The Kodak Deal: How Merrill Lynch Lowered Kodak's Borrowing Costs

The Kodak Deal ( I )
In early 1987, Eastman Kodak was seeking the best way to raise approximately US$ 75
million. The company wanted these funds at a lower cost that was available in both the
domestic U.S. market and the Eurobond market for straight US$ debt. The Capital Markets
team at Merrill Lynch sought to lower Kodak’s borrowing costs by utilizing innovative
funding techniques. The well-advertised solution was an innovative application of Merrill’s
global expertise –using the international debt market, currency swap market, interest rate
swap market, and foreign exchange market. By using these markets, an intermediary can
meet the financial needs of the customer while earning a healthy return.
Mandate and Response
Company K wanted to raise approximately US$ 75 million of five-year, fixed-rate debt
denominated in U.S. dollars. K’s name was well recognized in the financial markets and it
had a solid AA credit rating. The company could have issued straight bond in the domestic
U.S. market, which would have been considerably cheaper than a fixed-rate loan from a
bank. But Company K was willing to try an innovative financing method if it would serve
to lower total costs.
Intermediary M identified Company K’s market of comparative advantage as the Australian
dollar (A$) zero-coupon debt market. M reached this conclusion because it understood the
/conversion/tmp/scratch/375581538.doc
European investor’s appetite for foreign debt. M suggested the issuance of an A$ zero and
a currency swap of the A$ zero structure against fixed US$ rates.
Company K’s Perspective
The first step for Company K: Issue the A$ bond. K wanted to raise about US$ 75 million,
so Intermediary M instructed the corporation to issue an A$ 200 million zero. To determine
the US$ proceeds of such an issue, you should calculate the purchase price for the bond
given a 12.9588 % yield to maturity (YTM) and convert to U. S. Dollars at the spot
exchange rate. By subtracting the issuance costs before converting to U.S. dollars, you can
determine the net US$ proceeds and all-in cost.
Relevant Market Rates
 FX
Spot rate = US$ 0.7037/A$ (current exchange rate for the deal)
5-year forward rate = US$ 0.5371/A$
 BOND
5-year A$ zero-coupon rate = 12.9588 %

Bond issuance feeds and expenses = A$ 2.75 million
 SWAPS
5-year A$ zero swap rate against US$ LIBOR = 13.77 %

5-year Treasury rate = 7.52 %
5-yearUS$ fixed/LIBOR swap rate = T+80 = 8.32 % (semiannual payments)
5-year A$ zero swap versus fixed US$ = 13.54 % on A$
versus 8.07 % on US$ (semiannual payments)
Application
Calculate the price of a 5-year, zero-coupon bond with a face value of A$ 200 MM and
YTM of 12,9588 %.
The gross proceeds were approximately ____________ .
By subtracting the up-front costs of A$ 2.75 MM, you determine that the net proceeds are
____________ . Once you know the net proceeds, you can determine the all in cost.
Application
Calculate the all-in cost of a 5-year, zero-coupon with a face value of A$ 200 MM and net
proceeds of ____________ .
Answer: ____________ .
But K did not want to raise A$ funds. In order to provide the U.S. dollars which K needed,
intermediary paid the spot exchange rate of ____________ and receive a net proceed of
____________US$.
The company was not satisfied yet, because it had an obligation to pay A$ 200 MM in 5-
years. Company K wanted to make periodic fixed-rate payments on its US$ debt and repay
the principal at maturity. Intermediary M agreed to provide the A$ 200 MM to K in 5 years
if K would pay M a periodic fixed US$ interest rate and repay the principal to M in 5 years.
The representative rate from the list at the beginning of this case is ____________ per year,
with semiannual payments.
How the Client Raised Fixed-Rate U.S. Dollars
1) Cash flows in 1987

Investors  Company K  Intermediary M

Fees and expenses
2) Cash flows in 1992

Investors  Company K  Intermediary M
The Kodak Deal ( II )
Intermediary M’s Perspective
After agreeing to the swap with Company K, Intermediary M is obliged to receive
semiannual US$ interest payments and a principal payment of US$ 74.6 MM in 5-years. M
also is obliged in 1992 to pay principal plus interest compounded for 5-years totaling A$
200 MM. M does not want exposure to the risk of fluctuations in the US$/A$ exchange rate
for 5-years. If M could have found a counterparty to pay an A$ zero rate on a principal of
A$ 106 MM in exchange for receiving a fixed US$ rate on US$ 74.6 MM, the transaction
would have been easy to construct and hedge. Because the A$ zero-swap market is not well
developed, quoting an A$ zero swap against a fixed US$ rate takes some work.
Intermediary M found Australian Bank B to partly hedge US$ 48 MM of its risk. M entered
into a swap of A$ zero versus US$ LIBOR. The US$ principal amount was US$ 48 MM
which, at the spot rate, meant a principal amount of A$ 68.2 MM. In this deal, M agreed to
receive US$ 48 MM, pay US$ LIBOR on a principal of US$ 48 MM, and repay the US$ 48
MM at the termination of the swap. Bank B agreed to receive the A$ 68.2 MM, and pay the
total principal and accumulated interest at the termination of the deal. With the
representative swap quote of 13.77 % against US$ LIBOR, you can determine the currency
amount that Bank B agreed to pay. You determine the final payment in the same way as you
would calculate the final payment for an identical zero-coupon bond.
Application
Calculate the final A$ zero-swap payment for the above where A$ 68.2 MM was received
on the spot date, and principal plus interest compounded at an annual rate of 13.77 % are to
repaid in 5-years.
Answer: ____________ .
Because the intermediary would receive a fixed US$ rate from Company K but would pay a
floating US$ rate on its US$ 48 MM swap, it needed a floating US$ to fixed US$ swap to
hedge the resulting exposure. For this, it entered into a standar fixed-to-floating interest
swap with a notional amount of US$ 48 MM. Our representative rate for a 5-year, fixed-to-
floating interest rate swap is ____________ . With these two swaps, Intermediary M agreed
to pay fixed US$ rate in exchange for 13.77 % A$ zero rate, on a principal amount of US$
48 MM. This hedge two-thirds of M’s exposure.
How Intermediary M Hedged US$ 48 Million of Swap Risk
Swap Market
 
