www.giddy.org
Prof. Ian GiddyNew York University
CorporateFinancial Restructuring:
Summary
Copyright ©2000 Ian H. Giddy Summary 3
What is Corporate Restructuring?
Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.
Designed to increase the value of the firm Restructuring
Improve
capitalization
Change ownership
and control
Improve
debt composition
Copyright ©2000 Ian H. Giddy Summary 4
The Paths to Value Creation
Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced:The cost of capital can be reducedThe cash flows from existing assets to the
firm can be increasedThe expected growth rate in these cash
flows can be increased The length of the high growth period can
be extended.
Copyright ©2000 Ian H. Giddy Summary 5
Getting the Financing Right
Debt
Equity
Short term? Long term? Baht? Dollar? Yen?
Short term? Long term? Baht? Dollar? Yen?
Bonds? Asset-backed? Convertibles? Hybrids?
Bonds? Asset-backed? Convertibles? Hybrids?
Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?
Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?
Ownership & control? Ownership & control?
Copyright ©2000 Ian H. Giddy Summary 6
The Financing Life Cycle
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
Information availability
Copyright ©2000 Ian H. Giddy Summary 7
The Wrong Capital Structure: East vs West
VALUE OFTHE
FIRM
DEBT
RATIO
Optimal debt ratio?
Intel TPI
Asia in 5 years?
Copyright ©2000 Ian H. Giddy Summary 8
A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > OptimalOverlevered
Actual < OptimalUnderlevered
Is the firm under bankruptcy threat? Is the firm a takeover target?
Yes No
Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withnew equity or with retainedearnings.
No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.
Yes No
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withdebt.
No
Do your stockholders likedividends?
YesPay Dividends No
Buy back stock
Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.
Copyright ©2000 Ian H. Giddy Summary 9
When The Creditors are Prowling
Time for a Tiger
The financing
is bad
The company
is bad
Business
mix is bad
Raise equity
or
Change debt mix
Change control
or management
through M&A
Sell some businesses
or assets
to pay down debt
Reason
Remedy
Copyright ©2000 Ian H. Giddy Summary 10
The Financing SpectrumE
xpec
ted
Ret
urn
Risk
Senior secured debtSenior secured debt
EquityEquity
Senior unsecured debtSenior unsecured debt
Subordinated debtSubordinated debt
Preferred equityPreferred equity
Convertible debtConvertible debt
Copyright ©2000 Ian H. Giddy Summary 11
What Do Debt-Equity Swaps Do?
Overleverage creates financial distressOverleverage creates financial distress
Actual or potential defaultActual or potential default
Lenders take equity in lieu of repaymentLenders take equity in lieu of repayment
Lenders hold equity passivelyLenders hold equity passively Lenders replace managementLenders replace management Lenders sell equityLenders sell equity
Existing management buys timeExisting management buys time Change of control
means restructuring
Change of control
means restructuring
Financial engineering Bottom line “rationalization” Divestitures & outsourcing
Financial engineering Bottom line “rationalization” Divestitures & outsourcing
Copyright ©2000 Ian H. Giddy Summary 12
Siam Commercial Bank:
Transparency and Disclosure
A 275-page prospectus, which provided a breadth and depth of information previously unseen in an Asian issue.
"We went and looked back at US bank holding company offers - those that were US SEC Grade 3 compliant. We also went back and looked at a lot of the prospectuses for the recaps of US banks, like Mellon and Citibank. We looked at the level of disclosure they achieved and committed ourselves to exceeding that -- which SCB did.“
"When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."
Copyright ©2000 Ian H. Giddy Summary 13
New Equity for Asia
What investors?Portfolio investorsFinancial investorsCorporate investors
What returns should they expect?= Risk-free rate+ Corporate risk+ Financial risk (leverage/debt mismatch)+ “Agency cost” premium+ Country risk
What restructuring?
Copyright ©2000 Ian H. Giddy Summary 14
Designing Debt: Match the Business
Fixed/floating:How certain are the cash flows? Are operating profits
linked to interest rates or inflation?
Currency:Consider currency of the assets: currency of
denomination vs. currency of location vs. currency of determination.
Maturity or availability:Are the assets short term or long term? Should the
firm assume ease of refinancing, or buy an option on access to financing?
