Cash Flow Financing Company

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					15.437, Fall 2005
Options and Futures Markets

Case Write-up:
The Walt Disney Company’s Yen Financing


Team Members:

Krzysztof Fidkowski, kfid@mit.edu
Shivashis Nayak, snayak@mit.edu
Zachary Skolnik, zms@mit.edu
Joy Tang, joyt@mit.edu
Yujun (Eugene) Xiao, exiao@mit.edu
Bin Zhou, binzhou@mit.edu




                    October 13th, 2005
1. Should Disney hedge its yen royalty cas h flow? Why or why not?

If Disney chose to do hedging for its yen royalty cash flow, it will have the following
advantages and disadvantages:

Advantages
 Eliminating or reducing exchange and yen interest rate risks (especially when the yen
   was losing value relative to the dollar, and the exchange was volatile while the
   company will receive increasing amount royalty incomes each year).
 Avoiding accounting impact due to the exchange rate uncertainty in the future.
   Without hedging, earnings will be affected by the exchange rate change and will not
   be smooth if the exchange rate fluctuates.
 Allowing the company to focus on its core strategies: Disney is an operational
   company. It does not want to speculate.

Disadvantages
 Losing potential benefits of currency diversification: In terms of diversification,
    having a Yen inflow may be desirable (e.g. if dollar loses value). If the company fully
    hedged yen, it will not get such benefits.
 Introducing some other uncertainties: The hedging is based on the forecast that the
    company will keep receiving increasing yen cash flows in the future years. However,
    such forecast may not be guaranteed. If the company did the hedge, the yen incomes
    from Japan, for some reason, decreases or cease to come and yen appreciates in the
    future, the company may lose ground.
 Incurring potential PR issue: Hedging may be viewed by the public as a sign that the
    company is doing some speculation (remember the Metallgesellschaft case). In the
    mean time, the royalties do not comprise a large portion of Disney's revenue. As we
    can see, out of 1.7 billions of dollars income of the company in 1984, only 32.25
    millions (using dollar/yen exchange rate of 249 yen/dollar in 1994) was from the
    Japanese market. In this sense, PR issue may of more important concern than
    potential loss from the exchange rate change.

Considering the advantages and disadvantages mentioned above and the fact that Disney
is an operational company in the entertainment industry, its strategy should be focus on
company’s core business, exposing to the external risk probably should be avoided as
much as possible. And also as public company, Disney should consider its annual
performance in terms of accounting to give more confidence to shareholders, thus, we
believe that Disney should hedge the exchange risks of yen incomes.

In addition, although yen income was relatively small at that time, it was increasing at a
rate between 10% and 20%, much higher than that of the income increase achieved in the
US (around 4%). The company should look at managing the risks from this fact.

In conclusion, based on our analysis, the benefits from hedging outweigh the
disadvantages; therefore, Disney should hedge its yen cash flow. In the mean time, the
company should do the hedge carefully with flexible strategy. For example, to find out
whether to perform a full hedge and how to do it the right way to minimize the potential
disadvantages.
2. Assuming a hedge is desirable, what hedging techniques are available to the treasurer
and what are the advantages and disadvantages of each?

Mr. Anderson was exploring all the possible options available to reduce risk of Yen exposure
(Currency exchange risk), to reduce short term debt and to reduce transaction cost by opting a
long term contract. All the hedging options available to the treasurer of Walt Disney Co. are
as follows:

a) FX options: We do not know whether FX options are available or not.
   Cost:
   Advantage: Option contracts are marked to market and can provide the company with
   some flexibility
   Disadvantage: It will cost the company to buy such options

b) Futures: We do not have information whether FX futures are available or not.
   Cost: The initial cost of future contract is zero.
   Advantage: Relatively cheap way to perform hedging. Furtures have an open market so
   that the liquidity is good.
   Disadvantage: Futures contracts existed for maturity of two years and less. Also, Futures
   contract will not provide any cash flow now to reduce the short-term debt.

