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difference, the firm might have to consider changing the duration of its liabilities. For
instance, if Disney™s assets have a duration of 15 years, and its liabilities have a duration
of only 5 years, the firm should try to extend the duration of its liabilities. It can do so in
one of three ways. First, it can finance its new investments with debt of much longer


duration; thus, using 100-year bonds to finance the new theme park will increase the
weighted average duration of all its liabilities. Second, it can repay some of its short term
debt and replace it with long term debt. Third, it can exchange or swap short term debt
for long term debt.

9.9. ˜: Project and Firm Duration
Which of the following types of firms should be most likely to use project specific
financing (as opposed to financing the portfolio of projects)?
a. Firms with a few large homogeneous projects
b. Firms with a large number of small homogeneous projects
c. Firms with a few larger heterogeneous projects
d. Firms with a large number of small heterogeneous projects

B. The Fixed/Floating Rate Choice
One of the most common choices firms face Floating Rate Debt: The interest
rate on floating rate debt varies from
is whether to make the coupon rate on bonds (and
period to period and is linked to a
the interest rate on bank loans) a fixed rate or a
specified short term rate; for instance,
floating rate, pegged to an index rate such as the
many floating rate bonds have coupon
LIBOR. In making this decision, we once again rates that are tied to the London
Interbank Borrowing Rate (LIBOR).
examine the characteristics of the projects being
financed with the debt. In particular, we argue that
the use of floating rate debt should be more prevalent for firms that are uncertain about
the duration of future projects, and that have cash flows that move with the inflation rate.
Uncertainty about Future Projects
The duration of assets and liabilities can be matched up to select financing with
the right maturity if the assets and projects of a firm are well identified so that their
interest rate sensitivity can be estimated easily. For some firms, this estimation may be
difficult to do, however. The firm might be changing its business mix by divesting itself
of some assets and acquiring new assets. Alternatively, the industry to which the firm
belongs might be changing. In such cases, the firm may use short term or floating rate


loans that are easy to change13, until it feels more certain about its future investment
Cash Flows and Inflation
Floating rate loans have interest payments that increase as market interest rates
rise and fall as rates fall. If a firm has assets whose earnings increase as interest rates go
up, and decrease as interest rates go down, it should finance those assets with floating
rate loans. The expected inflation rate is a key ingredient determining interest rates. On
floating rate loans, this rate will lead to high interest payments in periods when inflation
is high, and low interest payments in periods when inflation is low. Firms whose earnings
increase in periods of high inflation, and decrease
PERLS: This is a bond, denominated in
in periods with low inflation should therefore also
the domestic currency, where the
be more likely to use floating rate loans.
principal payment at maturity is based
A number of factors determine whether a upon the domestic currency equivalent of
firm™s earnings move with inflation. One critical a fixed foreign currency amount. For
instance, this could be a dollar
ingredient is the degree of pricing power the firm
denominated bond with the payment at
possesses. Firms that have significant pricing
maturity set equal to the dollar value of
power, either because they produce a unique
1600 Deutsche Marks. Thus, if the dollar
product or because they are price-leaders in their strengthens against the DM during the
industries, have a much higher chance of being life of the bond, the principal payment
will decrease.
able to increase their earnings as inflation
increases. Consequently, these firms should gain more by using floating rate debt. Firms
that do not have pricing power are much more likely to be see cash flows decline with
unexpected inflation, and they should be more cautious about using floating rate debt.

