Financing Innovations and Capital Structure Choices

Aswath Damodaran

Stern School of Business

New York University

[email protected]
 Abstract

The last two decades have seen a stream of innovation in financial markets, especially in

the corporate bond arena. Some of these innovations were designed to give firms more

flexibility in designing cash flows on borrowings, allowing them to match up cash flows

on financing more closely to cash flows on assets, thus increasing their debt capacity.

These changes have been for the most part good news for corporate treasurers, but the

relentless torrent of innovation has also resulted in some firms issuing these new and

more complex securities for the wrong reasons. Some have done so to keep up with other

firms in their peer group, and other to take advantage of loopholes in the way ratings

agencies and regulatory agencies define debt and equity. In this context, it is worth

noting that as corporate bonds have become more complex, investment bankers once

more become indispensable to the process, proving both pricing and selling support. It is

important that firms recognize when complexity serves their interests, and when it can

end up hurting them.

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 Firms, until the mid-seventies, had fairly simple choices when it came to

financing. They could raise equity by issuing common stock or debt by borrowing from a

bank or by issuing bonds. When borrowing, firms could choose between different

maturities and degrees to which the debt was secured by the assets of the firm (secured,

unsecured and subordinated debt). A few firms were daring enough to issue convertible

bonds.

The surge in inflation in the late seventies and the concurrent increase in the

volatility of interest rates created the first wave of innovation in debt securities, with

floating rate debt becoming a viable choice for most borrowers. Through the eighties, the

innovation continued. Some of the innovations, such as the introduction of ratings

sensitive bonds (where coupon rates vary with the company's bond rating), and equity-

linked bond issues (such as LYONs and TIGRs) were driven by the need to reassure bond

investors that they would be protected in the event the borrower attempted to expropriate

wealth from them. Others, such as mortgage-backed securities, were created to allow

firms to securitize assets which had hitherto been idle. Much of this innovation was

facilitated by a greater understanding of how to incorporate multiple options into

borrowing instruments, and how to price these complex securities.

In the course of these innovations, investment banks also discovered the allure of

coming up with new and more complex securities - they were much more profitable than

ta raditional straight bond with a fixed maturity and coupon. Thus, corporate finance

departments have continued through the nineties to offer their clients new and different

ways of raising financing. While there are a number of different motivations for these

innovations, some of these new securities share a common feature. Without being

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convertible into equity (like convertible bonds), they manage to still be hybrid securities-

they preserve the tax advantage associated with debt and have cash flows that make them

look more like equity securities. This paper is designed to explore the rationale for the

use of such securities and the potential dangers to firms from their overuse.

A Rationale for Debt/Equity Securities

To see why securities that play a dual role (of debt and equity) are appealing to

firms, consider the traditional choice between debt and equity. The trade off is simple.

Debt has a tax advantage, but it brings with it a greater risk of bankruptcy for the firm,

because the obligation to make fixed payments (interest and principal payments) remains

even when earnings drop. Thus, the optimal debt ratio is one where the net difference

between the tax benefits and the expected bankruptcy cost is maximized:

Value of Levered Firm = Value of Unlevered Firm + PV of Tax Benefits - PV of

Expected Bankruptcy Costs

Since bankruptcy costs are largely a result of the fact that the firm has to make

fixed payments even in periods when earnings are poor, consider borrowing money on a

security where interest payments are not fixed but vary as earnings vary. This reduces the

expected bankruptcy cost and increases both the optimal debt ratio for a firm and the total

firm value at that leverage.

To see why firms should match up cash flows on assets to cash flows on liabilities, let us

begin by defining firm value as the present value of the cash flows generated by the

assets owned by the firm. This firm value will vary over time, not only as a function of

firm-specific factors such as project success but also as a function of broader macro

economic variables - interest rates, inflation rates, economic cycles and exchange rates.

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Figure 1 provides the time series of firm value for a hypothetical firm, where all of the

changes in firm value are assumed to occur as a result of changes in macro economic

variables.

