It's a case study of GM ( read corp 2.docx). Want to know the answer of Q1, Q2, Q3, Q4 ( from corp.docx)

General Motors Stephane Bello, an analyst in the Capital Markets group at General Motors (GM), oversaw liability portfolio analysis activities for America's largest domestic automaker. In February 1992, GM was planning to raise $400 million through a public offering of a noncallable five-year note, with a fixed interest rate of 7 5/8%. Guided by the firm's stated policy on liability portfolio management, the current structure of its liabilities, and his best reading of likely trends in the bond markets, Mr. Bello had to recommend to senior GM Treasurer's Office managers whether to modify GM's interest rate exposure on the issue and, if so, which transaction to select. Mr. Bello had been in the Capital Markets group at GM for one year, and during that time was responsible for analyzing the management of GM's interest-rate exposure and making recommendations about how GM could lower its borrowing costs through prudent use of interestrate derivative products. Before taking this position, Mr. Bello had worked for two years in GM's European Regional Treasury Center, engaged in foreign exchange and corporate financing transactions. Before joining GM, he had worked in a commercial bank for over a year. Mr. Bello could advise that the firm merely issue fixed-rate debt and not engage in any related transactions. He could also suggest that GM engage in a wide range of derivative activities, which included transacting in interest-rate swaps, caps, Treasury options, or swap options (swaptions). He had solicited competitive bids for each of these instruments from several bankers. His recommendation would hinge on his judgment of the future level of interest rates and volatility, the future shape of the yield curve, and the interest-risk exposure each instrument would create in light of the overall interest-rate management program at GM. Background on General Motors and the Auto Industry In 1991, General Motors was the world's largest automaker and the nation's largest industrial company. It was broadly organized into four major operating segments: Automotive; General Motors Acceptance Corporation (GMAC), which provided a variety of financial services; GM Hughes Electronics, acquired in 1985, which competed in the aerospace, defense electronics, space, and telecommunications industries; and Electronic Data Services (EDS), acquired in 1984, which provided data-processing services to large corporations and institutions. GM's Automotive segment designed, manufactured, assembled, and sold automobiles, trucks, parts, and accessories. Its automotive 293-123 Liability Management at General Motors 2 nameplates included Chevrolet, Pontiac, Oldsmobile, Buick, Cadillac, GMC Truck, and Saturn in the United States, as well as Holdens, OPEL, and Vauxhall in overseas countries. While GM's nonauto businesses produced profits in 1991, its auto business suffered a second consecutive year of large operating losses. In 1990 the automotive segment reported an operating loss of $3.4 billion, of which $3.3 billion was a special provision for scheduled plant closings and other restructurings. In 1991 the automotive segment reported an even greater loss, $6.2 billion, of which $2.8 billion was a special provision for scheduled plant closings. In 1991 GM cut its annual common stock dividend from $3.00 to $1.60, roughly the level it had been in 1983. In December 1991, GM's chairman and CEO, Robert C. Stempel, announced the newest cutbacks, which were scheduled to close 21 factories, cut 74,000 jobs, and slash capital spending over four years. 1 While analysts generally supported the firm's restructuring efforts, which would ultimately cut costs by $5 billion annually, North American auto operations were not expected to become profitable for at least a few years. Exhibit 2 gives selected financial information on General Motors at a consolidated level, and Exhibit 3 gives the performance of the firm's automotive segment over the past decade. Exhibit 3 also provides information on interest rates and exchange rates during the same period of time. Financial Policies at GM At least two aspects of GM's financial strategy were reviewed in great detail in 1991. In the first of these efforts, Ray Young (who oversaw corporate finance activities in the Treasurer's Office) and his staff carefully analyzed the corporation's current capital structure policy. (See Exhibit 1 for an organization chart of the Treasurer's Office at General Motors at the time of the case.) Ultimately their conclusions regarding the GM balance sheet were reviewed by GM's Treasurer, CFO, and other senior executives. Financial targets examined, which were not announced publicly, included book value debt-to-total capital ratios, interest coverage ratios, and cash flow coverage ratios. The target ranges were set mindful of the rating agencies' guidelines, competitor's debt policies, and Young's estimates of the firm's cost of funds and its likely access to capital under various scenarios. Of utmost concern was the shared belief that declines in the company's debt ratings could make raising funds very difficult and thus lead to unintended shrinkage in the firm's auto activities. The capital structure recommendation provided policy direction and guidance to the Capital Markets group charged with executing specific transactions. Nevertheless, the Capital Markets group had wide latitude: for example, issuing \"debt\" implied a set of decisions about which market the instrument would tap (domestic U.S., Euromarkets, or other), the maturity of the instrument, its interest rate (fixed or floating), and other specific terms like callable features, sinking funds, etc.2 In addition, the capital markets in the 1980s and early 1990s had developed an almost unbounded number of derivative instruments that could dramatically alter the fundamental economics of an offering. For example, a firm could issue a fixed-rate note, and then engage in a swap transaction with a financial institution to pay a floating rate tied to LIBOR and receive a fixed rate. The issuer then effectively transformed the fixed-rate issue into a LIBOR-linked floating-rate note. GM did not engage in derivative transactions to modify the interest-rate exposure of its debt offerings until 1989, when the manager of the Capital Markets group suggested that the firm 1 P. Ingrassia and J. White, \"GM Plans to Close 21 More Factories,\" Wall Street Journal, December 19, 1992, p. A3. 