Raising Capital Part 1: Debt

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1 Giddy Raising Capital: Debt /1 Raising Capital Part 1: Debt Prof. Ian Giddy New York University Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO CAPITAL M&A DEBT EQUITY MEASUREMENT TOOLS Copyright 2002 Ian H. Giddy Raising Capital: Debt 2

2 Giddy Raising Capital: Debt /2 Debt versus Equity Assets Uncertain value of of future cash flows Liabilities Debt Contractual int. int. & principal No No upside upside Senior Senior claims claims Control via via restrictions Equity Residual payments Upside Upside and and downside Residual claims claims Voting Voting control rights rights Copyright 2002 Ian H. Giddy Raising Capital: Debt 3 Getting the Financing Right Step 1: The Proportion of Equity & Debt Debt Equity Achieve lowest weighted average cost of capital May also affect the business side Copyright 2002 Ian H. Giddy Raising Capital: Debt 4

3 Giddy Raising Capital: Debt /3 Getting the Financing Right Step 2: The Kind of Equity & Debt Debt Equity Short Short term? term? Long Long term? term? Baht? Baht? Dollar? Dollar? Yen? Yen? Bonds? Bonds? Asset-backed? Asset-backed? Convertibles? Convertibles? Hybrids? Hybrids? Debt/Equity Debt/Equity Swaps? Swaps? Private? Private? Public? Public? Strategic Strategic partner? partner? Domestic? Domestic? ADRs? ADRs? Ownership Ownership & control? control? Copyright 2002 Ian H. Giddy Raising Capital: Debt 5 Costs and Benefits of Debt Benefits of Debt Tax Benefits Adds discipline to management Costs of Debt Bankruptcy Costs Agency Costs Loss of Future Flexibility Copyright 2002 Ian H. Giddy Raising Capital: Debt 6

4 Giddy Raising Capital: Debt /4 Tax Benefits of Debt Tax Benefits: Interest on debt is tax deductible whereas cash flows on equity (like dividends) are not. Tax benefit each year = t r B After tax interest rate of debt = (1-t) r Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure. Copyright 2002 Ian H. Giddy Raising Capital: Debt 7 Debt Adds Discipline to Management Equity is a cushion; Debt is a sword; The management of firms which have high cash flows left over each year are more likely to be complacent and inefficient. Copyright 2002 Ian H. Giddy Raising Capital: Debt 8

5 Giddy Raising Capital: Debt /5 Bankruptcy Cost The expected bankruptcy cost is a function of two variables-- the cost of going bankrupt direct costs: Legal and other Deadweight Costs indirect costs: Lost Sales... durable versus non-durable goods (cars) quality/safety is important (airlines) supplementary services (copiers) the probability of bankruptcy Copyright 2002 Ian H. Giddy Raising Capital: Debt 9 The Bankruptcy Cost Proposition Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cash flows of the firm, the less debt the firm can afford to use. Copyright 2002 Ian H. Giddy Raising Capital: Debt 10

6 Giddy Raising Capital: Debt /6 Agency Cost: Lenders Rights Stockholders incentives are different from bondholder incentives Taking on risky projects Withholding information Paying large dividends Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use. Copyright 2002 Ian H. Giddy Raising Capital: Debt 11 Loss of Future Financing Flexibility When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. Copyright 2002 Ian H. Giddy Raising Capital: Debt 12

7 Giddy Raising Capital: Debt /7 Debt Financing Techniques Prof. Ian Giddy New York University The International Capital Market International bank financing Eurobonds, foreign bonds and global bonds Bond ratings Eurobond issuance Copyright 2002 Ian H. Giddy Raising Capital: Debt 14

8 Giddy Raising Capital: Debt /8 Short-Term Financing: Evolution DIRECT COMMERCIAL PAPER ENHANCED BANK L/Cs INTERMEDIATED BANK LOANS Copyright 2002 Ian H. Giddy Raising Capital: Debt 15 Alternative Sources of Short-Term Financing FINANCING DOMESTIC LOANS EUROMARKET LOANS SYNDICATED EUROCREDITS NOTE ISSUANCE FACILITIES EUROCOMMERCIAL PAPER DEBT EQUITY Copyright 2002 Ian H. Giddy Raising Capital: Debt 20

9 Giddy Raising Capital: Debt /9 Alternative Sources of Long-Term Financing FINANCING Bank credits - syndicated DEBT lending and facilities Bonds Domestic, foreign, Euro Public, private Structured, such as principle-indexed notes Medium-term notes Asset-backed financing and leasing Project financing EQUITY Copyright 2002 Ian H. Giddy Raising Capital: Debt 21 Long-Term Financing: Evolution DIRECT PUBLIC BONDS ENHANCED BANK-GUARANTEED BONDS INTERMEDIATED BANK TERM LOANS Copyright 2002 Ian H. Giddy Raising Capital: Debt 22

10 Giddy Raising Capital: Debt /10 The Global Bond Market Domestic bonds Foreign bond (Issued within country of currency, by nonresident issuers) Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) Global Bonds (Issued in the domestic and the Eurobond markets simultaneously) Copyright 2002 Ian H. Giddy Raising Capital: Debt 23 The Global Bond Market Domestic bonds Foreign bond (Issued within country of currency, by nonresident issuers) Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) Global Bonds (Issued in the domestic and the Eurobond markets simultaneously) Copyright 2002 Ian H. Giddy Raising Capital: Debt 24

