Ocean Drilling, Inc.

Competing Bids
France (in FRF)
96M USD (534.72M FRF)
24M USD Down Pmt (72M
USD (75%) Financed)
10 1/2% APR
8 Year Term
Equal Annual Principle
Payments

Japan (in JPY)

90M USD (20,443.5M JPY)
18 M USD Down Pmt (72M
USD (80%) Financed)
8 3/4% APR
10-Year Term
Equal Annual Principle
Payments

Differential Cash Flows

Down Payment
Depreciation Tax Shield
Below Market Loan Payments
Tax Effects of Loan Amortization

Cash Flow Diagram

Now
USD

Depreciation
Tax Shield

Down Payment

FRF or JPY

Future

Below Market
Loan Payments
Tax Effects of
Loan Amortization

Down Payment
Occurs now at time 0, so there is no discounting
Occurs in FRF or JPY, but USD can be converted
to FRF or JPY at spot market rates
France down payment = 24M USD
Japan down payment = 18M USD
Difference is 6M USD, to Japans advantage

Cash Flow Diagram

Now
USD

Depreciation
Tax Shield

Down Payment

FRF or JPY

Future

Below Market
Loan Payments
Tax Effects of
Loan Amortization

USD Discount Rate

WACC used to evaluate project: reflects
risks of project operating cash flows
Cost of debt used to evaluate debt
financing: reflects risks of debt-related cash
flows
? Before-Tax Cost of Debt = 20%
? After-Tax Cost of Debt = 10%
Assume Marginal Tax Rate = 50%

Depreciation Tax Shield - France

5-Year Depreciation: 15M, 21M, 20M,
20M, 20M
Total = 96M
Depreciation Tax Shield: 7.5M, 10.5M,
10M, 10M, 10M
NPV @ 20% = 28.17M
NPV @ 10% = 36.05M

Depreciation Tax Shield - Japan

5-Year Depreciation: 13M, 20M, 19M,
19M, 19M
Total = 90M
Depreciation Tax Shield: 6.5M, 10M, 9.5M,
9.5M, 9.5M
NPV @ 20% = 26.26M
NPV @ 10% = 33.70M

Depreciation Tax Shield

@ 20% discount rate, difference is 1.91M
USD, to Frances advantage
@ 10% discount rate, difference is 2.35M
USD, to Frances advantage
The more expensive the equipment, the
more valuable the depreciation tax shield

Cash Flow Diagram

Now
USD

Depreciation
Tax Shield

Down Payment

FRF or JPY

Future

Below Market
Loan Payments
Tax Effects of
Loan Amortization

Loan Payments - FRF

Time

0
1
2
3
4
5
6
7
8

Total Price

535.68

Down Payment

133.92

Loan

401.76

Principle
Payments
0
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22

Beginning
Balance

401.76
351.54
301.32
251.1
200.88
150.66
100.44
50.22

Interest

42.18
36.91
31.64
26.37
21.09
15.82
10.55
5.27

After-Tax
Interest

21.09
18.46
15.82
13.18
10.55
7.91
5.27
2.64

Net
Cash Flow

-71.31
-68.68
-66.04
-63.40
-60.77
-58.13
-55.49
-52.86

Loan Payments - JPY

Time

0
1
2
3
4
5
6
7
8
9
10

Total Price

20457

Down Payment

4091.4

Loan

16366

Principle
Payments
0
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56

Beginning
Balance

16365.60
14729.04
13092.48
11455.92
9819.36
8182.80
6546.24
4909.68
3273.12
1636.56

Interest

1431.99
1288.79
1145.59
1002.39
859.19
716.00
572.80
429.60
286.40
143.20

After-Tax
Interest

716.00
644.40
572.80
501.20
429.60
358.00
286.40
214.80
143.20
71.60

Net
Cash Flow

-2352.56
-2280.96
-2209.36
-2137.76
-2066.16
-1994.56
-1922.96
-1851.36
-1779.76
-1708.16

Expected Spot Rates

Forward Rates - Forward Parity
Interest Rates - International Fisher Effect
Expected Inflation Rates - Purchasing
Power Parity
Other

