THE

RIGHT FINANCING
The perfect nancing for you. Yes, It exists!

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

Designing Debt: The Fundamental

Principle

The objecIve in designing debt is to make the cash ows on

debt match up as closely as possible with the cash ows that
the rm makes on its assets.
By doing so, we reduce our risk of default, increase debt
capacity and increase rm value.
Unmatched Debt

Matched Debt

Firm Value

Firm Value

Value of Debt

Value of Debt

Design the perfect nancing instrument

The perfect nancing instrument will

Have all of the tax advantages of debt
While preserving the exibility oered by equity
Start with the
Cash Flows
on Assets/
Projects

Define Debt
Characteristics

Duration

Duration/
Maturity

Currency

Effect of Inflation
Uncertainty about Future

Currency
Mix

Fixed vs. Floating Rate

* More floating rate
- if CF move with
inflation
- with greater uncertainty
on future

Growth Patterns

Straight versus
Convertible
- Convertible if
cash flows low
now but high
exp. growth

Cyclicality &
Other Effects

Special Features
on Debt
- Options to make
cash flows on debt
match cash flows
on assets

Commodity Bonds
Catastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

Ensuring that you have not crossed the line

drawn by the tax code
All of this design work is lost, however, if the
security that you have designed does not deliver the
tax benets.
In addiIon, there may be a trade o between
mismatching debt and geRng greater tax benets.

Overlay tax
preferences

Deductibility of cash flows

for tax purposes

Differences in tax rates

across different locales

Zero Coupons

If tax advantages are large enough, you might override results of previous step

While keeping equity research analysts, raIngs

agencies and regulators applauding

RaIngs agencies want companies to issue equity, since it

makes them safer.
Equity research analysts want them not to issue equity
because it dilutes earnings per share.
Regulatory authoriIes want to ensure that you meet their
requirements in terms of capital raIos (usually book value).
Financing that leaves all three groups happy is nirvana.

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

Operating Leases
MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?

Debt or Equity: The Strange Case of Trust

Preferred

Trust preferred stock has

A xed dividend payment, specied at the Ime of the issue

That is tax deducIble
And failing to make the payment can give preferred stockholders voIng
rights.

When trust preferred was rst created, raIngs agencies treated it

as equity. As they have become more savvy, raIngs agencies have
started giving rms only parIal equity credit for trust preferred.
Assuming that trust preferred stock gets treated as equity by
raIngs agencies, which of the following rms is the most
appropriate rm to be issuing it?
a.
b.

A rm that is under levered, but has a raIng constraint that would be

violated if it moved to its opImal
A rm that is over levered that is unable to issue debt because of the
raIng agency concerns.
7

Soothe bondholder fears

There are some rms that face skepIcism from bondholders when they
go out to raise debt, because
Of their past history of defaults or other acIons
They are small rms without any borrowing history
Bondholders tend to demand much higher interest rates from these rms
to reect these concerns.

Factor in agency
conflicts between stock
and bond holders

Observability of Cash Flows

by 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

If agency problems are substantial, consider issuing convertible bonds

Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LYONs

And do not lock in market mistakes that work

against you

RaIngs agencies can someImes under rate a rm, and

markets can underprice a rms stock or bonds. If this
occurs, rms should not lock in these mistakes by issuing
securiIes for the long term. In parIcular,
Issuing equity or equity based products (including converIbles),
when equity is under priced transfers wealth from exisIng
stockholders to the new stockholders
Issuing long term debt when a rm is under rated locks in rates
at levels that are far too high, given the rms default risk.

What is the soluIon

if you need to use equity?
if you need to use debt?

Designing Disneys Debt

Business

Project Cash Flow Characteristics

Movie projects are likely to
Be short-term
Have cash outflows primarily in dollars (because Disney makes most of its
movies in the U.S.), but cash inflows could have a substantial foreign currency
component (because of overseas revenues)
Have net cash flows that are heavily driven by whether the movie is a hit, which
is often difficult to predict

Type of Financing
Debt should be
Studio
1. Short-term
2. Primarily dollar
entertainment
debt.Mixed currency
debt, reflecting audience
make-up.
3. If possible, tied to the
success of movies.
Media networks Projects are likely to be
Debt should be
1. Short-term
1. Short-term
2. Primarily in dollars, though foreign component is growing, especially for ESPN. 2. Primarily dollar debt
3. Driven by advertising revenues and show success (Nielsen ratings)
3. If possible, linked to
network ratings
Park resorts
Projects are likely to be
Debt should be
1. Very long-term
1. Long-term
2. Currency will be a function of the region (rather than country) where park is 2. Mix of currencies, based
located.
on tourist makeup at the
3. Affected by success of studio entertainment and media networks divisions
park.
Consumer
products

Projects are likely to be short- to medium-term and linked to the success of the
movie division; most of Disneys product offerings and licensing revenues are
derived from their movie productions
Projects are likely to be short-term, with high growth potential and significant risk.
While cash flows will initially be primarily in US dollars, the mix of currencies will
shift as the business ages.

