B40'2302 Class

1
B40.2302 Class 9

• BM6 chapters 25.2-25.6, 26, 27
• 25 Leasing
• 26 Risk management
• 27 International risk management
• Based on slides created by Matthew Will
• Modified 11/07/2001 by Jeffrey Wurgler

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Leasing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 25.2-25.6

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
3
Topics Covered

• Why Lease?
• Operating (Short-term) Leases
• Financial (Long-term) Leases

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Why Lease?

• Sensible (Non-tax) Reasons for Leasing
• Short-term leases are convenient
• Cancellation options are valuable
• Maintenance may be provided
• Standardization leads to low transaction costs
• (Relative to bond or stock issue)

5
Why Lease?

• Sensible (Tax) Reasons for Leasing
• Tax shields can be used
• Lessor owns asset, and so deducts its
  depreciation
• If lessor can make better use of tax shield than
  lessee, then lessor should own equipment and pass
  on some tax benefits to lessee (in form of lower
  lease payments)
• So direct tax gain to lessor, indirect gain to
  lessee
• Reduces the alternative minimum tax (AMT)
• Corporate tax maxregular tax, AMT
• Leasing (as opposed to buying) reduces lessees
  AMT

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Why Lease?

• Dubious Reasons for Leasing
• Leasing avoids internal capital expenditure
  controls
• Leasing preserves capital

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Why Lease?

• Dubious Reasons for Leasing (contd.)
• Leases may be off-balance-sheet financing
• In Germany, all leases are off balance sheet
• In US, only operating leases are off balance
  sheet
• Leasing affects book income
• Leasing reduces book income bec. lease payments
  are expensed
• Buy-and-borrow alternative reduces book income
  through both interest and depreciation

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Operating Leases

• Review Suppose you decide to lease a machine
  for one year
• Q What is the rental payment in a competitive
  leasing industry?
• A The lessors equivalent annual cost (EAC)

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Operating Leases

• Example Calculate a competitive lease payment /
  EAC
• Acme Limo has a client who will sign a lease for
  7 years, with lease payments due at the start of
  each year. The following table shows the NPV of
  the limo if Acme purchases the new limo for
  75,000 and leases it out for 7 years.

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Operating Leases

• Bottom line for lessee Operating lease or buy?
• Buy if the lessees equivalent annual cost of
  ownership and operation is less than the best
  available operating lease rate
• Otherwise lease
• Complication If operating lease includes option
  to cancel/abandon, need to factor that in

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Financial Leases
Example - cont Greymare Bus Lines is considering
a lease. Your operating manager wants to buy a
new bus for 100,000. The bus has an 8 year
life. An alternative is to lease the bus for 8
years at 16,900 per year, but Greymare still
assumes all operating and maintenance costs.
Should Greymare buy or lease the bus?

• Cash flow consequences of the financial lease
  contract
• Greymare saves the 100,000 cost of the bus.
• Loss of depreciation benefit of owning the bus.
• 16,900 lease payment is due at the start of each
  year.
• Lease payments are tax deductible.

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Financial Leases
Cash flow consequences of the financial lease
contract
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Financial Leases

• How to discount CFs?
• Since lessor is essentially lending money to
  lessee, appropriate rate is the equivalent
  lending/borrowing rate
• Lender pays tax on interest it receives net
  return is after-tax interest rate
• Borrower deducts interest from taxable income
  net cost is after-tax interest rate
• Thus, after-tax interest rate is effective rate
  at which company can transfer debt-equivalent
  cash flows across time
• Suppose Greymare can borrow at 10. Then the
  lease payments should be discounted at
  (1-.35).10 .065.

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Financial Leases
Example contd. Greymare Bus Lines can borrow
at 10, thus the value of the lease should be
discounted at 6.5 or .10 x (1-.35). The result
will tell us if Greymare should lease or buy the
bus. ? Buy, dont lease
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Financial Leases
Example Equivalent loan cash flows Another way
to think about where the lease value comes from
(or goes) is to imagine a loan that generates
exactly the same year 1 - 7 cash outflows as the
lease. This costs same, but brings in
89.72 in year 0 (vs. 89.02 in the lease). Thus,
borrowing-and-buying is 89.72-89.020.70700
better than lease.
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Financial Leases

• Bottom line for lessee Financial lease or
  buy-and-borrow?
• Buy-and-borrow if can devise a borrowing plan
  that gives same cash flow as lease in every
  future period, but higher immediate cash flow
  (equivalently, buy-and-borrow if incremental
  lease cash flows are NPVlt0)
• Otherwise lease

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Leases in APV framework

• Can think of leases as financing that may have
  side effects.
• Thus, the APV of a project financed by a lease
• This is consistent with all the previous
  examples.

