Restructuring

Giddy/Applied Corporate Finance
Financial Restructuring 1
Corporate Financial Restructuring Prof Ian Giddy

New York University
What is Corporate Restructuring? Any substantial change in a companys financial structure, or ownership or control, or business portfolio. l Designed to increase the value of the firm
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Restructuring
Improve capitalization
Improve debt composition
Change ownership and control
Copyright 2002 Ian H. Giddy
www.giddy.org
Corporate Financial Restructuring 2
Its All About Value

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How can corporate and financial restructuring create value?

Assets Liabilities
Fix the business
Operating Cash Flows
Debt Equity
Or fix the financing
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Restructuring
Figure out what the business is worth now Fix the business mix divestitures Fix the business strategic partner or merger Fix the financing improve D/E structure Fix the kind of equity Fix the kind of debt or hybrid financing Fix management or control Use valuation model present value of free cash flows Value assets to be sold Value the merged firm with synergies Revalue firm under different leverage assumptions lowest WACC What can be done to make the equity more valuable to investors? What mix of debt is best suited to this business? Value the changes new control would produce
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Getting the Financing Right Step 1: The Proportion of Equity & Debt
Debt
n
Equity
Achieve lowest weighted average cost of capital May also affect the business side
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Getting the Financing Right Step 2: The Kind of Equity & Debt
n n n n
Short Shortterm? term?Long Longterm? term? Baht? Dollar? Baht? Dollar?Yen? Yen? Bonds? Bonds?Asset-backed? Asset-backed? Convertibles? Convertibles?Hybrids? Hybrids? Debt/Equity Debt/EquitySwaps? Swaps? Private? Private?Public? Public? Strategic Strategicpartner? partner? Domestic? Domestic?ADRs? ADRs? Ownership Ownership& &control? control?
Debt Equity
n n n n
n n n n n n n n n n
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Does Capital Structure Matter?

Assets value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm =D+E
You cannot change the value of the real business just by shuffling paper - Modigliani-Miller
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Most Value is Created on the Asset Side Only invest in assets (or keep assets) where ROE>required return on equity l Value-Based Management for performance evaluation
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Union Camp: Packaging Business
?
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Case Study: Marconi
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Does Capital Structure Matter? Yes!

Assets value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows)
COST OF CAPITAL
Debt Equity Value of the firm =D+E

Optimal debt ratio?
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DEBT RATIO

Assets value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows)
VALUE OFTHE FIRM
Debt Equity Value of the firm =D+E

Optimal debt ratio?
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DEBT RATIO

Assets value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm =D+E
Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs

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Changing Financial Mix

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Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.
Debt: Pros and Cons
Advantages of Borrowing
1. Tax Benefit: Higher tax rates --> Higher tax benefit 2. Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit
Disadvantages of Borrowing
1. Bankruptcy Cost: Higher business risk --> Higher Cost 2. Agency Cost: Greater the separation between stockholders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost
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See Saw
Business Uncertainty Operating Leverage
Financial Risk Financial Leverage

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Young and Old
Size
Financial Leverage
Operating Leverage Operating Leverage
Financial Leverage
Maturity
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SAP
10.20% 10.14%
Cost of Capital
9.66%
9.71%
9.45%
2%
14%
20%
26%
38%
Leverage
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Siderar: Steel Company in Argentina

Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Beta 0.68 0.73 0.80 0.88 0.99 1.14 1.44 1.95 2.93 5.86 Cost of Equity 16.95% 17.76% 18.77% 20.07% 21.81% 24.24% 29.16% 37.29% 52.94% 99.87% Bond Rating AAA AA AB+ BCCC CC C C C Interest rate on debt 11.55% 11.95% 12.75% 14.25% 16.25% 17.25% 18.75% 20.25% 20.25% 20.25% Tax Rate 33.45% 33.45% 33.45% 33.45% 33.45% 33.45% 25.67% 20.38% 17.83% 15.85% Cost of Debt (after-tax) 7.69% 7.95% 8.49% 9.48% 10.81% 11.48% 13.94% 16.12% 16.64% 17.04% WACC 16.95% 16.78% 16.71% 16.90% 17.41% 17.86% 20.02% 22.47% 23.90% 25.32% Firm Value (G) $1,046 $1,064 $1,071 $1,052 $1,001 $961 $803 $674 $615 $565
20.00% 15.00% 10.00% 5.00% 0.00% 0% 20% 40% 60% 80% 100% Debt Percentage
Value ($millions)
Cost of Capital
30.00% 25.00%
1200 1000 800 600 400 200 0 0% 20% 40% 60% 80% 100% Debt Percentage
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Capital Structure: East vs West
Nokia
TPI
VALUE OFTHE FIRM
Optimal debt ratio?
DEBT RATIO
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TPIs Refinancing Asias biggest debtor l Almost $4 billion in foreign currency debt financing domestic revenues l Protracted rescheduling results in $360 million debt/equity swap l No change in management or effective control l Still needs $1.2 billion new equity
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The Financing Spectrum
Equity Equity
n n
Expected Return
n n
Residual Residualreturns returns after aftercontractual contractual claims claims Control Controlthrough through voting votingrights rights
Senior Senior Debt Debt

