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Giddy/Bouygues

Capital Markets & New Economy 1

NYU/Bouygues

U.S. Capital Markets and Corporate Finance Prof Ian Giddy


New York University

Three Issues in Global Corporate Financing


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Financing European and American Enterprises


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The New European Capital Market Capital markets in USA and Asia Venture Capital and Corporate Venturing Why shareholder value matters Why the cost of capital matters How the market values acquisitions and divestitures Where the money comes from

Shareholder Value and the "Cost of Capital"


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Mergers, Acquisitions and Divestitures


u u

Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 3

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Capital Markets & New Economy 2

Managing Corporate Finance

Bank Bank Financing Financing


Corporate Finance Needs

Capital Capital Markets Markets

Risk Risk Management Management Instruments Instruments


Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 4

Three Issues in Global Corporate Financing


l

Financing European and American Enterprises


u u u

The New European Capital Market Capital markets in USA and Asia Venture Capital and Corporate Venturing Why shareholder value matters Why the cost of capital matters How the market values acquisitions and divestitures Where the money comes from

Shareholder Value and the "Cost of Capital"


u u

Mergers, Acquisitions and Divestitures


u u

Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 5

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Capital Markets & New Economy 3

Banking and Capital Markets: Europe vs. USA Banks vs. Markets l Relationships vs. Transactions l On Balance Sheet vs. Off l Domestic vs. Regional vs. Global l Debt vs. Equity l Bricks vs. Bytes
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U.S. Capital Markets and the New Economy 7

Banks vs. Markets Where are investors going? l What do todays shareholders expect? l Where are corporations going? l Where is your banker going?
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Common theme: The end of entitlement (which implies the end of special responsibilities)
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Capital Markets & New Economy 4

Relationships vs. Transactions


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Lower barriers to entry more price competition Frequent re-calculation of benefits: What will you do for me next? Shareholder pressure weakens traditional relationships, obligations In business, the effect is toward alliances, contract manufacturing, out-sourcing Stability requires new communities, the more broadly-based the better
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Copyright 2000 Ian H. Giddy

Financial Innovation and the Shorter Product Life Cycle More financial innovation l But most innovations fail l Fewer geographic barriers to entry l Fewer information barriers to entry
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Excess returns

Time
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Innovation as Value Creation Innovations are costly to develop and produce, and easily copied, so l For an innovation to succeed, it must create differentiated value for issuer, investor, or risk manager, by:
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u Unbundling:

create simple, more primitive instruments to isolate risks, or u Bundling: create tailor-made instruments to reduce costs, minimize taxes, or circumvent restrictions or imperfections.
Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 11

On Balance Sheet vs. Off All my assets are for sale, all the time l Maximize ROE by increasing capital turnover become originators instead of lenders Market value of transactions in Europe
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(1990-present) Euro bn
70,0
61,7

60,0 50,0 40,0 30,0 20,0 10,0 0,0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 (YTD)
5,4 5,7 1,6 9,1 5,3 6,9

Asset-Backed Asset-Backed Securities Securities

33,1

35,4

38,8

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Capital Markets & New Economy 6

Domestic, Regional or Global?


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Which are more mobile?


u Goods u Labor u Services u Financial

markets

services

Even domestic institutions must be able to compete in the world arena

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 13

Debt vs. Equity


Index ($)

A $1 10000 Investment in Different 1000 Types of Portfolios: 100 1926-1996


10

Small Company Stocks

$4,495.99 $1,370.95
Large Company Stocks

Long-Term Government Bonds

$33.73 $13.54 $8.85

1
Treasury Bills Inflation 0.1 1925 1935 1945 1955 1965 1975 1985 1995

Year-End

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Capital Markets & New Economy 7

Passive vs. Active Investors Its an internet information age l Domestic shareholders want global returns asset managers must beat benchmarks l Corporations or financial institutions which cling to underperforming assets will have lower ROE and share prices l Which makes them vulnerable to restructuring or takeover Europes new market for corporate control
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Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 15

