Financial: Fin 6212 Policy

Fin 6212 Financial Policy
LECTURE 5
PROF. NICHOLAS CHEN
Today’s plan
• Different Types of Debt Financing
• Public debt vs. private debt
• Sovereign debt and Municipal Bonds
• Asset-Backed Securities
• Agency conflicts between equity and debt holders
• Overinvestment/Excessive risk-taking (risk-shifting)
• Underinvestment/debt overhang
• Cash out
• Debt as a monitoring device for managers
• Free cash flow problem/empire building
• Leveraged buyout
Public Debt
• The Prospectus
• A public bond issue is similar to a stock issue.
• Indenture
• Included in a prospectus, it is a formal contract between a bond issuer and a trust
company.
• The trust company represents the bondholders and makes sure that the terms of the
indenture are enforced.
• In the case of default, the trust company represents the interests of the bond holders.
Public Debt (cont'd)
• Corporate bonds almost always pay coupons semiannually, although a
few corporations have issued zero-coupon bonds.
• Most corporate bonds have maturities of 30 years or less.
• In July 1993, Walt Disney Company issued $150 million with a
maturity of 100 years.
• Sleeping Beauty bond
• Types of Corporate Debt
• Unsecured Debt
A type of corporate debt that, in the event of bankruptcy, gives bondholders a claim to only
the assets of the firm that are not already pledged as collateral on other debt
• Notes
• A type of unsecured corporate debt
• Notes typically are coupon bonds with maturities shorter than 10 years.
• Debentures
• A type of unsecured corporate debt
• Debentures typically have longer maturities than notes.
Secured Debt
• A type of corporate debt in which specific assets are pledged as collateral.
• Mortgage Bonds
• Real property is pledged as collateral that bondholders have a direct claim to in the event
of bankruptcy.
• All classes of securities are paid from the same cash
flow source.
• Asset-Backed Bonds
• Specific assets are pledged as collateral that bondholders have a direct claim to in the
event of bankruptcy.
• Can be secured by any kind of assets
• Types of Corporate Debt
• Tranches
• Different classes of securities that comprise a single
bond issue
• All classes of securities are paid from the same cash
flow source.
• Seniority
• Seniority
• A bondholder’s priority in claiming assets not already securing other debt
• Most debenture issues contain clauses restricting the company from issuing new debt
with equal or higher priority than existing debt (debt covenant)
• Subordinated Debentures
• Debt that, in the event of a default, has a lower priority claim to the firm’s assets than
other outstanding debt
Hertz’s December 2005 Junk Bond Issues
Private Debt
• Private Debt
• Debt that is not publicly traded
• Has the advantage that it avoids the cost of registration but has the disadvantage of
being illiquid
Private Debt (cont'd)
• Term Loans
• Term Loan
• A bank loan that lasts for a specific term
• Syndicated Bank Loan

• A single loan that is funded by a group of banks rather than just a single bank
• Revolving Line of Credit

• A credit commitment for a specific time period, typically two to three years, which a
company can use as needed
• Think about credit card credit line vs. mortgage/car loans
Private Debt
Private Debt (con’t)
China’s P2P lenders brace for renewed regulatory crackdown
Financial Times (April 2, 2018)
Collapse of Chinese peer-to-peer lenders sparks investor
flight (Financial Times, July 22, 2018)
• A wave of defaults is sweeping across China’s Rmb1.3tn ($190bn) peer-to-
peer lending industry, causing investors to withdraw funds and platforms to
collapse, the latest casualties of Beijing’s broader crackdown on debt and
financial risk.
• About 150 online lending platforms have suffered “problems” since the
beginning of June this year, compared with 217 such cases in all of 2017,
according to Online Lending House, a research group that tracks the
industry.
• The group defines “problems” as investors being unable to withdraw