Figure 1: Firm Value over time

Firm Value

Value of Debt

Time (t)
This firm can choose to finance these assets with any financing mix it wants. The value

of equity at any point in time is the difference between the value of the firm and the value

of outstanding debt. Assume, for instance, that the firm chooses to finance the assets

shown in Figure 1 using very short term debt, and that this debt is unaffected by changes

in macro economic variables. Figure 2 provides the firm value, debt value and equity

value over time for the firm.

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 Figure 2: Firm Value over time with Short Term Debtt

Firm Value

Firm is bankrupt

Time (t)

Note that there are periods when the firm value drops below the debt value, which would

suggest that the firm is flirting with bankruptcy in those periods. Firms that weigh this

possibility into their financing decision will therefore borrow much less.

Now consider a firm which finances the assets described in Figure 1 with debt

that matches up exactly to the assets, in terms of cash flows, and also in terms of the

sensitivity of debt value to changes in macro economic variables. Figure 3 provides the

firm value, debt value and equity value for this firm.

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 Figure 3: Firm Value over time with Matched Debtt

Firm Value
Value of Equity

Value of Debt

Time (t)
Since debt value and firm value move together here, the possibility of default is

significantly reduced. This, in turn, will allow the firm to carry much more debt, and the

added debt should provide tax benefits that make the firm more valuable. Thus, matching

liability cash flows to asset cash flows allows firms to have higher optimal debt ratios.

Examples of Securities

To examine how such securities would work, consider two innovations from the

last decade. The first is the commodity bond, where the coupon payments on the bond are

linked to the price of a specific commodity, such as gold or oil. For a gold mining

company, whose earnings are driven primarily by the price of gold, issuing commodity

bonds is an option that allows it to get the tax advantage associated with interest

payments, while reducing the risk of bankruptcy (that would have been associated with

issuing straight bonds) in the event of a sharp drop in gold prices. The second is the

catastrophe bond, where coupon payments and principal payments (in some cases) can be

reduced or suspended in the event of a specified catastrophe (such as an earthquake or a

flood). For an insurance firm, which has significant exposure to liability claimes in a state

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like California, this bond can provide a way of using debt without the concurrent risk of

bankruptcy that would accompany a major natural disaster.

As an example of a catastrophe 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 hurricane, but the principal would be protected. In

return, the investors in these bonds, in October 1997, were earning an extra yield of

almost 1.5% on the principal-at-risk bonds and almost 0.5% on the principal-protected

bonds.

Where is the increase in value coming from?

It is important to note that the value added from these securities does not come

from fooling the bond buyers. They will clearly charge an appropriate premium over the

interest rate that they would have settled for on a straight bond. Thus, an insurance

company which issues catastrophe bonds will have to pay a higher interest rate than one

that issues a straight bond. If the firm had not issued these bonds, however, the expected

bankruptcy cost might have prevented them from ever borrowing. Even with a higher

interest rate, the catastrophe bonds may be less expensive than using equity.

The increase in value does not come from risk reduction, per se. As the

diversification argument goes, investors could have accomplished the same results using

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other traded securities (such as options or futures). Even in the case of risks that private

investors cannot easily trade on (such as the risk of a catastrophe), the argument can be

made that investors choose to expose themselves to this risk by buying stock in the

insurance firm. This diversification argument does not hold for private or closely held

firms, where the reduction in risk can lead to an increase in value.

The real source of the increase in value comes from the increase in debt capacity,

which allows firm to have a larger tax benefit with lower expected bankruptcy costs,

leading to a higher overall value for both the firm and its stockholders. It stands to reason,

then, that this value increment will not be garnered by firms which do not take advantage

of the cash flow matching on the debt to borrow more. For such firms, it can be argued

that the new securities will create little or no value.

