The Walt Disney Company’s Yen Financing.docx

BUFN 770 International InvestmentsThe Walt Disney Companys Yen FinancingThe Walt Disney Companys Yen FinancingIssueThe Walt Disney Company is a diversified international company which operated entertainment and recreational complexes, produced motion picture and television features, developed community real estate projects, and sold consumer products. In July 1984, Disney was concerned about possible foreign-exchange exposure due to future yen royalty receipts from Tokyo Disneyland. The royalty receipts had been just over 8 billion during fiscal 1984 and were expected to grow very fast over the next few years. Since yen depreciated against dollar recently, Rolf Anderson, the director of finance at Disney, was considering various ways of hedging this exposure. In the meantime, Borrowings and debt ratio increase a lot in at the end of fiscal 1984 due to the acquisition of Arvida and its the expenditure for the repurchase of 4.2 million shares of the companys common stock. Therefore, Disney needed a solution that can hedge the foreign-exchange exposure and reduce its short-term debt at the same time. Therere four different ways of hedging this exposure(1) foreign-exchange (FX) options, futures, and forwards (2) swap out of existing dollar debt into a yen liability (3) ten-year term loan (4) swap out of ten-year ECU Eurobonds into a yen liability.Alternatives(1) Foreign-exchange options, futures, and forwards Mr. Anderson could sell FX options, futures and forwards to hedge the exchange risk created by the increasing yen royalty receipts if the yen continued to depreciate in the years ahead. However, liquid markets for options and futures contracts exist only for maturities of two years or less. And Mr. Anderson probably needed to hedge for more than two year. Therefore, options and futures should be ruled out.Disney could also use the forward exchange market to lock its dollar value of its yen royalties. However, long-dated outright forward rates (Exhibit 5) were priced very conservatively by banks, and the bid-offer spreads tended to open quite wide. Moreover, Banks are usually not eager to take on the risk of changes in future level of spot exchange rates. Thus, it would not be a wise choice for Disney to hedge by selling yen forwards.(2) Swapping out of existing dollar debt into yen liabilityDisney could enter into a Dollar-Yen swap, which converts more of its existing dollar debt into a yen liability. However, this is not an ideal option. First, since Disneys Eurodollar note issues matured in one to four years, this type of hedge would be short term. Besides, attractive yen swap rates for maturities less than four years were had to find. In addition, this arrangement would not provide any additional cash, thus Disney couldnt reduce the short-term debt on the balance sheet right away. Moreover, Disney was unable to issue longer maturity Eurodollar debt issue because of Disneys recent Eurodollar note issue and the companys temporarily high debt ratio. Finally, in the Euroyen bond market, Disney was also ineligible to issue Euroyen bonds under the current Japanese Ministry of Finance guidelines.(3) Ten-year term loanDisney could also hedge the future yen royalty receipts by creating a yen liability through a term loan from a Japanese bank at the Japanese long-term prime rate. Under this alternative, Disney would borrow a 15 billion ten-year bullet loan, with principal repaid at final maturity, which required interest of 7.50% paid semiannually and front-end fees of 0.75%.As Table 1 shows, the cash inflow net of front-end fees of 0.75% at time 0 is 15,000M*(1-0.75%) =14,887.50 M. Afterwards, the cash outflows would be 15,000*7.5%/2 = 562.5 from year 0.5 to year 9.5. Finally, the principal of 15,000 and interest expenses of 562.5 would be both paid at year 10. The IRR of these cash flows was 3.8042%, which means that the effective annualized cost of borrowing Yen for Disney would be (1+3.8042%)2-1=7.75% under semi-annual compounding.We also calculate the hedged amount as the percentage of royalty receipts in the following years. We assume that the Royalty receipt grows per half year from 8 billion in 1984 at a rate in Table 1. As a result, the coverage ratio become lower and lower afterwards except at year 10, indicating that Disney would face larger exchange rate risk in the later year. The advantages of this alternative:1) Disney could exchange the initial yen proceeds for dollars at the spot rate to reduce its short-term borrowings.2) No default riskDisney doesnt have to worry about the default risk of its counterparty which is a bank compared to forward hedge or swap hedge.3) Disney can hedge a portion of its royalty receipts in the future.The disadvantages of this alternative:1) The borrowing cost of 7.75% is higher than that of Euro-yen swap, which will be discussed later.2) The payment pattern of this alternative remains the same every year, while the yen royalties would grow very fast in the first few years. So a large portion of royalty receipt from year 0.5 would not be hedged, thus increasing the exchange rate exposure of Disney.