n n
n n
Returns Returns independent independentof ofthe the value valueof ofthe the business business Control Controlthrough through covenants covenants
Risk
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The Difference
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The Ministry of Finance received a preferred share while investors received a preferred share and a warrant allowing them to purchase the ministry's share at a 13.3% premium (equivalent to the cost of carry) during a three-year period. The preferred shares carry a 5.25% dividend and full voting rights "When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it." Alternatives: Thai Farmers Bank: SLIPS, Bankok Bank: CAPs
Transparency and Disclosure

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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 The Creditors are Prowling

Time for a Tiger
Reason
The financing is bad
Business mix is bad
The company is bad
Remedy
Raise equity or Change debt mix
Sell some businesses or assets to pay down debt
Change control or management through M&A
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Case Study: Marconi
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The Cost of Capital: What Returns do Investors Expect?

Index ($)
Small Company Stocks
10000
$4,495.99 $1,370.95
Large Company Stocks
1000
100
Long-Term Government Bonds
10
$33.73 $13.54 $8.85
1
Treasury Bills Inflation
0.1
Year-End
1925 1935 1945 1 9 5 5 1 9 6 5 1975 1985 1995
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Estimating the Cost of Debt

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If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate. If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated,
u u
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and it has recently borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt
The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.
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Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread
> 8.50 6.50 - 8.50 5.50 - 6.50 4.25 - 5.50 3.00 - 4.25 2.50 - 3.00 2.00 - 2.50 1.75 - 2.00 1.50 - 1.75 1.25 - 1.50 0.80 - 1.25 0.65 - 0.80 0.20 - 0.65 < 0.20
AAA AA A+ A A BBB BB B+ B B CCC CC C D

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0.20% 0.50% 0.80% 1.00% 1.25% 1.50% 2.00% 2.50% 3.25% 4.25% 5.00% 6.00% 7.50% 10.00%
Other Factors Affecting Ratios Medians of Key Ratios : 1993-1995
AAA Pretax Interest Coverage EBITDA Interest Coverage 13.50 17.08
AA 9.67 12.80 69.1% 26.8% 21.4% 17.8% 21.1% 33.6%
A 5.76 8.18 45.5% 20.9% 19.1% 15.7% 31.6% 39.7%
BBB 3.94 6.00 33.3% 7.2% 13.9% 13.5% 42.7% 47.8%
BB 2.14 3.49 17.7% 1.4% 12.0% 13.5% 55.6% 59.4%
B 1.51 2.45 11.2% 1.2% 7.6% 12.5% 62.2% 67.4%
CCC 0.96 1.51 6.7% 0.96% 5.2% 12.2% 69.5% 69.1%
Funds from Operations / Total Debt 98.2% (%) Free Operating Cashflow/ Total 60.0% Debt (%) Pretax Return on Permanent Capital 29.3% (%) Operating Income/Sales (%) 22.6% Long Term Debt/ Capital 13.3% Total Debt/Capitalization 25.9%
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The Cost of Equity

Equity is not free! Expected return = Risk-free rate + Risk Premium
E(RRisky) = RRisk-free -+ Risk Premium
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The Cost of Equity

Consider the standard approach to estimating cost of equity: Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf) where, Rf = Riskfree rate E(Rm) = Expected Return on the Market Index (Diversified Portfolio)
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In practice,
u Short term government security rates are used as risk free
rates
u Historical risk premiums are used for the risk premium u Betas are estimated by regressing stock returns against market
returns
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The Weighted Average Cost of Capital