Passive vs. Active Investors


u Investors

expect results or sell their shares; friendly holdings become too costly, opportunity costs become explicit u Venture capital, private equity funds attract investors by offering higher returns u Market-based returns now expected by investors and lenders, and required of managers; local differences persist, but diminishing

Copyright 2000 Ian H. Giddy

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Capital Markets & New Economy 8

Bricks vs. Bytes Its a Nasdaq world, and its moving at internet time l The old economy needs the new economy to meet shareholder Check expectations Checkyour yourown own banks banksonline online and andmobile mobile To B2B, or not to be? financial financialservices services l E-business or m-business? l Equity, not debt, is financing the new economy
l
Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 17

Whither European Financial Services? The Anglo-Saxon model of transparent financial markets is coming, at internet speed l All assets must meet the test of the market global shareholder return standards l Otherwise
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Capital Markets & New Economy 9

Example: Deutsche-Dresdner What is Deutsches strategy? l Does the Dresdner acquisition advance that strategy? l What does it take to succeed in investment banking?
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Deutsche-Dresdner case study

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 19

The Commercial Banking Model

Assets

Liabilities

Loans Loans n n Net Netinterest interest revenues revenues

Deposits Deposits n n Net Netinterest interest costs costs

Goal: Add assets with positive net interest margin

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Capital Markets & New Economy 10

The Investment Banking Model

Sales
Customer-Driven Securities

Corporate Finance

Goal: Originate deals and sell them in the capital market as quickly as possible

Capital Markets
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U.S. Capital Markets and the New Economy 21

The Asian Bet High growth disguised speculative financing structures l Governments shielded companies and banks from capital market discipline l Too much debt l Too much foreign-currency debt l Closely held ownership relying on reinvested earnings
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Capital Markets & New Economy 11

The Asian Bet High growth disguised speculative financing structures l Governments shielded companies and The excesses The three three excesses banks from capital market discipline n nToo Too much much debt debt l Too much n Too ndebt Too much much labor labor l Too much debt n Too nforeign-currency Too much much capacity capacity l Closely held ownership relying on reinvested earnings
l
Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 23

Corporate Finance
CORPORATE CORPORATEFINANCE FINANCE DECISONS DECISONS

INVESTMENT INVESTMENT
PORTFOLIO CAPITAL

FINANCING FINANCING

RISK RISKMGT MGT


MEASUREMENT

DEBT M&A

EQUITY TOOLS

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The CFO Questions


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How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? How should we finance our growth? What kind of equity? How much (cheap) debt should we have? What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? How should we manage our financial risks? Whats our plan for creating shareholder value?
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Copyright 2000 Ian H. Giddy

Corporate Financing Life-Cycle


Leverage

Growth companies
Copyright 2000 Ian H. Giddy

Mature companies
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Capital Markets & New Economy 13

Firm Characteristics as Growth Changes


Variable Risk Dividend Payout Net Cap Ex Return on Capital Leverage High Growth Firms tend to be above-average risk pay little or no dividends have high net cap ex earn high ROC (excess return) have little or no debt Stable Growth Firms tend to be average risk pay high dividends have low net cap ex earn ROC closer to WACC higher leverage

Earnings

0 Gearing
Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 27

Three Issues in Global Corporate Financing


l

Financing European and American Enterprises


u u u

The New European Capital Market Capital markets in USA and Asia Venture Capital and Corporate Venturing Why shareholder value matters Why the cost of capital matters How the market values acquisitions and divestitures Where the money comes from

Shareholder Value and the "Cost of Capital"


u u

Mergers, Acquisitions and Divestitures


u u

Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 28

Giddy/Bouygues

Capital Markets & New Economy 14

The Goal of Financial Management


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What are firm decision-makers hired to do?

