Ibmcfdebt

IBM
Designing Debt
Prof. Ian Giddy

New York University
First Principles
z 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.
z Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
z 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.
z Manage financial risk
Copyright ©2004 Ian H. Giddy Designing Debt 3

The Agenda
z What determines the optimal mix of

debt and equity for a company?
z How does altering the mix of debt and
equity affect the value of a company?
z What is the right kind of debt for a
company?

Corporate Finance
CORPORATE
CORPORATEFINANCE
FINANCE
DECISONS
DECISONS
INVESTMENT
INVESTMENT FINANCING
FINANCING RISK
RISKMGT
MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT EQUITY
M&A TOOLS

Corporate Finance
CORPORATE
CORPORATEFINANCE
FINANCE
DECISONS
DECISONS
INVESTMENT
INVESTMENT
INVESTMENT FINANCING
FINANCING RISK
RISKMGT
MGT
PORTFOLIO
MEASUREMENT
CAPITAL RISK
FINANCING
DEBT EQUITY
M&A MANAGEMENT TOOLS

Foreign Exchange Exposure
Value of the Euro
1.3
1.25
1.2
1.15
US Dollars
1.1
1.05
1
0.95
0.9
0.85
0.8
9
00
01
02
03
04
9
3
l-9
l-0
l-0
l-0
l-0
-9
n-
n-
n-
n-
n-
n
Ju
Ju
Ju
Ju
Ju
Ja
Ja
Ja
Ja
Ja
Ja
Source: pacific.commerce.ubc.ca/xr
What Hedging Instruments?
What Protection Needed?
Volatility & Complex risks

Direction
Direction Or arbitrage
OTC options, Forwards, Exotics, Hybrids,

Futures, structured
Caps and Floors Swaps notes

Heineken and the Euro
z How was the Dutch

company Heineken Euro
affected by the fall in 1.15
the Euro in 1999- 1.1
1.05
2000?
US$ per Euro

1
z Look at 0.95
0.9
The Euro 0.85
The company’s sales 0.8
10/18/1999
12/18/1999
2/18/2000
4/18/2000
6/18/2000
8/18/2000
10/18/2000
The company’s
production

z How was the Dutch

company HeinekenLocation Fixed Assets Sales
affected by the fall in
The Nether 2,341 15% 1,063 15%
the Euro in 1999- Rest of Eu 8,874 57% 4,027 57%
Western H 1,972 13% 895 13%
2000? Africa 685 4% 311 4%
Asia Pacifi 1,613 10% 732 10%
z Look at 1548500% 100% 7,028 100%
The Euro
Data: 1999 figures, millions of Euro
The company’s sales Source: http://www.heinekencorp.nl
The company’s
production

z How was the Dutch

company Heineken
affected by the fall in
the Euro in 1999-
2000?
z Look at
The Euro
The company’s sales
The company’s
production

Translation vs Economic Exposure
Accounting exposure
z Exposure = "Exposed" assets - "exposed"
liabilities
Economic exposure
z Exposure = How will an unanticipated exchange
rate change affect the cash flows of the firm?
Domestic sales
Exports
Domestic costs
Import costs

A Hedging Roadmap
Motivations for Hedge
Driven by Driven by company

company views needs
Volatility: options, Company has Company has

Direction: economic natural
forwards, debt exposure hedge
Market risk Forwards,

No need for hedging
remains swaps or debt

Case Study: IBM
Source: IBM Annual Report, 2001

Financing Choices
Assets’ value is the From

present value of the
How much debt?
cash flows from the
real business of the to
firm What kind of debt?
Value of the firm
=PV(Cash Flows)
You cannot change the value of the

real business just by shuffling paper
- Modigliani-Miller
Corporate Financing Choices:
What Kind of Debt?
z Fixed/floating
z Currency of denomination
z Maturity or availability
z Domestic/Euro
z Public/private
z Asset-based
z Credit enhanced
z Swapped
z Equity-linked
Ciba-Geigy:
What Kind of
Debt?
Short Term or Long Term?
z In 1992, Ciba had fixed assets of

SF13.9 billion and capital expenditures
of SF1.9 billion.
z Yet the majority of Ciba's debt is in the
short-term commercial paper, bank
debt, and suppliers-credit markets.
z 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.
Currency of Denomination of Ciba's
Debt? What Should It Be?
z Geographic location of sales and capital