c) Forwards: Buy Yen forward contract matching with Disney’s future cash flow. This will
   reduce the foreign exchange risk.
   Cost: The current cost is zero
   Advantage: FX forwards were available for long term through Disney’s bank.
   Disadvantage: FX forward contracts tied up with Disney’s valuable credit line. Forward
   contracts will not provide any cash flow in 1984 to reduce the short-term debt.

d) Swapping out existing Eurodollar bond/notes liabilities in to Yen liabilities: Disney has
   already swapped $50M worth of 12.5% Eurodollar note due in 3/15/89 into a Yen
   liability. There were still $150M and $75M Eurodollar notes (12.5%) liability due in year
   87 and 89 respectively can be converted into Yen liability.
   Cost: 7.4%
   Advantage: Low cost solution.
   Disadvantage: Attractive Yen swap rates for maturities less than 4 years were hard to
   find. Eurodollar notes issued by Disney will mature in one to 4 years. This arrangement
   would not provide any additional cash and Disney wants to reduce its short-term debt.


e) Swapping out of existing dollar debt in to a yen liability: In 1984, total bank loan as
   $408M with relatively high interest short-term bank loan under revolving line of credit
   and bank term loans. So swapping out fraction of this short-term bank loans with a Yen
   liability will only provide a short term solutions to exchange rate risk, interest rate risk.
   Cost:
   Advantage: Probably a low cost solution (Need to calculate)
   Disadvantage: Very short-term solution. This arrangement would not provide any
   additional cash and Disney wants to reduce its short-term debt.
f) Take a Yen loan from the bank (10 year, 7.5% semiannual, 0.75% front-end fees). Disney
   gets cash at time 0 (Yen converted to dollars at the current exchange rate), then pays the
   loan back using the Royalties cash flow.
   Cost:
   Advantage: Disney will be able to hedge much beyond three or four years. Bank can give
   a loan for 10 years; hence, risk of Yen exposure can be hedged for 10 years. The company
   could convert short-term debt to long term debt.
   Disadvantage: Taking such a loan would cut into Disney’s credit line with its banks.

g) EuroYen issue, swapped into dollars. However, under the Japanese finance guidelines,
   Disney is ineligible to issue Euroyen bonds.
   At time 0, Disney can convert the Yen receipt from the EuroYen issue into dollar at spot
   price. Yen Royalties will pay off the Coupon payments.
   Cost: Negligible transaction cost.
   Advantage: Negligible transaction cost.
   Disadvantage: Not available because of the government regulation

h) Eurodollar bond and short Yen forwards: Issuing long term Eurodollar bond is impossible
   because of the company’s temporarily high debt ratio and Disney’s recent Eurodollar note
   issue.
   Cost:
   Advantage:
   Disadvantage:

i) Hedge part of the potential yen cash flow: This is not a new approach but a consideration
   for the company if it will do any hedging: Disney has a Yen term loan due 2/1/93 (see
   Exhibit 3), with outstanding principal of 12.5 billion Yen, and requiring semiannual Yen
   principal payments of 765 million Yen. This is still a long term liability in Yen (8 years
   from 1985). Thus, Disney could hedge by matching forecasted Yen royalty receipts with
   this loan liability. If the expected Yen royalty receipts were expected to be higher, Disney
   could at least hedge only the difference, not the full Yen royalty revenue. Not accounting
   for this Yen loan could lead to over-hedging and losses if the Yen strengthens relative to
   the dollar and/or if revenues from the royalties decrease.
   Cost:
   Advantage:
   Disadvantage:

j) Eurobond swapped with Yen. (Goldman’s proposal)
   Cost:
   Advantage:
   Disadvantage:



3. Goldman’s proposal for an ECU bond issue accompanied by an ECU/Yen s wap.

a)
One of Disney’s direct hedging options is to create a Yen liability through a long-term loan
from a Japanese bank, at the Japanese long-term prime rate. Specifically, Disney was offered
a ¥15 billion loan, with 7.5% interest paid semiannually, principal repaid at final maturity,
and front-end fees of 0.75%. Thus, the amount received at t=0 is ¥14,887.5 million, and the
required semi-annual payments are ¥562.5 million, with ¥15,000 million principal at year 10.
The all- in cost of this loan (i.e. the internal rate of return) is calculated to be 7.608%. (bin:
agree)