Forward Rates
Time
Spot
Midpoint

FRF

JPY

5.570/80 227.15/227.30
5.575
227.225

6-Month Midpoint
Premium/(Discount)

5.6775
-3.61%

219.9500
6.62%

12-Month Midpoint
Premium/(Discount)

5.7800
-3.55%

212.4000
6.98%

2-Year Midpoint
Premium/(Discount)

6.0300
-3.77%

197.2500
7.60%

5-Year Midpoint
No Quote
Premium/(Discount)

184.1500
4.68%

Interest Rate-Based Forecasts

USD

FRF

JPY

0.161

0.179

0.109

Factor

1.01550388

0.95521102

Spot
1
2
3
4
5
6
7
8
9
10

5.5750
5.6615
5.7493
5.8385
5.9291
6.0211
6.1145
6.2093
6.3057
6.4035
6.5028

227.2250
217.0478
207.3265
198.0405
189.1705
180.6977
172.6045
164.8737
157.4892
150.4354
143.6975

Long-Term
Interest Rates

Expected USD Loan Payments:

France Loan
Time

0
1
2
3
4
5
6
7
8

Net FRF
Cash Flow

-71.31
-68.68
-66.04
-63.40
-60.77
-58.13
-55.49
-52.86

Forecast
Spot Rate

5.66
5.75
5.84
5.93
6.02
6.11
6.21
6.31

Net USD
Cash Flow
72.00
-12.60
-11.95
-11.31
-10.69
-10.09
-9.51
-8.94
-8.38

Expected USD Loan Payments:

Japan Loan
Time

0
1
2
3
4
5
6
7
8
9
10

Net JPY
Cash Flow

-2352.56
-2280.96
-2209.36
-2137.76
-2066.16
-1994.56
-1922.96
-1851.36
-1779.76
-1708.16

Forecast
Spot Rate

217.05
207.33
198.04
189.17
180.70
172.60
164.87
157.49
150.44
143.70

Net USD
Cash Flow

72.00
-10.84
-11.00
-11.16
-11.30
-11.43
-11.56
-11.66
-11.76
-11.83
-11.89

Value of Discount Financing

Time

0
1
2
3
4
5
6
7
8
9
10

Net USD
Cash Flow
FRF Loan

Net USD
Cash Flow
JPY Loan

72.00
-12.60
-11.95
-11.31
-10.69
-10.09
-9.51
-8.94
-8.38

72.00
-10.84
-11.00
-11.16
-11.30
-11.43
-11.56
-11.66
-11.76
-11.83
-11.89

Discount Rate
NPV

20%
29.82

20%
24.75

Discount Rate
NPV

10%
14.75

10%
2.26

Discount Financing
@ 20% discount rate, difference is 5.07M USD, to
Frances advantage
@ 10% discount rate, difference is 12.48M USD,
to Frances advantage
The greater the difference between the market rate
and the loan rate, the greater the value of the
discount financing: France = 7.4% (17.9%10.5%); Japan = 2.15% (10.9% - 8.75%)
The higher the discount rate, the smaller the value
of the payments compared to the amount
borrowed

Cash Flow Diagram

Now
USD

Depreciation
Tax Shield

Down Payment

FRF or JPY

Future

Below Market
Loan Payments
Tax Effects of
Loan Amortization

Loan Amortization
The USD value of the loan will decline by the
same amount each year on the balance sheet
The amount by which the loan declines will not be
equal to the cash required to make the loan
payment: the FRF loan will require fewer USD
each year and the JPY loan will require more USD
each year
The gain (on the FRF loan) is taxable, and the loss
(on the JPY loan) provides a tax shield.