2 At the time of the case, GM policy mandated that all borrowings executed by the domestic capital markets group were to be in U.S. dollars or swapped into U.S. dollars. The group was not permitted to borrow in unhedged foreign currencies. In addition, by tradition, the borrowings to support domestic auto operations were over five years in maturity, given that General Motors Acceptance Corporation (GMAC), the automaker's financing arm, typically raised extensive short maturity funds. For the exclusive use of A. Singh, 2016. experiment with swaps and other interest-rate derivatives to lower GM's borrowing costs. This effort proceeded after receiving ultimate approval from the Finance Committee of the Board of Directors. However, throughout 1989 and 1990, GM's borrowing needs were modest, and thus it engaged in very few interest-rate derivative transactions. The early transactions were structured as relatively low-risk experiments designed to reduce GM's cost of debt. Because the group lacked internal capabilities to price interest-rate derivatives, it was decided that GM would engage in transactions only when they could obtain independent prices from competing financial institutions.3 Requiring multiple vendors to submit bids may have ruled out some of the most esoteric transactions in the market, but it also gave GM some assurance that it would not be at the mercy of one bank if it wanted to unwind its positions before maturity. Beginning with its 1990 annual report, GM notified the public of its use of interest rate derivatives to manage its exposure as part of its SFAS 105 disclosure: The Corporation primarily utilizes interest-rate-forward contracts or options to manage its interest-rate exposure. Interest-rate-forward contracts are contractual agreements between the Corporation and another party to exchange fixed and floating interest-rate payments periodically over the life of the agreement without the exchange of underlying principal amounts. Interest-rate options generally permit but do not require the purchaser of the option to exchange interestrate payments in the future. At December 31, 1990, the total notional amount of such agreements with offbalance sheet risk was approximately $7,787 million. 4 By the end of 1991, this notional principal equaled $7,354 million. 5 The amounts disclosed in GM's annual reports included interest-rate derivatives transactions executed by GMAC. However, the New York Treasurer's Office was not directly involved with GMAC's liability management program, which was handled out of GMAC's Treasury operations in Detroit. The required disclosure contained in the GM financial statements did not reveal the number, complexity, or economic exposure brought about by the firm's recent interest-rate management activities. For example, in its first two years of managing interest-rate risk actively, GM had entered into seven different transactions, including a single interest swap and a handful of more complicated swap options or swaptions. In 1991, GM's liability management program became more formalized and increased in scope, for in that year the firm entered into 40 interest-rate derivative transactions. This increase in scale was facilitated by the hiring of a full-time analyst charged with analyzing and recommending potential structures to manage GM's growing liability portfolio. The heightened activity also led to a formal 3 At first, GM sought price quotations from a large number of banks to ensure that it received fair pricing. In one early instance, it contacted ten banks for quotations on a multi $100-million cap transaction. (The seller of a cap agrees to pay any positive difference between prevailing floating rates and a preset fixed interest rate.) By contacting this large number of institutions for a transaction of this magnitude, GM's intentions became known. Over the course of the day in which it had hoped to enter into the cap transaction, the pricing of the transaction became materially less attractive to GM. GM staff suspected that this movement in prices was due at least in part to certain banks taking positions to be able to profit by taking the other side of the cap transaction. As a result of this experience, GM contacted a smaller number of institutions, but still demanded that all transactions have competitive market quotations. On newer products like swap options (discussed later in this case), GM found relatively large differences among the bids from its group of bankers. On older products like \"plain vanilla\" interest-rate swaps, bids from competing banks were very similar. 4 1990 Annual Report. Notional principal represents the principal amount upon which a swap or option contract's payoff is based. For example, if you own a call option that gives you the right to buy $100,000 of treasury notes in 60 days for a given price, the notional principal for this contract would be $100,000. 5 In comparison, the firm's off-balance sheet exposure to foreign-exchange forward contracts and exchange options was $16,774 million and $12,301 million, respectively, in 1990 and 1991. 