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3. Option-linked Bonds

In recent years, firms have recognized the
Commodity Bonds: Commodity bonds
value of combining options with straight bonds
are bonds where the interest and/or the
to create bonds that more closely match the
principal payments are linked to the price of the
firm™s specific needs. Consider two examples. In commodity. In most cases, the payments will
the first, commodity companies issued bonds increase with the price of the commodity and
decrease if it drops.
linking the principal and even interest payments
to the price of the commodity. Thus interest payments would rise if the price of the
commodity increased, and vice versa. The benefit for the company was that it tailored the
cash flows on the bond to the cash flows of the firm and reduced the likelihood of default.
These commodity linked bonds can be viewed as a combination of a straight security and
a call option on the underlying commodity. In the second example, consider insurance
companies that have recently issued bonds whereby the principal on the bond is reduced
in the case of a specified catastrophe, and remains unaffected in its absence. For instance,
an insurance firm that has the bulk of its revenues coming from homeowners™ insurance
in California, might attach a provision that reduces principal and/or interest in the case of
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a major earthquake. Again, the rationale is to provide the firm with some breathing room
when it needs it the most - when a catastrophe creates huge cash outflows for the firm.


Illustration 7.1: Financing Choices in 2003-04 “ Disney and Aracruz
Table 7.1 summarizes the existing debt and preferred stock at Disney, broken
down by maturity, currency and whether the debt is fixed or floating rate.

Table 7.1: Debt and Preferred Stock Breakdown for Disney: September 2003

Type of Debt 2003 Stated interest rate Float Fiixed Matures in
Medium term paper 8114 6.07% 1510 6604 2006-2022
Convertible Senior Notes 1323 2.13% 0 1323 2023
Other U.S. dollar denominated
debt 597 5.74% 0 597 2004-2032
Privately Placed Debt 343 7% 343 0 2007
Euro medium-term debt 1519 2.84% 1099 420 2004-2007
Preferred Stock 485 7.56% 102 383 2004
Capital Cities Debt 191 9.08% 0 191 2021
Other 528 NA 0 528 2006
Total 13100 5.16% 3054 10046

Of the total debt and preferred stock of $13,100 million, 23.31% is floating rate and
11.6% is in foreign currency (euros). In addition, Disney did specify that $2,457 million
in debt would come due in the next year, which is 18.76% of the total debt outstanding.
In addition, as noted in chapter 4, Disney has more than $ 2 billion in operating lease
commitments, with a present value of $1.75 billion.

Aracruz reported as $1,371 million in gross debt outstanding in December 2003
and provided the breakdown of the debt in table 7.2:

Table 7.2: Debt Outstanding (in US dollar terms) at Aracruz

Debt Due in Local Currency US Dollar Total % Due
2004 43.2 348.9 392.1 28.59%
2005 38.3 85 123.3 8.99%
2006 38.4 177.9 216.3 15.77%
2007 38.4 228.5 266.9 19.46%
2008 36.5 124.2 160.7 11.72%
2009 and after 18.2 194 212.2 15.47%
Total 213 1158.5 1371.5
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Of the total debt, 15.53% is in local currency and none of the debt was floating rate debt.

Financing Choices and a Firm™s Life Cycle
While we spent the last section looking at the different financing choices available
to a firm, they all represent external financing, i.e, funds raised from outside the firm.
Many firms meet the bulk of their funding needs internally, with cash flows from existing
assets. In this section, we begin by presenting the distinction between internal and
external financing, and the factors that may affect how much firms draw on each source.
We then turn our attention again to external financing. We consider how and why the
financing choices may change as a firm goes through different stages of its life cycle,
from start-up to expansion to high growth to stable growth and on to decline. We will
follow up by looking why some choices dominate in some stages and do not play a role
in others.

Internal versus External Financing

Cash flows generated by the existing assets of a firm can be categorized as
internal financing. Since these cash flows belong to the equity owners of the business,
they are called internal equity. Cash flows raised outside the firm whether from private
sources or from financial markets can be categorized as external financing. External
financing can, of course, take the form of new debt, new equity or hybrids.
A firm may prefer internal to external financing for several reasons. For private
firms, external financing is typically difficult to raise, and even when it is available
(through a venture capitalist, for instance) it is accompanied by a loss of control and
flexibility. For publicly traded firms, external financing may be easier to raise, but it is
still expensive in terms of issuance costs (in the case of new equity) or lost flexibility (in
the case of new debt). Internally generated cash flows, on the other hand, can be used to
finance operations without incurring large transactions costs or losing flexibility.
Despite these advantages, there are limits to the use of internal financing to fund
projects. First, firms have to recognize that internal equity has the same cost as external
equity, before the transactions cost differences are factored in. The cost of equity,
computed using a risk and return model such as the CAPM or APM, applies as much to
internal as to external equity. Thus, Disney has a cost of equity of 10.00% for internal
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equity (or retained earnings) and external equity (new stock or equity option issues). This
equivalence implies that a project financed with internal equity should pass the same test
as a project financed with external equity; Disney has to earn a return on equity for
investors that is greater than 10% on projects funded with either external equity or
retained earnings. Second, internal equity is clearly limited to the cash flows generated
by the firm for its stockholders. Even if the firm does not pay dividends, these cash flows
may not be sufficient to finance the firm™s projects. Depending entirely upon internal
equity can therefore result in project delays or the possible loss of these projects to
competitors. Third, managers should not make the mistake of thinking that the stock price
does not matter, just because they use only internal equity for financing projects. In
reality, stockholders in firms whose stock prices have dropped are much less likely to
trust their managers to reinvest their cash flows for them than are stockholders in firms
with rising stock prices.

