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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
Copyright ©2000 Ian H. Giddy Financial Risk Management 3
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 4
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 5
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 6
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 7
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 8
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 9
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?
Giddy/NYU Financial Risk Management /2
Prof. Ian GiddyNew York University
Managing Leverage Risk
Copyright ©2000 Ian H. Giddy Financial Risk Management 11
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 13
Does Capital Structure Matter? Yes!
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
COSTOF
CAPITAL
DEBTRATIO
Optimal debt ratio?
Copyright ©2000 Ian H. Giddy Financial Risk Management 14
Does Capital Structure Matter? Yes!
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
DEBTRATIO
Optimal debt ratio?
Copyright ©2000 Ian H. Giddy Financial Risk Management 15
Does Capital Structure Matter? Yes!
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 of Firm= PV(Cash Flows) + PV(Tax Shield) - Distress Costs
Copyright ©2000 Ian H. Giddy Financial Risk Management 16
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 17
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 18
See Saw
Business Uncertainty
Financial Risk
Operating Leverage
Financial Leverage
Giddy/NYU Financial Risk Management /3
Copyright ©2000 Ian H. Giddy Financial Risk Management 19
Young and Old
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
Copyright ©2000 Ian H. Giddy Financial Risk Management 20
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%
Copyright ©2000 Ian H. Giddy Financial Risk Management 21
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 22
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 23
Capital Structure: East vs West
VALUE OFTHE
FIRM
DEBTRATIO
Optimal debt ratio?
Intel Sammi
Copyright ©2000 Ian H. Giddy Financial Risk Management 24
Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas
Copyright ©2000 Ian H. Giddy Financial Risk Management 25
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 26
How Should the Acquisition Have Been Financed?
Assets added:$210 million
Assets added:$210 million
Debt added:$210 million(C$250m)
Debt added:$210 million(C$250m)
Copyright ©2000 Ian H. Giddy Financial Risk Management 27
How Should the Acquisition Have Been Financed?
Assets added:$210 million
Assets added:$210 million
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
Giddy/NYU Financial Risk Management /4
Copyright ©2000 Ian H. Giddy Financial Risk Management 28
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%
Copyright ©2000 Ian H. Giddy Financial Risk Management 29
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 30
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 31
March 1997
Sammi Steel is bankrupt!
ALTO
Copyright ©2000 Ian H. Giddy Financial Risk Management 32
March 1997
Sammi Steel is bankrupt!
ALTOfinancefixit.comn Diagnosisn Preventionn and Cure
financefixit.comn Diagnosisn Preventionn and Cure
Copyright ©2000 Ian H. Giddy Financial Risk Management 33
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)
FromHow much debt?toWhat kind of debt?andWhat kind of equity?
You can make a difference- Pepper-Giddy
Copyright ©2000 Ian H. Giddy Financial Risk Management 35
Corporate Finance
CORPORATE FINANCEDECISONS
CORPORATE FINANCEDECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©2000 Ian H. Giddy Financial Risk Management 36
Capital Structure: East vs West
VALUE OFTHE
FIRM
DEBTRATIO
Optimal debt ratio?
Nokia TPI
Copyright ©2000 Ian H. Giddy Financial Risk Management 37
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
Giddy/NYU Financial Risk Management /5
Copyright ©2000 Ian H. Giddy Financial Risk Management 38
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 39
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 40
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 41
What Are The Alternatives?
l Key: Make the new securities attractive to:uExisting lendersuNew lendersuNew bond investorsuNew equity investors
Copyright ©2000 Ian H. Giddy Financial Risk Management 42
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 43
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 45
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 46
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 47
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)
Giddy/NYU Financial Risk Management /6
Copyright ©2000 Ian H. Giddy Financial Risk Management 48
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 49
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 50
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 51
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 52
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 53
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."
Copyright ©2000 Ian H. Giddy Financial Risk Management 54
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 55
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 56
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
Giddy/NYU Financial Risk Management /7
Copyright ©2000 Ian H. Giddy Financial Risk Management 57
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 58
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 59
How Risky is Siderar?
