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These bottom-up estimates suggest that Disney should be issuing long term fixed-rate debt with a duration of 4.71 years, and that firms in this sector are relatively unaffected by both the overall economy. Like Disney, firms in these businesses tend to be hurt by a stronger dollar, but,, unlike Disney, they do not seem have much pricing power (note the negative coefficient on inflation. The sector averages also have the advantage of more precision than the firm-specific estimates and can be relied on more. Overall Recommendations

Based upon the analyses of firm value and operating income, as well as the sector averages, our recommendations would essentially match those of the intuitive approach,

23 These sector estimates were obtained by aggregating the firm values of all firms in a sector on a quarter-by-quarter basis going back 12 years, and then regressing changes in this aggregate firm value against changes in the macro-economic variable each quarter.

but they would have more depth to because of the additional information we have acquired from the quantitative analysis:

• The debt issued should be long term and should have duration of between 4 and 5 years.

• A significant portion of the debt should be floating rate debt, reflecting Disney's capacity to pass inflation through to its customers and the fact that operating income tends to increase as interest rates go up.

• Given Disney's sensitivity to a stronger dollar, a portion of the debt should be in foreign currencies. The specific currency used and the magnitude of the foreign currency debt should reflect where Disney makes its revenues. Based upon 2003 numbers at least, this would indicate that about 20% of the debt should be in Euros and about 10% of the debt in Japanese Yen reflecting Disney's larger exposures in Europe and Asia. As its broadcasting businesses expand into Latin America, it may want to consider using either Mexican Peso or Brazilian Real debt as well.

These conclusions can be used to both design the new debt issues that the firm will be making going forward, and to evaluate the existing debt on the firm's books to see if there is a mismatching of assets and financing in the current firm. Examining Disney's debt at the end of 2003, we note the following.

• Disney has $13.1 billion in debt with an average maturity of 11.53 years. Even allowing for the fact that the maturity of debt is higher than the duration, this would indicate that Disney's debt is far too long term for its existing business mix.

• Of the debt, about 12% is Euro debt and no yen denominated debt. Based upon our analysis, a larger portion of Disney's debt should be in foreign currencies.

• Disney has about $1.3 billion in convertible debt and some floating rate debt, though no information is provided on its magnitude. If floating rate debt is a relatively small portion of existing debt, our analysis would indicate that Disney should be using more of it.

If Disney accepts the recommendation that its debt should be more short term, more foreign currency and more floating rate debt, it can get there in two ways:

It can swap some of its existing long term, fixed rate, dollar debt with shorter term, floating rate, foreign currency debt. Given Disney's standing in financial markets and its large market capitalization, this should not be difficult to do. If Disney is planning new debt issues, either to get to a higher debt ratio or to fund new investments, it can use primarily short term, floating rate, foreign currency debt to fund these new investments. While it may be mismatching the funding on these investments, its debt matching will become better at the company level.

macrodur.xls: This spreadsheet allows you to estimate the sensitivity of firm value and operating income to changes in macro-economic variables.

dursect.xls: There is a dataset on the web that summarizes the results of regressing firm value against macroeconomic variables, by sector, for U.S. companies.

Illustration 9.7: Estimating the Right Financing Mix for Bookscape, Aracruz and Deutsche Bank

While we will not examine the right financing type for Bookscape, Aracruz and Deutsche Bank in the same level of detail as we did for Disney, we will summarize, based upon our understanding of their businesses, what we think will be the best kind of financing for each of these firms:

• Bookscape: Given Bookscape's dependence upon revenues at its New York bookstores, we would design the debt to be

• Long term, since the store is a long term investment

• Dollar-denominated, since all the cash flows are in dollars

• Fixed rate debt, since Bookscapes lack of pricing power makes it unlikely that they can keep pace with inflation

It is worth noting that operating leases fulfill all of these conditions, making it the apprpriate debt for Bookscape. Since that is the only debt that Bookscape carries currently, we would suggest no changes.

• Aracruz: Aracruz operates most of its paper plants in Brazil, but gets a significant proportion of its products overseas. More than 80% of its revenues in 2003 were to other countries, and the bulk of these revenues were dollar-denominated. Given this structure, we would design debt to be

• Long term, since a typical paper plant has a life in excess of 20 years,

• Dollar-denominated, since the cash inflows are primarily in dollars,

• Given the volatility of paper prices, we would try to link the interest rate on debt to pulp prices, if possible.

The existing debt at Aracruz is primarily dollar debt but it is short term, with an average maturity of 3.20 years. While this may reflect the difficulties that Brazilian firms have faced in borrowing long term historically, the constraints on borrowing long term are easing for many emerging market companies that derive the bulk of their revenues in dollars. • Deutsche Bank: In the case of Deutsche Bank, the recommendation is made simpler by the fact that the debt ratio we are analyzing is the long-term debt ratio. In addition to being long term, however, the debt should reflect

• The mix of currencies in which Deutsche Bank gets its cash flows, which should lead to significant dollar (from its U.S. holdings) and British Pound (from its Morgan Grenfell subsidiary) debt issues. In future years, this would expand to include more emerging market debt issues to reflect Deutsche Bank's greater dependence on cash flows from these markets.

• The changing mix of Deutsche Bank's business to reflect its increasing role in investment banking.

It is possible that Deutsche Bank's reputation in Europe may allow it to borrow more cheaply in some markets (say, Germany) than in others. If that is the case, it can either issue its dollar-denominated or pound-denominated debt in those markets, or issued debt in Euros and then swap the debt into U.S. dollar or British pound debt.

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