Growth, Risk and Financing

As firms grow and mature, their cash flows and risk exposure follow fairly
predictable patterns. Cash flows become larger, relative to firm value, and risk
approaches the average risk for all firms. The financing choices that a firm makes will
reflect these changes. To understand these choices, let us consider five stages in a firm™s
life cycle:
1. Start-up: This represents the initial stage after a business has been formed. Generally,
this business will be a private business, funded by owner™s equity and perhaps bank
debt. It will also be restricted in its funding needs, as it attempts to gain customers
and get established.
2. Expansion: Once a firm succeeds in attracting customers and establishing a presence
in the market, its funding needs increase as it looks to expand. Since this firm is
unlikely to be generating high cash flows internally at this stage and investment needs
will be high, the owners will generally look to private equity or venture capital
initially to fill the gap. Some firms in this position will make the transition to publicly
traded firms and raise the funds they need by issuing common stock.
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3. High Growth: With the transition to a publicly traded firm, financing choices
increase. While the firm™s revenues are growing rapidly, earnings are likely to lag
behind revenues, and internal cash flows lag behind reinvestment needs. Generally,
publicly traded firms at this stage will look to more equity issues, in the form of
common stock, warrants and other equity options. If they are using debt, convertible
debt is most likely to be used to raise capital.
4. Mature Growth: As growth starts leveling off, firms will generally find two
phenomena occurring. The earnings and cash flows will continue to increase rapidly,
reflecting past investments, and the need to invest in new projects will decline. The
net effect will be an increase in the proportion of funding needs covered by internal
financing, and a change in the type of external financing used. These firms will be
more likely to use debt in the form of bank debt or corporate bonds to finance their
investment needs.
5. Decline: The last stage in this life cycle is decline. Firms in this stage will find both
revenues and earnings starting to decline, as their businesses mature and new
competitors overtake them. Existing investments are likely to continue to produce
cash flows, albeit at a declining pace, and the firm has little need for new investments.
Thus, internal financing is likely to exceed reinvestment needs. Firms are unlikely to
be making fresh stock or bond issues, but are more likely to be retiring existing debt
and buying back stock. In a sense, the firm is gradually liquidating itself.
Figure 7.2 summarizes both the internal financing capabilities and external financing
choices of firms at different stages in the growth life cycle.
Not all firms go through these five phases, and the choices are not the same for all of
them. First, many firms never make it past the start-up stage in this process. Of the tens
of thousands of businesses that are started each year by entrepreneurs, many fail to
survive, and even those that survive often continue as small businesses with little
expansion potential. Second, not all successful private firms become publicly traded
corporations. Some firms, like Cargill and Koch Industries, remain private and manage to
raise enough capital to continue growing at healthy rates over long periods. Thirdly, there
are firms like Microsoft that are in high growth and seem to have no need for external
financing, as internal funds prove more than sufficient to finance this growth. There are
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high growth firms that issue debt, and low growth firms that raise equity capital. In short,
there are numerous exceptions, but the life cycle framework still provides a useful device
to explain why different kinds of firms do what they do, and what causes them to deviate
from the prescribed financing choices.
Note that while we look at a firm™s choices in terms of debt and equity at different
stages in the growth life cycle, there are two things we do not do in this analysis. First,
we do not explain in any detail why firms at each stage in the growth life cycle pick the
types of financing that they do. Second, we do not consider what kind of debt is best for a
firm “ short term or long term, dollar or foreign currency, fixed rate or floating rate. The
reason is that this choice has more to do with the types of assets the firm owns and the
nature of the cash flows from these assets, than with where in its life cycle a firm is in.
We will return to examine this issue in more detail in chapter 9.
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Figure 7.2: Life Cycle Analysis of Financing




Revenues
$ Revenues/
Earnings


Earnings



Time




External funding High, but High, relative Moderate, relative Declining, as a
Low, as projects dry
needs constrained by to firm value. to firm value. percent of firm
up.
infrastructure value


Negative or
Internal financing Negative or Low, relative to High, relative to More than funding needs
low
low funding needs funding needs


External Owner™s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock
Convertibles
Stage 1 Stage 2 Stage 4 Stage 5
Growth stage Stage 3
Start-up Rapid Expansion Mature Growth Decline
High Growth

Financing
Accessing private equity Inital Public offering Seasoned equity issue Bond issues
Transitions
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How Firms have Actually Raised Funds

In the first part of this chapter, we noted the range of choices in terms of both debt
and equity that are available to firms to raise funds. Before we look at which of these
choices firms should use, it is worth noting how firms have historically raised funds for
operations. While firms have used debt, equity and hybrids to raise funds, their
dependence on each source has varied across time. In the United States, for instance,
firms have generally raised external financing through debt issues rather than equity
issues, and have primarily raised equity funds internally from operations. Figure 7.3
illustrates the proportion of funds from new debt and equity issues, as well as from
internal funds, for U.S. corporations between 1975 and 2001.

Figure 7.3: External and Internal Financing at US Firms


100%



90%



80%



70%



60%



50%



40%

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