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preferred is viewed as equity by ratings agencies, allowing the firms issuing it to retain
high ratings.15
When securities are designed in such a way, the real question is whether the
markets are fooled, and if so, for how long. A firm that substitutes leases and trust
preferred for debt may fool the ratings agencies and even the debt markets for some
period of time, but it cannot evade the reality that it is much more levered and hence
much riskier.
This balancing act becomes even more precarious for regulated firms such as
banks and insurance companies. These firms also have to make sure that any financing
actions they take are viewed favorably by regulatory authorities. For instance, financial
service firms have to maintain equity capital ratios that exceed regulatory minimums.
However, regulatory authorities use a different definition of equity capital than ratings
agencies and equity research analysts, and firms can exploit these differences. For
instance, banks are among the heaviest users of preferred stock, since preferred stock is
treated as equity by bank regulators. In the last few years, insurance companies in the

15Ratings agencies initially treated trust preferred as equity. Over time, they have become more cautious.
By the late nineties, firms were being given credit for only a portion of the trust preferred (about 40%).


United States have issued surplus notes16, which are considered debt for tax purposes and
equity under insurance accounting rules, enabling them to have the best of both worlds ““
they could issue debt, while counting it as equity.17

IV. The Effects of Asymmetric Information
Firms generally have more information about their future prospects than do
financial markets. This asymmetry in information creates frictions when firms try to raise
funds. In particular, firms with good prospects try to distinguish themselves from firms
without such prospects by taking actions that are costly and difficult to imitate. Firms
also try to design securities to reduce the effect of uncertainty in future cash flows. Firms
may therefore issue securities that may not be optimal from the standpoint of matching
their asset cash flows but are specifically designed to convey information to financial
markets and reduce the effects of uncertain cash flows on value.
A number of researchers have used this information asymmetry argument to draw
very different conclusions about the debt structure firms should use. Myers (1977) argued
that firms tend to under invest as a consequence of the asymmetry of information. One
proposed solution to the problem is to issue short term debt, even if the assets being
financed are long term assets.18 Flannery (1986) and Kale and Noe (1990) note that while
both short-tem and long-term debt will be mispriced in the presence of asymmetric
information, long-term debt will be mispriced more.19 Consequently, they argue that high
quality firms will issue short-term debt, while low quality firms will issue long-term debt.
Goswami, Noe, and Rebello (1995) analyze the design of securities and relate it to
uncertainty about future cash flows.20 They conclude that if the asymmetry of
information concerns uncertainty about long-term cash flows, firms should issue coupon-

16 As defined in chapter 16, surplus notes are bonds where the interest payments need to be made only if
the firm is profitable. If it is not, the interest payments are cumulated and paid in subsequent periods.
17 In 1994 and 1995, insurance companies issued a total of $ 6 billion of surplus notes in the private
placement market.
18 Myers, S.C., 1977, Determinants Of Corporate Borrowing, Journal of Financial Economics, v5(2), 147-
19 Flannery, M. J. Asymmetric Information And Risky Debt Maturity Choice, Journal of Finance, 1986,
v41(1), 19-38; Kale, J.R. and T. H. Noe, Risky Debt Maturity Choice in A Sequential Game Equilibrium,
Journal of Financial Research, 8, 155-165.
20 Goswami, G.,T. Noe and M. Rebello. Debt Financing Under Asymmetric Information, Journal of
Finance, 1995, v50(2), 633-659.


bearing long term debt, with restrictions on dividends. In contrast, firms with uncertainty
about near-term cash flows and significant refinancing risk should issue long term debt,
without restrictions on dividend payments. When uncertainty about information is
uniformly distributed across time, firms should finance with short term debt.

V. Implications for Agency Costs
The final consideration in designing securities is the provision of features
intended to reduce the agency conflicts between stockholders and bondholders. As we
noted in Chapter 7, differences between bondholders and stockholders on investment,
financing and dividend policy decisions can influence capital structure decisions, either
by increasing the costs of borrowing or by increasing the constraints associated with
borrowing. In some cases, firms design securities with the specific intent of reducing this
conflict and its associated costs:
We explained that convertible bonds are a good choice for growth companies because

of their cash flow characteristics. Convertible bonds can also reduce the anxiety of
bondholders about equity investors investing in riskier projects and expropriating
wealth, by allowing bondholders to become stockholders if the stock price increases
More corporate bonds include embedded put options that allow bondholders to put

the bonds back at face value if the firm takes a specified action (such as increasing
leverage) or if its rating drops. In a variation, in 1988, Manufacturer Hanover issued
rating sensitive notes promising bondholders higher coupons if the firm™s rating
deteriorated over time. Thus, bond investors would be protected in the event of a
Merrill Lynch introduced LYONs (Liquid Yield Option Notes), which incorporated

put and conversion features to protect against both the risk shifting and claim
substitution to which bondholders are exposed.
Barclay and Smith (1996) examine debt issues by U.S. companies between 1981
and 1993 and conclude that high growth firms are more likely to issue short term debt


with higher priority.21 This finding is consistent with both the information asymmetry
argument and the agency cost argument, since lenders are more exposed to both costs
with high growth firms.

In Summary
In choosing the right financing vehicles to use, firms should begin by examining
the characteristics of the assets they are financing and try to match the maturity, interest
rate and currency mix, and special features of their financing to these characteristics.
They can then superimpose tax considerations, the views of analysts and ratings agencies,
agency costs and the effects of asymmetric information to modify this financing mix.
Figure 9.5 summarizes the discussion on the preceding pages.

