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The Walt Disney Company’s Yen Financing International Financial Economics Universiteit van Amsterdam

Question 1

Should Walt Disney Company hedge its yen exposure? Why? On April 1983 Tokyo Disneyland started to operate. The Japanese company that operated this park paid royalties on certain revenues to Walt Disney Productions. The Yen royalties receipts in 1984 already reached a height of 8 billion Yen. The director of finance of the Walt Disney Company expected a further growth of 10% to 20% per year over the following years.

In the mean time there existed a problem of a depreciation of the Yen, the Japanese currency depreciated with almost 8% against the US Dollar. The Walt Disney Company was concerned for further depreciation of the Yen Royalties. This was because the amount of royalties was expected to grow at a high level and with a depreciation against the US Dollar this would counter its investment and expansion plans for the future. To attempt the risk of possible exposure of Disney to future fluctuations in the Yen/Dollar sport rate, the company can choose to hedge its Yen royalties cash flows.

This can be done by using financial instruments to reduce or even entirely eliminate the impact of exchange rates on the cash flows of the Yen royalties. These financial instruments include for example forward contracts, futures contracts, swaps and options. Besides reducing the risk and impact of exchange rates and interest rates, hedging has more advantages. The first advantage is important for Disney since the appreciating Yen will reduce the US Dollar value of the increasing royalties from Japan. Hedging can be used to hold profits and surviving hard market periods, like the depreciation of the Yen.

Earnings and cash flows are influenced by exchange rate or interest rate changes which avoids steadiness. With hedging Disney is also not required to monitor daily market volatility and the company can concentrate on its investing and expansion plans. When the market is performing well or moves sidewise the benefits of hedging can decrease or in the worst situation disappear. When the Yen for example starts to appreciate or if the Dollar falls, Disney won’t be able to obtain the total benefits which it would have received without hedging.

Various ways of hedging can be seen as speculation, which also involves the giving up of diversification. Another problem Disney confronted was that in the 1980’s futures and option contracts in liquid markets only had maturities of a maximum of two years and long-term forward contract quotes showed very large bid-ask spreads. Hedging is also for a part based on expectations, Disney based the hedging on increasing royalties from Japan but this could change anytime in the future. Walt Disney Corporations received an amount of almost 8 billion Yen in royalties during the fiscal book year of 1984.

This was an amount of approximately 33. 7 million U. S. Dollars. In the first years the Yen income was just a small part of the total income of Disney, but it was expected to increase at high levels in the coming years with 10% to 20%. This implied that the part of income from Yen royalties would grow to bigger amounts. This implied for attempting risks. In this way the advantages for hedging are more important because the increasing Yen royalties are protected against exchange rate risks. This way the company can safely conduct its financial plans of investments and expansion.

Question 2

Discuss briefly the main hedging techniques WD may adopt. Walt Disney has several possibilities to hedge its position with respect to the future Yen inflows. The main problem as stated in the answer to question 1, is that Walt Disney wants to lower its exposure to future fluctuations in the yen/dollar spot rate and reduce its short-term debt. In this case, we will discuss the following hedging techniques: 1 Foreign exchange (FX) options Foreign exchange options have the advantage that Disney has the right, but not the obligation to exercise the options.

When, due to certain circumstances, the Yen amounts are not delivered, Disney has no obligation towards the option writer. The disadvantages are that foreign exchange options have maximum maturities of two years and that when buying the options, transactions costs have to be incurred. Because of the disadvantages with respect to long term illiquidity, foreign exchange options are not a suitable solution. 2 Futures Futures have the disadvantage that, just like options, the maximum maturities are two years.

An advantage of futures is that they are marking to market, which is the most crucial difference between forward and futures. This implies that marking to market avoids payment equal to that day’s price change or default on the marked to market payment. With respect to forward contracts, defaulting implies that investors save the amount lost over the entire life of the contract. Again, because of the disadvantages with respect to long term illiquidity, futures are also not a suitable solution. 3 Forwards Forwards have the advantage that they have longer maturities then foreign exchange options and futures.

