Question 1: Jaguar Land Rover PLC: Bond Valuation
Synopsis
Jaguar Land Rover, plc (JLR) announced two Senior Notes (bonds) issues in early 2015; the primary purpose of the bond issues was to replace their existing debt with new debt that was available at less than half the original rates of interest. Students will analyze whether this common financial management strategy adopted by many companies is indeed beneficial to the firm or its stakeholders, or both. Students are also challenged to determine the specific situations when this strategy can be justified.
This case is relatively short and designed to drive home the fundamental point that the value of an asset is the present value of its future cash flows at the prevailing market yield and that in efficient markets a firm does not stand to gain by shifting to cheaper debt. Most textbook examples and cases demonstrating the inverse relationship between yield and bond prices assume that a change in the market yield has led to change in the coupon rates for new issues. An interesting aspect of this case is that the substantial reduction in JLR’s credit worthiness, thereby employing a change in the company’s fundamental standing In such a scenario, does the firm benefit by replacing expensive debt with cheaper debt? The case is designed to evaluate bond valuation and reissuance.
There are 4 questions to address in this assignment you should complete this in one page plus the valuation (spreadsheet) analysis from Q2 below
1. What factors might have enabled JLR to raise new debt at less than half the coupon rate of interest in 2015, compared with the debt raise in 2011.
2. Compute the amount at which existing bondholders might be willing to surrender their holdings? [Attach the spreadsheet to the assignment or past the results here}.
3. Assuming JLR purchased all existing outstanding bonds at the price worked out in Q2; work out the incremental cash flows of this bond issue vis-à-vis the original issue. Does this financing strategy result in cost savings for JR? (This will also be calculated within the spreadsheet for question 2).
I have loaded a completed spreadsheet for these questions.
4. What other benefits, if any, might accrue to JLR because of this financing strategy? Does this strategy add value to the firm? What other benefits, if any, might accrue to JLR as a result of this financing strategy? Explain how this strategy adds value to the firm? To the existing bondholders? To JLR’s equity-holders?
Question 2
Modern Manufacturing Pension Plan Alternative Asset Allocation / Consideration
Keith North is Chair of the investment committee responsible for the governance of the Modern Manufacturing (MM) defined benefit pension plan. The fund is fully funded (no long term liabilities) and has followed a 60% public equities and 40% bonds since North has been chair. North meets with Desmond King, an actuarial and pension consultant, to discuss issues raised at the last committee meeting.
North notes that he investment committee would like to explore the benefits of adding alternative investments to the pension plan’s strategic asset allocation. North states:
Statement 1:
The committee would like to know which alternative asset would best mitigate the risks to the portfolio due to unexpected inflation and provide a relatively low correlation with public equities to provide diversification benefits.
The (MM) pension plan has been able to fund the annual pension payments without any corporate contributions for a number of years. The committee is interested in potential changes to the asset mix that could increase the probability of achieving the long term investment target return of 6%, while maintaining the pension funding status of the plan. King notes that fixed income yields are expected to remain low for the foreseeable future. North asks:
Statement 2
If the public equity allocation remains at 60%, is there a single asset class that could be used for the balance of th portfolio to achieve the greatest probability of maintaining the pension funding status over a long time horizon?
Under this hypothetical scenario, the balance of the portfolio can be allocated to either bonds, hedge funds, or private equities.
King confirms with North that the committee has historically used traditional approach to define the opportunity set based on distinct macroeconomic regimes, and she proposed that a risk-based approach might be a better method. Although the traditional approach is relatively powerful for its ability to handle liquidity and manager selection issues compared to a risk-based approach, they both acknowledge that a number of limitations are associated with the existing approach.
King presets a report (Exhibit 1) that proposed a new strategic asset allocation for the pension plan. North states that one of the concerns that the investment committee will have regarding the new allocations is that the pension fund needs to be able to fund an upcoming early retirement incentive program (ERIP) that MM will be offering to its employees within the next two years. Employers who have reached the age of 55 and whose age added to the number of years of company service sum to 75 or more can retire 10 years early and receive the defined benefit pension normally payable at age 65.
Exhibit 1 Proposed Asset Allocation of MM Defined Benefit Pension Plan
Asset Public Fixed Private Hedge Public Total
Class Equities Income Equities Funds Real Estate
Target 45% 25% 10% 10% 10% 100%
Range 35% – 55% 15% – 35% 0% – 12% 0% – 12% 0% – 12% —–
North and King then discuss suitability considerations related to the allocation in Exhibit 1. North understands that one of the drawbacks of including the proposed alternative asset classes is that daily reporting will no longer be available. Investment reports for alternatives will likely be received after monthly or quarter-end deadlines used for the plan’s traditional investments. King emphasizes that in a typical private equity structure, the pension fund makes a commitment of capital to a blind pool as part of the private investment partnership.
