Moving to Optimal D/E

1. Moving to Optimal D/E 05/22/08 Ch. 9

2. Moving to Optimal D/E • We have the tools (to find optimal D/E) • We can rebuild the company borrowing structure • “The Six-Million Dollar” Company • How long will it take to build the new borrowing structure? • Should we do it immediately? • Should we do it gradually? • Should we do it at all?

3. Changing to Optimal D/E • From old TV series to Shakespeare • To Change or not to Change, that is the question • If under levered – maybe no change • Debt comes with covenants (thou shalt not) • Excess debt capacity provides flexibility • Future is unknown and D/E moves around… • If over levered – strong incentive to change • Reduce probability of bankruptcy

4. Changing to Optimal D/E • Gradual versus Immediate Change • Degree of confidence in estimation of optimal D/E • As Charles Barkley would say, “that’s terrible…” • Me too syndrome • I want to me like Mike…match competition’s D/E • Likelihood of takeover • Under levered firms more likely to be targets because debt capacity of company can be used to aid takeover (Disney page 401) • Immediate Change – capture extra firm value

5. Ways to Change D/E • Recapitalization (author’s paths 1 & 3) • As you add new projects you choose the funding that moves you to the desired D/E • Debt for Equity or Equity for Debt Swaps • Sell off assets and repurchase stock • Change Dividend Policy (paths 2 & 4) • Stock repurchases are dividends • See Disney Page 412, Table 9.6 • Increase dividends – stock prices fall by the size of the dividend, reduces market value of equity

6. Choosing Financing Instruments • Match the cash flows… • Determine the income stream from period to period • How should Disney finance a movie? (pg 431) • Find a financing instrument that matches the income stream or remains well below the income stream • Save good times to support bad times • Story of employee bonus pay problem • Interest rate sensitive income and debt … • Immunization – “bank immunization strategy” • Match duration of assets and liabilities • Offset negative impact of interest rate changes

7. What is Duration? • Duration is the sensitivity of the cash flow to changes in the interest rate • First applied to bonds • Longer the duration the greater the price change given a change in interest rates • Duration is a time measure • Weight times Wait = Duration • Weight is PV of Cash Flow / Price (NPV of project) • Wait is the time period

8. Duration Calculation… • Table 9.9 – Disney Theme Park • Need, cost of capital to discount future cash flow • Estimate of the cash flow in both amount and timing • Find the PV of each cash flow • Add up all PVs and find NPV (price) • Divide each PV by NPV and multiple by waiting time • Add up the weighted waiting times for duration • Duration provides sensitivity of cash flow to interest rate changes

9. Disney’s Bangkok Theme Park • Project duration is 50 years • Sell 50 year zero coupon bond BUT • Easier to match asset duration with liability duration (bank immunization again) • So you try and estimate the duration of the balance sheet (assets vs. liabilities) • Sell higher duration bonds to if assets duration greater than liabilities duration

10. Choosing Financing Instruments • Back to the original topic – choice of financing instruments • Floating Rate Bonds – If the cash flows are interest rate sensitive (go up with interest rate and fall with interest rate) tie the repayment schedule to the ups and downs of the cash flow • Coupon rate is tied to a benchmark rate such as LIBOR plus 250 basis points • Foreign Bonds or Hybrid Foreign Bonds • Borrow in country of project

11. Choosing Financing Instruments • Convertible Bonds • These will change the D/E structure • When company is doing good (rising stock prices) bondholders switch to stock • When company is not doing good (flat or falling stock prices) bondholders stay in bonds • Tax Angle • Advantage of debt is the tax shield • Does hybrid financing look more like equity? Could lose the tax shield • Tax rates also change over time…impacting the tax shield

12. Sensitivity to Macro Variables • Disney and Macro Economic Variables • Regressions on Interest Rate Changes • Δ Firm Value = 0.2081 – 4.16 (Δ rates) • But the coefficient has a t-stat of 0.75 • Regressions on GDP • Δ Firm Value = 0.2165 + 0.26 (Δ GDP) • But the coefficient has a t-stat of 0.07 • Regressions on Exchange Rates (weighted) • Δ Firm Value = 0.2060 – 2.05 (Δ FX rates) • and the coefficient has a t-stat of 2.52

13. Sensitivity to Macro Variables • Disney also can measure changes in operating income against macro variables • Looking at the regressions on pages 434 and 435 we see • Operating Income is significantly tied to changes in inflation…as inflation increases so does operating income • Coefficient is 9.27 with t-stat of 1.95 • What can Disney do given these regressions?

14. Conclusion • Many factors influence the choice of D/E • Finding the Optimal D/E is difficult because • Measurement tools are not very accurate on a company by company basis • Optimal D/E is a moving target • If finding Optimal D/E difficult • Caution is often used in moving to a new D/E • Firms may not move at all, move slowly, or try to capture the elusive extra firm value • Matching firm characteristics to financing is subjective but can be intuitive

15. Tuesday Homework • Problem #1 • Problem #2 • Problem #7 • Problem #8 • Problem #10 • Problem #13 • Problem #14