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Managing Risk

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 26

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
19
Topics Covered

• Insurance
• Futures contracts
• Forward contracts
• Swaps
• How to set up a hedge

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Insurance

• Most businesses insure against fire, theft,
  environmental liability, vehicle accidents, etc.
• Insurance transfers risk from company to insurer
• Insurers pool risks
• The claims on any individual policy are very
  risky
• but the claims on a large portfolio of policies
  may be quite predictable
• This gives insurers a risk-bearing advantage
• Of course, insurers cannot diversify away macro
  risks
• In same way that investors cant diversify away
  systematic risk

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Insurance

• Example
• An offshore oil platform is valued at 1
  billion. Expert meteorologist reports indicate
  that a 1 in 10,000 chance exists that the
  platform may be destroyed by a storm over the
  course of the next year. What is the fair
  price of insurance?
• Answer
• There is no systematic risk its all due to
  the weather
• Therefore no systematic risk premium required
• The expected loss per year is
• (1/10,000)1 billion 100,000 fair
  price
• But for several reasons wed expect a higher
  price

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Insurance

• Why would an insurance company probably not offer
  a policy on this oil platform for 100,000/yr?
• Administrative costs
• Adverse selection
• Moral hazard
• If these costs are large, there may be cheaper
  ways to protect against risk

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Insurance British Petroleum

• During the 1980s BP paid out 115m/year in
  insurance, recovered 25m/year in claims
• BP has decided to cut down insurance
• BP felt it was better-placed to assess risk
• And insurance was not competitively priced
• So now BP assumes more risk than when it insured
• BP guesses a big loss of 500m happens every 30
  years
• Even so, this is lt1 of BP market equity !
• BP can afford not to insure against these risks

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Hedging

• Hedging
• Taking on one risk to offset another
• Some basic tools for hedging
• Futures
• Forwards
• Swaps

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Futures

• Futures contract - A contract between two parties
  for the delivery of an asset, at a negotiated
  price, on a set future date
• Example
• Wheat farmer expects to have 100,000 bushels of
  wheat next Sept.
• Hes worried that price may decline in the
  meantime
• To hedge this risk, he can sell 100,000 bushels
  of Sept. wheat futures at a price that is set
  today
• Bottom line -- perfect hedge
• If price rises, value of his wheat goes up but
  futures contract value falls
• If price falls, value of his wheat falls but
  futures contract value rises

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Futures
Futures are standardized contracts, traded on
organized futures exchanges Commodity
Futures -Sugar -Corn -OJ -Lumber -Wheat
-Soybeans -Pork bellies -Oil -Copper -Silver
-... Financial Futures -Tbills -Japanese
govt. bonds -SP 500 -DJIA index -...
SUGAR
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Futures

• When you buy a financial future, you end up with
  the same security that you would have if you
  bought in the spot market (i.e. on-the-spot
  today)
• Except
• You dont pay up front, so you earn interest on
  purchase price
• You miss out on any dividend or interest in
  interim
• Therefore for a financial future
• Futures price/(1rf)t
• Spot price PV(foregone interest or
  dividends)

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Futures

• Futures price/(1rf)t
• Spot price PV(foregone interest or
  dividends)
• Example Stock index futures
• Q Suppose 6-month stock index futures trade at
  1,235 when index is at 1,212. 6-month interest
  rate is 5 and average dividend yield of stocks
  in index is 1.2/year. Are these s consistent?
• A Yes
• Futures price/(1rf)t 1,235/(1.05)1/2
  1,205
• Spot price PV(foregone interest or dividends)
  
• 1,212 1,212(1/2)(.012)/(1.05)1/2 1,205

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Futures

• When you buy a commodities future, you end up
  with the same commodity that you would have if
  you bought in the spot market
• Except
• You dont pay up front, so you earn interest on
  purchase price
• You dont have to store the commodity in the
  interim saves on storage costs
• You dont get a convenience yield the value
  of having the real thing
• So for a commodities future
• Futures price/(1rf)t
• Spot price PV(storage costs)
  PV(convenience yield)

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Forwards

• Futures contracts are standardized, exchange
  traded
• Forward contracts are tailor-made futures
  contracts, not exchange traded
• Main forward market is in foreign currency
• Also forward interest-rate contracts