4 review of GM's liability management policies. This review sought to evaluate the firm's first two years of experience in managing the structure of its debt, as well as to lay out guidelines for future liability management activities. This policy review set broad boundaries within which interest rate management of Central Office debt obligations would take place. 6 The 1991 Review of GM's Liability Management Program The 1991 review established a rationale and a set of policies for managing the debt of GM's auto operations, just as the review of capital structure provided a long-term view of the firm's mix of debt and equity. The report covered the goal of the program, the economic rationale for a \"home base\" mix of fixed/floating obligations, the role of changing market conditions on the active management of the portfolio, corporate governance concerns, and criteria for counterparty credit exposure. The following excerpts summarize key findings: Goal: \"To actively manage the Central Office liabilities to take advantage of the cyclical nature and volatility of domestic interest rates and shifts in the shape of the yield curve to reduce GM's overall cost of funds. Home base: \"Asset/Liability management can be broadly defined as matching the nature of a company's liabilities to its assets to limit the impact of interest-rate movements on the company's net cash flows and hence corporate value. In general, this is accomplished by adjusting a firm's financial liability portfolio such that any impact on operating cash flow caused by movements in interest rates is largely offset by changes in the value of the firm's liability portfolio. \"(In) industrial companies . . . the impact of changes in interest rates on operating cash flows is hard to quantify. . . . In addition, the right-hand side of an industrial company's balance sheet tends to comprise a higher percentage of equity and noninterest-bearing liabilities (i.e., accounts payable, reserves for warranties, incentives, and deferred taxes) than a financial institution's. This means that, even if the correlation between changes in interest rates and changes in operating cash flows could be perfectly established, the value of financial liabilities would probably have to be hedged to an extreme to obtain the desired results. \"GM's North American automotive revenues and hence operating cash flows are strongly influenced by movements in interest-rates . . . a 1% decrease in auto loan rates results in a 0.2% increase in the dollar volume of cars sold.7 . . . GM's automotive operations behave more like fixed-rate assets than floating-rate assets... Therefore, GM's Central Office liability portfolio should be predominantly fixed-rate in nature to provide the greatest insulation to GM's cash flows from a rising interest-rate/slow automotive market. \"Although a fixed/floating rate mix of 100/0 would completely insulate GM's debt service cash flows from rising interest rates,..(1) it would ignore the cost benefits to be derived by 6 GM's overseas automobile operations, GMAC, GM Hughes, and EDS managed their own liabilities. However, because the Treasurer of the corporation had overall responsibility for the firm's balance sheet, these subsidiaries (other than GMAC) needed Treasurer's Office approval to issue debt beyond certain forecast levels, but the subsidiaries had great latitude in executing details of the transactions. In addition, interest rate and currency exposures were managed directly by the subsidiaries. The \"Central Office\" debt that the 1991 review addressed was the $7.2 billion in debt specifically associated with domestic auto operations, which was managed by treasury staff in GM's New York office. 7 Caserwriter's Note: Exhibit 3 shows measures of GM's auto division's performance and cash flow as well as various macroeconomic variables. 5 holding some short-term debt in light of the generally upward sloping shape of the yield curve; and (2) it would force GM to issue fixed-rate debt even when interest rates are at high historical levels.8 [The report then summarized GM's interest costs for its Central Office debt portfolio, under various fixed/floating proportions in two scenarios: the fixed-floating spread holds at the historical average level, and the fixed-floating spread widens to early 1980s levels.] \"Given the outlook for weak operating profits in upcoming years, it does not appear appropriate to assume a significant amount of risk with the Central Office debt portfolio. However, neither does it appear appropriate to ignore the savings over time of floating-rate debt. Although not a scientifically determined mix, a fixed/floating split in the neighborhood of 75%-80% fixed/25%-20% floating appears to be an appropriate balance of these considerations...[or a] home base.\" Active management around home base: \"Essentially, a liability management program is an attempt to take advantage of the cyclical nature of interest rates, the volatility of interest rates, and the changing shape of the yield curve. By adjusting the composition of GM's liability portfolio in step with changes in rates over time, GM should be able to accomplish a meaningful reduction in total debt service costs. \"In general, a fixed/floating mix of less than 75/25 reflects GM's belief that short-term (floating) rates are more attractive than long-term fixed-interest rates, while a fixed/floating mix of greater than 75/25 reflects GM's belief that long-term fixed rates are more attractive than short-term (floating) rates. In addition, option strategies can add flexibility and significantly reduce GM's overall cost of funds. In general, GM would sell options when interest-rate volatility is high or when an abnormally shaped yield curve provides opportunities.