In Practice: The Role of Derivatives and Swaps
In the last 30 years, the futures and options markets have developed to the point
that firms can hedge exchange rate, interest rate, commodity price and other risks using
derivatives. In fact, firms can use derivatives to protect themselves against risk exposures
that are generated by mismatching debt and assets. Thus, a firm that borrows in dollars to
fund projects denominated in Yen can use dollar/yen forward, futures and options
contracts to reduce or even eliminate the resulting risk. Given the existence of these
derivatives, you may wonder why it is even necessary to go through the process that we
have just described to arrive at the perfect debt. We would offer tow reasons. The first is
that the use of derivatives can be costly, if used recurrently. Thus, a firm with a stable
portion of its revenues coming from Yen will find it cheaper to use Yen debt rather than
using derivatives to correct mismatched debt. Derivatives are useful, however, to hedge
against risk exposure that is transient and volatile. A company like Boeing, for instance,
whose currency exposure can shift from year to year depending upon who they sell
planes to will find it cheaper to use derivatives to hedge the shifting risk. The second
problem with derivatives is that while they are widely available in some cases, they are
much more difficult to find in others. Thus, a Brazilian firm that borrows in US dollars to

21Barclay, M.J., and C.W. Smith, On Financial Architecture: Leverage, Maturity and Priority, Journal of
Applied Corporate Finance, v8(4), 4-17.


fund Brazilian real denominated projects will find it very difficult to hedge against risk
beyond the short term because there are no long term forward and futures contracts
available for dollars versus Real.
What about swaps? Swaps can be useful for firms that have a much better
reputation among investors in one country (usually, the domestic market in which they
operate) than in other markets. In such cases, these firms may choose to raise their funds
domestically even for overseas projects, because they get better terms on their financing.
This creates a mismatch between cash inflows and outflows, which can be resolved by
using currency swaps, where a firm™s liabilities in one currency can be swapped for
liabilities in another currency. This enables the firm to take advantage of its reputation
effect and match cash flows at the same time.Generally speaking, swaps can be used to
take advantage of any “market” imperfections that a firm might observe. Thus, if floating
rate debt is attractively priced relative to fixed rate debt, a firm which does not need
floating rate debt can issue it, and then swap it for fixed rate debt at a later date.


FIGURE 9.5: The Design of Debt: An Overview of the Process Examples

Start with the
Cyclicality &
Cash Flows
Growth Patterns Other Effects
on Assets/ Duration Currency Effect of Inflation
Projects Uncertainty about Future

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
* More floating rate Convertible on Debt Catastrophe Notes
Duration/ Currency
- if CF move with inflation - Convertible if - Options to make
Define Debt Maturity Mix
- with greater uncertainty cash flows low cash flows on debt
on future now but high match cash flows
exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed

Deductibility of cash flows Differences in tax rates
Overlay tax Zero Coupons
for tax purposes across different locales
If tax advantages are large enough, you might override results of previous step

Consider Analyst Concerns Ratings Agency Regulatory Concerns
Operating Leases
ratings agency - Effect on EPS - Effect on Ratios - Measures used
& analyst concerns - Value relative to comparables - Ratios relative to comparables
Surplus Notes

Can securities be designed that can make these different entities happy?

Observability of Cash Flows Type of Assets financed
Existing Debt covenants Convertibiles
by Lenders - Tangible and liquid assets
Factor in agency - Restrictions on Financing Puttable Bonds
- Less observable cash flows create less agency problems
conflicts between stock Rating Sensitive
lead to more conflicts
and bond holders Notes
If agency problems are substantial, consider issuing convertible bonds

Consider Information Uncertainty about Future Cashflows Credibility & Quality of the Firm
Asymmetries - When there is more uncertainty, it - Firms with credibility problems
may be better to use short term debt will issue more short term debt


Illustration 9.6: Coming Up With The Financing Details: Disney
In this illustration, we describe how we would make financing choices for Disney,
using two approaches, one intuitive and the other more quantitative. Both approaches
should be considered in light of the analysis done in the previous chapter, which
suggested that Disney had untapped debt potential that could be used for future projects.
Intuitive Approach
The intuitive approach begins with an analysis of the characteristics of a typical
project and uses it to make recommendations for the firm™s financing. For Disney, the
analysis is complicated by the fact that as a diverse entertainment business with theme
park holdings, its typical project varies by type of business. In chapter 4, we broke down
Disney into four businesses “ movies, broadcasting, theme parks and consumer products.
In table 9.11 , we consider the typical project in each business and the appropriate debt
for each:
Figure 9.11: Designing Disney™s perfect debt “ Intuitive Analysis
Business Project Cash Flow Characteristics Type of Financing
Movies Projects are likely to Debt should be
1. Be short term 1. Short term
2. Have cash outflows primarily in dollars 2. Primarily dollar
(since Disney makes most of its movies debt.
in the U.S.) but cash inflows could have a 3. If possible, tied
substantial foreign currency component to the success of
(because of overseas sales) movies. (Lion
3. Have net cash flows that are heavily King or Nemo
driven by whether the movie is a “hit”, Bonds)
which is often difficult to predict.
Broadcasting Projects are likely to be Debt should be
1. Short term 1. Short term
2. Primarily in dollars, though foreign 2. Primarily dollar
component is growing debt
3. Driven by advertising revenues and show 3. If possible,
success linked to
network ratings.
Theme Parks Projects are likely to be Debt should be
1. Very long term 1. Long term
2. Primarily in dollars, but a significant 2. Mix of
proportion of revenues come from foreign currencies,


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