Loan Amortization: France

Time

0
1
2
3
4
5
6
7
8

Loan
Amortization
USD
0.00
-9.00
-9.00
-9.00
-9.00
-9.00
-9.00
-9.00
-9.00

Loan Principle
Payment
FRF
0.00
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22
-50.22

Expected
Spot Rates

5.5750
5.6615
5.7493
5.8385
5.9291
6.0211
6.1145
6.2093
6.3057

Loan Principle
Payment
USD

-8.87
-8.73
-8.60
-8.47
-8.34
-8.21
-8.09
-7.96

Foreign Exchange
Gain/Loss
USD

0.13
0.27
0.40
0.53
0.66
0.79
0.91
1.04

Tax Effect
USD

0.06
0.13
0.20
0.26
0.33
0.39
0.46
0.52

Loan Amortization: Japan

Time

0
1
2
3
4
5
6
7
8
9
10

Loan
Amortization
USD
0.00
-7.20
-7.20
-7.20
-7.20
-7.20
-7.20
-7.20
-7.20
-7.20
-7.20

Loan Principle
Payment
FRF
0.00
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56
-1636.56

Expected
Spot Rates

227.2250
217.0478
207.3265
198.0405
189.1705
180.6977
172.6045
164.8737
157.4892
150.4354
143.6975

Loan Principle
Payment
USD

-7.54
-7.89
-8.26
-8.65
-9.06
-9.48
-9.93
-10.39
-10.88
-11.39

Foreign Exchange
Gain/Loss
USD

-0.34
-0.69
-1.06
-1.45
-1.86
-2.28
-2.73
-3.19
-3.68
-4.19

Tax Effect
USD

-0.17
-0.35
-0.53
-0.73
-0.93
-1.14
-1.36
-1.60
-1.84
-2.09

Tax Effect of Loan Amortization

Time

0
1
2
3
4
5
6
7
8
9
10

Net USD
Cash Flow
FRF Loan

Net USD
Cash Flow
JPY Loan

0.06
0.13
0.20
0.26
0.33
0.39
0.46
0.52

-0.17
-0.35
-0.53
-0.73
-0.93
-1.14
-1.36
-1.60
-1.84
-2.09

Discount Rate
NPV

20%
0.90

20%
(3.24)

Discount Rate
NPV

10%
1.40

10%
(5.59)

Tax Effect of Loan Amortization

@ 20% discount rate, difference is 4.14M
USD, to Japans advantage
@ 10% discount rate, difference is 6.99M
USD, to Japans advantage
The stronger the foreign currency, the more
valuable the tax effect of loan amortization

Net Differential Value

>0: Advantage to France
<0: Advantage to Japan
Discount Rate

20%

10%

Down Payment

-6.00

-6.00

Depreciation Tax Shield

1.91

2.35

Below Market Loan Payments

5.07

12.48

Tax Effect of Loan Amortization

-4.14

-6.99

Total

-3.16

1.84

20% or 10% Discount Rate?

There are two benefits to below-market financing: reduced
after-tax interest and increased debt capacity
If the company can realize both benefits, the after-tax cost
of debt (10%) is the appropriate discount rate
If the company can not take advantage of the increased
debt capacity (as for Ocean Drilling), the before tax cost of
debt (20%) is the appropriate discount rate
With the shipyard financing, Ocean Drillings ratio of
senior debt to the sum of subordinated debt plus
shareholders equity will be 1.28 ((240+72)/(50+194)).
Their loan covenant requires it to be less than 1.25.

Financial Summary
The terms of the Japanese loan look better
The Japanese loan is 3.16M USD better
than the French loan using the correct 20%
(before-tax cost of debt) discount rate
The French loan is 1.84M USD better than
the Japanese loan using the more familiar
10% (after-tax cost of debt) discount rate

Practical Considerations
The difference between the loans is at best
3.5% (3.16M/90M) of the purchase price if
purchased in Japan (and only 1.9%
(1.84M/96M) of the purchase price if
purchased in France)
Because these differences are based on
uncertain estimates of future exchange
rates, they are not financially significant

Hedging
The firm faces substantial operating risk;
therefore, it should attempt to reduce financial risk
Forward Hedge: FRF forward rates are available
for only 2 years (25% of the life of the loan) and
JPY forward rates are available for only 5 years
(50% of the life of the loan)
Money Market Hedge: Ocean Drilling does not
have the debt capacity to use a money market
hedge
Swap: The appropriate hedging tool