Mean
The riskier the better!The riskier the better!
Copyright ©2000 Ian H. Giddy Financial Risk Management 60
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 61
Payoffs to Shareholders on Liquidation
Copyright ©2000 Ian H. Giddy Financial Risk Management 62
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 63
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 65
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?
Giddy/NYU Financial Risk Management /8
Copyright ©2000 Ian H. Giddy Financial Risk Management 66
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 67
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 68
Corporate Hedging Decisions:Frutas Amazonas
Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.
Copyright ©2000 Ian H. Giddy Financial Risk Management 69
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 70
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 71
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?)
Copyright ©2000 Ian H. Giddy Financial Risk Management 72
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 74
Market Risks: Definitions
Three Views of
Market Price Risk:lTransactions
lBalance Sheet/PortfoliolEconomic risk.
TransactionsExposure
TransactionsExposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©2000 Ian H. Giddy Financial Risk Management 75
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
Giddy/NYU Financial Risk Management /9
Copyright ©2000 Ian H. Giddy Financial Risk Management 76
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 77
Austin Computer
NT$
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©2000 Ian H. Giddy Financial Risk Management 78
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!
Copyright ©2000 Ian H. Giddy Financial Risk Management 79
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 80
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 81
Photronics: Translation Exposure
Copyright ©2000 Ian H. Giddy Financial Risk Management 82
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 83
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 84
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.
Giddy/NYU Financial Risk Management /10
Copyright ©2000 Ian H. Giddy Financial Risk Management 85
Salmon for Chile
l Exporting salmon from Chile to Japan; finance inuPesos?uDollars?uYen?uKrone?
Ciba-Geigy
Copyright ©2000 Ian H. Giddy Financial Risk Management 87
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 88
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 89
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 90
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
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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)
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 93
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.
Giddy/NYU Financial Risk Management /11
Copyright ©2000 Ian H. Giddy Financial Risk Management 94
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 95
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%
Copyright ©2000 Ian H. Giddy Financial Risk Management 96
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.
Copyright ©2000 Ian H. Giddy Financial Risk Management 99
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 ©2000 Ian H. Giddy Financial Risk Management 100
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 101
Corporate Finance
CORPORATE FINANCEDECISONS
CORPORATE FINANCEDECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©2000 Ian H. Giddy Financial Risk Management 102
Young and Old
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
Copyright ©2000 Ian H. Giddy Financial Risk Management 103
Domestic and Global
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
Copyright ©2000 Ian H. Giddy Financial Risk Management 106
FAMILYOR STATEOWNERSHIP
Emerging Market Companies:Life-Cycle Financing
DOMESTICBANKDEBT
DOMESTICPUBLICBONDSAND PAPER
EURO,FOREIGN,AND GLOBALBONDS
MEDIUM-TERM NOTEAND CPPROGRAMS
DEBT
EQUITY
DOMESTICPUBLICEQUITY
LIMITEDFOREIGNEQUITY
GLOBALEQUITY
Giddy/NYU Financial Risk Management /12
Copyright ©2000 Ian H. Giddy Financial Risk Management 107
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 109
Banpu
Copyright ©2000 Ian H. Giddy Financial Risk Management 110
Corporate Financing Choices:What Kind of Debt for Banpu?
l Fixed/floatingl Currency of denomination
l Maturity or availabilityl Domestic/Euro
l Straight/convertible
Copyright ©2000 Ian H. Giddy Financial Risk Management 111
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%
Copyright ©2000 Ian H. Giddy Financial Risk Management 112
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%
Copyright ©2000 Ian H. Giddy Financial Risk Management 113
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?
Copyright ©2000 Ian H. Giddy Financial Risk Management 114
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
Copyright ©2000 Ian H. Giddy Financial Risk Management 119
www.giddy.org
Ian GiddyNYU Stern School of BusinessTel 212-998-0332; Fax [email protected]://www.giddy.orgAlso see:giddyonline.comfinancefixit.comglobalsecuritization.com