(4) Swap out of ten-year ECU Eurobonds into a yen liability.MotivationTo hedge the risk created by the yen royalties, Goldman Sachs suggest that Disney issue 10-year ECU Eurobonds that would be swapped into a yen liability at a potentially more attractive all-in yen cost than a yen term loan. The counterparty to this swap would be a French state-owned utility who wished to take on an ECU liability through swapping some of its yen debt for ECU debt. Rated AAA, the utility could issue Euroyen bonds at a very favorable rate while it couldnt borrow ECU, which most closely matched its natural currency flows, easily at a low rate because of its high frequency of borrowing ECU. Therefore, both Disney and the utility could enter into a swap intermediated by Industrial Bank of Japan (IBJ), in which Disney would take on a yen liability and the utility would take on an ECU liability. TransactionDescribed in Table 2, Disney would exchange its ECU Eurobond net proceeds of ECU 78.499M (=ECU80M*100.25%-ECU80*2%-$0.075/0.742) in exchange for IBJ making future ECU payments to Disney. At the same time it would receive the yen equivalent of the net ECU proceeds from the Eurobond. And it would also make future semiannual yen payments to IBJ. On the other hand, the utility would make ECU payments to IBJ (Table2, Column C). In return, IBJ would pay yen semiannually to the IBJ (Table 2, Column D). However, the ECU principle to be “received” by the utility were actually not received and was strictly notional. Hence, there was no exchange of principle at inception for the utility. The transaction is illustrated in Chart 1.BenefitsAccording to the swap flows of ECU/Yen Swap in Exhibit 7, we could calculate the IRR of Disneys yen cash flows: 3.4457%. Thus, the semi-annual compounding annualized cost would be 7.01 %= (1+3.4457%)2-1. Moreover, the annualized IRR of Disneys ECU cash flows could be easily calculated using function IRR in Excel: 9.47%. Similarly, we could get the annualized IRR of French Utilitys ECU cash flows: 9.19%. Walt DisneyRather than borrowing yen at 7.75%, Disney could create a yen liability with cost of 7.01% incurred by the French utility under its agreement with IBJ. Disney had effectively managed to replace a 7.75% loan with a 7.01% loan. Therefore, Disney would save 74 basis points through swap.French UtilitySimilarly, the French Utility no longer had to borrow ECU from the ECU Eurobond market at the prevailing rate of 9.37% (Exhibit 8), but realized 9.19% all-in cost incurred by this swap. Under this scenario, the French Utility actually managed to reduce its cost of debt by 18 basis points.IBJIBJ would charge commission fee on the ECU payments. Fees are calculated in Table 2 Column E, which was the difference between the ECU payments that the utility made to IBJ (Table 2 Column C) and that IBJ had to make to Disney (Table 2 Column A). Therefore, some of the benefits would be shared by IBJ. We assume IBJ was not involved in the swap and French Utilitys swap flows would become Table 2 Column F with an annualized IRR of 9.12%, which indicates that all the commission fees were assumed to charge on the utilitys ECU payments. In this way, the utilitys cost increased by 7 basis points (=9.19%-9.12%) because of IBJs involvement.The advantages for Disney:(1) Disney could convert the initial yen proceeds for dollars at the spot rate in order to reduce its short-term borrowings.(2) The sinking fund payments that began in 6 years created a higher yen liability for Disney starting from year 5, which could be better matched with the growing yen royalties. Therefore, the amount of yen royalties hedged was relatively higher than that in the term loan (See Table 3).(3) The all-in cost of 7.01% in swap is 74 basis points lower than that of the term loan because this currency swap allowed both companies to exploit their advantages across a network of currencies.(4) Little credit risk IBJ would assume counterparty default risk because it would continue making payments to Disney in the event of default.The disadvantages for Disney:(1) Disney would be exposed to the fluctuation in the ECU/USD spot rate if it wanted to exchange its future ECU receipts in the swap for US dollar.(2) The ECU Eurobond market was not mature enough. If the ECU Eurobonds were launched, Disney would be only the second U.S. corporation to access this market and the first ECU bond incorporating an amortization schedule to repay the bonds principal. So, the market may not be able to understand it.(3) IBJ would charge fee in the swap.(4) Exchange rate Risk If the spot rates of Yen/ECU in the future decreased a lot from the contracted rate of 92/ECU(=0.7420*248) , Disney would have a potential loss.RecommendationAs we discussed before, Mr. Anderson should not choose to use FX options, futures, and forwards or swap out of existing dollar debt into a yen liability. Disney should hedge its exchange risk by entering into a currency swap intermediated by IBJ because its benefit from the swap substantially outweighed that in the term loan although the swap would still have several risks to which Mr. Anderson needed to pay attention.AppendixTable 1 Cash flows of Yen Term LoanyearYen(million)Effective Yen flowGrowth rate of RoyaltiesYen Royalties% hedged015000.0014887.5080000.5-562.5-562.54%83206.76%1-562.5-562.55%87366.44%1.5-562.5-562.56%9260.166.07%2-562.5-562.57%9908.3715.68%2.5-562.5-562.58%10701.045.26%3-562.5-562.59%11664.134.82%3.5-562.5-562.510%12830.554.38%4-562.5-562.510%14113.63.99%4.5-562.5-562.510%15524.963.62%5-562.5-562.59%16922.213.32%5.5-562.5-562.58%18275.993.08%6-562.5-562.57%19555.312.88%6.5-562.5-562.56%20728.622.71%7-562.5-562.55%21765.062.58%7.5-562.5-562.54%22635.662.49%8-562.5-562.53%23314.732.41%8.5-562.5-562.53%24014.172.34%9-562.5-562.53%24734.592.27%9.5-562.5-562.53%25476.632.21%10-15562.5-15562.53%26240.9359.31%IRR3.8042%Annualized rate7.7532%Table 2 ECU/Yen Swap Flows in Millions (assuming $/ECU of 0.7420 and yen/$ of 248)Disneys Swap Flows: Received from/(paid to) IBJFrench Utilitys Swap Flows: Received from/(paid to) IBJFees charged by IBJFrench Utilitys ECU payment without IBJ involvedColumn AColumn BColumn CColumn DColumn EColumn FPeriodECUYenECUYenECU0(78.499)14445.15380.000(14445.153)80.0000.5(483.226)483.22617.300(483.226)(7.350)483.2260.0500(7.300)1.5(483.226)483.22627.300(483.226)(7.350)483.2260.0500(7.300)2.5(483.226)483.22637.300(483.226)(7.350)483.2260.0500(7.300)3.5(483.226)48