Company K  Intermediary M  Australian Bank B
 
Application
List the cash flows from Intermediary M’s perspective of the two swaps. Show that the
combination was effectively a swap from zero-coupon A$ to fixed-rate US$.
Date To swap Counterparty From Swap Counterparty To Bank B From Bank B
May 1987
Nov 1987
May 1988
Nov 1988
May 1989
Nov 1989
May 1990
Nov 1990
May 1991
Nov 1991
May 1992
Looking at the total cash flows on the spot date, we see that M had agreed to receive A$
106 MM from Company K and pay A$ 68.2 MM to Bank B. This left a surplus of A$ 37.8
MM. These were funds that M could use to cover the deficit it would experience in US$
payments. The intermediary would receive US$ 48 MM from Bank B, yet have to pay US$
74.6 MM to Company K. This deficit of US4 26.6 MM had to be purchased. Thus, with
Australian Bank A, M entered into a spot FX transaction whereby it paid A$ 37.8 MM in
exchange for receiving US$ 26.6 MM (a spot rate of US$ 0.7038/A$). With this
transaction, M balanced the spot inflows and outflows in both currencies.
Likewise, Intermediary M had an A$ mismatch on the forward (maturity) date. M was
obligated to pay Company K A$ 200 MM, but would receive only A$ 130 MM from Bank
B. The shortfall of A$ 70 MM had to be purchased for delivery on that date. Given the
forward exchange rate at the beginning of this chapter, you can determine how many U.S.
dollars M had to pay to Bank A in exchange for A$ 70 MM in 1992.
Application
Calculate how many U.S. dollars were needed to buy A$ 70 million given the forward
exchange rate listed as US$ 0.5371/A$. Add this number to the US$ 48 MM that
Intermediary M agreed to pay to Bank B on the maturity date, then subtract the US$ 74.6
MM that Company K agreed to pay to the intermediary on that date.
Answer: ____________ .
This created a total outflow to the banks of ____________ on the forward date, partly offset
by the inflow from Company K. The net outflow from Intermediary M on the forward date
would be ____________.
M had no net flows on the spot date and a net outflow on the forward date, but the
intermediate interest payments were not matching, which compensated for the forward loss
and created a profitable overall return.
M agreed to pay 8.32 % interest on US$ 48 MM to its bank counterparties, but received
8.07% interest from Company K on US$ 74.6 MM. The difference is a net inflow that M
would receive semiannually for 5-years.
Application
Calculate the US$ amount of the interest payments that Intermediary M will pay to its bank
counterparties. Determine the amount that M will receive from Company K. Subtract the
amount paid from the amount received to determine the net inflow the intermediary
receives every six months.
Intermediary M would have the following cash flows:
Date M Receives M Pays Net Cash Flows
May 1987
Nov 1987
May 1988
Nov 1988
May 1989
Nov 1989
May 1990
Nov 1990
May 1991
Nov 1991
May 1992
Because Intermediary M will enjoy a ____________ inflow every six months, it could enter
into a transaction by which it would pay an amount semiannually and receive
____________ on the forward date. This would match the remaining cash flow imbalances,
but also would introduce unwanted credit risk, because M would be making 5-years of
payments before getting any return from its counterparty. Without any other transactions,
the intermediary already had created a series of positive inflows that would be partly offset
by the outflow at the maturity of these deals. You can calculate the IRR of these cash flows
to determine the rate at which M had effectively borrowed these positive cash flows. You
can also determine the net value today of the complete deal by calculating the present value
(PV) of these net cash flows.
Application
Calculate the IRR of Intermediary M’s cash flows. Then determine the PV of the cash
stream using half of 8.32 % as the six-month discount rate.
This cash flow generates a semiannual IRR of ____________ (annual rate = _________ ).
This means that M has a loan increases by ____________ every six months, for which it
pays little interest. For a more objective sense of the value of the swap to M, you can refer
to the PV of the cash flows. Using an 8.32 % discount rate, the PV is approximately
____________.

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The Kodak Deal ( I )

funding techniques. The well-advertised solution was an innovative application of Merrill’s

Mandate and Response

Company K wanted to raise approximately US$ 75 million of five-year, fixed-rate debt

to lower total costs.

Intermediary M identified Company K’s market of comparative advantage as the Australian

a currency swap of the A$ zero structure against fixed US$ rates.

Company K’s Perspective

so Intermediary M instructed the corporation to issue an A$ 200 million zero. To determine

determine the net US$ proceeds and all-in cost.

Relevant Market Rates

5-year A$ zero-coupon rate = 12.9588 %

5-year A$ zero swap rate against US$ LIBOR = 13.77 %

The gross proceeds were approximately ____________ .

the principal at maturity. Intermediary M agreed to provide the A$ 200 MM to K in 5 years

with semiannual payments.

1) Cash flows in 1987

2) Cash flows in 1992

Intermediary M’s Perspective

After agreeing to the swap with Company K, Intermediary M is obliged to receive

would calculate the final payment for an identical zero-coupon bond.

48 MM. This hedge two-thirds of M’s exposure.

How Intermediary M Hedged US$ 48 Million of Swap Risk

Company K  Intermediary M  Australian Bank B

Date To swap Counterparty From Swap Counterparty To Bank B From Bank B

Date M Receives M Pays Net Cash Flows

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