Next to this, forward contracts can be custom made to Disney’s situation. The disadvantage is that the forward contracts will be calculated into the bank’s exposure towards Disney (tying up their credit lines). Also the future inflow of Yen is uncertain (due to the growth level), so it is hard to fit this into a forward contract. Also the bid-ask spreads for long maturities are very high, so that the costs associated with the trade are also high. Due to the above disadvantages, forward contracts are also no suitable solution for Disney to hedge its Yen exposure. 4 Foreign currency swap

A disadvantage is that short-term (Disney’s Eurodollar note issues matured in 1 to 4 years) and attractive Yen swap short maturities are hard to find. Last, this arrangement would not provide Disney with extra cash to reduce its short-term debt. So this hedging possibility was also no solution to the exposure problem. 5 EuroYen bonds EuroYen bonds have the disadvantage that they are not possible within the current Japanese Central Bank guidelines. 6 Yen loan Disney could take a Yen loan at the bank and then exchange the principal amount into dollars at the spot rate and make the Yen interest payments with the Yen inflow.

This was Mr. Anderson preferred solution, but then Goldman Sachs suggested another solution to Disney, namely the issue of 10-year ECU Eurobonds that would be swapped into a Yen liability. 7 Goldman Sach Solution: As mentioned above, Goldman Sach suggested to issue a 10 year ECU Eurobonds that would be swapped into a yen liability at an attractive all in yen cost. Industrial Bank of Japan (IBJ) will act as an intermediary with the counterparty, French Utility Company. IBJ will pay semiannual payment to the French Utility Company that is equal to the debt service on the yen term loan.

In return, French Utility Company will pay ECU to IBJ. Disney will receive ECU and convert it into USD. Mr. Anderson was attracted by this solution due to the prospect that costs are below the yen loan.

Question 3

Evaluate quantitatively the merit of the various hedging alternatives and make explicit recommendation. 1 Yen Term loan Disney would take a JPY 15 billion 10-year bullet loan and pay the principal amount at maturity. The JPY 15 billion would be exchanged at the spot rate for dollars so that Disney could lower its short-term with the long-term (10 years) debt. Time| Cash flow| | Disney receives JPY 15 billion and pays the front-end fees of 0. 75% (JPY 0. 1125 billion) ending up with JPY 14. 8875 billion. | 1-19| Disney pay’s a semi-annual interest rate of 3. 75% (7. 5%)/2, equaling JPY 0. 5625 billion| 20| Disney pays the principal amount of JPY 15 billion plus the last interest term of JPY 0. 5625 billion. Total cash flow in this period is 15. 5625 billion. | Table 1 To calculate the semi-annual costs, we will use the following equation: Internal rate of return (semiannual): 3,78670% Internal rate of return (Annual): 7. 58% 2 ECU Eurobonds

As mentioned above, Goldman Sach suggested to issue a 10 year ECU Eurobonds, therefore we made the following assumption are taken into account: * Disney issue a ten-year ECU 80 million Eurobonds at 100. 25% of par with a coupon of 9,125%; * The ten-year ECU 80 million Eurobonds will be swapped into a yen liability at an attractive all in Yen cost; * IBJ charges an underwriting fee of 2%; * Additional expenses were capped at $75,000; * ECU Eurobonds have an annual sinking fund payment of ECU 16 million beginning in the sixth year and continuing until maturity (see Exhibit 6 on page 9, Walt Disney case). Disney exchange ECU Eurobonds to IBJ for ECU payments that exactly match the coupons and principal payments of Eurobonds (see Exhibit 7, column A, on page 10, Walt Disney case); * Disney receive Yen equivalent of the net ECU proceeds from Eurobond and convert at the spot rate; * Disney pay future semiannual Yen swap according to Exhibit 7, column B, on page 10, Walt Disney case); * Disney exchange their initial yen for dollars at the spot rate in order to reduce its short term borrowing; * Note that the ECU spot exchange rate is $0. 420 per ECU and Yen/Dollar is Yen 248 per dollar. Time| Cash flow| 0| Disney issues ECU 80 million bonds Eurobonds at 100. 25% of par (80 million x 1. 0025 – 80 million x 0. 02 – USD 75,0000/ 0. 7420 USD/ECU)=(80,2 million – 1,6 million – 1,010,781. 1671) ending up with ECU 78,498,921. 83| 1-5| Disney is accountable for its yearly coupon of 9,125% (80 million x 0. 09125) that is equal to ECU 7,300,000| 6-10| The annual sinking fund is 16 million and begins at the sixth year. Note that the sinking fund will continue until maturity.

