Corporate Financing Choices

1. Michigan/TMA Corporate FinancingChoices Prof. Ian Giddy New York University

2. 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

3. 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

4. Debt? Equity? What kind?

5. 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 Does Capital Structure Matter? You cannot change the value of the real business just by shuffling paper - Modigliani-Miller

6. 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 ?

7. 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 Is There an Optimal Capital Structure? Optimal debt ratio? VALUE OFTHE FIRM DEBT RATIO

8. How Much Debt? A $19.95 company...an “ISP” Profits: Zero ~ Risks: High

9. Ciba-Geigy

10. 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?

11. 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?

12. Ciba: How Much Debt?

13. Ciba: Are Revenues Stable? Ciba Sales and Earnings (in billions of Swiss francs) 100 10 1 Legend Sales Profits 0.1 1982 1984 1986 1988 1990 1992

14. Measuring Financial Leverage • Two variants of debt ratio • Debt 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.

15. 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 = ke (E/(D+E)) + kd (D/(D+E))

16. 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.

17. 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.

18. 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? Financing Choices You cannot change the value of the real business just by shuffling paper - Modigliani-Miller

19. 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

20. 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.

21. Currency of Denomination of Ciba's Debt? What Should It Be? • Geographic location of sales and capital assets. • Currency distribution of sales. • Nature of the company's businesses

22. Currency of Ciba’s Assets and Debt Geographic distribution Geographic distribution Estimated Estimated of of Currency Currency currency currency Fixed Fixed distribution distribution distribution of distribution of Sales Sales Remarks on economic exposure Remarks on economic exposure assets assets of sales of sales debt debt Switzerland Switzerland 41% 41% 2.4% 2.4% Net short position because much of Net short position because much of 9% 9% production, but little of sales, here production, but little of sales, here 43% U.K. U.K.   5.4% 5.4% Part of sales effectively U.S. dollar Part of sales effectively U.S. dollar 7% 7% denominated denominated   27% 27% Other Other 34.6% 34.6% 21% 21% Europe Europe U.S. and U.S. and 23% 23% 32% 32% 41.3% 41.3% 54% 54% Canada Canada Latin Latin 4% 4% 7% 7% 5.3% 5.3% Most of sales effectively dollar Most of sales effectively dollar 2% 2% America America denominated denominated Asia Asia 4% 4% 13% 13% 10.9% 10.9% Part of sales effectively U.S. dollar Part of sales effectively U.S. dollar 6% 6% denominated denominated Rest of the Rest of the 1% 1% 5% 5% Most of sales effectively dollar Most of sales effectively dollar 1% 1% world world denominated denominated

23. 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?

24. 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.

25. When Debt and Equity are Not Enough Assets Liabilities Value of future cash flows Claims on the cash flows

26. When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights

27. When Debt and Equity are Not Enough What if... Assets Liabilities Claims are inadequate? Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Returns are inadequate? Equity Residual payments Upside and downside Residual claims Voting control rights

28. When Debt and Equity are Not Enough Alternatives Assets Liabilities Collateralized Asset-securitized Project financing Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Preferred Warrants Convertible Equity Residual payments Upside and downside Residual claims Voting control rights

29. Asset Securitization: Sell Your Cake and Eat It Too SPONSORING COMPANY ACCOUNTS RECEIVABLE CONTINUED SERVICING OF ASSETS SALE OR SPECIAL ASSIGNMENT PURPOSE VEHICLE ISSUES ACCOUNTS ASSET-BACKED RECEIVABLE CERTIFICATES

30. Cremonini Securitization Sale of Receivables Cremonini Group Purchaser SPC Subordinated Lender Purchase 98% Lire 16%inter. Receivables & Contract Rights Goods & Services Purchase Price & fee 98% Receivables Subordinated Note Italian Obligors Issuer Crystal Castle (SPC) Spread Account Lire 2% interest 84% Dollars 84% FX and Interest Rate Swap Swiss Bank Investors Lire Pledges: SPC’s stock, receivables, contract rights Senior Euronotes Guaranty of SPC’s Lire Obligation FSA Guaranty of Euronotes

31. Managing Hybrid Securities • Principles of hybrid instruments • Market imperfections as motives for hybrids • Hybrids in the Eurobond market: • Asset-backed securities • Warrant bonds and convertibles • Index-linked bonds • Application: callable bonds

32. A Day in the Lifeof the Eurobond Market • Examine the deals • Why were each done in that particular form? • What determines the pricing? • Can you break the hybrids into their component parts?

33. A Day in the Life...

34. Equity-Linked Eurobonds • Eurobonds with warrants • Marui • Convertible Eurobonds • Battle Mountaingold • Index-linked Eurobonds • Bank of Montreal

35. Warrants V a l u e o f W a r r a n t ($) 0 Market Value Market Premium Theoretical Value Price Per Share of Common Stock ($)

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

37. Nikkei-Linked PRINCIPAL REPAYMENT 19,000 28,000

38. 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.

39. 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.

40. 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?

41. 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.

42. What Conditions Permit Hybrids to Thrive? • Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond • Tax Distortions Example: Money Market Preferred • Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond • Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs)

43. 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.

44. Profit (Loss) with 100% Principal Protection Profit (Loss) with 90% Principal Protection 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Case Study: Endesa Equity-Linked Notes • Client’s objectives • The “Guaranteed Minimum Return” product • How is this priced? Who else could benefit from it? 60% 50% 40% 30% Profit (Loss) 20% 10% 0% -10% -20% Index Level at maturity (Initial index level = 100)

45. 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.

46. Anatomy of a Deal

47. 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-.10 • Is not too concerned about specific timing of issue, amount or maturity • Is willing to consider hybrid structures.

48. Anatomy of a Deal Investor: • Has distinctive preference for high grade investments • Looking for investments that will improve portfolio returns relative to relevant indexes • Invests in both floating rate and fixed rate sterling and dollar securities • Can buy options to hedge portfolio but cannot sell options

49. Anatomy of a Deal Intermediary: • Has experience and technical and legal background in structure finance • Has active swap and option trading and positioning capabilities • Has clients looking for caps and other forms of interest rate protection.

50. The Deal • Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures • Structuring a MTN in such a way as to meet the investor’s needs and constraints • Line up all potential counterparties and negociate numbers acceptable to all sides • Upon issuer’s and investor’s approval, place the securities