Interactive

Debt should be
1. Medium-term
2. Dollar debt
Debt should be short-term,
convertible US dollar debt.

10

RecommendaIons for Disney

The debt issued should be long term and should have duraIon of about 4
to 5 years.
A signicant porIon of the debt should be oaIng rate debt, reecIng
Disneys capacity to pass inaIon through to its customers and the fact
that operaIng income tends to increase as interest rates go up.
Given Disneys sensiIvity to a stronger dollar, a porIon of the debt
should be in foreign currencies. The specic currency used and the
magnitude of the foreign currency debt should reect where Disney
makes its revenues. Based upon 2013 numbers at least, this would
indicate that about 18% of its debt should be foreign currency debt. As its
broadcasIng businesses expand into LaIn America, it may want to
consider using either Mexican Peso or Brazilian Real debt as well.

11

Analyzing Disneys Current Debt

Disney has $14.3 billion in interest-bearing debt with a face-value weighted

average maturity of 7.92 years. Allowing for the fact that the maturity of debt is
higher than the duraIon, this would indicate that Disneys debt may be a lihle
longer than would be opImal, but not by much.
Of the debt, about 5.49% of the debt is in non-US dollar currencies (Indian rupees
and Hong Kong dollars), but the rest is in US dollars and the company has no Euro
debt. Based on our analysis, we would suggest that Disney increase its proporIon
of Euro debt to about 12% and Ie the choice of currency on future debt issues to
its expansion plans.
Disney has no converIble debt and about 5.67% of its debt is oaIng rate debt,
which looks low, given the companys pricing power. While the mix of debt in
2013 may be reecIve of a desire to lock in low long-term interest rates on debt,
as rates rise, the company should consider expanding its use of foreign currency
debt.

12

AdjusIng Debt at Disney

It can swap some of its exisIng xed rate, dollar debt for
oaIng rate, foreign currency debt. Given Disneys
standing in nancial markets and its large market
capitalizaIon, this should not be dicult to do.
If Disney is planning new debt issues, either to get to a
higher debt raIo or to fund new investments, it can use
primarily oaIng rate, foreign currency debt to fund
these new investments. Although it may be mismatching
the funding on these investments, its debt matching will
become beher at the company level.

13

Debt Design for Bookscape & Vale

Bookscape: Given Bookscapes dependence on revenues at its New York

bookstore, we would design the debt to be
RecommendaIon: Long-term, dollar denominated, xed rate debt
Actual: Long term operaIng lease on the store
Vale: Vales mines are spread around the world, and it generates a large
porIon of its revenues in China (37%). Its mines typically have very long lives
and require large up-front investments, and the costs are usually in the local
currencies but its revenues are in US dollars.

RecommendaIon: Long term, dollar-denominated debt (with hedging of local

currency risk exposure) and if possible, Ied to commodity prices.
Actual: The exisIng debt at Vale is primarily US dollar debt (65.48%), with an
average maturity of 14.70 years. All of the debt, as far as we can assess, is xed
rate and there is no commodity-linked debt.

14

And for Tata Motors and Baidu

Tata Motors: As an manufacturing rm, with big chunks of its of its revenues
coming from India and China (about 24% apiece) and the rest spread across
developed markets.

RecommendaIon: Medium to long term, xed rate debt in a mix of currencies reecIng
operaIons.
Actual: The exisIng debt at Tata Motors is a mix of Indian rupee debt (about 71%) and Euro
debt (about 29%), with an average maturity of 5.33 years and it is almost enIrely xed rate
debt.

Baidu: Baidu has relaIvely lihle debt at the moment, reecIng its status as a
young, technology company.

RecommendaIon: ConverIble, Chinese Yuan debt.

Actual: About 82% of Baidus debt is in US dollars and Euros currently, with an average
maturity of 5.80 years. A small porIon is oaIng rate debt, but very lihle of the debt is
converIble.

15

6 ApplicaIon Test: Choosing your Financing

Type

Based upon the business that your rm is in, and the

typical investments that it makes, what kind of
nancing would you expect your rm to use in terms
of
a.
b.
c.
d.

DuraIon (long term or short term)

Currency
Fixed or FloaIng rate
Straight or ConverIble

16

Task
Determine the
right type of
nancing for
your rm, given
its characterisIcs

17

Read
Chapter 9