money, police investigating a platform, or owners running away.
Today’s plan
• Cash out
Types of Debt
• Sovereign Debt
• Sovereign Debt
• Debt issued by national governments
• U.S. Treasury securities represents the single largest sector of the U.S. bond market.
• Government debt is potentially defaultable
Existing U.S.Treasury Securities
Sovereign Debt
• The U.S. Treasury issues:
• Treasury Bills
• Pure discount bonds with maturities up to 26 weeks
• Treasury Notes
• Semi-annual coupon bonds with maturities of 2 to 10 years
• Treasury Bonds
• Semi-annual coupon bonds with maturities longer than 10 years
• Long Bonds
• Bonds issued by the U.S. Treasury with the longest outstanding maturities (currently 30 years)
Sovereign Debt (cont'd)
• TIPS (Treasury-Inflation-Protected Securities)
• An inflation-indexed bond issued by the U.S. Treasury with maturities of 5, 10,
and 20 years
• They are standard fixed-rate coupon bonds with one difference: The
outstanding principal is adjusted for inflation.
Example
• Problem
• On April 15, 1998, the U.S. Treasury issued a
thirty-year inflation-indexed note with a coupon of 3%.
• On the date of issue, the consumer price index (CPI) was 161.740.
• On July 21 2016, the CPI had increased to 239.411 (see
https://fred.stlouisfed.org/series/CPIAUCSL) .
• What coupon payment was made on July 12, 2016?
Most recent CPI
Example (cont’d)
• Solution
• Between the issue date and July 21, 2016, the CPI appreciated by:
• ________________________
• Consequently, the principal amount of the bond increased to:

• _____________________________
• The semi-annual coupon payment was:

• _____________________________
• Treasury securities are sold by auction.
• Two types of bids are allowed.
• Competitive bidders submit sealed bids in terms of yields and the amount of bonds they
are willing to purchase. The Treasury then accepts the lowest-yield (highest-price)
competitive bids up to the amount required to fund the deal.
• Noncompetitive bidders (usually individuals) just submit the amount of bonds they wish
to purchase and are guaranteed to have their orders filled at the auction.
• STRIPS (Separate Trading of Registered Interest and Principal
Securities)
• Zero-coupon Treasury securities with maturities longer than one year that
trade in the bond market
• The Treasury itself does not issue STRIPS. Instead, investment banks purchase Treasury
notes and bonds and then resell each coupon and principal payment separately as a
zero-coupon bond.
• Sovereign debt of other countries
Brazil Government Gross Debt to GDP
Olympics of 2016 and Brazil
• The state government of Rio de Janeiro is preparing to host the Olympics in

seven months but is facing a financial crisis.
• Officials have already slashed $400 million from the state budget as Brazil
faces its worst recession since 1931, and need to cover a further $800
million shortfall before the 2015 accounts can be finalized.
• The state government is one of the branches of Brazil’s government that is

underwriting the operating costs of the Olympics, to be held here from
Aug. 5.
Months after the Olympics of 2016
Rio de Janeiro is broke
• The state of Rio is broke. It hasn’t been able to pay its bills since long before the
games. A federal bailout kept police on the streets and hospitals open while
Olympics tourists were in town. But now the money has dried up, and public
employees aren’t being paid.
• The state government is voting on an austerity package that could slash state
workers' wages and pensions by 30 percent. That’s triggered violent protests and
led demonstrators to briefly storm the state Legislature last month.
• Meanwhile, crime is surging across the state. From January to October, murders
increased by 18 percent, and street robberies jumped by 48 percent compared to
the same time last year, according to the state’s security institute.
36
37
38
Municipal Bonds
• Municipal Bonds (Munis)
• Bonds issued by state and local governments
• They are not taxable at the federal level (and sometimes
at the state and local level as well).
• Sometimes referred to as tax-exempt bonds
Municipal Bonds (cont'd)
• Municipal Bonds (Munis)
• Most pay semi-annual interest
• Fixed Rate
• Has the same coupon over the life of the bond
• Floating Rate
• The coupon of the bond is adjusted periodically
Municipal Bonds (cont'd)
Hong Kong Government Bond and Rating
• http://www.worldgovernmentbonds.com/country/hong-kong/
• Sept 6, 2019 (Reuters) - Global credit rating agency Fitch Ratings

