0:11

Let's go through the solution of assignment one.

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

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

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

Â If you pay low interest rates on your debt,

Â those interest rates might also reduce discount rates,

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

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

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

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

Â change as we discussed in module one.

Â In many cases,

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

Â However, on the other hand though,

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

Â low interest rates may allow firms to reduce interest coverage.

Â If you're thinking about module two, for

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

Â Credit ratings are partly determined by interest coverage ratios and

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

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

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

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

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

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

Â borrow money if the interest rates are low.

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

Â this question as well.

Â 1:51

Question two is about financial distress, right?

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

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

Â So that is though a trigger to financial distress,

Â not necessarily bankruptcy, right?

Â Companies have options, even if they cannot pay interest,

Â they can sell assets, for example, right?

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

Â they can try to refinance debt, right?

Â Maybe reducing interest rate by refinancing that or

Â they can try to issue equity.

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

Â be costly.

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

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

Â down using the data that we have available, right?

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

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

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

Â 2:56

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

Â are not random.

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

Â These come from Trump's tax plan.

Â So that is the idea, of course.

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

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

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

Â if tax rates change like that.

Â So we talked about capital structure and payout and

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

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

Â to reduce the corporate tax rate.

Â 3:34

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

Â companies should have less incentive to borrow money.

Â Right? Because the tax benefits of

Â that are going to be reduced.

Â The tax benefit of that depends on tax rates.

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

Â So, we should expect to see lower leverage ratios.

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

Â we should see companies decreasing leverage.

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

Â one issue we talked about in module one is that

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

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

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

Â But I think as we discuss it, corporate taxes

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

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

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

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

Â Payout policy depends on personal taxes, right?

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

Â because dividends were taxed at the personal tax rate.

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

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

Â to the specific tax rates on dividends and capital gains.

Â And those are the ones that should matter most.

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

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

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

Â However, there could be an indirect effect.

Â So this is interesting right?

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

Â As I think is the hope of the government

Â that companies will become more profitable and invest more.

Â There may be an indirect effect, right?

Â So if profitability increases,

Â perhaps companies are going to increase payout as well.

Â But we have to wait and see what happens.

Â And this is kind of an open question.

Â There are many possibilities here.

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

Â 5:45

Question four is about credit ratings, right?

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

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

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

Â insurance companies invest, how banks lend money.

Â So a rating downgrade is a key factor

Â when companies consider whether to increase leverage or not.

Â Rating downgrades is going to really be in our minds.

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

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

Â both strategic and

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

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

Â 6:34

Question five is about bank debt, right?

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

Â but the reduction is because the bank has additional control.

Â So the central trade off about bank debt is that

Â companies might be able to reduce interest payments.

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

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

Â Companies are going to have to post collateral.

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

Â move away from bank debt to bond.

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

Â a more mathematical question.

Â And we talked about the notion that recovery rates and

Â interest rates are related.

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

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

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

Â there are two outcomes.

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

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

Â If the company defaults, then there is recovery.

Â Given that the bank has 80% recovery,

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

Â So using the formula that we derived

Â 8:00

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

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

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

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

Â We don't know the P, so

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

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

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

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

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

Â you can go to the bond example, right?

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

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

Â if the bond defaults because they have less control.

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

Â And now the question is,

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

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

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

Â And get an X of 6.75.

Â Okay, so this is essentially some algebraic manipulations, but

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

Â notion that recovery rates and interest rates are fundamentally related.

Â So it's not just the probability of default,

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

Â All right, so here is a summary.

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

Â 9:49

Okay?

Â So we talked about this in the videos.

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

Â All right.

Â So it's not a free transaction.

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

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

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

Â So really dilution, or avoiding dilution, or reducing dilution

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

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

Â course.

Â 10:45

There is no, as we discussed in the lecture,

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

Â why firms need to pay dividends.

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

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

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

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

Â it's, right now it's a puzzle.

Â 11:13

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

Â So what I asked you to do is just to

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

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

Â has mostly borrows from the bond market, right?

Â So as many large public companies,

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

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

Â It has an undrawn credit line.

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

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

Â The credit line is really used for companies for

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

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

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

Â insurance role for company.

Â If all the other sources dry up,

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

Â 12:52

And here comes Panera Bread, right?

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

Â Panera raises most of its debt from term loans.

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

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

Â raises bank debt instead of bonds.

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

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

Â It has an undrawn credit of 210 and

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

Â So if you think about interest rates, right?

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

Â If you're thinking about leverage ratios, right?

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

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

Â Whereas Panera has a leverage ratio of about 10%,

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

Â 13:58

However, because Starbucks borrows from the bond market and

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

Â Starbucks bonds, Panera bank.

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

Â Panera.

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

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

Â This was supposed To be the surprise of the solution.

Â I actually got some data on loans issued by Primera.

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

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

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

Â maybe a little bit shorter, okay?

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

Â So, this coupon is not fixed over time.

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

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

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

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

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

Â [NOISE]

Â