Copyright ©2000 Ian H. Giddy Summary 15
Designing Debt
Duration Currency Effect of InflationUncertainty about Future
Growth PatternsCyclicality &Other Effects
Define DebtCharacteristics
Duration/Maturity
CurrencyMix
Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future
Straight versusConvertible- Convertible ifcash flows low now but highexp. growth
Special Featureson Debt- Options to make cash flows on debt match cash flows on assets
Start with the Cash Flowson Assets/Projects
Overlay taxpreferences
Deductibility of cash flowsfor tax purposes
Differences in tax ratesacross different locales
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
Factor in agencyconflicts between stockand bond holders
Observability of Cash Flowsby 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
Consider Information Asymmetries
Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt
Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt
If agency problems are substantial, consider issuing convertible bonds
Can securities be designed that can make these different entities happy?
If tax advantages are large enough, you might override results of previous step
Zero Coupons
Operating LeasesMIPsSurplus Notes
ConvertibilesPuttable BondsRating Sensitive
NotesLYONs
Commodity BondsCatastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
Copyright ©2000 Ian H. Giddy Summary 16
When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
Alternatives
Collateralized Asset-securitized Project financing
Preferred Warrants Convertible
Copyright ©2000 Ian H. Giddy Summary 17
Why Use a Hybrid?
Motivations for Hybrids
Linked to business risk
Linked to
market risk
Cannot hedge
with derivatives
Driven by investor needs
Company hedges
Company does not
hedge
Debt or
equity are
Not good enough
Copyright ©2000 Ian H. Giddy Summary 18
Corporation or Financial Institution requires additional funds to givecustomers financing or to finance a future revenue stream.
Are funds freely available from banks ?
Does the firm/FI have good, self-liquidatingassets ?
Do the assets have a sufficiently high yieldto cover servicing and other costs ?
Would the assets be worth more (have a cheaper all-in funding cost) if they were
isolated from the company/FI ?
Securitize the assets
Borrow frombanks
Issue equity ormezzanine capital
Get out of thefinancingbusiness
Use assets as collateral foron-balancesheet debt
No
Yes
Yes
Yes
Yes
No
No
No
Asset Securitization:The Decision Process
Copyright ©2000 Ian H. Giddy Summary 19
Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF
Expected GrowthReinvestment Rate* Return on Capital
FCFF1 FCFF2 FCFF3 FCFF4 FCFF5
Forever
Firm is in stable growth:Grows at constant rateforever
Terminal Value= FCFF n+1/(r-gn)
FCFFn.........
Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)
WeightsBased on Market Value
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity
Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows
+Beta- Measures market risk X
Risk Premium- Premium for averagerisk investment
Type of Business
Operating Leverage
FinancialLeverage
Base EquityPremium
Country RiskPremium
DISCOUNTED CASHFLOW VALUATION
Copyright ©2000 Ian H. Giddy Summary 20
Private Business: Owner hasall his wealth invested in thebusiness
Venture Capitalist: Haswealth invested in a numberof companies in one sector
Publicly traded companywith investors who are diversified domesticallyorIPO to investors who aredomestically diversified
Publicly traded companywith investors who are diverisified globallyorIPO to global investors
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
TotalRisk
Risk added to sectorportfolio
Risk added to domestic portfolio
Risk added to global portfolio
StandardDeviation
Beta relative to sector
Beta relative to local index
Beta relative to global index
40%
25%
15%
10%
100/.4=250
100/.25=400
100/.15=667
100/.10=1000
Investor Type Cares about Risk Measure Cost ofEquity
Firm Value
Valuing a Firm from Different Risk PerspectivesFirm is assumed to have a cash flow of 100 each year forever.
Copyright ©2000 Ian H. Giddy Summary 21
The Building Blocks of Valuation
Choose aCash Flow Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Net Income
- (1- ) (Capital Exp. - Deprec’n)
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE)
[ = Debt Ratio]
Cashflows to Firm
EBIT (1- tax rate)
- (Capital Exp. - Deprec’n)
- Change in Work. Capital
= Free Cash flow to Firm (FCFF)
& A Discount Rate Cost of Equity
Basis: The riskier the investment, the greater is the cost of equity.
Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
Cost of Capital
WACC = ke ( E/ (D+E))
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
& a growth pattern
t
g
Stable Growth
g
Two-Stage Growth
|High Growth Stable
g
Three-Stage Growth
|High Growth StableTransition
Copyright ©2000 Ian H. Giddy Summary 22
A Framework for Analyzing Companies with Negative or Abnormally Low Earnings
Why are the earnings negative or abnormally low?
