0:11

Let's go through the solution of assignment one.

The first question is about this notion of cheap debt, all right?

So you might think that low interest rate means that debt is cheap, but one

issue that we learn in module one is that that's not necessarily the case, right?

If you pay low interest rates on your debt,

those interest rates might also reduce discount rates,

especially if the reduction in interest rates comes from government, right?

So if government rates are low, that's going to reduce interest payments, but

those interest payments are also going to be discounted at lower rate.

So, The NPV of the debt issuance may actually not necessarily

change as we discussed in module one.

In many cases,

the net present value of that issuance is actually going to be close to zero, okay?

However, on the other hand though,

a couple more issues that you could have discussed on this question is that

low interest rates may allow firms to reduce interest coverage.

If you're thinking about module two, for

example, you know companies also care about credit ratings, right?

Credit ratings are partly determined by interest coverage ratios and

paying lower interest might allow for the firm to achieve a higher credit rating.

In fact, when we talked about acquisitions in module four,

you're going to see how this idea can be applied to a real world case.

The other issue is that low rates, in some cases, might help small companies, right?

If the government reduces interest rates, you know, maybe for

large companies this doesn't matter, but small companies might find it easier to

borrow money if the interest rates are low.

So I think those would be valid considerations you could have discussing

this question as well.

1:51

Question two is about financial distress, right?

So the idea is that financial distress might happen when your operating income,

when your profits become lower than your interest rate, right?

So that is though a trigger to financial distress,

not necessarily bankruptcy, right?

Companies have options, even if they cannot pay interest,

they can sell assets, for example, right?

To raise cash and pay interest, they can cut investments to try to increase EBIT,

they can try to refinance debt, right?

Maybe reducing interest rate by refinancing that or

they can try to issue equity.

What we discussed in module one is that all of these options are going to

be costly.

All right, they are going to generate cost for companies, for example.

Issuing equity is going to cause the company stock price to go

down using the data that we have available, right?

So these options are costly, but the company is not necessarily bankrupt.

You should try to avoid financial distress, but you're not

necessarily going to go bankrupt when your EBIT become lower than your interest rate.

2:56

Question three is actually interesting because the numbers that I pulled out

are not random.

They actually come from the new president's tax plan, okay?

These come from Trump's tax plan.

So that is the idea, of course.

By the time I'm recording this, the plan hasn't been implemented yet.

So we don't know if it's going to happen or not.

But we can start thinking about what would happen to corporate policies

if tax rates change like that.

So we talked about capital structure and payout and

we also discussed how taxes may affect capital structure and payout.

In terms of capital structure, one of the proposals is, of course,

to reduce the corporate tax rate.

3:34

And if corporate tax rates are low, a side effect of this is that

companies should have less incentive to borrow money.

Right? Because the tax benefits of

that are going to be reduced.

The tax benefit of that depends on tax rates.

The higher the tax rate, the greater the tax benefit.

So, we should expect to see lower leverage ratios.

That would be a prediction a researcher would make if corporate tax rates go down,

we should see companies decreasing leverage.

On the other hand, there is also a proposal to reduce personal taxes and

one issue we talked about in module one is that

a reduction in personal taxes might reduce personal tax rates on debt investors.

So when investors receive payments, they're going to pay lower taxes.

That may counteract the reduction in corporate taxes a little bit.

But I think as we discuss it, corporate taxes

tend to dominate personal tax effect, so we should see lower leverage.

So that might be a positive aspect of having these changes in tax rates.

In terms of payout, it's a little bit less obvious,

because corporate tax rates don't directly change payout policy.

Payout policy depends on personal taxes, right?

But if you think about it, personal taxes, they used to mail in the past,

because dividends were taxed at the personal tax rate.

But now there are special tax rates for dividends and capital gains.

So we really don't know what's going to happen

to the specific tax rates on dividends and capital gains.

And those are the ones that should matter most.

So I think that should be one consideration you should have added

to your answer is that the personal tax really is not the most relevant

tax when we're thinking about dividends and capital gains.

However, there could be an indirect effect.

So this is interesting right?

If corporate profits increase as a result of the lower taxes.

As I think is the hope of the government

that companies will become more profitable and invest more.

There may be an indirect effect, right?

So if profitability increases,

perhaps companies are going to increase payout as well.

But we have to wait and see what happens.

And this is kind of an open question.

There are many possibilities here.

And as long as you are more or less on target, it should be okay.

5:45

Question four is about credit ratings, right?

So one key idea we learned is that credit ratings matter over and

above leverage ratios, so credit rating effects a company's ability to

access financial markets because there are lots of regulations that restrict how

insurance companies invest, how banks lend money.

So a rating downgrade is a key factor

when companies consider whether to increase leverage or not.

Rating downgrades is going to really be in our minds.

You are going to see this idea applied again in module four,

which is when we are really going to use real world examples of acquisitions and

both strategic and

private equity to think about whether companies should change leverage or not.

And we'll talk about this rating downgrade idea further later in the course.

6:34

Question five is about bank debt, right?

So the idea is that bank debt Is likely to be cheaper than market financing,

but the reduction is because the bank has additional control.

So the central trade off about bank debt is that

companies might be able to reduce interest payments.

But that is going to come at a cost of giving additional control to investors.

So companies are going to have to comply with a larger number of covenants.