\" Corporate control concerns: \"All swap and swap-option transactions (must) be reviewed with and executed under the approval of the Treasurer. . . . Transaction reviews would be conducted with consideration given to historical interest rates, the current interest-rate environment as well as the forecast of our position on the interest-rate cycle and the fit of the transaction within the strategic shift in the Central Office fixed/floating mix. The fixed/floating mix will be maintained within the range of 100/0 and 50/50 which should provide GM with sufficient flexibility to actively manage GM's portfolio while maintaining a minimum conservative level of 50% fixed-rate debt.\" Counterparty exposure: The final section of the report described GM's policies regarding swap and option counterparty creditworthiness. Specifically, it detailed the minimum credit ratings required for various types of financial transactions, and the maximum allowable exposure the firm could have to any one financial institution. The February 1992 Decision In determining what recommendation to make about the interest-rate exposure of the proposed $400-million fixed-rate offering, Stephane Bello had to sort through the mandates of the 1991 policy review, GM's current interest-rate exposure, his best guess of future interest rates, and the specific 8 Casewriter's Note: Exhibit 4 gives selected historical information on interest rates. alternatives from which he could choose. The first two of these were quite clear: the memo set broad restrictions on the liability management activities, especially given the current portfolio of debt obligations and interest-rate derivatives, summarized in Exhibit 5. His recommendation would also be affected by his \"rate view\" and the instruments at his disposal. Development of the February 1992 \"Rate View\" Predictions of the level of interest rates, the shape of the yield curve, and volatility of interest rates would figure prominently in Mr. Bello's recommendation. The Treasurer, charged with managing the liability management program, relied on his finance staff and the firm's bankers for input. Mr. Bello and other members of the Capital Markets group at GM were in contact with over 20 economists who offered their insights. Exhibit 6 summarizes a few banks' published forecasts as of February 1992. In addition, internal GM data on forecasts of auto sales and other items provided some information about the direction of the economy. Due to the size of GM in the economy and to the magnitude of its banking needs, the staff at GM felt that it had access to more, better, and more timely information than the market as a whole with which it could make more intelligent interest-rate calls. Nevertheless, they acknowledged that arriving at a rate view was an art, not a science, and that their predictions would sometimes be in error. In February 1992 the rate view shared by the Capital Markets section of the Treasurer's Office was that \"rates were likely to decline from their current levels as the market digests the heavy supply of bonds sold by the U.S. Treasury\" due to the recent quarterly refunding of Treasury debt, and that the bond market \"is likely to rally (i.e., rates will decline) over the next two months as participants focus on fundamentals that point to a continued weak economy during the first half of the year.\" In addition, they felt that \"there is currently a high level of uncertainty in the market with regard to the direction of interest rates over the next few months.\" Finally, they agreed that the yield curve would flatten as the spread between long and short rates converged. Exhibit 7 shows interest rates and forward rates in February 1992. Stephane Bello's Alternatives While GM's Treasurer was ultimately responsible for the liability management program, the degree to which the execution of the program was delegated depended on the scope, novelty, and change in rate view implied by the transaction. Transactions of large size or novel structure, or those whose positions reflected fundamental shifts in rate view, were carefully scrutinized by senior Treasury managers. On transactions like the one Mr. Bello was currently contemplating, his recommendation would carry much weight. The terms of the $400-million five-year 7 5/8% coupon note that would be issued were straightforward. GM would make ten semiannual interest payments of $15.25 million and a final principal repayment of $400 million at maturity. Before maturity, GM had no call provisions, nor did the note establish a sinking fund. GM had no right to extend the maturity of the note beyond five years. The notes would be sold to the public for 99.976 per $100 value, for gross proceeds of $399,904,000. GM would pay its underwriters commissions of $1.8 million and expenses of $175,000. Mr. Bello had an almost unlimited set of alternatives for adjusting GM's interest-rate exposure on this offering. Five generic alternatives were: (1) enter into an interest-rate swap; (2) sell caps; (3) buy or sell an option on an interest-rate swap (known as a swap option or swaption); (4) buy or sell options on a five-year Treasury instrument; or (5) do nothing. The following discussion describes the various choices open to GM, and Exhibit 8 gives representative quotes on these instruments from counterparties meeting GM's credit standards. GM's policy was that any interest-rate derivative position it entered into must be acceptable to the firm if GM was forced to hold it to maturity, or if a counterparty exercised any options against GM. However, GM's expectation, based on its rate view at the time the derivatives were put in place, was that it would be able to unwind its position within six months at a profit.9 As a result, GM entered into transactions only with multiple bidders, where the firm was likely to be able to unwind its position in the near term with a minimum of transaction costs. Swaps To transform the five-year fixed-rate obligation into a floating-rate obligation, GM could enter into an interest-rate swap. In an interest-rate swap, two parties in effect agree to exchange their interest rate obligations. For