The Derivative Alternative

Firms can create the equivalent of these debt/equity securities, by issuing straight

debt and using derivatives to make the net cash flows on the debt match up to the cash

flows on the assets. For instance, a gold mining company can issue long term straight

bonds and sell futures contracts on gold (or buy put options on gold) to create cash flows

similar to those in commodity bonds. As a general rule, firms should compare the long

term costs of using this approach to the costs associated with using bonds with these

features incorporated in them and choose the cheaper alternative. The use of straight

bonds in conjunctionwith derivatives can create larger costs in the long term but it does

provide for more flexibility where firms can vary the degree to which they match debt

cash flows and cash flows on assets from period to period.

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 As a general rule, it seems reasonable to argue that firms which have long term,

stable exposure to specific risk should try to incorporate protection against this risk into

their financing. Firms which have short term and/or time-varying exposure to a specific

risk will be better off using derivatives to protect themselves against this risk.

Alternate and Less Compelling Reasons for the Use of

Debt/Equity Securities

In this paper, so far, we have established a good reason for the creation and

issuance of many of the complex securities that have been created in recent years. In this

section, we will look at other reasons for the issuance of these securities that are, in our

view, less compelling and could potentially get firms into trouble.

1. To Take Advantage of Ratings Agency and Regulatory Loopholes

There is an alternative rationale used by some firms for issuing securities that

look like debt on some dimensions and equity on others. Firms are rightfully concerned

about the views of equity research analysts and ratings agencies on the actions they take,

though they often overestimate the influence of both groups. Analysts represent

stockholders, and ratings agencies represent bond holders; 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 actions using very different criteria. In

general, analysts view a firm’s actions through the prism of higher earnings per share and

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by looking at the firm relative to comparable firms, using multiples such as PE or PBV

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. Optimally,

firms would like to issue securities that look like cheap debt to equity research analysts

and safe equity to ratings agencies. To the degree that analysts and ratings agencies rely

on rigid definitions of debt and equity, firms can exploit limitations in these definitions to

present a security as debt to analysts and equity to ratings agencies. As an example,

consider the use of trust preferred stock by some firms. These are securities where firms

make fixed payments that are tax deductible, making them debt in the views of many

equity research analysts. They generally have perpetual lives, and can lay claim to the

cash flows and assets of the firm only after other debt holders have been paid, making

them quasi-equity in the eyes of the ratings agencies.

Firms such as banks and insurance firms have a third group that they have to keep

happy - regulators. To the degree that regulatory constraints exist on the capital structure

of these firms, they look for ways to issue securities that preserve the tax advantages of

debt, while meeting the regulatory definition of equity. As an example, insurance

companies in the United States have issued surplus notes, which are considered debt for

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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.1

There is clearly nothing untoward about a firm taking a financing issue that makes

sense from a fundamental standpoint, and then working with it to make it palatable and

even attractive to equity research analysts, ratings agencies and regulators. Thus a firm

which has excess debt capacity, which feels that it is being scrutinized closely by the

ratings agencies, can choose to issue trust preferred. The real danger is when firms issue

securities that cannot be justified on a fundamental basis, solely to take advantage of

loopholes in how ratings agencies or regulatory agencies define debt and equity. When

securities are designed in such a way, the real question is whether the markets are fooled

and if so, for how long. A over-levered firm that substitutes trust preferred for debt may

fool the ratings agency 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.

2. To Be At the Forefront of Financial Innovation

There are some firms that feel straight bonds are passe, and that only stodgy

corporate finance departments would issue such securities. The reality, however, is that

there are some firms whose asset and cash flow structure is such that the right securities

for them might be long-term dollar-denominated straight bonds with no special features.

If such firms issue more complex securities, out of the misguided view that it reveals how

sophisticated they are, they incur unnecessary costs. They may also end up with a

1 In 1994 and 1995, insurance companies issued a total of $ 6 billion of surplus notes in the private

placement market.

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mismatch on cash flows on debt and cash flows on assets that ends up lowering their

capacity to carry debt.

The simple rule in corporate finance is that firms should issue the securities that

are best suited to the assets that they are financing and should not be influenced by how

other firms around them, even in their peer group, are choosing to finance their needs.

The herd mentality is strong and tough to fight, but it should not be allowed to determine

financing choices.