TemporaryProblems
Cyclicality:Eg. Auto firmin recession
StructuralProblems: Eg. Cable co. with high infrastruccture investments.
LeverageProblems: Eg. An otherwise healthy firm with too much debt.
Long-termOperatingProblems: Eg. A firm with significant production or cost problems.
Normalize Earnings
Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time.:(a) If problem is structural: Target for operating margins of stable firms in the sector.(b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period, which could be its own optimal or the industry average.(c) If problem is operating: Target for an industry-average operating margin.
If firm’s size has notchanged significantlyover time
Average DollarEarnings (Net Income if Equity and EBIT if Firm made bythe firm over time
If firm’s size has changedover time
Use firm’s average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC)
Copyright ©2000 Ian H. Giddy Summary 23
What’s a Company Worth?The Options Approach
Present Value of Expected Cash Flows if Option Excercised
Value of the Firm or project
The Value Enhancement ChainGimme’ Odds on. Could work if..
Assets in Place 1. Divest assets/projects withDivestiture Value >
Continuing Value2. Terminate projects with
Liquidation Value >
Continuing Value3. Eliminate operating
expenses that generate nocurrent revenues and no
growth.
1. Reduce net working capitalrequirements, by reducing
inventory and accountsreceivable, or by increasingaccounts payable.
2. Reduce capital maintenanceexpenditures on assets in
place.
1. Change pricing strategy tomaximize the product of
profit margins and turnoverratio.
Expected Growth Eliminate new capital
expenditures that are expected
to earn less than the cost ofcapital
Increase reinvestment rate or
marginal return on capital or
both in firm’s existingbusinesses.
Increase reinvestment rate or
marginal return on capital or
both in new businesses.
Length of High Growth Period If any of the firm’s products orservices can be patented and
protected, do so
Use economies of scale or costadvantages to create higher
return on capital.
1. Build up brand name2. Increase the cost of
switching from product andreduce cost of switching to
it.
Cost of Financing 1. Use swaps and derivativesto match debt more closely
to firm’s assets2. Recapitalize to move the
firm towards its optimaldebt ratio.
1. Change financing type anduse innovative securities to
reflect the types of assetsbeing financed
2. Use the optimal financingmix to finance new
investments.3. Make cost structure more
flexible to reduce operatingleverage.
Reduce the operating risk of thefirm, by making products less
discretionary to customers.
Copyright ©2000 Ian H. Giddy Summary 25
Ipoh-KelantanIpoh-Kelantan
Ipoh Kelantan Combined Synergy Optimal DebtGrowth 5% 5% 5% 6% 6%Tax rate 35% 35% 35% 35% 35%Initial Revenues 4400 3125 7525 7525 7525COGS 87.50% 89% 86.00% 86.00%WC 10% 10% 10% 10% 10%Beta 1.70 1.50 1.40 1.40 1.51 Cost of debt 8.50% 8.50% 7.75% 7.75% 8.00%Equity Market Value 2000 1300 3300 3300 2968Debt Market Value 160 250 410 410 742
T+1 T+1 T+1 T+1Revenues 4620 3281 7901 7977 7977-COGS 4043 2920 6963 6860 6860-Depreciation 200 74 274 274 274=EBIT 378 287 664 843 843EBIT(1-Tax) 245 187 432 548 548+Depreciation 200 74 274 274 274-CapEx -180 -67 -247 -247 -247-Change in WC -22 -16 -38 -45 -45-Free Cash Flow to Firm 243 178 422 530 530Cost of Equity (from CAPM) 16.35% 15.25% 14.70% 14.70% 15.28%Cost of Debt 5.53% 5.53% 5.04% 5.04% 5.20%WACC 15.55% 13.68% 13.63% 13.63% 13.27%
Firm Value 2307 2054 4885 6944 7294Equity Value 2147 1804 4475 6534 6552 TotalIncrease 2060 18 2078
101%
Copyright ©2000 Ian H. Giddy Summary 26
The Gains From an Acquisition
Gains from merger
Synergies Control
Top line Financial
restructuring
Business
Restructuring
(M&A)
Bottom line
Copyright ©2000 Ian H. Giddy Summary 27
The Final Question
How do we get paid?How do we get paid?
www.giddy.org
http:giddy.org/dbshttp:giddy.org/dbs
Top Related