example, GM could agree to pay, over the next five years, a floating rate (based on LIBOR) on $400 million and to receive a fixed interest rate. The counterparty to this transaction would agree to pay a fixed interest rate on the $400 million and receive a floating rate. The $400 million principal amount of the swap (called the notional amount) never changes hands. In practice, the two offsetting interest payments are netted against one another so that only the difference between the payments is exchanged.10 Typically, no funds change hands at the initiation of a swap. Since 1986 the Treasurer's Office had entered into eight interest-rate swaps, seven of which were done in 1991.11 In the early 1980s when first introduced, interest-rate swaps were executed between different borrowers who would come to market simultaneously and also enter into the swap agreement, often with a financial intermediary serving as broker and as guarantor of the differential interest payments. However, financial intermediaries soon began to become dealers in the swap market, taking positions and managing the interest rate and credit risk of their portfolio of swaps on their \"swaps book.\" GM's policies regarding its swap counterparties were thus designed to reduce its exposure were one of its financial intermediary swap counterparties to fail. A wide variety of interest-rate swap structures could be used: counterparties could agree to virtually any structure of the notional principal (e.g., flat, amortizing over time, stepping up over time) and any set of different interest rates (e.g., fixed for LIBOR, fixed for Treasury bills, LIBOR for Treasury bills). In addition, swaps could be structured for current execution or for future execution (e.g., in a forward, deferred, or delayed-start swap, the counterparties agree to enter into a particular swap whose payments will not begin until some point in the future.) Typically, swap participants were free to buy out their counterparties by paying the market price reflecting the net gain to the other party of canceling the contract. 9 GM entered into interest-rate derivative contracts only in conjunction with particular financing transactions. While Stephane Bello could unwind a position, say by buying back a swap, he was not free to purchase or sell additional interestrate derivatives except as related to a debt issuance. This policy was put in place to discourage pure speculation on interest rates. In addition, by attaching its derivative positions to underlying security instruments, GM would receive \"hedge treatment\" from a tax and financial reporting standards. Under this treatment, gains or losses on hedge positions are not marked to market each year, but rather amortized over the life of the security to which the instrument is attached. 10 Before a market for swaps emerged, firms would occasionally enter into parallel loans, or simultaneous loans, in which they would transfer to one another the equal principal amounts of the loans and make fixed or floating interest payments to one another. The swap arrangements obviate the need to exchange principal and require firms to make only the net interest payments each period. 11 These numbers include only Central Office activities, i.e., financings for GM's domestic auto operations. In the same period, this office entered into nine currency swaps, six of them completed before 1991. While the $400-million note had a maturity of five years, GM could enter into a swap for less than that period of time. As many as 20 financial institutions around the world met GM's credit criteria and could offer GM quotes for these plain-vanilla swaps. A swap of under $200 million could be easily and quietly handled by a single large counterparty, but larger deals would more likely involve several institutions and attract attention. Given the commodity nature of the plain-vanilla swaps business, spreads that compensated the market makers were thin, with usually only a few basis points separating bid and ask. Caps Firms wishing to change their interest-rate exposure can buy or sell interest-rate caps, floors, or collars. Suppose a corporation has floating-rate debt outstanding whose rate was linked to LIBOR. To limit its maximum interest payments, the corporation can pay a premium and buy a cap that pays the difference between LIBOR and the rate cap if LIBOR exceeded the cap rate, or zero otherwise. Entering into this transaction in conjunction with an underlying floating-rate issue gives the corporation a floating-rate obligation whose maximum interest rate is the rate cap. In conjunction with its issuance of fixed-rate debt, GM would not be a likely buyer of caps, but it could sell them. By selling a cap, GM would be obligated to pay any positive difference between LIBOR and the rate cap. In return for writing this contract, GM would be paid a premium, which would reduce the all-in-cost of the borrowing associated with the cap transaction. Exhibit 8 shows premia GM would receive for selling caps at various rate caps. Corporations could also purchase floors, which place a lower limit on their interest charges. A collar is a long position in a cap and a short position in a floor, typically set up so that the premium from writing the floor equals the premium for buying the cap. GM had never entered into a cap transaction before 1991, but in 1991 and 1992 it entered into 13 transactions, with notional principal of $2.6 billion. Plain-vanilla caps were sold by as wide a group of market makers as plain-vanilla swaps, but more esoteric cap products were offered for sale by only five or six of GM's qualified counterparties. Swaptions Stephane Bello could also propose that GM buy or sell a swaption, an option to enter into an interest-rate swap with specified terms. For example, GM had in 1991 sold a \"2- by 3-year swap option\" in conjunction with a $250-million