General Motors is not in the business of making automobiles. General Motors is in the business of making money. Alfred P. Sloan

Possible goals: Size, market share, profits l Three equivalent goals of financial management:
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u Maximize

shareholder wealth u Maximize share price u Maximize firm value


Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 29

The Goal of Financial Management


Value-based management drives our performance targets and incentives. We have set ambitious short and medium-term financial and operating targets and, to help meet these, have aligned the interests of management and employees with those of our shareholders and customers. Our incentive systems are linked to key aspects of shareholder value, such as margins and asset productivity. Our strategic focus is centred on profitable growth, better margins through innovation and higher productivity, improved asset management, and turnarounds in operations whose past performance has not been world class.
Copyright 2000 Ian H. Giddy

One companys statement

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Capital Markets & New Economy 15

First Principles of Creating Shareholder Value


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Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
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The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
u

The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics

Minimize unnecessary financial risks.

Objective: Maximize the Value of the Firm


Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 31

The Classical Objective Function


STOCKHOLDERS Hire & fire managers Maximize - Board stockholder - Annual Meeting wealth Lend No Social Money Costs BONDHOLDERS SOCIETY Managers Protect Costs can be bondholder traced to firm Interests Reveal information honestly and on time Markets are efficient and assess effect on value

FINANCIAL MARKETS

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What Can Go Wrong?


STOCKHOLDERS Managers put their interests over shareholders Lend Significant Money Social Costs BONDHOLDERS SOCIETY Managers Some costs Bondholders cannot be can get traced to firm ripped off Delay bad news or Markets make provide misleading mistakes and can information overreact
FINANCIAL MARKETS

Have little control over managers

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 33

A Contrast: Disney vs. Campbell Soup


BEST PRACTICES Majority of outside directors Bans insiders on nominating committee Bans former execs from board Mandatory retirement age CAMPBELL SOUP Only one insider among 15 directors Yes DISNEY 7 of 17 members are insiders No: CEO is chairman of panel No None Never No No None Yes None

Yes 70, with none over 64 Outside directors meet w/o CEO Annually Appointment of 'lead director'' Yes Governance committee Yes Self-evaluation of effectiveness Every two years Director pensions None Share-ownership requirement 3,000 shares

Copyright 2000 Ian H. Giddy

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Capital Markets & New Economy 17

Overpaying on Takeovers
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The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time. Many mergers do not work, as evidenced by a number of measures.
u u

The profitability of merged firms relative to their peer groups, does not increase significantly after mergers. An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work.
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Copyright 2000 Ian H. Giddy

Whats a Company Worth to Another Company? Required Returns l Types of Models


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u Balance

Bouygues Bouygues

sheet models u Dividend discount & corporate cash flow models u Price/Earnings ratios u Option models

Estimating Growth Rates l Application: How These Change with M&A


l
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Capital Markets & New Economy 18

Equity Valuation: From the Balance Sheet

Bouygues Bouygues
Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity

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U.S. Capital Markets and the New Economy 37

Relative Valuation
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Do valuation ratios make sense?


Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) Price/Book (P/BV) ratios q and variants (Tobin's Q) Price/Sales ratios

It depends on how they are used -- and whats behind them!

Copyright 2000 Ian H. Giddy

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Capital Markets & New Economy 19

Valuing a Firm with DCF: An Illustration


Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items

Projected free cash flows to the firm (FCFF)

Year 1 FCFF

Year 2 FCFF

Year 3 FCFF

Year 4 FCFF

Terminal year FCFF

Discount to present using weighted average cost of capital (WACC) Present value of free cash flows
Copyright 2000 Ian H. Giddy

Stable growth model or P/E comparable

+ cash, securities & excess assets

- Market value of debt

Value of shareholders equity


U.S. Capital Markets and the New Economy 39

www.giddy.org

More Simply, Invest Only When

Return on Assets

exceeds

Cost of Financing

Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 40

Giddy/Bouygues

Capital Markets & New Economy 20

Three Issues in Global Corporate Financing


l

Financing European and American Enterprises


u u u

The New European Capital Market Capital markets in USA and Asia Venture Capital and Corporate Venturing Why shareholder value matters Why the cost of capital matters How the market values acquisitions and divestitures Where the money comes from