downgraded Hong Kong’s long-term foreign currency issuer default
rating to “AA” from “AA+” after months of unrest and protests in the
region.
• Hong Kong’s rating outlook is negative, Fitch Ratings said on Friday.
Today’s plan
• Cash out
Asset-Backed Securities
• Securities made up of other financial securities
• Security’s cash flows come from the cash flows of the underlying financial
securities that “back” it.
• Asset securitization
• The process of creating an asset-backed security
Asset-Backed Securities (cont'd)
• Mortgage-backed security
• Largest sector of the asset-backed security market
• Backed by home mortgages
• Largest issuers are U.S. government agencies and sponsored enterprises, such
as the Government National Mortgage Association (GNMA).
Asset-Backed Securities (cont'd)
• Private organizations, such as banks, also issue asset-backed
securities.
• Backed by home mortgages, auto loans, credit card receivables, student
loans, and other loans.
• Collateralized debt obligation (CDO)
• A re-securitization of other asset-backed securities.
• Often divided into tranches that are assigned different repayment priority.
Today’s plan
• Cash out
Gamble in Las Vegas to save FedEx
Excess risk-taking
Equity as a call option: Equity = max(Asset – Debt, 0)
• Equity = max(Asset – Debt, 0)
Debt
51
Gamble in Las Vegas to save FedEx
Simple Example of Risk-shifting
Circular File Company has $50 of 1-year debt
Book balance sheet
Circular File Company (Book Values)

Net W.C. 20 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets 100 100 Total liabilities
Simple Example of Risk-shifting (Con’t)
Circular File Company has $50 of one-year debt
Market balance sheet
Circular File Company (M arket Values)

Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities
Circular File Company may invest $10 as follows
Now Possible Payoffs Next Year

$150 (10% probabilit y)
Invest $10
$0 (90% probabilit y)
• Assume the discount rate is 0.5
• What is the static NPV?
• ___________
• What is the NPV in the good case?
• _______________
• What is the NPV in the bad case?
• ________________
Circular File Company value (post project)
Good luck: equity: 5 to 70; bond: 25 to 50

Fixed assets 10+90=100 70 Common stock
Total assets 30+90 =120 120 Total liabilities
Circular File Company value (post project)
Bad luck: equity: __________; bond: _________

Fixed assets 10 +0=10 0 Common stock
Total assets 30-10 = 20 20 Total liabilities
Today’s plan
• Cash out
Debt Overhang and Under-investment
(cont'd)
• Under-investment Problem
• A situation in which equity holders choose ____________________ project
because the firm is in financial distress and the value of undertaking the
investment opportunity will accrue to bondholders rather than themselves.
Default Payoff Scenarios
Debt Overhang and Under-investment
(cont'd)
• When a firm faces financial distress, it may choose not to finance new,
positive-NPV projects.
• This is also called a debt overhang problem.
The cutoff point btw overinvestment and
underinvestment
• What is the cutoff point btw overinvestment and underinvestment?
• A: ___________________________________
• Does the risk of new investment matter?

• A: _____________________________________
Today’s plan
• Cash out
Cashing Out
• When a firm faces financial distress, managers have an incentive to
withdraw money from the firm, if possible.
• For example, if it is likely the company will default, the firm may sell assets
below market value and use the funds to pay an immediate cash dividend to
the shareholders or just himself/herself.
• This is another form of under-investment that occurs when a firm faces financial
distress.
A potential cash out from the recent acquisition
(South China Morning Post, Feb 17, 2017)
• Billionaire actress Zhao Wei has suffered a major setback in her quest to profit
from stock investments in China, after local banks declined to extend credit lines
to the celebrity for a 30 billion rmb acquisition of a little-known animation
company listed in Shanghai. Her own input is 6000 million yuan.
• The acquisition target, Zhejiang People Culture, plunged by its 10 per cent daily
limit on Thursday morning upon trading resumption. For the past week Chinese
securities regulators have been looking into Zhao’s source of funding and the
buyer, Longwei Culture & Media, owned by the Chinese star.
• In a dramatic twist, Zhao’s venture said on Thursday the reason it had to abandon
its bid for a controlling 29 per cent stake of the animation firm was that a number
of Chinese banks, which it did not name in its filing to the Shanghai Stock
Exchange, had turned down its request for financing.
• Most bizarre thing: Zhejiang People Culture gave up the bidder termination fee
of 1.5 billion (5% of 30 billion rmb). Too nice to be true?
How to price the bidder termination fee of
1.5 billion?
• See my research paper:
• When Buyers Get Cold Feet: What is the Value of a Bidder
Termination Provision in a Takeover?, with Xiaofei Zhao, Hamed
Mahmudi, and Aazam Virani.
• Winner of CELS 2016 Theodore Eisenberg Poster Prize
• Key point: _________________________

Today’s plan
• Cash out
Management Entrenchment (Empire building)
• Management Entrenchment Theory