fixed-rate debt offering. By the terms of that swaption, GM's counterparty had the right, but not the obligation, to enter into a swap with GM in which the counterparty would pay a fixed rate and receive LIBOR for one year, beginning two years from the execution of the contract. In return for writing (selling) this swaption, GM received a cash premium. A put (or receiver) swaption gives the owner the right to enter into an interest rate swap, in which they receive fixed and pay floating. A call (or payer) swaption gives the holder the right to pay fixed and receive floating. As in the swap market, a wide variety of forms of swaptions existed. GM could sell a swaption under which its counterparty had the right to force GM to pay floating and receive fixed. The counterparty would exercise this option when interest rates were high. In this case, GM would be left paying high floating rates to honor its swaption terms, offset in part by the premium it would receive for having sold the option. If interest rates were low at the time at which the swaption could be exercised, the counterparty would choose not to exercise. In this case, GM would be left with paying its fixed-rate obligation but would have lowered its all-in-costs of borrowing by the amount of the premium it was paid. Mr. Bello had received bids from various banks to which GM could sell these swaptions, and he was considering two proposals. Both gave the counterparty the right, at the end of a fixed period of time, to force GM to pay LIBOR and receive a fixed rate for the length of the swap. In the \"3 by 5\" European swaption proposal, at the end of the third year the counterparty had the right to force GM to receive 9% and pay LIBOR for the following two years. In the \"2 by 5\" proposal, the counterparty had to decide at the end of two years whether to force GM into a three-year swap of 9% for LIBOR. Exhibit 8 gives the premia for these transactions. GM entered into 25 swaption transactions in 1991, with notional principal involved of $2.6 billion. There were only a handful of qualified banks from which GM received swaption quotations, and it usually solicited bids from two or three institutions. Treasury Bond Options One of its bankers suggested that in light of its current rate view, GM might want to engage in a \"bull spread\" using five-year Treasury note options, in which GM would buy call options on the fiveyear Treasury note and simultaneously sell call options on the same amount. These European overthecounter options gave their holders the right, but not the obligation, to buy the five-year Treasury note on the maturity date at the exercise price.12 Both options would have the same maturity (60 days) but have different strike prices. The calls GM would buy would have a strike price equal to the current price of the five-year Treasury note (98.095), which was yielding 6.66%. The call options GM would sell would have a strike price of 99.045, to yield 6.46% or 20 basis points below the current yield on five-year Treasury notes. Do Nothing Finally, Mr. Bello could recommend that GM not enter any additional interest-rate derivative contracts in conjunction with the note offering. However, he recognized that \"doing nothing\" was as much of a decision as any of the more elaborate choices available. Mr. Bello's Recommendation Mr. Bello mentally reviewed the factors that would enter into his decision once again: the policy guidelines, GM's current interest-rate exposure, his \"rate view,\" and the instruments at his disposal. Despite his relatively junior status at GM, his recommendations would carry a great deal of weight because he was the only GM employee whose full-time job it was to manage the interestrate liability of the firm's auto operations. He had collected all the available data by talking to scores of bankers proposing variants of the products described above, and by speaking to many economists whose views of the bond market were quite contradictory. It was his job to make a recommendation, and his managers awaited his advice. 12 The terms of these over-the-counter options differed from the Treasury note derivatives traded on the Chicago Board of Trade. The exchange-listed derivatives are options on Treasury note futures, not on the underlying Treasury notes themselves. In these futures options, the holder of a call has the right, but not the obligation, to acquire a long position in an underlying futures contract for a cash payment equal to the current futures prices minus the exercise price. A futures contract is an agreement in which two parties commit to buy and sell a specific asset at a prespecified time in the future for a prespecified price. The CEO of General Motors (GM) would like you to prepare a memo that discusses GM's risk management strategy. You must provide recommendations about whether and how to modify the interest rate exposure of the most recent debt financing, taking into consideration liability management policy guidelines, the existing interest rate exposure, interest rate expectations, and the available risk management products. The memo should include an executive summary and be three to four pages long with any useful tables or graphs attached. If you need to make any assumptions, make them clear. Calculations should be relegated to an appendix. A memo that consists of a mess of calculations and numbers would not be acceptable. The memo can be worked on in groups of up to six people. The CEO of GM is also willing to sit in on a thirty-minute presentation that brings across the main points of the report. The case presentation should be about 30 minutes in length. It should also be presented in a professional manner, and with a logical flow, so that the CEO can easily understand your main points. The presentation should be informative, concise, and should keep the listener engaged. The presenter should also be prepared to answer questions from the audience. A maximum of two people from your group should present your findings. The following questions should be addressed in the memo: 1) Provide an overview of GM and its financial policies. 