11 Giddy Raising Capital: Debt /11 International Bond Markets are Linked Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY Domestic US - Gov't - Corporate Foreign Bonds "Yankee" Domestic Japanese - Gov't - Corporate Foreign Bonds "Samurai" BOND MARKETS OUTSIDE COUNTRY OF CURRENCY Eurodollar Bond Market Currency Swaps Long-dated Forward Exchange Euroyen Bond Market Copyright 2002 Ian H. Giddy Raising Capital: Debt 25 Foreign Bonds A foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower The three largest foreign bond markets are Japan, Switzerland, and the U.S., representing issuance of about $40 billion in bonds annually Copyright 2002 Ian H. Giddy Raising Capital: Debt 26

12 Giddy Raising Capital: Debt /12 Private Placements and Rule 144A The private placement exemption from registration and disclosure is extended to Eurobonds as long as the U.S. investors meet the following requirements: They are large and sophisticated There are only a few investors They have access to information and analysis similar to that which would ordinarily be contained in a registered offering prospectus They are capable of sustaining the risk of losses, and They intend to purchase the bonds for their own investment portfolios, and not for resale. Copyright 2002 Ian H. Giddy Raising Capital: Debt 27 Characteristics of Eurobonds Issued outside country of currency Not subject to domestic registration or disclosure requirements In most cases take form of private placements Placed through syndicates in many countries who sell principally to nonresidents Bonds are structured so as to be free of withholding tax Bearer form But... Eurobonds usually influenced de facto by government and banks of country of currency Copyright 2002 Ian H. Giddy Raising Capital: Debt 28

13 Giddy Raising Capital: Debt /13 Pricing Bonds: The Yield Curve bondsonline.com Copyright 2002 Ian H. Giddy Raising Capital: Debt 29 Benchmark Bonds Copyright 2002 Ian H. Giddy Raising Capital: Debt 30

14 Giddy Raising Capital: Debt /14 Corporate Bonds: Spread over Benchmark Copyright 2002 Ian H. Giddy Raising Capital: Debt 31 Bond Credit Ratings Moody s Aaa Aa A Baa Ba B Caa Ca C Standard & Poor s AAA AA A BBB BB B CCC CC C D Interpretation High-quality debt instruments Strong to adequate ability to pay principal and interest Ability to pay interest and principal speculative In default Copyright 2002 Ian H. Giddy Raising Capital: Debt 32

15 Giddy Raising Capital: Debt /15 Rating Criteria Profitability Capital Structure Business Model Management Quality of earnings Ebitda margins Interest coverage indicators Volatility of earnings Cost Managemen t Indebtedness ratios Distribution of debt maturities Effects of concentrated ownership on funding capabilities Barriers to entry Management Competitive environment Market position Diversification: Clients, Products, Geographic Structure Strategy and Objectives Performance Record Copyright 2002 Ian H. Giddy Raising Capital: Debt 33 Rating Process Issuer/Banker Requests rating List information requirements Due diligence & Meeting with management Pool credit analysis Legal analysis Stress testing Credit enhancement negotiation Deal documentation Rating committee Presale report Final report Surveillance Copyright 2002 Ian H. Giddy Raising Capital: Debt 34

16 Giddy Raising Capital: Debt /16 Ratings and Spreads Corporate bond spreads: basis points over Treasury curve Rating 1 year 2 year 3 year 5 year 7 year 10 year 30 year Aaa/AAA Aa1/AA Aa2/AA Aa3/AA A1/A A2/A A3/A Baa1/BBB Baa2/BBB Baa3/BBB Ba1/BB Ba2/BB Ba3/BB B1/B B2/B B3/B Caa/CCC Copyright 2002 Ian H. Giddy Raising Capital: Debt 35 Protection Against Default: Examples Collateral Covenants Subordination of future debt Dividend restrictions Sinking funds Copyright 2002 Ian H. Giddy Raising Capital: Debt 36

17 Giddy Raising Capital: Debt /17 Global Bonds Copyright 2002 Ian H. Giddy Raising Capital: Debt 37 Key Dates in the Issuance of a Eurobond Issuance need or opportunity identified Issuer discusses deal with lead manager Announcement of Eurobond issue Syndicate formed, bonds "presold" prior to final terms Offering day: Eurobond issued Final terms, bonds sold by selling group to investors Closing day: Eurobonds delivered, Issuer gets money Copyright 2002 Ian H. Giddy Raising Capital: Debt 38

18 Giddy Raising Capital: Debt /18 Issuing a Bond: Key Players in the Issuance of a Eurobond SELLING GROUP UNDER- WRITERS MANAGERS Copyright 2002 Ian H. Giddy Raising Capital: Debt 39 Underwriting Economics Management Fee 20% Management Fee: Normally shared equally among managers (may be subject to a praecipium for Global Coordinator or Lead Manager) Underwriting Fee 20% Underwriting Fee: Based on underwriting commitment (often less expenses of offering) Selling Concession 60% Selling Concession: Payable as a percentage of allocation (determined by book-runner) Copyright 2002 Ian H. Giddy Raising Capital: Debt 40

19 Giddy Raising Capital: Debt /19 Application A Day in the Life of the Eurobond Market Examine the deals Which were structured financing? Why were each done in that particular form? What determines the pricing? What is the effective cost of financing to the different companies? Copyright 2002 Ian H. Giddy Raising Capital: Debt 42

20 Giddy Raising Capital: Debt /20 A Day in the Life... Copyright 2002 Ian H. Giddy Raising Capital: Debt 43 Equity-Linked Eurobonds Convertible Eurobonds Korea Tobacco Eurobonds with warrants Keppel Index-linked Eurobonds Credit Agricole Indosuez Copyright 2002 Ian H. Giddy Raising Capital: Debt 44

21 Giddy Raising Capital: Debt /21 Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO CAPITAL M&A DEBT EQUITY MEASUREMENT TOOLS Copyright 2002 Ian H. Giddy Raising Capital: Debt 45 Ian Giddy NYU Stern School of Business Tel ; Fax Copyright 2002 Ian H. Giddy Raising Capital: Debt 46

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