Choice
1. Equity - Retained earnings - New stock issues - Warrants
Cost
Cost of equity - depends upon riskiness of the stock - will be affected by level of interest rates
Cost of equity = riskless rate + beta * risk premium

2. Debt - Bank borrowing - Bond issues Cost of debt - depends upon default risk of the firm - will be affected by level of interest rates - provides a tax advantage because interest is tax -deductible
Cost of debt = Borrowing rate (1 - tax rate)

Debt + equity = Capital Cost of capital = Weighted average of cost of equity and cost of debt; weights based upon market value.
Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]
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Next, Minimize the Cost of Capital by Changing the Financial Mix

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The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm. Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt. But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.
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This is What Were Trying to Do

D/(D+E) ke 0 10% kd After-tax Cost of Debt WACC 4.80% 5.10% 5.40% 5.40% 5.70% 6.30% 7.20% 8.10% 9.00% 10.20% 11.40% 10.50% 10.41% 10.36% 10.23% 10.14% 10.15% 10.32% 10.50% 10.64% 11.02% 11.40%
10.50% 8% 11% 8.50%
20% 11.60% 9.00% 30% 12.30% 9.00% 40% 13.10% 9.50% 50% 60% 14% 10.50% 15% 12%
70% 16.10%13.50% 80% 17.20% 15% 90% 18.40% 17% 100% 19.70% 19%
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Cost of Capital and Leverage: Method

Equity
Estimated Beta With current leverage From regression Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Cost of equity With different leverage E(R)=Rf+Bl( Rm -Rf)
Debt
Leverage, EBITDA And interest cost
Interest Coverage EBITDA/Interest
Rating (other factors too!)
Cost of debt With different leverage Rate=Rf +Spread+?

Case Study: SAP
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Case Study: SAP

Interest Interest rate expense 5.65% 11 5.65% 153 6.37% 331 6.56% 505 10.90% 1,112 Interest Debt / coverage capitaliz Debt/book ratio ation equity 138.76 1% 0.1 10.28 7% 0.7 4.73 14% 1.4 3.10 21% 2.1 1.41 27% 2.7
Debt 0 2500 5000 7500 10000
Rating AAA AAA A AB+
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Should SAP take on additional debt? If so, how much? What is the weighted average cost of capital before and after the additional debt? What will be the estimated price per share after the company takes on new debt?
A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal Overlevered Is the firm under bankruptcy threat? Yes Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital
Actual < Optimal Underlevered Is the firm a takeover target? Yes Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital
Yes No Take good projects with 1. Pay off debt with retained new equity or with retained earnings. earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt.
Yes Take good projects with debt.
No Do your stockholders like dividends?
Yes Pay Dividends

No Buy back stock
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Contact Info
Ian H. Giddy NYU Stern School of Business Tel 212-998-0426; Fax 212-995-4233 Ian.giddy@nyu.edu http://giddy.org
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Giddy/Applied Corporate Finance

Corporate Financial Restructuring Prof Ian Giddy

Improve debt composition

Change ownership and control

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 2

Giddy/Applied Corporate Finance

Its All About Value

How can corporate and financial restructuring create value?

Fix the business

Operating Cash Flows

Or fix the financing

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 3

Copyright 2002 Ian H. Giddy

Giddy/Applied Corporate Finance

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 5

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 6

Giddy/Applied Corporate Finance

Does Capital Structure Matter?

Corporate Financial Restructuring 7

Corporate Financial Restructuring 8

Giddy/Applied Corporate Finance

Case Study: Marconi

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 9

Does Capital Structure Matter? Yes!

Debt Equity Value of the firm =D+E

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 10

Giddy/Applied Corporate Finance

Does Capital Structure Matter? Yes!

Debt Equity Value of the firm =D+E

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 11

Does Capital Structure Matter? Yes!

Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs

Corporate Financial Restructuring 12

Giddy/Applied Corporate Finance

Changing Financial Mix

Copyright 2002 Ian H. Giddy

Debt: Pros and Cons

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 14

Giddy/Applied Corporate Finance

Financial Risk Financial Leverage

Corporate Financial Restructuring 15

Young and Old

Operating Leverage Operating Leverage

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 16

Giddy/Applied Corporate Finance

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 17

Siderar: Steel Company in Argentina

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 18

Giddy/Applied Corporate Finance

Capital Structure: East vs West

VALUE OFTHE FIRM

Optimal debt ratio?

Copyright 2002 Ian H. Giddy