Companies are going to have to post collateral.

So companies that are very financially healthy may choose not to do that and

move away from bank debt to bond.

And here's another question on banks versus bond financing,

a more mathematical question.

And we talked about the notion that recovery rates and

interest rates are related.

And I think this example really allows you to calculate that on your own.

So here is the same chart we used in class, in the videos.

And we have the situation where the bank is lending the money today and

there are two outcomes.

There is a 5% interest rate, but the idea is that

the bank is only going to get the interest rate if the company does not default.

If the company defaults, then there is recovery.

Given that the bank has 80% recovery,

the return here is going to be minus 20%, right?

So using the formula that we derived

8:00

in the module, we can figure out the expected return,

the expected return is one minus the probability of the default bank 5%.

Plus the probability of default minus times minus twenty percent, okay?

And in the question I told you that the expected return is 4.25, right?

We don't know the P, so

the math here it would be to back out where the P should be.

And you know, it's a linear so it should be quite straightforward.

You can even do this by trial and error in Excel.

You would find out that the probability of default is 3%, okay?

So then what we can do after we find out the probability of default is 3%,

you can go to the bond example, right?

So now we know that there is a 3% probability of default and

the difference is that the bond holders will face a larger negative return

if the bond defaults because they have less control.

So there is minus 60% return instead of minus 20, right?

And now the question is,

what should be the return that gives you the same expected return?

What should be the interest payment that gives you the same expected return and

we can use the same equation now to solve for the x.

And get an X of 6.75.

Okay, so this is essentially some algebraic manipulations, but

if you go through this exercise and really understand it, I think you will get this

notion that recovery rates and interest rates are fundamentally related.

So it's not just the probability of default,

it's also the recovery rate that determines interest rates.

All right, so here is a summary.

Essentially, banks have a lower interest rate because they have greater recovery.

9:49

Okay?

So we talked about this in the videos.

To reduce shares though a repurchase, the company has to spend cash.

All right.

So it's not a free transaction.

And if the shares are priced at the fair value, in fact,

what should happen is the reduction in cash should exactly compensate.

The number, the reduction of shares outstanding and the MVP should be zero.

So really dilution, or avoiding dilution, or reducing dilution

is not the reason why stock repurchasing creates the stock price.

This is something that I would really like you to remember after you go through this

course.

10:45

There is no, as we discussed in the lecture,

the reason why there is a dividend puzzle is because there is no clear reason

why firms need to pay dividends.

Most of the advantages of dividends can be perfectly replicated using stock

repurchase and stock repurchase are likely to be more tax efficient.

So this is something that I think we will learn more in the future, you know,

why is it that dividends are so important for our companies.

it's, right now it's a puzzle.

11:13

Question nine and ten are about the real world data of Starbucks and Panera Bread.

So what I asked you to do is just to

go over the Excel spreadsheets that I posted in Coursera and figure this out.

It shouldn't have been too hard to see that Starbucks

has mostly borrows from the bond market, right?

So as many large public companies,

what Starbucks does is avoid having term loans, so there's actually zero here.

Raises most of its debt from the bond market, right?

It has an undrawn credit line.

Right, so the only role of bank financing for Starbucks is to provide this

credit line, but the company is not really using it, right?

The credit line is really used for companies for

insurance purposes, as we discussed in module two, right?

And we discussed this before in corporate finance one as well.

It's one of the key ideas of financing is that the credit line has this

insurance role for company.

If all the other sources dry up,

presumably Starbucks can still rely on the credit line, right?

12:52

And here comes Panera Bread, right?

The key contrast is similar to what we did in the lecture.

Panera raises most of its debt from term loans.

Right, it's a smaller company, but perhaps riskier, right?

And what it does to mitigate the financing issues is that it

raises bank debt instead of bonds.

Right, you can see for example, that most of the debt is actually secured, right?

Panera has both term loans and it's drawing down on a credit line.

It has an undrawn credit of 210 and

it has drawn $40 million from its credit line, right?

So if you think about interest rates, right?

It's interesting because Panera is smaller and it also has higher leverage, right?

If you're thinking about leverage ratios, right?

The leverage ratio of Starbucks is actually pretty close to zero.

It has only $3.6 billion in debt and $83 billion in equity, right?

Whereas Panera has a leverage ratio of about 10%,

it's not super high, but it's higher than Starbucks.

13:58

However, because Starbucks borrows from the bond market and

Panera borrows from bonds, sorry, from banks, right?

Starbucks bonds, Panera bank.

What I would actually predict is that interest rates should not be higher for

Panera.

In fact perhaps, Panera is paying even lower interest rates than Starbucks.

And what I did, I didn't give you this data.

This was supposed To be the surprise of the solution.

I actually got some data on loans issued by Primera.

This is recent data on the coupon payment of the recent loans that were

issued by the company and you can see that they were around 1.5%.

The maturity is close to the maturity of the Starbucks bonds that we looked at,

maybe a little bit shorter, okay?

One issue you can see, that this a floating rate bond, okay?

So, this coupon is not fixed over time.

It's going to change, it might change with the changing benchmarks.

So right now, we are in times when interest rates are going up, it might be

the case that Panera may actually have to pay a higher interest rate going forward.

But it is right now, it's paying 1.5%.

So it's consistent with the ideas that we discussed in the course.

[NOISE]