2) Discuss the 1991 review of GM's liability management program. 3) What are some rationales for hedging financial risks? First discuss the lack of rationale in a ModiglianiMiller world with no frictions, and then introduce frictions so that rationales for hedging can be justified. 4) Discuss some possible objectives for GM when managing interest rate risk. An objective could ensure that interest rates do not affect at least one of following: firm cash flows; firm value; the share price; ability to invest in new projects. Discuss in the context of GM's state policies on pages 4-6. (this question ties in with Questions 2 and 3) 5) The following argument for maintaining a debt portfolio that is predominantly fixed rate is mentioned on page four: \"... a 1% decrease in auto loan rates results in a 0.2% increase in the dollar volume of cars sold.\" a) Provide qualitative rationales that are for and against this argument. That is, provide reasons for why a decrease in interest rates (from the point of view of the borrower that purchases the car) could result in an increase or decrease in the dollar volume of cars sold. b) Is this argument even valid in its focus on the dollar volume of cars sold? Explain. c) One wonders where the numbers come from in this argument. Using Exhibit 3, run a linear regression of percent change in revenues (Y-variable) on percent change in 6-month T-Bill rates (X-variable). Use the following alternatives for the Y-variable: percent change in (operating profits excluding special charges + depreciation); percent change in (operating profits excluding special charges + depreciation - capital expenditures). o = 11 o If 1 is negative, use the absolute value of 1 in the denominator to calculate . o The same goes for other measures of cash flows Use the following alternatives for the X-variable: percent change in 30-year T-bond rates; percent change in LIBOR (6 month). o = = % 1 % This should produce nine regressions. d) Are your nine estimated coefficients from part (c) similar? What does this imply about the reliability of the assumption that lower interest rates result in a small increase in the dollar volume of cars sold? Do we truly know that GM is adversely exposed to increases in interest rates? 6) On page 4, the stated goal of GM is to actively manage liabilities and take advantage of cyclicality and volatility in interest rates and shifts in the yield curve. It is said that there is a fine line between risk management and speculation. It is also notoriously difficult to forecast interest rates. With these statements in mind, comment of GM's stated goal. 7) Suppose that it is true that a 1% decrease (increase) in auto loan rates results in a 0.2% increase (decrease) in the dollar volume of cars sold and operating profits. Is a mix of fixed and floating-rate debt consistent with GM's stated objective? 8) GM issued a 5-year fixed rate note with a 7.625% coupon payment (assume annual payments) and a $400M face value. They received $399.9M minus commissions and expenses. What is the cost of debt? Hint: find the discount rate such that the PV of the coupon payments and face value equals the $399.9M minus commissions and expenses 9) Consider the following choices for GM: a. Five-year interest rate swap. b. The purchase and/or sale of a 9 percent cap on LIBOR. c. The purchase of a bull spread. d. Doing nothing. Would any of these choices reduce the cost of debt for GM? Qualitative discussions of each choice will suffice. 10) Based on your analysis, in terms of risk management, what is your recommendation for GM? For this question, assume that it is true that a 1% decrease (increase) in auto loan rates results in a 0.2% increase (decrease) in the dollar volume of cars sold and operating profits. Question one i) Overview of GM The General Motors was the world`s largest manufacturer of automobiles as well as the largest industrial company within the US in the year 1991. Its operations of the company are mainly divided into four segments of operations: Automotive which deals in designing, manufacturing, assembling and selling of automotive parts, trucks and other accessories, General Motors Acceptance Corporation (GMAC) which provide a variety of financial services, GM Hughes Electronics which engaged aerospace ,electronics, defense electronics space and telecommunication industries. The segment acquired in 1985 and Electronic Data Services (EDS) that engaged in data processing services offering such services to large organizations which handle loads of data. It was also acquired in1984. In 1990, GMs auto industry reported a loss amounting to $3.4 billion despite the vibrancy of its non-auto business. Out of this, 3.3 billion was a special provision for schedules plant closings and other restructuring. This figures changed to $6.2 billion and $2.8 respectively in the year 1991. In attempts to restructure the company, the annual Common stock dividends were cut from $ 3.00 to $1.60 per share in the year 1991. The three dollar rate had been in existence since 1983. In addition the company`s CEO, Robert C. Stempel announced new set of cutbacks which included closing down 21 factories, cutting 74,000jobs and reducing capital spending. These efforts were considered favourable by analysts as they would cumulatively cut GMs costs by $5 billion ii) GM`s Financial Policies The book value, debt-to -total capital ratios, interest coverage ratios and cash coverage ratios are included in the financial targets which are not announced publicly. The target ranges are set with respect to the guidelines of rating agencies, debt policies of competitors as well as Young`s estimate of the