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Forwards

• Example Lock in a rate today on a loan tomorrow
  
• (a homemade forward loan)
• Suppose you borrow 90.91 for one year at 10,
  and you lend 90.91 for two years at 12
• These are interest rates today, i.e. spot
  interest rates
• Net cash flow
• Year 0 90.91 90.91 0
• Year 1 -90.911.10 -100
• Year 2 90.911.121.12 114.04
• So paid out 100 at year 1, take in 114.04 at year
  2, essentially you made a forward loan at
  locked-in interest rate of
• Fwd. rate (1r2)2/(1 r1) 1 (1.12)2/(1.1)
  1 .1404

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Swaps

• Swap contract - An agreement between two parties
  (counterparties) lend to each other on
  different terms, e.g. in different currencies, or
  one at fixed rate and the other at a floating
  rate

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Swaps

• Example Currency swap
• USA Inc. wants to borrow euros to finance
  European operations, but it gets better rates in
  US
• So it issues US debt (say 10M of 8, 5-year
  notes)
• And contracts with a bank to swap its future
  dollar liability for euros
• Combined effect convert an 8 dollar loan into a
  5.9 euro loan (see next page)

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Swaps
Net cash flow to USA Inc. after the currency swap
Bottom line currency swap turned dollar debt
into euro debt
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Swaps

• Example Fixed-to-floating interest rate swap
• Bancorp has made a 5-year, 50m loan at a fixed
  rate of 8 annual interest payments are 4m
• Bank wants to swap the 4m, 5-year annuity (the
  fixed interest payments) into a floating rate
  annuity
• Bank has ability to borrow at 6 for 5 years. So
  4m interest annuity could support a fixed-rate
  loan of 4/.06 66.67m.
• Bank can construct homemade swap by borrowing
  66.67m at 6 for 5 years, then simultaneously
  lend this amount at LIBOR (a floating rate)
• Bottom line banks fixed rate interest stream
  has been converted into a floating-rate stream
• (Easier way to do all this Bank could just call
  a swap dealer)

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Setting up a hedge

• In our futures examples, firm has hedged by
  buying one asset and selling an equal amount of
  another
• In practice, the appropriate hedge ratio may
  not be 1.0
• The asset to be hedged may not move 1-to-1 with
  the available hedge contract
• Suppose you own A and you want to hedge by making
  an offsetting sale of B. If percentage changes
  in value of A and B are related as follows
• Expected change in A a (change in B)
• Then delta is the hedge ratio the of
  units of B that should be sold to hedge each unit
  of A

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Setting up a hedge

• You can calculate deltas by brute force, or you
  can use finance theory to set up a hedge
• Example Suppose a leasing company has a lease
  contract to receive a fixed 1m for 5 years.
• If interest rates go up (down), the value of the
  lease payments go down (up)
• The company can hedge this interest rate risk by
  financing the leased asset with a package of debt
  that has exactly the same duration as the lease
  payments
• So if interest rates change, the lease payments
  value changes, but the debt obligations change by
  an equal amount
• We say the company is immunized against interest
  rate risk

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Managing International Risk

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 27

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
39
Topics Covered

• Foreign Exchange Markets
• Some Basic Relationships
• Hedging Currency Risk
• International Capital Budgeting

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Foreign Exchange Markets

• Exchange Rate - Amount of one currency needed to
  purchase one unit of another.
• Spot Exchange Rate Price of currency for
  immediate delivery.
• Forward Exchange Rate Price for future delivery.

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Foreign Exchange Markets

• Example - The yen spot price is 112.645 yen per
  dollar and the 3 month forward rate is 111.300
  yen per dollar. What is the forward premium,
  expressed as an annual rate?
• So yen trades at a 4.8 forward premium relative
  to dollar
• (could also say dollar sells at a 4.8 forward
  discount)

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Exchange Rate Relationships

• How are these various quantities related?
• (i inflation, fforward rate, sspot rate,
  rinterest rate)

?
?
?
?
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Exchange Rate Relationships

• In simplest world (people are risk-neutral and
  face no transaction costs for international
  trade), they are all equal (!)

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Exchange Rate Relationships

• Leg 1) Interest Rate Parity Theory links
  interest rates and exchange rates
• It says that the ratio between the interest rates
  in two different countries is equal to the ratio
  of the forward and spot exchange rates.

