Designing the Perfect Debt

Aswath Damodaran

Designing Debt: The Fundamental Principle

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The objective 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.

Aswath Damodaran

Firm with mismatched debt

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Firm with matched Debt

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Design the perfect nancing instrument

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The perfect nancing instrument will

Have all of the tax advantages of debt While preserving the exibility offered by equity

Start with the Cash Flows on Assets/ Projects

Duration

Currency

Effect of Inflation Uncertainty about Future

Growth Patterns

Cyclicality & Other Effects

Define Debt Characteristics

Duration/ Maturity

Currency Mix

Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future

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

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

Aswath Damodaran

Ensuring that you have not crossed the line drawn by the tax code
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All of this design work is lost, however, if the security that you have designed does not deliver the tax benets. In addition, there may be a trade off between mismatching debt and getting 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

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While keeping equity research analysts, ratings agencies and regulators applauding
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Ratings 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 authorities want to ensure that you meet their requirements in terms of capital ratios (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?

Aswath Damodaran

Debt or Equity: The Strange Case of Trust Preferred

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Trust preferred stock has

A xed dividend payment, specied at the time of the issue That is tax deductible And failing to make the payment can cause ? (Can it cause default?)

When trust preferred was rst created, ratings agencies treated it as equity. As they have become more savvy, ratings agencies have started giving rms only partial equity credit for trust preferred.

Aswath Damodaran

Debt, Equity and Quasi Equity

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Assuming that trust preferred stock gets treated as equity by ratings agencies, which of the following rms is the most appropriate rm to be issuing it? A rm that is under levered, but has a rating constraint that would be violated if it moved to its optimal A rm that is over levered that is unable to issue debt because of the rating agency concerns.

Aswath Damodaran

Soothe bondholder fears

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There are some rms that face skepticism from bondholders when they go out to raise debt, because
Of their past history of defaults or other actions They are small rms without any borrowing history

Bondholders tend to demand much higher interest rates from these rms to reect these concerns.
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 Convertibiles Puttable Bonds Rating Sensitive Notes LYONs

Factor in agency conflicts between stock and bond holders

If agency problems are substantial, consider issuing convertible bonds

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And do not lock in market mistakes that work against you

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Ratings agencies can sometimes under rate a rm, and markets can under price a rms stock or bonds. If this occurs, rms should not lock in these mistakes by issuing securities for the long term. In particular,
Issuing equity or equity based products (including convertibles), when equity is under priced transfers wealth from existing 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. If you need to use equity? If you need to use debt?

What is the solution

Aswath Damodaran

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Designing Debt: Bringing it all together

Start with the

Cash Flows on Assets/ Projects

Duration

Currency

Effect of Ination Uncertainty about Future

Growth Patterns

Cyclicality & Other Effects

Dene Debt Characteristics

Duration/ Maturity

Currency Mix

Fixed vs. Floating Rate * More oating rate - if CF move with ination - with greater uncertainty on future

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

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

Commodity Bonds Catastrophe Notes

Design debt to have cash ows that match up to cash ows on the assets nanced Deductibility of cash ows for tax purposes Differences in tax rates across different locales

Overlay tax preferences Consider ratings agency & analyst concerns

Zero Coupons

If tax advantages are large enough, you might override results of previous step 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? Observability of Cash Flows by Lenders - Less observable cash ows lead to more conicts Type of Assets nanced - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing Convertibiles Puttable Bonds Rating Sensitive Notes LYONs

Factor in agency conicts between stock and bond holders Consider Information Asymmetries Aswath Damodaran

If agency problems are substantial, consider issuing convertible bonds Uncertainty about Future Cashows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt

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Approaches for evaluating Asset Cash Flows

I. Intuitive Approach
Are the projects typically long term or short term? What is the cash ow pattern on projects? How much growth potential does the rm have relative to current projects? How cyclical are the cash ows? What specic factors determine the cash ows on projects? Project cash ows on a typical project for the rm Do scenario analyses on these cash ows, based upon different macro economic scenarios Operating Cash Flows Firm Value

II. Project Cash Flow Approach

III. Historical Data

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I. Intuitive Approach - Disney

Business Movies

Broadcasting

Project Cash Flow Characteristics Projects are likely to 1. Be short term 2. Have cash outflows primarily in dollars (since Disney makes most of its movies in the U.S.) but cash inflows could have a substantial foreign currency component (because of overseas sales) 3. Have net cash flows that are heavily driven by whether the movie is a hit, which is often difficult to predict. Projects are likely to be 1. Short term 2. Primarily in dollars, though foreign component is growing 3. Driven by advertising revenues and show success