cost of capital of the firm coupled with its likelihood of accessing capital under various scenarios. Raising funds can be hampered by decline in the company`s debt thus lead to decline in the firms auto activities. Before 1989, GM shied away from transactions involving derivatives as a means of modifying interest rate risk on debt offerings. Question two Discussion of GM's Liability Management Program of 1991 To pull the company out of loss, the activities geared towards restructuring the company were indeed timely and in real benefit to the company`s future prospects. These included reduction in the dividend issued, closing down of factories and retrenchment of 74,000 employees. A combination of these activities was estimated by analysts that it would help GM reduce its operating costs by a significant $5 billion. If such restructuring was not done and had the loss making trend continued, the auto section of the company could have under extreme circumstances even collapsed. Reduction in declared dividends acted to save income earned for purposes of being ploughed back into the business. This reduces the need to finance business through debt whose repayment reduces a company`s net income. The move also enhances ability of the business to expand its operations without financial strain because it will have the required liquidity to support its operations. Closing down factories helps save operational costs which are incurred in operating machines, paying rent for the factory premises, incurring social responsibility costs as well as paying the staff. This focuses attention to factories that are more efficient that is those with (highly qualified employees and up to date technology) which improve operational excellence and consequently t boosts profits. Staff cost is one of the largest costs a manufacturing company incurs. This means that if a company is struggling, one of the costs to be keen to reduce is the staff cost. By retrenching 74,000 employees, GM was able to save a considerable amount of money which could otherwise have been paid as staff cost. Even though the restructuring ways had a potential beneficial impact to the company`s future survival, it is an inhumane act to terminate one`s employment as it may result into increased suffering among the family members of those affected by the retrenchment. Closing down of company`s factories too would lead idle capacity which could have otherwise been used to boost production. Question three i) The Rationales for Hedging Financial Risks As opposed to the small shareholders who can diversify financial risks, managers as agents of shareholders are undiversified as they invest the earned income from labour as well as personal assets into the firm hence they hedge. To reduce expected bankruptcy costs such as retention of company`s assets by regulators and supervisors, managers usually opt to hedge. Sometimes especially in the case of small companies, access to capital may prove elusive thus they find it useful to transfer risk to those who can manage the risk better, that is, those who are diversified better and have a wider access to the capital markets. Through hedging, a company can increase its debt capacity and attain its desired capital structure that is the mix of its debt and equity financing. Hedging helps firms reduce their tax liability since some of the funds used in hedging such as insurance premiums are tax deductible. ii) The lack of rationale in a Modigliani-Miller world with no frictions Modigliani Miller mention that annuities are purchased by few individuals as such investments are viewed as risky. They also mention that people in the productive age do not buy sufficient life insurance. They also maintain that excess number of retired people have life insurance. In addition, they also propose that those who purchase annuities hold life insurance too at the same time. Lastly they hold that most annuity policies have clauses that guarantee the least amount of repayment. iii) Introducing rationality When the annuities are viewed in the broader scope, they stop being very risky investments. For instance if someone invests say, $10,000 in life insurance premiums, the person is certain that incase the insured risk happens, he will surely get the sum assured. If the individual dies in a few weeks time he will probably receive some few thousand dollars in income. There is also a possibility too of the same individual receiving more than $10,000 if he lives past the life expectancy. Question four Objectives for GM when managing interest rate risk Since the GM is struggling to revive the auto segment, the objective of hedging interest rate risk would be: To reduce their interest expense on loans: The GM is aiming to reduce its operating costs considerably to bring it back to profitability. Interest expense is likely to eat into their profits hence plunge the company back to liquidity crisis. By hedging, they will be able to avoid such a risk. Since GM desires more sources of funds, it may choose to hedge if there are expectations that the future interest rates will be higher. The high interest rates may eat into the profits of the company hence plunge it further into losses- a situation which is undesirable considering the current financial position of the company. Question nine a) Yes, the swap would reduce GM's exposure to interest. For instance if the interest rates are high, the company can swap the rate with another company which can handle the risk better hence reduce its exposure significantly. b) Yes, This too would reduce as the capping will protect the company from excessive volatility in interest rates c) Yes, by obtaining an option at lower strike call and selling it at a higher strike call, they`ll increase their income significantly. d) No, if they do nothing the cost of debt may be negatively affected by fluctuations in interest rates.