Description
Walt Disney case used in Strategic Financial Management.
KeyWords: Yen Financing, Swaps, French Utility
The Walt Disney Company’s Yen Financing
Q.1: Should Walt Disney hedge its yen royalty cash flows? Why or why not? If so, how much should be hedged and over what time frame? The arguments in favour of hedging are: 1. The trend from years 1980 to 1985 indicates that yen has been depreciating against the dollar. 2. Walt Disney expects to earn higher revenues in future from Tokyo Disneyland. 3. While revenues are earned in yen, it has to repay its debt in Dollars. 4. As per the past trend, if Walt Disney does not hedge and yen continues to depreciate, it would translate lower dollars in the future and impact its debt serving capacity. The arguments against hedging are: 1. US Inflation over the years has been higher than Japanese Inflation. 2. If the Purchasing Power Parity condition were to hold, then higher inflation would mean the dollar depreciating against yen 3. The forward market quotes also point to an appreciating yen. 4. Walt Disney is earning in yen from Tokyo Disneyland and then converting it to Dollars. It also expects higher amount of revenues in yen in the near future. 5. Hedging dollar against yen based on today’s rate would limit the company’s chances of earning more dollars due to appreciating yen in the future. As there are arguments both in favour and against hedging, we would advise Walt Disney to go for hedging of yen against the dollar. Also instead of hedging for the entire amount of revenues it can opt for partial hedge. This would limit its losses in case of yen depreciation and also help it earn profits in case of yen appreciation. Q.3: Why does a market for currency swap exist? Swaps exist so that a desired risk profile may be obtained by an organization. For example, a company that receives its cash flows in Euros might prefer to receive them in Yen. Swaps allow the change in risk in several of these ways. Swaps provide institutions with vehicles to obtain cheaper financing by exploiting arbitrage opportunities across financial markets. It also helps in accessing different markets which are otherwise restricted to individual companies, or too costly. For example, in the less-regulated Eurodollar market, the costs of issue
could be considerably less than in the U.S. However, not all firms have direct access to the Eurodollar market. The swap contract provides firms with access and permits more firms to take advantage of this regulatory arbitrage. Relative to other alternative risk management, swaps are more flexible and tend to reduce cost of borrowing through indirect access to markets (that may otherwise be unavailable or unfavourable for tapping to meet fund requirements due to prevailing regulations) Liquid markets for Options & Futures Contracts tend to exist for low maturity periods only.
Who benefits and who loses in such an arrangement? Risks in swaps Interest Rate & Exchange Rate Variations
Besides risk arising from fluctuations in the interest rates, currency swaps are exposed to risk resulting from variations in the exchange rate. The magnitude of the exposure depends on the type of instruments that are swapped. Fixed-tofixed swaps are exposed to interest rate changes in the fixed rate currency and to changes in the exchange rate. Floating-to-floating currency swaps are exposed only in terms of changes in the exchange rates. Consider a fixed-to-fixed currency swap on a notional amount of USD 50million where the bank pays fixed dollars of 10% to A and receives fixed Swiss francs of 5% from A. From B, the bank receives fixed dollars of 10% and pays fixed francs at 5%. If A defaults, the bank will have to borrow USD 50million at the prevailing interest rate, buy francs at the current spot rate and invest the proceeds in fixed francs for the remaining life of the swap. If the prevailing dollar interest rate is lower than the contract dollar rate of 10%, the bank gains. In the opposite case the bank loses. If the dollar has appreciated since the contract’s effective date, the bank will gain. If it has depreciated, the bank will lose. If the prevailing swiss franc interest rate is higher than the contract rate of 5%, the bank gains. If it’s lower, the bank loses. If B defaults, the bank will borrow francs, buy dollar spot with the proceeds and lend dollars with the remaining life of the swap. The bank gains if the franc rate is lower than 5% and loses if it is higher. The bank gains if dollar has depreciated and loses if it has appreciated. The bank gains if the dollar rate is higher then 10% and loses if it is lower. The magnitude of the gain or the loss depends on which party defaults, when the default occurs, the levels of the US dollar and Swiss franc interest rates, and the prevailing exchange rate. Counter Party Risk:
Swaps holders are exposed to default risk. A default on one party exposes the other party to interest rate risk and possible loss of funds. Risk for banks:
Pricing risk occurs from banks - from arranging a swap contract with one enduser without having arranged at offsetting swap with another end-user. Until an offsetting swap is arranged, the bank has an open swap position and is vulnerable to an adverse change is swap prices. The capital requirement also reduces the possibility of a destabilizing disruption to the financial markets as a result of “systemic risk” from swaps because swaps dealers tend to have numerous swaps deals with each of the other dealers, a problem at one bank could be transmitted to other banks and ultimately cause multiple failures
Q.4: Evaluate Goldman’s proposal for an ECU bond issue accompanied by an ECU / yen swap. How does its “all-in” yen cost compare to that of the yen term loan? Alternative 1 --- JPY Term Loan One of the viable choices was to create a yen liability through a term loan from a Japanese bank at the Japanese long-term prime rate. It could hedge the JPY royalties, and the proceeds could be used to pay off some of the short-term debt and diversify the maturity structure of Disney’s debt. We tried to figure out the cost (interest rate) of this Eurobond by using the info below: Summary of loan terms: ¥15 billion ten-year bullet loan Coupon Payments Period Coupon Front End Fees Principal(Yen mm) Net Proceeds IRR Semi Annual 10 7.50% 0.75% 15000 14887.5 7.75%
Alternative 2 --- ECU Eurobond + ECU/YEN Swap ECU Eurobond Goldman was prepared to underwrite ECU80 million ten-year Eurobonds with sinking fund. If the ECU Eurobonds were launched, Disney would be only the second U.S. corporation to access this market and be the first ECU bond incorporating an amortization schedule to repay the bond’s principal. Summary of ECU Eurobond: 10-Year ECU Eurobond with Sinking Fund (in millions) Par ECU 80 million Price 100.250% Coupon 9.125% Fees 2.000% Expenses $75,000 Dollar/ECU 0.7420 Cash Flows of 10-Year ECU Eurobond Cash Flow Year Cash flow (Million in ECU)
1 78.4994 2 (7.300) 3 (7.300) 4 (7.300) 5 (7.300) 6 (23.300) 7 (21.840) 8 (20.380) 9 (18.920) 10 (17.460) Based on the above information: IRR=All-in Cost of the ECU Eurobond=9.47267% Swap Cash Flows
Disney’s JPY debt as a result of this SWAP: IRR = All –in –cost = 7.00% Through this SWAP, Disney could reduce 75 basis points on the cost compared with JPY loan. French Utility’s ECU Debt as a result of this SWAP: IRR = All-in Cost =9.19% (<9.37%) For French Utility, It could reduce 18 basis points on the cost compared with JPY loan. From the above analysis, we can conclude that Disney should accept the SWAP solution as suggested by Goldman Sachs than the direct JPY term loan in terms of their cost. However the market reception of the ECU bond issue by Disney and the counterparty default risk should not be ignored and taken into consideration.
French Utility’s Benefit from this transaction: If we look at the French Utility’s Outstanding Publicly Traded Eurobonds, then JPY bond has a yield to maturity of 6.83%. But since it has been interested in swapping some of its yen debt to ECU debt, Goldman Sachs has suggested Walt Disney that it would be a interested party in such a deal. So assuming that French Utility undergoes such a deal then it would have a yen debt which is of the value of around 14,445 Mn Yen. The present value of such a yen debt at current exchange rates would be around 78.5 Mn Euros. The IRR of these cash flows is 9.19% which is the French Utility’s cost of debt due to the swap. This helps the French Utility in reducing its ECU cost of debt from around 9.37% to 9.19% whish is beneficial to the company as it helps in reducing the debt by 18 basis points.
doc_984314677.doc
Walt Disney case used in Strategic Financial Management.