Type of Financing Debt should be 1. Short term 2. Primarily dollar debt. 3. If possible, tied to the success of movies. (Lion King or Nemo Bonds)

Theme Parks

Consumer Products

Debt should be 1. Short term 2. Primarily dollar debt 3. If possible, linked to network ratings. Projects are likely to be Debt should be 1. Very long term 1. Long term 2. Primarily in dollars, but a significant proportion of revenues come 2. Mix of currencies, based upon from foreign tourists, who are likely to stay away if the dollar tourist make up. strengthens 3. Affected by success of movie and broadcasting divisions. Projects are likely to be short to medium term and linked to the success of Debt should be the movie division. M ost of Disneys product offerings are derived from a. Medium term their movie productions. b. Dollar debt.

Aswath Damodaran

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! Application Test: Choosing your Financing Type

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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
Duration (long term or short term) Currency Fixed or Floating rate Straight or Convertible

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II. Project Specic Financing

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With project specic nancing, you match the nancing choices to the project being funded. The benet is that the the debt is truly customized to the project. Project specic nancing makes the most sense when you have a few large, independent projects to be nanced. It becomes both impractical and costly when rms have portfolios of projects with interdependent cashows.

Aswath Damodaran

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Duration of Disney Theme Park

Year Annual Cashflow Terminal Value Present Value Present value *t 0 -$2,000 -$2,000 $0 1 -$1,000 -$904 -$904 2 -$833 -$680 -$1,361 3 -$224 -$165 -$496 4 $417 $278 $1,112 5 $559 $337 $1,684 6 $614 $334 $2,006 7 $658 $324 $2,265 8 $726 $323 $2,582 9 $802 $322 $2,899 10 $837 $9,857 $3,882 $38,821 $2,050 $48,609 Duration = 48609/2050 = 23.71 years

Aswath Damodaran

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The perfect theme park debt

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The perfect debt for this theme park would have a duration of roughly 23.71 years and be in a mix of Asian currencies, reecting where the visitors to the park are coming from. If possible, you would tie the interest payments on the debt to the number of visitors at the park.

Aswath Damodaran

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III. Firm-wide nancing

Rather than look at individual projects, you could consider the rm to be a portfolio of projects. The rms past history should then provide clues as to what type of debt makes the most sense. In particular, you can look at
1. Operating Cash Flows
l The question of how sensitive a rms asset cash ows are to a variety of factors, such as interest rates, ination, currency rates and the economy, can be directly tested by regressing changes in the operating income against changes in these variables. This analysis is useful in determining the coupon/interest payment structure of the debt. The rm value is clearly a function of the level of operating income, but it also incorporates other factors such as expected growth & cost of capital. The rm value analysis is useful in determining the overall structure of the debt, particularly maturity.

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2. Firm Value

Aswath Damodaran

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Disney: Historical Data

Period 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 Operating Income $2,713 $2,384 $2,832 $2,525 $3,580 $3,843 $3,945 $3,024 $2,262 $1,804 $1,560 $1,287 $1,004 $1,287 $1,109 $789 $707 $281 $206 $143 $134 $141 Firm value $68,239 $53,708 $45,030 $47,717 $88,558 $65,487 $64,236 $65,489 $54,972 $33,071 $22,694 $25,048 $17,122 $14,963 $16,015 $9,195 $8,371 $5,631 $3,655 $2,024 $1,817 $2,108

Aswath Damodaran

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The Macroeconomic Data

Period T.Bond Rate Change in rate GDP (Deflated) % Chg in GDP 2003 4.29% 0.40% 10493 3.60% 2002 3.87% -0.82% 10128 2.98% 2001 4.73% -1.20% 9835 -0.02% 2000 6.00% 0.30% 9837 3.53% 1999 5.68% -0.21% 9502 4.43% 1998 5.90% -0.19% 9099 3.70% 1997 6.10% -0.56% 8774 4.79% 1996 6.70% 0.49% 8373 3.97% 1995 6.18% -1.32% 8053 2.46% 1994 7.60% 2.11% 7860 4.30% 1993 5.38% -0.91% 7536 2.25% 1992 6.35% -1.01% 7370 3.50% 1991 7.44% -1.24% 7121 -0.14% 1990 8.79% 0.47% 7131 1.68% 1989 8.28% -0.60% 7013 3.76% 1988 8.93% -0.60% 6759 4.10% 1987 9.59% 2.02% 6493 3.19% 1986 7.42% -2.58% 6292 3.11% 1985 10.27% -1.11% 6102 3.39% 1984 11.51% -0.26% 5902 4.18% 1983 11.80% 1.20% 5665 6.72% 1982 10.47% -3.08% 5308 -1.61% CPI Change in CPI Weighted Dollar % Change in $ 2.04% 0.01% 88.82 -14.51% 2.03% -0.10% 103.9 -3.47% 2.13% -1.27% 107.64 1.85% 3.44% 0.86% 105.68 11.51% 2.56% 1.05% 94.77 -0.59% 1.49% -0.65% 95.33 0.95% 2.15% -0.82% 94.43 7.54% 2.99% 0.18% 87.81 4.36% 2.81% 0.19% 84.14 -1.07% 2.61% -0.14% 85.05 -5.38% 2.75% -0.44% 89.89 4.26% 3.20% 0.27% 86.22 -2.31% 2.92% -3.17% 88.26 4.55% 6.29% 1.72% 84.42 -11.23% 4.49% 0.23% 95.10 4.17% 4.25% -0.36% 91.29 -5.34% 4.63% 3.11% 96.44 -8.59% 1.47% -1.70% 105.50 -15.30% 3.23% -0.64% 124.56 -10.36% 3.90% -0.05% 138.96 8.01% 3.95% -0.05% 128.65 4.47% 4% -4.50% 123.14 6.48%