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Exchange Rate Relationships
Interest Rate Parity Example - You have
1,000,000 to invest for one year. You can buy a
1- year Japanese bond (in yen) _at_ 0.25 or a
1-year US bond (in dollars) _at_ 5. The spot
exchange rate is 112.645 yen1. The 1-year
forward exchange rate is 107.495 yen1 Which
bond will you prefer?
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Exchange Rate Relationships
Interest Rate Parity Example - You have
1,000,000 to invest for one year. You can buy a
1- year Japanese bond (in yen) _at_ 0.25 or a
1-year US bond (in dollars) _at_ 5. The spot
exchange rate is 112.645 yen1. The 1-year
forward exchange rate is 107.495 yen1. Which
bond to prefer?
Next years payoff to dollar bond 1,000,000 x
1.05 1,050,000 Next years payoff to Yen
bond 1,000,000 x 112.645 x 1.0025
112,927,000 yen 112,927,000/107.495
1,050,000 In other words, you are indifferent
only if the interest rate differential
(1.0025)/(1.05) equals the difference between the
forward and spot exchange rates
(107.495/112.645), as it does here. (If this
interest rate parity doesnt hold, youd have
an arbitrage opportunity. Hence, it must hold.)
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Exchange Rate Relationships

• Leg 2) Expectations Theory of Forward Rates
  links forward rates to expected spot rates
• It says that in risk-neutral world, the expected
  future spot exchange rate equals the forward rate
  

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Exchange Rate Relationships

• Expectations theory logic
• Suppose one-year forward rate on yen is 107.495
• But that traders expect the future spot rate to
  be 120.
• ? Then no trader would be willing to buy yen
  forward, since would get more yen by waiting and
  buying spot.
• ? Thus the forward rate will have to rise until
  the two rates are equal

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Exchange Rate Relationships

• Leg 3) Purchasing Power Parity (PPP) implies
  that
• And so the expected difference in inflation rates
  equals the expected change in spot rates

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Exchange Rate Relationships

• PPP intuition
• If 1 buys a McDonalds hamburger in the USA, it
  also buys (after currency conversion) a hamburger
  in Japan
• So spot exchange rates should be set such that
  1 has the same purchasing power around the
  world else, there would be import/export
  arbitrage buy goods where 1 buys a lot, sell
  them where 1 doesnt buy much.
• And if this relationship is to hold tomorrow as
  well, then the expected change in the spot rate
  must reflect relative inflation.

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Exchange Rate Relationships

• Leg 4) International Fisher Effect relates
  relative interest rates to inflation rates
• Says that expected inflation accounts for
  differences in current interest rates, i.e. real
  interest rates are the same across countries

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Exchange Rate Relationships

• Example International Fisher effect
• Claims that the real interest rate in each
  country is about equal. Suppose Japan and US,
  interest rates as before, expected deflation in
  Japan is 2.5, inflation in US is 2. Then real
  interest rates are about equal, Intl. Fisher
  effect holds.

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Hedging Currency Risk

• Outland Steel Current situation
• Has profitable export business
• Contracts involve substantial payment delays
• Company invoices in , so it is naturally
  protected against exchange rates
• But wonders if its losing sales to firms that
  are willing to accept foreign currencies

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Hedging Currency Risk

• Outland Steel Proposal 1
• Accept foreign currency payments
• But if value of that currency declines before
  payment is made, company may suffer a big loss in
  dollar terms
• and hedge by selling the currency forward
• If contract is to receive X yen next year, then
  sell X yen forward today. Lock in dollar rate
  today.
• Cost of this insurance is the difference
  between the forward rate and the expected spot
  rate next year
• Cost 0 if these are equal, as in expectations
  theory (leg 2)

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Hedging Currency Risk

• Outland Steel Proposal 2
• Accept foreign currency payments
• and hedge by borrowing foreign currency against
  foreign receivables, sell the currency spot,
  invest dollar proceeds in the US
• Interest rate parity theory (leg 1) says that
  the difference between selling forward and
  selling spot equals the difference between
  foreign interest that you pay, and dollar
  interest you receive
• This should be equally effective as proposal 1

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International Capital Budgeting
Equivalent Intl. Capital Budgeting Techniques

• 1) (Easy) Discount foreign CFs at foreign cost of
  capital. (Can then convert this present value to
  using spot exchange rate.)
• 2) (Hard) Convert to assuming all currency risk
  was hedged (use forward exchange rates), and then
  discount with cost of capital.
• These techniques are equivalent (verify BM6 p.
  806-807)
• Thus, hedging allows you to separate the
  investment decision from decision to take on
  currency risk