• A theory that suggests managers choose a capital structure to avoid the
discipline of debt and maintain their own job security
• Managers seek to minimize leverage to prevent the job loss that would
accompany financial distress, but are constrained from using too little debt
(to keep shareholders happy).
Empire building
• Managers may engage in empire building.
• Managers often prefer to run larger firms rather than smaller ones, so they
will take on investments that increase the size, but not necessarily the
profitability, of the firm.
• Managers of large firms tend to earn higher salaries, and they may also have more
prestige and garner greater publicity than managers of small firms.
• Thus, managers may expand unprofitable divisions, pay too much for acquisitions, make
unnecessary capital expenditures, or hire unnecessary employees.
Empire building(cont'd)
• Managers may over-invest because they
are overconfident.
• Even when managers attempt to act in shareholders’ interests, they may
make mistakes.
• Managers tend to be bullish on the firm’s prospects and may believe that new
opportunities are better than they actually are.
• Free Cash Flow Hypothesis
• The view that _______________________is more likely to occur when firms
have high levels of cash flow in excess of what is needed after making all
positive-NPV investments and payments to debt holders
Wasteful spending: Private perks
• When cash is tight, managers will be motivated to run the firm as
efficiently as possible.
• According to the free cash flow hypothesis,
leverage increases firm value because it commits the firm to making future
interest payments, thereby reducing excess cash flows and wasteful
investment by managers.
The 10 Chinese Celebrities Who Own Private Jets
1. Liu Tao 刘涛
2. Brigitte Lin 林青霞
3. Zhao Benshan 赵本山
4. Jackie Chan 成龙
5. Jay Chou 周杰伦
6. Zhang Ziyi 章子怡
7. Chen Daoming 陈道明
8. Jet Li 李连杰
9. Fan Bingbing 范冰冰
10. Feng Xiaogang 冯小刚
• Leverage can reduce the degree of managerial entrenchment because
___________________________.
• Managers who are less entrenched may be more concerned about their performance and
less likely to engage in wasteful investment.
• In addition, when the firm is highly levered, creditors themselves will closely
monitor the actions of managers, providing an additional layer of management
oversight.
Leverage and Commitment
• Leverage may also tie managers’ hands and commit them to pursue
strategies with greater vigor than they would
___________________________________.
• A firm with greater leverage may also become a fiercer competitor
and act more aggressively in protecting its markets because it cannot
risk the possibility of bankruptcy.
Agency Costs
and the Tradeoff Theory
• The value of the levered firm can now be shown to be
V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)

 PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)
Optimal Leverage with Taxes, Financial Distress, and Agency Costs
The Optimal Debt Level
• R&D-Intensive Firms
• Firms with high R&D costs and future growth opportunities typically maintain
___________ debt levels.
• These firms tend to have low current free cash flows and risky business
strategies.
The Optimal Debt Level (cont'd)
• Low-Growth, Mature Firms
• Mature, low-growth firms with stable cash flows and tangible assets often
carry a ___________debt load.
• These firms tend to have high free cash flows with few good investment
opportunities.
• To reduce the agency problem, the firm choose to issue more debt.
Today’s plan
• Cash out
Leveraged Buy Outs
Leveraged Buyout Examples
Leveraged Buyouts
The three main characteristics of LBOs
1. High debt
2. Incentives
• __________________
3. Private ownership
Privatization
Motives for Privatization
1. Increased efficiency
2. _______ ownership
Private Equity Partnership
Investment Phase Payout Phase
General Partner put up General Partner get carried

1% of capital interest in 20% of profits
Mgmt fees
Limited Limited
partners partners get
Partnership Partnership investment
put in
99% of back, then
capital 80% of profits
Company 1
Company 2
Investment in Sale or IPO of
diversified companies
portfolio of
companies
Company N

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Fin 6212 Financial Policy

• Syndicated Bank Loan

• Revolving Line of Credit

• The group defines “problems” as investors being unable to withdraw

• Consequently, the principal amount of the bond increased to:

• The semi-annual coupon payment was:

• The state government of Rio de Janeiro is preparing to host the Olympics in

• The state government is one of the branches of Brazil’s government that is

• Sept 6, 2019 (Reuters) - Global credit rating agency Fitch Ratings

• Equity = max(Asset – Debt, 0)

Circular File Company (Book Values)

Circular File Company (M arket Values)

Now Possible Payoffs Next Year

Circular File Company (M arket Values)

Circular File Company (M arket Values)

• Does the risk of new investment matter?

• Key point: _________________________

• Management Entrenchment Theory

V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)

General Partner put up General Partner get carried

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