In order to explain the new strategic asset allocation to the investment committee. North asks King why a risk factor-based approach should be used rather than a mean-variance-optimization technique. Kings makes the following statements:
Statement 3:
Risk factor-based approaches to asset allocation produce more robust asset allocation proposals.
Statement 4:
A mean-variance optimization typically over allocates to the private alternative asset classes due to stale pricing.
King notes that the current macroeconomic environment could lead to a bear market within a few years. North asks King to discuss the potential impact on liquidity planning associated with the actions of the fund’s general partners in the forecasted environment.
North concludes the meeting by reviewing the information in Exhibit 2 pertaining to three potential private equity funds analyzed by King. King discloses the following due diligence findings from a recent manager search:
Fund A retains administrators, custodians, and auditors with impeccable reputations;
Fund B has achieved its performance in a manner that appears to conflict with its reported investment philosophy; Fund C has recently experienced the loss of three key investment professionals.
Exhibit 2 Potential Private Equity Funds, Internal Rates of Return (IRR)
Private Equity
Fund Fund A Fund B Fund C
5-year IRR 12.9% 13.2% 13.3%
1. Based on Statement 1, King should recommend?
A. hedge funds
B. private equities
C. commodity futures
Comment on why you chose your answer
2. In answering the question raised in Statement 2, King would most likely:
A. Bonds
B. Hedge funds
C. Private equities
Comment on why you chose your answer
3. A limitation of the existing approach used by the committee to define the opportunity set is that it:
a. Is difficult to communicate
b. Overestimates the portfolio diversification
c. Is sensitive to the historical look-back period
Comment on why you chose your answer
4. Based on Exhibit 1 and h proposed asset allocation, the greatest risk associated with the ERIP is:
a. Liability
b. Leverage
c. Liquidity
Comment on why you chose your answer
5. The suitability concern discussed by Droll and King most likely deals with:
a. Governance
b. Transparency
c. Investment horizon
Comment on why you chose your answer
6. Which of King’s statements regarding the asset allocation approaches is correct?
a. Only statement 3
b. Only statement 4
c. Both statement 3 and statement 4
Comment on why you chose statement 3, statement 4 or both statement 3 and/or 4.
7. Based on the forecasted environment, liquidity planning should take into account that general partners may
a. Call capital at a slower pace
b. Make distributions at a faster pace
c. Exercise an option to extend the life of the fund.
Comment on why you chose your answer.
8. Based on Exhibit 2 and King’s due diligence, the pension committee should consider investing in:
a. Fund A
b. Fund B
c. Fund C
Comment on why you chose either Fund A, Fund B or Fund C.
Note on Risk Factor-Based Optimization
Increasingly, investors believe that viewing investment decisions through a risk factor lens (e.g., growth, inflation, credit risk) may improve the investment process. Separating fundamentally similar investments, like public and private equities, into distinct asset classes ignores the probability that both are exposed to the same risk factors. Let’s assume that an investor starts the asset allocation exercise by first allocating the overall risk budget across the main risk factors. Instead of setting expectations for distinct asset classes, the investor may start thinking about the return expectations and correlation of the fundamental risk factors. For example, the global equity risk factor (a practical proxy for macroeconomic-oriented “growth”) is expected to generate the highest return. The investor expects the duration and value factors to generate negative returns because stronger economic growth fueled by advances in technology would lead to rising rates and better returns for growth stocks. An investor may be concerned about rising inflation, so she has assigned a positive expected return to the inflation factor.
Although a risk factor-driven approach is conceptually very elegant, we must mention a few caveats:
■ While generally accepted asset class definitions provide a common language among the investment community, risk factors may be defined quite differently investor-to-investor. It’s important to establish a common understanding of factor definitions and factor return expectations among the parties to an asset allocation exercise. This includes an agreement as to what financial instruments can be used to best match the factor exposures if they are not directly investable.
■ Correlations among risk factors, just like correlations across asset classes, may dramatically shift under changing market conditions; thus, careful testing needs to be applied to understand how changing market conditions will affect the asset allocation.
■ Some factor sensitivities are stable (like the nominal interest rate sensitivity of government bonds), while others are very unstable (like the inflation sensitivity of commodities). Factor sensitivities also need to be very carefully tested to validate whether the invested portfolio would truly deliver the desired factor exposures and not deliver unintended factor returns.