Aswath Damodaran

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I. Sensitivity to Interest Rate Changes

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How sensitive is the rms value and operating income to changes in the level of interest rates? The answer to this question is important because it
it provides a measure of the duration of the rms projects it provides insight into whether the rm should be using xed or oating rate debt.

Aswath Damodaran

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Firm Value versus Interest Rate Changes

Regressing changes in rm value against changes in interest rates over this period yields the following regression Change in Firm Value = 0.2081 - 4.16 (Change in Interest Rates) (2.91) (0.75) T statistics are in brackets. The coefcient on the regression (-4.16) measures how much the value of Disney as a rm changes for a unit change in interest rates.

Aswath Damodaran

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Why the coefcient on the regression is duration..

The duration of a straight bond or loan issued by a company can be written in terms of the coupons (interest payments) on the bond (loan) and the face value of the bond to be
"t = N t * Coupon t + N * Face Value $ t (1 + r) (1 + r) N $ dP/P # Duration of Bond = = t =1 t =N dr/r " Coupont Face Value % $ ' t + (1 + r) N ' $ # t =1 (1 + r) &

% ' ' &

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The duration of a bond measures how much the price of the bond changes for a unit change in interest rates. Holding other factors constant, the duration of a bond will increase with the maturity of the bond, and decrease with the coupon rate on the bond.

Aswath Damodaran

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Duration: Comparing Approaches

!P/!r= Percentage Change in Value for a percentage change in Interest Rates

Traditional Duration Measures

Regression: !P = a + b (!r)

Uses: 1. Projected Cash Flows Assumes: 1. Cash Flows are unaffected by changes in interest rates 2. Changes in interest rates are small.

Uses: 1. Historical data on changes in firm value (market) and interest rates Assumes: 1. Past project cash flows are similar to future project cash flows. 2. Relationship between cash flows and interest rates is stable. 3. Changes in market value reflect changes in the value of the firm.

Aswath Damodaran

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Operating Income versus Interest Rates

Regressing changes in operating cash ow against changes in interest rates over this period yields the following regression
Change in Operating Income = 0.2189 + 6.59 (Change in Interest Rates) (2.74) (1.06) Conclusion: Disneys operating income,un like its rm value, has moved with interest rates.

Generally speaking, the operating cash ows are smoothed out more than the value and hence will exhibit lower duration that the rm value.

Aswath Damodaran

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II. Sensitivity to Changes in GDP/ GNP

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How sensitive is the rms value and operating income to changes in the GNP/GDP? The answer to this question is important because
it provides insight into whether the rms cash ows are cyclical and whether the cash ows on the rms debt should be designed to protect against cyclical factors.

If the cash ows and rm value are sensitive to movements in the economy, the rm will either have to issue less debt overall, or add special features to the debt to tie cash ows on the debt to the rms cash ows.

Aswath Damodaran

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Regression Results

Regressing changes in rm value against changes in the GDP over this period yields the following regression
Change in Firm Value = 0.2165 + 0.26 (GDP Growth) (1.56) (0.07) Conclusion: Disney is not very sensitive to economic growth

Regressing changes in operating cash ow against changes in GDP over this period yields the following regression Change in Operating Income = 0.1725 + 0.66 (GDP Growth) (1.10) (0.15)
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Conclusion: Disneys operating income is not sensitive to economic growth either.