The proposed ECU bond would be underwritten by Goldman, at a 2% underwriting fee. The
details of this sinking- fund bond are given in Exhibit 6 in the case presentation. Accounting
for the underwriting fee and the additional $75,000 = ECU101,078 initial expenses to Disney,
the all- in cost of the ECU bond before the swap can be calculated. As shown from the data in
Table 1 (part c), this all- in cost turns out to be 9.473%. (bin: agree)

Using the data in Exhibit 8 in the case presentation, the French utility has similar duration (10
year) borrowing at yield-to- maturities of 9.37% for the ECU and 6.83% for Yen. The all- in
cost may be slightly higher, as possible front-end fees are not shown. (bin: agree)

b) French company has saturated the Eurobond market, meaning its borrowing cost in
Eurobonds is high. Disney can issue Eurobonds at a lower rate [need details here]

c) The ECU Eurobond into Yen swap agreement is illustrated in Figure 1.


           ¥t Royalties

                                  ¥t       IBJ          ¥t         French
                Disney                                             Utility
                                ECUt                  ECUt

         ECU0         ECUt                                                 ¥t

         Eurobond Holders                                        Yen Liability


Figure 1: Eurobond Yen swap arrangement showing the currency flows among Disney, IBJ,
   and the French Utility. Note that the Yen royalties to Disney are projected, and hence
               uncertain, while the remaining cash flows are arranged at t=0.


Specifically, at t=0, Disney issues an 10 year ECU Eurobond underwritten by Goldman at the
all- in cost of 9.473%. It converts the initial receipts from the issue to dollars at the current
rate to obtain new financing. At future times, the intermediary, the Industrial Bank of Japan
(IBJ), makes annual ECU payments to the Eurobond holders (through Disney), including the
sinking fund payments beginning in the sixth year. In return, Disney makes semi-annual Yen
payments to IBJ. On the other side, the French utility counterparty makes ECU payments
annually to IBJ and receives Yen semi-annually. The ECU amount paid by the utility exceeds
that received by Disney (i.e. the Eurobond holders) since IBJ keeps a bid-ask spread. The
utility uses the received Yen to finance an existing liability, while Disney receives the Yen
from projected royalty payments.
Table 1 shows the arranged cash flows for Disney, not including the projected royalty
payments, as those are uncertain. The all- in cost of the Eurobond swapped into Yen can be
found by calculating the internal rate of return of the Yen receipts (-payments) shown in the
last column. Such a calculation yields 6.891% (annualized) for the all- in cost to Disney.
Compared to the alternate direct hedging strategy via a loan discussed in part a, which yielded
a 7.608% all- in cost, Disney gains almost 72 basis points by using the Eurobond swapped into
Yen.

For the French utility company, the receipts (-payments) are shown in Table 2. Note that no
cash is exchanged at t=0, as the principal amounts are strictly notional. Using the notional
Eurobond face value, the all- in cost of the ECU payments by the utility company can be
calculated as the internal rate of return of the values in the second column. This value is
found to be 9.188%. This is the rate at which the French company effectively borrows ECU.
Comparing this to the 9.37% YTM on comparable ECU borrowing by the French utility (part
a), the utility gains 18 basis points.

IBJ receives the bid-ask spread from the ECU payments that the utility company makes and
that Disney receives. These values are shown in Table 3. Using an ECU80 million principal,
these values can be converted to basis points (e.g. ECU .05 million = .05/80*100*100 = 6.25
basis points), which add up to 50 basis points.

