Financial

Engineering

Cases in Financial Engineering

Instructor: Chen Miaoxin

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Financial

Engineering

The Case of RJR

Nabisco Holding Capital Corporation

Financial

Engineering

Reference:

Robert M. Dammon, Kenneth B. Dunn. And Chester S. Pratt. 1993. The Relative Pricing of High-Yield Debt: The Case of RJR Nabisco Holdings Capital Corporation. the American Economic Review, 83 ( Dec.)

Financial

Engineering

Part One: Background

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EngineeringBackground 1

The firm known in 1991 as RJR Nabisco was a descendant of the tobacco firm R.J. Reynolds, founded in 1875.

Through acquisitions in the 1960s, the tobacco firm entered a variety of food businesses.

After its 1985 merger, the firm was renamed RJR Nabisco.

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EngineeringBackground 2

In the late 1980s the food products industry experienced massive consolidation through mergers.

In 1988 two main bidders proposed to take the RJR Nabisco private in a leveraged buyout contest:– The Management Group – Kohlberg, Kravis, Roberts &Co. (KKR), a firm s

pecializing in leveraged buyouts

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EngineeringBackground 3

At the end of a bidding war, KKR prevailed by offering shareholders $81 per share in cash plus a package of bonds valued at $28.

The day before the first announcement of a possible takeover for RJR Nabisco, its stock had traded at $77.25.

Thus, KKR offered common shareholders a 41% premium over the firm’s pre-takeover value.

To finance the buyout, KKR increased RJR’s debt from $5 billion to $29 billion.

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EngineeringBackground 4

The new firm was structured as a series of holding companies.

Each of these related entities had separate obligations, issued either in conjunction with the acquisition or, in the case of RJR Nabisco, Inc, the operating company, carried over from the taken-over firm.

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Engineering

Part Two: Description of Securities

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EngineeringIssuance

In May 1989, RJR holdings Capital Corporation issued three nearly identical debt securities in connection with the leveraged buyout of RJR Nabisco by KKR– $1.0 billion of 15-percent payment-in-kind subordinated

debentures due 2001 (pay-in-kind bond)– $4.1 billion of subordinated discount debentures due

2001 (deferred-coupon bond)– $525 million of 13.5-percent subordinated debentures

due 2001 (cash-paying bond)

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Engineering

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EngineeringDifference

The major difference among the three securities is the form in which interest is paid.

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EngineeringThe difference 1

The 13.5-percent cash-paying bond pays interest in cash.

The bankruptcy claim of the cash-paying bond is par plus accrued interest.

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EngineeringThe difference 2

After May 15, 1994, the deferred-coupon and pay-in-kind bonds become identical 15-percent cash-paying bonds.

Prior to May 16, 1994, interest on the 15-percent pay-in-kind bond may, at the option of RJR, be paid either in cash or through the issuance of additional pay-in-kind bonds valued at 100 percent of par.

The bankruptcy claim of the pay-in-kind bond is par plus accrued interest.

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EngineeringThe difference 3

The deferred-coupon bond was issued on May 15, 1989, at a price of $48.656 per $100 of face value.

Through May 15, 1994, the deferred-coupon bond pays no coupon but accretes to face value on May 15, 1994, at a rate of 15 percent per year, compounded semiannually.

Prior to May 15, 1994, the bankruptcy claim of the deferred-coupon bond is its accreted value.

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Engineering

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EngineeringThe difference 4

The deferred-coupon bond and pay-in-kind bonds trade flat (i.e., without accrued interest due upon settlement) prior to May 15, 1994, while the settlement price of these two bonds is the quoted price plus accrued interest after May 15, 1994.

The settlement price of the 13.5-percent cash-paying bond is always its quoted price plus accrued interest.

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Engineering

Part Three: Theoretical Pricing Restrictions

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EngineeringNotation

Assumption: there are no market imperfections. We denote the quoted price (per $100 of face val

ue) at time t of – the cash-paying bond by – the deferred-coupon bond by– the pay-in-kind bond by

We let vt denote the settlement price (i.e., the quoted price plus accrued interest ) at time t of a bond whose quoted price is pt.

ctp

dtp

ptp

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EngineeringPrior to May 15,1994

Since the deferred-coupon and pay-in-kind bonds trade flat prior to May 15, 1994,

for t≤T*, where T* is May 15, 1994.

d dt t

p pt t

v p

v p

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EngineeringAfter May 15, 1994

After May 15, 1994, both the deferred-coupon and pay-in-kind bonds become identical 15-percent cash-paying bonds.

In addition to paying a lower coupon, the 13.5-percent cash-paying bond also has a lower call-price schedule (see table 2) than either the deferred-coupon or pay-in-kind bonds.

As a result, the following arbitrage restriction must hold after May 15, 1994:

where the inequality assumed the absence of refinancing costs.

*(1) c d pt t tv v v for t T

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Engineering1. Deferred-coupon and cash-paying bonds

Consider a portfolio consisting of one deferred-coupon bond and U.S. Treasury strips with face values of $6.75 that mature at each of the coupon payment dates through May 15, 1994.

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EngineeringCont.

Beyond May 15, 1994, the deferred-coupon bond is more valuable than the cash-paying bond due to its higher coupon and call-price schedule [see equation (1)].

Prior to May 15, 1994, the portfolio of one deferred-coupon bond plus treasury strips has the same promised payments as the cash-paying bond, but less default risk because the payments on the Treasury strips are riskless, whereas the interest payments on the cash-paying bond are risky.

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EngineeringCont.

Therefore,

where qit is the Treasury-strip price at time t for a dollar of payment at the ith coupon payment date, and m is the number of coupon payments remaining on the cash-paying bond through May 15, 1994.

1

(2) 6.75m

c dt t it

i

v p q

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EngineeringCont.

Under the assumption of a positive time value of money (qit<1), a weaker form of the arbitrage bound is derived by setting qit=1 in equation (2) to obtain (3) $6.75c d

t tv p m