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

Currency of Ciba’s Assets and Debt
Geographic distribution
of Estimated
Currency currency
Fixed distribution distribution of
assets Sales of sales Remarks on economic exposure debt
Switzerland 41% 2.4% Net short position because much of 9%

production, but little of sales, here
U.K. $ 43% 5.4% Part of sales effectively U.S. dollar 7%

$27% denominated
Other 34.6% 21%
Europe
U.S. and 23% 32% 41.3% 54%

Canada
Latin 4% 7% 5.3% Most of sales effectively dollar 2%

America denominated
Asia 4% 13% 10.9% Part of sales effectively U.S. dollar 6%

denominated
Rest of the 1% 5% Most of sales effectively dollar 1%

world denominated

What Kind of Debt?
Some Considerations
z Fixed/floating:
How certain are the cash flows? Are operating profits
linked to interest rates or inflation?
z Currency:
Consider currency of the assets: currency of
denomination vs. currency of location vs. currency of
determination.
z 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?

Designing Debt
Start with the Cyclicality &

Cash Flows Duration Currency Effect of Inflation
Growth Patterns Other Effects
on Assets/ Uncertainty about Future
Projects
Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
Duration/ Currency * More floating rate Convertible on Debt Catastrophe Notes
Define Debt Maturity Mix - if CF move with - Convertible if - Options to make
Characteristics inflation
- with greater uncertainty
cash flows low
now but high
cash flows on debt
match cash flows
on future exp. growth on assets
Design debt to have cash flows that match up to cash flows on the assets financed
Deductibility of cash flows Differences in tax rates

Overlay tax for tax purposes across different locales Zero Coupons
preferences
If tax advantages are large enough, you might override results of previous step
Consider Analyst Concerns Ratings Agency Regulatory Concerns

ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes
Can securities be designed that can make these different entities happy?
Observability of Cash Flows Type of Assets financed

by Lenders - Tangible and liquid assets Existing Debt covenants Convertibiles
Factor in agency - Less observable cash flows create less agency problems - Restrictions on Financing Puttable Bonds
conflicts between stock lead to more conflicts Rating Sensitive
and bond holders Notes
If agency problems are substantial, consider issuing convertible bonds LYONs
Consider Information Uncertainty about Future Cashflows Credibility & Quality of the Firm
Asymmetries - When there is more uncertainty, it - Firms with credibility problems
may be better to use short term debt will issue more short term debt
Approaches for Evaluating
Asset Cash Flows
z 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?
z 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
z III. Historical Data
Operating Cash Flows
Firm Value
The Financing Details:
Intuitive Approach for Disney
Business Project Cash Flow Characteristics Type of Financing
Creative Projects are likely to Debt should be
Content 1. be short term 1. short term
2. have cash outflows are primarily in dollars (but cash inflows 2. primarily dollar
could have a substantial foreign currency component 3. if possible, tied to the
3. have net cash flows which are heavily driven by whether the success of movies.
movie or T.V series is a “hit”
Retailing Projects are likely to be Debt should be in the form
1. medium term (tied to store life) of operating leases.
2. primarily in dollars (most in US still)
3. cyclical
Broadcasting Projects are likely to be Debt should be
1. short term 1. short term
2. primarily in dollars, though foreign component is growing 2. primarily dollar debt
3. driven by advertising revenues and show success 3. if possible, linked to
network ratings.

Financing Details: Other Divisions
Theme Parks Projects are likely to be Debt should be
1. very long term 1. long term
2. primarily in dollars, but a significant proportion of revenues 2. mix of currencies, based
come from foreign tourists. upon tourist make up.
3. affected by success of movie and broadcasting divisions.
Real Estate Projects are likely to be Debt should be
1. long term 1. long term
2. primarily in dollars. 2. dollars
3. affected by real estate values in the area 3. real-estate linked
(Mortgage Bonds)

FINANCING ALTERNATIVES
AVAILABLE TO MAJOR CORPORATIONS
Debt?
Debt? Subsidized funds
Project
Equity?
Equity? Fixed
Bank
debt
finance
Term loan
Revolving
facility
What
What kind?
kind? Dollar
Private
Real estate
Leasing
Long placement
term Asset
DEBT backed
Unsecured
Non-
Floating dollar Domestic
Public
offering
Eurobond
US CP
MTN
ARP
Short
term FRN
Euro CP
VRN
Bank debt
Hybrid Straight
Callable Stripped
EQUITY Index-linked
Unstripped
Convertible
With warrants
Equity options
Private sale
Full rights Domestic
Public offering
Restricted International
Case Study: IBM
Source: morningstar.com

Geography

Debt

Hybrid Financial Instruments
Prof. Ian Giddy

New York University
Managing Hybrid Securities
z Principles of hybrid instruments

z Market imperfections as motives for
hybrids
z Hybrids in the Eurobond market:
Asset-backed securities
Warrant bonds and convertibles
Index-linked bonds
z Application: callable bonds

A Day in the Life
of the Eurobond Market
z Examine the deals

Why were each done in that particular
form?
What determines the pricing?
z Can you break the hybrids into their

component parts?