The interest payments will amount to 21,900,000 (For the calculations interest payments please look at table 2)| 6-10| Cash flow: year 6: 23,300,000; year 7: 21,480,000; year 8: 20,380,000; year 9: 18,920,000; year 10: 17,460,000; ( For the Cash Flow please look at table 3)| 20| To calculate the internal rate of return we use the NPV equation (see above) Internal rate of return: 9. 473% (See Table 3 for calculations)| ECU Eurobonds Yen Swap Royalties Bondholders Bondholders Bondholders ECU ECU ECU JPY JPY JPY

FRENCH UTILITY

Figure 1: Swap agreement between Walt Disney Company, IBJ and French Utility. The proposed hedging technique by Goldman Sach is shown in above (figure 1). In short, Disney issue a 10 year ECU Eurobonds and swapped into a yen liability. IBJ will act as an intermediary with French Utility Company. IBJ will pay semiannual payment to the French Utility Company that is equal to the debt service on the yen term loan. In return, French Utility Company will pay ECU to IBJ. Disney will receive ECU and convert it into USD.

According to Exhibit 8 page 10, Walt Disney case, the French Utility Company pays an annual payment of ECU 400 million. The first six years this amount a payment of ECU 50 million per year and then it decreases with ECU 10 million per year. Disney Before the swap Disney’s cost of finance is 7. 58% (see Yen term loan). After the swap Disney cost of finance is 6. 89% (2 x 3. 445%). In case of a swap, Disney will benefit by 69 basis points. French Utility Before the swap Utility’s cost of finance is 9. 37%. After the swap Utility’s cost of finance is 9. 1875% (see table 3, Column 5) .

In case of a swap, Utility will benefit by 18. 25 basis points. IBJ IBJ will also benefit from the swap. They will receive ECU 50. 000 per year in the first six years, and then 40. 000, 30. 000, 20. 000 and 10. 000 respectively in the last four year. IBJ will make a total of ECU 400. 000 over the ten years of the swap. Comparative advantages Table 2 In table 2, it’s shown that both parties (Disney and the French Utility) can benefit with the swap. The French Utility has an absolute advantage in both markets (Yen and ECU) so it can borrow cheaper in both markets.

But the French Utility has a comparative advantage in Yen (it has the biggest positive difference with respect to Disney), while Disney has a comparative advantage in the ECU market (it has the lowest negative difference with respect to the Utility). So according to table 2 and both comparative advantages, Disney should issue ECU debt and the Utility should issue Yen debt. Then both parties will service each other’s debt (Disney will service the Yen debt and the Utility will service the ECU debt, both trough the IBJ).

With the swap, both parties gain by receiving a lower interest rate and saving valuable transaction costs.

Table 3 Table 4 [ 1 ]. Average 1984 Yen/Dollar rate is 237. 30 8,000,000,000/237. 30 = 33. 7 million U. S. Dollars. [ 2 ]. Note that the semiannual costs is calculate by Excel (all IRR (or NPV’s) in this document are calculated by Excel) [ 3 ]. We have used the Yen payments in table 3 to compute the cost of finance [ 4 ]. Please look at Exhibit 8, page 10, Walt Disney Case [ 5 ]. We have used the Yen payments in table 3 to compute the cost of finance