Finally, the payments to/from Eurobond holders are shown in Table 4. Since the bond is
selling at 100.25% of par, the initial payment is ECU80.2 million. The internal rate of return
of the bond is calculated as 9.079%.

d) origin: IBJ always makes money. Disney and utility: they have different borrowing costs.
Mention counter-party risk assumed by the intermediary (the parties may have)
The two company have different borrowing costs in Euro and Yen market and can take
advantage to borrow in the market where they have relatively lower borrowing cost. Although
Disney seems to have higher borrowing costs in both the Euro (9.473%) and Yen (7.608%)
market than those of the French utility who is a AAA company (9.37% in Euro and 6.83% in
Yen), relatively speaking, the base point differences are 78 and 10 higher for Disney. So it
seems if Disney help borrow Euro and provide Yen, the two companies will both benefit. The
cost savings are from the borrowing cost differences in the tow market for the two companies.
                     Table 1: Disney Receipts (-Payments)
                                                    Swap with IB J
                              ECU from
                              Bondholders      ECU
                     Year     (Millions) [1]   (Millions)        Yen (Millions) [2]
                          0           78.499           -78.499         14445.153
                        0.5                                              -483.226
                          1             -7.3              7.3            -483.226
                        1.5                                              -483.226
                          2             -7.3              7.3            -483.226
                        2.5                                              -483.226
                          3             -7.3              7.3            -483.226
                        3.5                                              -483.226
                          4             -7.3              7.3            -483.226
                        4.5                                              -483.226
                          5             -7.3              7.3          -1808.141
                        5.5                                              -1764.65
                          6           -23.3              23.3            -1721.16
                        6.5                                              -1677.67
                          7          -21.84             21.84          -1634.179
                        7.5                                            -1590.689
                          8          -20.38             20.38          -1547.199
                        8.5                                            -1503.708
                          9          -18.92             18.92          -1460.218
                        9.5                                            -1416.728
                         10          -17.46             17.46            -1520.45



[1]   Bond sells for 100.25% of par, whic h is ECU 80 Million. Initial receipt reflects
      2% underwriting fee and $75,000 (= ECU 101,078) expenses paid by Disney
      to Goldman
[2]   Disney converts the initial bond receipts (shown in Yen for the all-in cost
      calculation) to dollars. The t=0 exchange rate is .7420 $/ECU and 248 ¥/$
                          Table 2: French Utility Recipts (-Payments)
                                             Swap with IB J


                          Year    ECU (Millions) [3]    Yen (Millions) [3]
                             0                    80          -14445.153
                           0.5                                     483.226
                             1                  -7.35              483.226
                           1.5                                     483.226
                             2                  -7.35              483.226
                           2.5                                     483.226
                             3                  -7.35              483.226
                           3.5                                     483.226
                             4                  -7.35              483.226
                           4.5                                     483.226
                             5                  -7.35            1808.141
                           5.5                                     1764.65
                             6                 -23.35              1721.16
                           6.5                                     1677.67
                             7                 -21.88            1634.179
                           7.5                                   1590.689
                             8                 -20.41            1547.199
                           8.5                                   1503.708
                             9                 -18.94            1460.218
                           9.5                                   1416.728
                            10                 -17.47              1520.45



[3]   The amount paid to/received from the French utility at t=0 is strictly a notional
      principal. In reality, no cash is exchanged at t=0 between the utility and IB J.
                                                   Table 4: ECU
Table 3: IBJ Receipts                              Bondholder receipts



         Net ECU             Net Yen
Year     (Millions)          (Millions)            Year       ECU
     0                   0                0            0         -80.2
   0.5                                    0          0.5
     1                0.05                0            1               7.3
   1.5                                    0          1.5
     2                0.05                0            2               7.3
   2.5                                    0          2.5
     3                0.05                0            3               7.3
   3.5                                    0          3.5
     4                0.05                0            4               7.3
   4.5                                    0          4.5
     5                0.05                0            5               7.3
   5.5                                    0          5.5
     6                0.05                0            6           23.3
   6.5                                    0          6.5
     7                0.04                0            7         21.84
   7.5                                    0          7.5
     8                0.03                0            8         20.38
   8.5                                    0          8.5
     9                0.02                0            9         18.92
   9.5                                    0          9.5
    10                0.01                0           10         17.46

  Table 5: Borrower Cost
                                                   Difference
                                      Frenc h      (Disney - French
                         Disney       Utility      Utility)
  Yen IRR Cost             7.61%           6.83%               0.78%
  Euro IRR Cost            9.47%           9.37%               0.10%

				
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