C. The Currency Choice
Many of the points we have made about interest rate risk exposure also apply to
currency risk exposure. If any of a firm™s assets or projects creates cash flows
denominated in a currency other than the one in which the equity is denominated,
currency risk exists. The liabilities of a firm can be issued in these currencies to reduce

13 The presence of derivatives provides an alternative for firms that are faced with this uncertainty. They
can use the financing mix that is most appropriate given their current asset mix and use derivatives to
manage the intermediate risk.


the currency risk. A firm that expects 20% of its cash flows to be in Euros, for example,
would attempt to issue Euro-denominated debt in the same proportion to mitigate the
currency risk. If the Euro weakens and the assets become less valuable, the value of the
debt will decline proportionately.
In recent years, firms have used more sophisticated variations on traditional bonds
to manage foreign exchange risk on investments. For instance, Philip Morris issued a
dual currency bond in 1985 ““ coupon payments were made in Swiss Francs, while the
principal payment was in U.S. Dollars. In 1987, Westinghouse issued Principal Exchange
Rate Linked Securities (PERLS), in which the principal payment was the US Dollar value
of 70.13 New Zealand dollars. Finally, firms have issued bonds embedded with foreign
currency options called Indexed Currency Option Notes (ICON), which combine a fixed
rate bond with an option on a foreign currency. This approach is likely to work only for
firms that have fairly predictable currency flows, however. For firms that do not have
predictable currency flows, currency options or futures may be a cheaper way to manage
currency risk, since the currency exposure changes from period to period.
D. The Choice between Straight and Convertible Bonds
Firms vary in terms of how much of their value comes from projects or assets
they already own and how much comes from future growth. Firms that derive the bulk of
their value from future growth should use different types of financing and design their
financing differently than do those that derive most of their value from assets in place.
This is so because the current cash flows on high growth firms will be low, relative to the
market value. These cash flows can be expected to grow substantially over time, as the
firm invests in new projects. Accordingly, the financing approach should not create large
cash outflows early; it can create substantial cash outflows later, however, reflecting the
cash flow patterns of the firm. In addition, the financing should exploit the value that the
perception of high growth adds to securities, and it should put relatively few constraints
on investment policies.
Straight bonds do not quite fit the bill, because they create large interest payments
and do not gain much value from the high growth perceptions. Furthermore, they are
likely include covenants designed to protect the bondholders, which restrict investment
and future financing policy. Convertible bonds, by contrast, create much lower interest


payments, impose fewer constraints, and gain value from higher growth perceptions.
They might be converted into common stock, but only if the firm is successful. In 1999,
for instance, Amazon.com, the online retailer, raised $ 1.25 billion from a convertible
bond issue with a coupon rate of 3.5%.
E. Special Financing Features
Every firm is exposed to risk, coming from macro economic sources such as
recessions, acts of god such as the weather, acts of competitors or technological shifts. If
a firm™s exposure to any or all these sources of risk is substantial, it may choose not to
borrow, rather than risk default. One way in which firms can partially protect themselves
against this default risk is to incorporate special features into bonds or debt, shielding
themselves against the most serious risk or risks. Two examples of bonds provide good
Insurance companies, for instance, have issued bonds whose payments can be

drastically curtailed if there is a catastrophe14 that creates a substantial liability for the
insurance company. By doing so, they reduce their debt payments in those periods
when their overall cash flows are most negative, thereby reducing their likelihood of
Companies in commodity businesses have issued bonds whose principal and interest

payments are tied to the price of the commodity. Since the operating cash flows in
these firms are also positively correlated with commodity prices, adding this feature
to debt decreases the likelihood of default and allows the firm to use more debt. In
1980, for instance, Sunshine Mining issued 15-year silver linked bond issues, which
combined a debt issue with an option on silver prices. As silver prices increased, the
coupon rate on the bond increased; as silver prices decreased, the coupon rate on the
bond decreased as well.