3. To Fool Bond Buyers

While no firm (or investment banker advising it) would ever admit to such a

motive, the creation of more and more complex securities, with options piled on top and

other options, has clearly made bond valuation difficult to do for anyone without a

research department filled with doctorates in mathematics. To some issuers, the difficulty

that bond buyers face in pricing complex bonds provides an opportunity to issue these

bonds at prices above their true value.

This rationale has two major flaws. The first is that even if this can be done, firms

that do it lose valuable credibility with financial markets, and subsequent issues will be

greeted with skepticism by bond buyers. The second is that it is not a good idea to take

advantage of your own investors, whether they be stock or bond investors, since it is their

firm once they make the investment. The third is that investors are often much more

sophisticated than issuers give them credit for, and in many cases end up being right in

the long term.

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4. To Make Financial Intermediaries Indispensable

It is perhaps coincidence that the greatest wave of innovation has occurred in

bond markets, and that much of this innovation started occurring at the same time as

corporations were gaining more confidence in and control over the process of issuance.

The advent of shelf registration and the breakdown of relationship investment banking in

the late seventies put considerable pressure on the fees that investment banks were able to

charge on conventional straight bonds.

The more complex instruments that emerged from all of the financial innovation

of the last two decades have made investment bankers indispensable once again. First,

only the investment bankers have the "quant" power, with their well-stocked research

departments to actually price these securities. Second, the complexity of these securities

is such that they appeal to only certain sub-sets of investors; the investment banker is

familiar with these investors, knows how to reach them and has the salespeople to place

securities with them. Not surprisingly, these complex securities earn much larger

commissions for investment banks.

It is possible that I am just paranoid, and that investment bankers have only their

client's best interests at heart. It is also possible that they would not recommend these

more complex securities to firms when simpler securities may be all that is needed.

A General Framework for Designing Securities

In deciding on the optimal financing mix, firms should begin by examining the

characteristics of the assets that they own: Are they long term of short term? How

sensitive are they to economic conditions and inflation? What currencies are the cash

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flows in?. They should try to match up the maturity, interest rate and currency mix, and

special features on their financing to these characteristics. They can then superimpose a

series of considerations that may lead the firm to deviate from or modify this financing

mix. First, consider the tax savings that may accrue from using different financing

vehicles, and weigh the tax benefits against the costs of deviating from the mix. Next,

examine the influence that equity research analysts and ratings agency views have on the

choice of financing vehicle; instruments that are looked on favorably by either or, better

still, both groups will clearly be preferred to those that evoke strong negative responses

from them. Finally, factor in the difficulty that you might have in conveying information

to markets; in the presence of asymmetric information, firms may have to make financing

choices that do not reflect their asset mix. Finally, allow for the possibility that you may

want to structure their financing to reduce agency conflicts between stockholders and

bondholders. These steps are summarized in Figure 4.

Conclusion

The innovations in corporate bonds that have occurred in the last two decades

have been caused by a number of factors. The increase in volatility in interest rates that

accompanied higher inflation in the late seventies and the globalization of U.S. firms (and

the consequent exposure to exchange rate risk) played a role. Firms also recognized that

adding options to debt, whether these options were on commodity prices, currency rates

or related to the occurrence of specific events, could reduce their exposure to bankruptcy

risk and increase their capacity to borrow more. Thus, securities have become more

complex over time.

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 It is also worth noting, however, that some firms have issued more complex

securities for the wrong reasons - to be like other firms that might have issued similar

securities, to take advantage of loopholes in the way ratings agencies and regulatory

agencies define debt and equity and fool bond buyers. Investment banks which generate

larger fees on complex securities clearly have their own incentives to get firms to use

these securities.

As in all commercial transactions, firms should look out for their own interests.

They should recognize that issuing these innovative securities which are unsuited to their

needs not only exposes them to unnecessary expenses, but may actually increase their

risk of bankruptcy and reduce debt capacity. Fooling ratings agencies, regulatory

authorities and bond buyers is a short-term tactic that will boomerang on firms in the long

term.

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