Aswath Damodaran

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III. Sensitivity to Currency Changes

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How sensitive is the rms value and operating income to changes in exchange rates? The answer to this question is important, because
it provides a measure of how sensitive cash ows and rm value are to changes in the currency it provides guidance on whether the rm should issue debt in another currency that it may be exposed to.

If cash ows and rm value are sensitive to changes in the dollar, the rm should
gure out which currency its cash ows are in; and issued some debt in that currency

Aswath Damodaran

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Regression Results

Regressing changes in rm value against changes in the dollar over this period yields the following regression
Change in Firm Value = 0.2060 -2.04 (Change in Dollar) (3.40) (2.52) Conclusion: Disneys value is sensitive to exchange rate changes, decreasing as the dollar strengthens.

Regressing changes in operating cash ow against changes in the dollar over this period yields the following regression
Change in Operating Income = 0.1768 -1.76( Change in Dollar) (2.42) (1.81) Conclusion: Disneys operating income is also impacted by the dollar. A stronger dollar seems to hurt operating income.

Aswath Damodaran

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IV. Sensitivity to Ination

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How sensitive is the rms value and operating income to changes in the ination rate? The answer to this question is important, because
it provides a measure of whether cash ows are positively or negatively impacted by ination. it then helps in the design of debt; whether the debt should be xed or oating rate debt.

If cash ows move with ination, increasing (decreasing) as ination increases (decreases), the debt should have a larger oating rate component.

Aswath Damodaran

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Regression Results

Regressing changes in rm value against changes in ination over this period yields the following regression
Change in Firm Value = 0.2262 + 0.57 (Change in Ination Rate) (3.22) (0.13) Conclusion: Disneys rm value does not seem to be affected too much by changes in the ination rate.

Regressing changes in operating cash ow against changes in ination over this period yields the following regression
Change in Operating Income = 0.2192 +9.27 ( Change in Ination Rate) (3.01) (1.95) Conclusion: Disneys operating income seems to increase in periods when ination increases. However, this increase in operating income seems to be offset by the increase in discount rates leading to a much more muted effect on value.

Aswath Damodaran

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Summarizing
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Looking at the four macroeconomic regressions, we would conclude that

Disneys assets have a duration of 4.17 years Disney is not a cyclical rm Disney is hurt by a stronger dollar Disneys operating income tends to move with ination

All of the regression coefcients have substantial standard errors associated with them. One way to reduce the error (a la bottom up betas) is to use sectorwide averages for each of the coefcients.

Aswath Damodaran

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Bottom-up Estimates

Coefficients on firm value regression Interest Rate s GDP Growth Movie s Theme Parks Broadcasting Consumer Products Disney -3.70 -6.47 -4.50 -4.88 -4.71 0.56 0.22 0.70 0.13 0.54 Inflation Currency 1.41 -1.45 -3.05 -5.51 -1.71 -1.23 -3.21 -1.58 -3.01 -1.89 Disney Weights 25.62% 20.09% 49.25% 5.04% 100%

Aswath Damodaran

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Recommendations for Disney

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The debt issued should be long term and should have duration of between 4 and 5 years. A signicant portion of the debt should be oating rate debt, reecting Disneys capacity to pass ination through to its customers and the fact that operating income tends to increase as interest rates go up. Given Disneys sensitivity to a stronger dollar, a portion 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 2003 numbers at least, this would indicate that about 20% of the debt should be in Euros and about 10% of the debt in Japanese Yen reecting Disneys larger exposures in Europe and Asia. As its broadcasting businesses expand into Latin America, it may want to consider using either Mexican Peso or Brazilian Real debt as well.

Aswath Damodaran

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Analyzing Disneys Current Debt

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Disney has $13.1 billion in debt with an average maturity of 11.53 years. Even allowing for the fact that the maturity of debt is higher than the duration, this would indicate that Disneys debt is far too long term for its existing business mix. Of the debt, about 12% is Euro debt and no yen denominated debt. Based upon our analysis, a larger portion of Disneys debt should be in foreign currencies. Disney has about $1.3 billion in convertible debt and some oating rate debt, though no information is provided on its magnitude. If oating rate debt is a relatively small portion of existing debt, our analysis would indicate that Disney should be using more of it.

Aswath Damodaran

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Adjusting Debt at Disney

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It can swap some of its existing long term, xed rate, dollar debt with shorter term, oating rate, foreign currency debt. Given Disneys standing in nancial markets and its large market capitalization, this should not be difcult to do. If Disney is planning new debt issues, either to get to a higher debt ratio or to fund new investments, it can use primarily short term, oating rate, foreign currency debt to fund these new investments. While it may be mismatching the funding on these investments, its debt matching will become better at the company level.

Aswath Damodaran

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