KeyWords: Yen Financing, Swaps, French Utility
The Walt Disney Company’s Yen Financing
Q.1: Should Walt Disney hedge its yen royalty cash flows? Why or why not? If so, how much should be hedged and over what time frame? The arguments in favour of hedging are: 1. The trend from years 1980 to 1985 indicates that yen has been depreciating against the dollar. 2. Walt Disney expects to earn higher revenues in future from Tokyo Disneyland. 3. While revenues are earned in yen, it has to repay its debt in Dollars. 4. As per the past trend, if Walt Disney does not hedge and yen continues to depreciate, it would translate lower dollars in the future and impact its debt serving capacity. The arguments against hedging are: 1. US Inflation over the years has been higher than Japanese Inflation. 2. If the Purchasing Power Parity condition were to hold, then higher inflation would mean the dollar depreciating against yen 3. The forward market quotes also point to an appreciating yen. 4. Walt Disney is earning in yen from Tokyo Disneyland and then converting it to Dollars. It also expects higher amount of revenues in yen in the near future. 5. Hedging dollar against yen based on today’s rate would limit the company’s chances of earning more dollars due to appreciating yen in the future. As there are arguments both in favour and against hedging, we would advise Walt Disney to go for hedging of yen against the dollar. Also instead of hedging for the entire amount of revenues it can opt for partial hedge. This would limit its losses in case of yen depreciation and also help it earn profits in case of yen appreciation. Q.3: Why does a market for currency swap exist? Swaps exist so that a desired risk profile may be obtained by an organization. For example, a company that receives its cash flows in Euros might prefer to receive them in Yen. Swaps allow the change in risk in several of these ways. Swaps provide institutions with vehicles to obtain cheaper financing by exploiting arbitrage opportunities across financial markets. It also helps in accessing different markets which are otherwise restricted to individual companies, or too costly. For example, in the less-regulated Eurodollar market, the costs of issue
could be considerably less than in the U.S. However, not all firms have direct access to the Eurodollar market. The swap contract provides firms with access and permits more firms to take advantage of this regulatory arbitrage. Relative to other alternative risk management, swaps are more flexible and tend to reduce cost of borrowing through indirect access to markets (that may otherwise be unavailable or unfavourable for tapping to meet fund requirements due to prevailing regulations) Liquid markets for Options & Futures Contracts tend to exist for low maturity periods only.
Who benefits and who loses in such an arrangement? Risks in swaps Interest Rate & Exchange Rate Variations
Besides risk arising from fluctuations in the interest rates, currency swaps are exposed to risk resulting from variations in the exchange rate. The magnitude of the exposure depends on the type of instruments that are swapped. Fixed-tofixed swaps are exposed to interest rate changes in the fixed rate currency and to changes in the exchange rate. Floating-to-floating currency swaps are exposed only in terms of changes in the exchange rates. Consider a fixed-to-fixed currency swap on a notional amount of USD 50million where the bank pays fixed dollars of 10% to A and receives fixed Swiss francs of 5% from A. From B, the bank receives fixed dollars of 10% and pays fixed francs at 5%. If A defaults, the bank will have to borrow USD 50million at the prevailing interest rate, buy francs at the current spot rate and invest the proceeds in fixed francs for the remaining life of the swap. If the prevailing dollar interest rate is lower than the contract dollar rate of 10%, the bank gains. In the opposite case the bank loses. If the dollar has appreciated since the contract’s effective date, the bank will gain. If it has depreciated, the bank will lose. If the prevailing swiss franc interest rate is higher than the contract rate of 5%, the bank gains. If it’s lower, the bank loses. If B defaults, the bank will borrow francs, buy dollar spot with the proceeds and lend dollars with the remaining life of the swap. The bank gains if the franc rate is lower than 5% and loses if it is higher. The bank gains if dollar has depreciated and loses if it has appreciated. The bank gains if the dollar rate is higher then 10% and loses if it is lower. The magnitude of the gain or the loss depends on which party defaults, when the default occurs, the levels of the US dollar and Swiss franc interest rates, and the prevailing exchange rate. Counter Party Risk:
Swaps holders are exposed to default risk. A default on one party exposes the other party to interest rate risk and possible loss of funds. Risk for banks:
Pricing risk occurs from banks - from arranging a swap contract with one enduser without having arranged at offsetting swap with another end-user. Until an offsetting swap is arranged, the bank has an open swap position and is vulnerable to an adverse change is swap prices. The capital requirement also reduces the possibility of a destabilizing disruption to the financial markets as a result of “systemic risk” from swaps because swaps dealers tend to have numerous swaps deals with each of the other dealers, a problem at one bank could be transmitted to other banks and ultimately cause multiple failures
Q.4: Evaluate Goldman’s proposal for an ECU bond issue accompanied by an ECU / yen swap. How does its “all-in” yen cost compare to that of the yen term loan? Alternative 1 --- JPY Term Loan One of the viable choices was to create a yen liability through a term loan from a Japanese bank at the Japanese long-term prime rate. It could hedge the JPY royalties, and the proceeds could be used to pay off some of the short-term debt and diversify the maturity structure of Disney’s debt. We tried to figure out the cost (interest rate) of this Eurobond by using the info below: Summary of loan terms: ¥15 billion ten-year bullet loan Coupon Payments Period Coupon Front End Fees Principal(Yen mm) Net Proceeds IRR Semi Annual 10 7.50% 0.75% 15000 14887.5 7.75%
Alternative 2 --- ECU Eurobond + ECU/YEN Swap ECU Eurobond Goldman was prepared to underwrite ECU80 million ten-year Eurobonds with sinking fund. If the ECU Eurobonds were launched, Disney would be only the second U.S. corporation to access this market and be the first ECU bond incorporating an amortization schedule to repay the bond’s principal. Summary of ECU Eurobond: 10-Year ECU Eurobond with Sinking Fund (in millions) Par ECU 80 million Price 100.250% Coupon 9.125% Fees 2.000% Expenses $75,000 Dollar/ECU 0.7420 Cash Flows of 10-Year ECU Eurobond Cash Flow Year Cash flow (Million in ECU)
1 78.4994 2 (7.300) 3 (7.300) 4 (7.300) 5 (7.300) 6 (23.300) 7 (21.840) 8 (20.380) 9 (18.920) 10 (17.460) Based on the above information: IRR=All-in Cost of the ECU Eurobond=9.47267% Swap Cash Flows
Disney’s JPY debt as a result of this SWAP: IRR = All –in –cost = 7.00% Through this SWAP, Disney could reduce 75 basis points on the cost compared with JPY loan. French Utility’s ECU Debt as a result of this SWAP: IRR = All-in Cost =9.19% (<9.37%) For French Utility, It could reduce 18 basis points on the cost compared with JPY loan. From the above analysis, we can conclude that Disney should accept the SWAP solution as suggested by Goldman Sachs than the direct JPY term loan in terms of their cost. However the market reception of the ECU bond issue by Disney and the counterparty default risk should not be ignored and taken into consideration.
French Utility’s Benefit from this transaction: If we look at the French Utility’s Outstanding Publicly Traded Eurobonds, then JPY bond has a yield to maturity of 6.83%. But since it has been interested in swapping some of its yen debt to ECU debt, Goldman Sachs has suggested Walt Disney that it would be a interested party in such a deal. So assuming that French Utility undergoes such a deal then it would have a yen debt which is of the value of around 14,445 Mn Yen. The present value of such a yen debt at current exchange rates would be around 78.5 Mn Euros. The IRR of these cash flows is 9.19% which is the French Utility’s cost of debt due to the swap. This helps the French Utility in reducing its ECU cost of debt from around 9.37% to 9.19% whish is beneficial to the company as it helps in reducing the debt by 18 basis points.
doc_984314677.doc