A Day in the Life...

Equity-Linked Bonds
z Bonds with warrants

z Convertible Bonds
z Index-linked Bonds
These are all example of hybrid bonds

and should be priced by decomposition

Convertibles
V Conversion
a
l Value
u
e
o
Market
f Value
C Market Premium
o
n
v
e
r
t
i
Straight
b Bond Value
l
e
B
o
n
d
($) 0
Price Per Share of Common Stock
Warrants
V
a
l
u
e
o
f
W
a Market
r Value
r Theoretical
a Market Premium
n Value
t
($)
0
Price Per Share of Common Stock ($)

Index-Linked
PRINCIPAL
REPAYMENT

First Principles
z 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.
z Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
z 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.
z Manage financial risk

Contact
Prof. Ian Giddy

NYU Stern School of Business
44 West 4th Street
New York, NY 10012
Tel 212-998-0426; Fax 212-995-4233

ian.giddy@nyu.edu
www.giddy.org

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IBM

Prof. Ian Giddy

z Invest in projects that yield a return greater than the minimum

Copyright ©2004 Ian H. Giddy Designing Debt 3

z What determines the optimal mix of

Copyright ©2004 Ian H. Giddy Designing Debt 4

Copyright ©2004 Ian H. Giddy Designing Debt 5

Copyright ©2004 Ian H. Giddy Designing Debt 8

Value of the Euro

What Protection Needed?

Volatility & Complex risks

OTC options, Forwards, Exotics, Hybrids,

Copyright ©2004 Ian H. Giddy Designing Debt 10

z How was the Dutch

affected by the fall in 1.15

the Euro in 1999- 1.1

US$ per Euro

 The Euro 0.85

 The company’s sales 0.8

Copyright ©2004 Ian H. Giddy Designing Debt 12

z How was the Dutch

Copyright ©2004 Ian H. Giddy Designing Debt 13

z How was the Dutch

Copyright ©2004 Ian H. Giddy Designing Debt 14

Copyright ©2004 Ian H. Giddy Designing Debt 15

Motivations for Hedge

Driven by Driven by company

Volatility: options, Company has Company has

Market risk Forwards,

Copyright ©2004 Ian H. Giddy Designing Debt 16

Source: IBM Annual Report, 2001

Copyright ©2004 Ian H. Giddy Designing Debt 18

Assets’ value is the From

You cannot change the value of the

z In 1992, Ciba had fixed assets of

z Geographic location of sales and capital

Copyright ©2004 Ian H. Giddy Designing Debt 23

Switzerland 41% 2.4% Net short position because much of 9%

U.K. $ 43% 5.4% Part of sales effectively U.S. dollar 7%

U.S. and 23% 32% 41.3% 54%

Latin 4% 7% 5.3% Most of sales effectively dollar 2%

Asia 4% 13% 10.9% Part of sales effectively U.S. dollar 6%

Rest of the 1% 5% Most of sales effectively dollar 1%

Copyright ©2004 Ian H. Giddy Designing Debt 24

Copyright ©2004 Ian H. Giddy Designing Debt 25

Start with the Cyclicality &

Deductibility of cash flows Differences in tax rates

Consider Analyst Concerns Ratings Agency Regulatory Concerns

Observability of Cash Flows Type of Assets financed

Copyright ©2004 Ian H. Giddy Designing Debt 28

Theme Parks Projects are likely to be Debt should be

1. very long term 1. long term

2. primarily in dollars, but a significant proportion of revenues 2. mix of currencies, based

come from foreign tourists. upon tourist make up.

3. affected by success of movie and broadcasting divisions.

Real Estate Projects are likely to be Debt should be

1. long term 1. long term

2. primarily in dollars. 2. dollars

3. affected by real estate values in the area 3. real-estate linked

The Euro 0.85

The company’s sales 0.8