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
Copyright ©1998 Ian H. Giddy Designing Debt 9
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
Ciba-Geigy: What Kind of Debt?
Copyright ©1998 Ian H. Giddy Designing Debt 11
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.
Copyright ©1998 Ian H. Giddy Designing Debt 12
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?
Copyright ©1998 Ian H. Giddy Designing Debt 13
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%
Copyright ©1998 Ian H. Giddy Designing Debt 14
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?
Copyright ©1998 Ian H. Giddy Designing Debt 15
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.
Copyright ©1998 Ian H. Giddy Designing Debt 16
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
Copyright ©1998 Ian H. Giddy Designing Debt 17
Approaches for Evaluating Asset Cash Flows
I. Intuitive Approach Are the projects typically long term or short term? What is the
cash flow pattern on projects? How much growth potential does the firm have relative to
current projects? How cyclical are the cash flows? What specific factors
determine the cash flows on projects?
II. Project Cash Flow Approach Project cash flows on a typical project for the firm Do scenario analyses on these cash flows, based upon
different macro economic scenarios
III. Historical Data Operating Cash Flows Firm Value
Copyright ©1998 Ian H. Giddy Designing Debt 18
The Financing Details: Intuitive Approach for Disney
Business Project Cash Flow Characteristics Type of Financing
Creative
Content
Projects are likely to
1. be short term
2. have cash outflows are primarily in dollars (but cash inflows
could have a substantial foreign currency component
3. have net cash flows which are heavily driven by whether the
movie or T.V series is a “hit”
Debt should be
1. short term
2. primarily dollar
3. if possible, tied to the
success of movies.
Retailing Projects are likely to be
1. medium term (tied to store life)
2. primarily in dollars (most in US still)
3. cyclical
Debt should be in the form
of operating leases.
Broadcasting Projects are likely to be
1. short term
2. primarily in dollars, though foreign component is growing
3. driven by advertising revenues and show success
Debt should be
1. short term
2. primarily dollar debt
3. if possible, linked to
network ratings.
Copyright ©1998 Ian H. Giddy Designing Debt 19
Financing Details: Other Divisions
Theme Parks Projects are likely to be
1. very long term
2. pr imarily in dollars, but a significant proportion of revenues
come from foreign tourists.
3. affected by success of movie and broadcasting divisions.
Debt should be
1. long term
2. mix of currencies, based
upon tourist make up.
Real Estate Projects are likely to be
1. long term
2. pr imarily in dollars.
3. affected by real estate values in the area
Debt should be
1. long term
2. dollars
3. real-estate linked
(Mortgage Bonds)
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?
Copyright ©1998 Ian H. Giddy Designing Debt 21
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
Copyright ©1998 Ian H. Giddy Designing Debt 23
When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
What if...
Claims
are inadequate?
Returns
are inadequate?
Copyright ©1998 Ian H. Giddy Designing Debt 24
When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
Alternatives
Collateralized Asset-securitized Project financing
Preferred Warrants Convertible
Prof. Ian Giddy
New York University
Hybrid Financial Instruments
Copyright ©1998 Ian H. Giddy Designing Debt 26
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
Copyright ©1998 Ian H. Giddy Designing Debt 27
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?
Copyright ©1998 Ian H. Giddy Designing Debt 28
A Day in the Life...
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % PricePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) Pta10bn 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 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % PricePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) Pta10bn 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 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % PricePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) Pta10bn 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 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % PricePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) Pta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank
Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
Copyright ©1998 Ian H. Giddy Designing Debt 29
Equity-Linked Eurobonds
Eurobonds with warrantsMarui
Convertible EurobondsBattle Mountaingold
Index-linked EurobondsBank of Montreal
Copyright ©1998 Ian H. Giddy Designing Debt 30
Warrants
TheoreticalValue
Market ValueMarket Premium
Value
of
Warrant
($)
0Price Per Share of Common Stock ($)
Copyright ©1998 Ian H. Giddy Designing Debt 31
Convertibles
ConversionValue
StraightBond Value
Market ValueMarket Premium
Value
of
Convertible
Bond
($) 0
Price Per Share of Common Stock
Copyright ©1998 Ian H. Giddy Designing Debt 32
Nikkei-Linked
28,00019,000
PRINCIPAL
REPAYMENT
Copyright ©1998 Ian H. Giddy Designing Debt 33
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.
Copyright ©1998 Ian H. Giddy Designing Debt 34
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)
Copyright ©1998 Ian H. Giddy Designing Debt 35
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.
Copyright ©1998 Ian H. Giddy Designing Debt 36
Medium-Term Notes:Anatomy of a Deal
Copyright ©1998 Ian H. Giddy Designing Debt 37
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.
Copyright ©1998 Ian H. Giddy Designing Debt 38
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
Copyright ©1998 Ian H. Giddy Designing Debt 39
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.
Copyright ©1998 Ian H. Giddy Designing Debt 40
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
Copyright ©1998 Ian H. Giddy Designing Debt 41
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.
Copyright ©1998 Ian H. Giddy Designing Debt 42
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
Copyright ©1998 Ian H. Giddy Designing Debt 43
The Parties in the Deal
SCOTTISH
LIFE
CSFB
DEUTSCHE
Copyright ©1998 Ian H. Giddy Designing Debt 48
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.
Copyright ©1998 Ian H. Giddy Designing Debt 49
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?)
Copyright ©1998 Ian H. Giddy Designing Debt 50
First Principles Again
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.
Copyright ©1998 Ian H. Giddy Designing Debt 54
www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
http://www.giddy.org