Shareholder Value and the "Cost of Capital"


u u

Mergers, Acquisitions and Divestitures


u u

Copyright 2000 Ian H. Giddy

www.giddy.org

U.S. Capital Markets and the New Economy 41

Goals of Acquisitions Rationale: Firm A should merge with Firm B if [Value of AB > Value of A + Value of B + Cost of transaction] l Synergy l Gain market power l Discipline l Taxes l Financing
Copyright 2000 Ian H. Giddy

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Capital Markets & New Economy 21

Fallacies of Acquisitions
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Size (shareholders would rather have their money back, eg Credit Lyonnais) l Downstream/upstream integration (internal transfer at nonmarket prices, eg Dow/Conoco, Aramco/Texaco) l Diversification into unrelated industries (Kodak/Sterling Drug)

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 43

Do Acquisitions Benefit Shareholders? Successful Bids Technique Tender offer Merger Proxy contest
n

Target 30% 20% 8%

Bidders 4% 0 na

Note: Abnormal price changes are price changes adjusted to eliminate the effects of marketwide price changes

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 44

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Capital Markets & New Economy 22

Do Acquisitions Benefit Shareholders? Unsuccessful Bids Technique Tender offer Merger Proxy contest Target -3% -3% 8% Bidders -1% -5% na

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 45

The Price: Who Gets What?


Daimler Market value before deal leaked Value added by merger Merged Value Shareholders get Which is now worth Shareholders' shares of the gain Premium, as % 57.2% $57.3 $4.5 9% 42.8% $42.9 $13.5 46% $52.8 Chrysler $29.4 Combined $82.2 $18.0 $100.2 100% $100.2 $18

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When Shareholders Gain From an Acquisition


Gains from merger

Synergies

Control

Top line

Bottom line

Financial restructuring

Business Restructuring (M&A)

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U.S. Capital Markets and the New Economy 47

What is Corporate Restructuring? Any substantial change in a companys financial structure, or ownership or control, or business portfolio. l Designed to increase the value of the firm
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Restructuring

Improve capitalization

Improve debt composition

Change ownership and control

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Capital Markets & New Economy 24

Its All About Value


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How can corporate and financial restructuring create value?


Assets Liabilities

Fix the business

Operating Cash Flows

Debt Equity

Or fix the financing

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 49

Restructuring
Figure out what the business is worth now Fix the business mix divestitures Fix the business strategic partner or merger Fix the financing improve D/E structure Fix the kind of equity Fix the kind of debt or hybrid financing Fix management or control Use valuation model present value of free cash flows Value assets to be sold Value the merged firm with synergies Revalue firm under different leverage assumptions lowest WACC What can be done to make the equity more valuable to investors? What mix of debt is best suited to this business? Value the changes new control would produce
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Copyright 2000 Ian H. Giddy

Giddy/Bouygues

Capital Markets & New Economy 25

Getting the Financing Right Step 1: The Proportion of Equity & Debt

Debt
n

Equity

Achieve lowest weighted average cost of capital May also affect the business side

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 51

Getting the Financing Right Step 2: The Kind of Equity & Debt

n n n n

Short Shortterm? term?Long Longterm? term? Baht? Dollar? Baht? Dollar?Yen? Yen? Bonds? Bonds?Asset-backed? Asset-backed? Convertibles? Convertibles?Hybrids? Hybrids? Debt/Equity Debt/EquitySwaps? Swaps? Private? Private?Public? Public? Strategic Strategicpartner? partner? Domestic? Domestic?ADRs? ADRs? Ownership Ownership& &control? control?

Debt Equity

n n n n

n n n n n n n n n n

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The CFO Questions at Bouygues


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How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? How should we finance our growth? What kind of equity? How much (cheap) debt should we have? What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? How should we manage our financial risks? Whats our plan for creating shareholder value?
www.giddy.org U.S. Capital Markets and the New Economy 53

Copyright 2000 Ian H. Giddy

Ian H. Giddy
Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332; Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org

Copyright 2000 Ian H. Giddy

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U.S. Capital Markets and the New Economy 57