14 As an example of a catastophe bond issue, consider the bond issue made by USAA Insurance Company.
The company privately placed $ 477 million of these bonds, backed up by reinsurance premiums, in June
1997. The company was protected in the event of any hurricane that created more that $ 1 billion in damage
to the East Coast anytime before June 1998. The bonds came in two classes; in the first class, called
principal-at-risk, the company could reduce the principal on the bond in the event of a hurricane; in the
second class, which was less risky to investors, the coupon payments would be suspended in the event of a
hurricance, but the principal would be protected. In return, the investors in these bonds, in October 1997,


In Practice: Customized Bonds
In keeping with the notion of customizing bonds to match asset cashflows, firms
have come up with increasingly creative solutions in recent years. In this endeavor, they
have been assisted by two developments. The first is that investors in bond markets are
more open to both pricing and buying complex bonds than they were in the 1970s and
even the 1980s. The second is that advancements in option pricing allow us to value
complicated securities with multiple options embedded in them. Let us consider a few
In the early 1990s, David Bowie acquired the rights to all of his songs, bundled

them and sold bonds backed record sales. What made the bonds unique was the
fact that the interest rate on the bonds was tied to the sales of his record “ higher
(lower) rates with higher (lower) sales.
In 2001, an Italian soccer team issued bonds to fund the construction of a stadium

but tied the interest rate on the bond to the success of the team. Specifically, the
interest rate on the bond would rise if the team stayed in the first division (and
draw larger crowds and revenues) and drop if the team dropped to the second

9.10. ˜: Special Features and Interest Rates
Adding special features to bonds, such as linking coupon payments to commodity
prices or catastrophes, will reduce their attractiveness to investors and make the interest
rates paid on them higher. It follows then that
a. companies should not add these special features to bonds
b. adding these special features cannot create value for the firm if the bonds are fairly
c. adding special features can still create value even if the bonds are fairly priced

were earnings an extra yield of almost 1.5% on the principal-at-risk bonds and almost 0.5% on the
principal-protected bonds.


II. Tax Implications
As firms become more creative with their financing choices and structure debt
that behaves more and more like equity, there is a danger that the tax authorities might
decide to treat the financing as equity and prevent the firm from deducting interest
payments. Since the primary benefit of borrowing is a tax benefit, it is important that
firms preserve and, if possible, increase this tax benefit.
It is also conceivable that the favorable tax treatment of some financing choices
may encourage firms to use them more than others, even if it means deviating from the
choices that would be dictated by the asset characteristics. Thus, a firm that has assets
that generate cash flows in Japanese yen may decide to issue dollar-denominated bonds
to finance these assets, if it derives a larger tax benefit from issuing dollar debt than yen
The danger of structuring financing with the intention of saving on taxes is that
changes in the tax law can very quickly render the benefit moot and leave the firm with a
financing mix, that is unsuited to its asset mix.

III. Views of Ratings Agencies, Equity Research Analysts and Regulatory
Firms are rightfully concerned about the views of equity research analysts and
ratings agencies on their actions, though in our view, they often overestimate the
influence of both groups. Analysts represent stockholders, and ratings agencies represent
bondholders; consequently they take very different views of the same actions. For
instance, analysts may view a stock repurchase by a company with limited project
opportunities as a positive action, while ratings agencies may view it as a negative action
and lower ratings in response. Analysts and ratings agencies also measure the impact of
financing choices made by a firm, using very different criteria. In general, analysts view a
firm™s actions through the prism of higher earnings per share and by looking at the firm
relative to comparable firms, using multiples such as price earnings or price to book
value ratios. Ratings agencies, on the other hand, measure the effect of actions on the
financial ratios, such as debt ratios and coverage ratios, which they then use to assess
default risk and assign ratings.


Given the weight attached to the views of both these groups, firms sometimes
design securities with the intent of satisfying both groups. In some cases, they find ways
of raising funds that seem to make both groups happy, at least on the surface. To
illustrate, consider the use of leasing, before generally accepted accounting principles
required capitalizing of leases. Leasing increased the real leverage of the company, and
thus, the earnings per share, but it did not affect the measured leverage of the company
because it was not viewed as debt. To the degree that analysts and ratings agencies rely
on quantitative measures and do not properly factor in the effects of these actions, firms
can exploit their limitations. In fact, they still do with operating leases. In a more recent
example, trust preferred stock, , has become popular largely because of the different ways
in which it is viewed by different entities. It is viewed as debt by the equity research
analysts and tax authorities, with the preferred dividend being tax deductible. Trust


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