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

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