UniversityofWashington SchoolofBusiness

version2.0 April2004

Walt Disney Companys Sleeping Beauty Bonds Duration Analysis* In July 1993, the Walt Disney Company issued $300,000,000 in senior debentures (bonds). The debentures carried an interest rate of 7.55%, payable semiannually, and were priced at par. They were due to be repaid on July 15, 2093, a full one hundred years after the date of issue. However, at the companys option, the debentures could be repaid (in whole or in part) any time after July 15, 2023 or 30 years after the issue date. Beauty, the fairy tale princess and heroine of a popular Disney animated film, according to legend, slept under enchantment in a magic castle for one hundred years. The Disney 100year debentures were immediately dubbed the Sleeping Beauties. The issue caused a lot of comment among traders of portfolio managers. Its crazy, said William Gross, head of fixed-income investments at Piper Capital Management Company. Look at the path of Coney Island over the last fifty years and see what happens to amusement parks.1 Scott Jacobson, head of fixed-income research at Piper Capital Management, felt that the bonds were too risky for his clients, but if corporate treasurers can get away with it, why not?2 Other interpreted the successful sales of the bonds as a vote of confidence in the Disney Company and U.S. economy policy. It shows that people believe the Mouse will still be singing and dancing in 100 years, said Tom Deegan (head of corporate communications at Disney).3 And Alan Greenspan, Chairman of the Federal Reserve Board of Governors called the bonds one of the more important indicators that the long-term inflation expectations that have so bedeviled our economy and financial markets seem to be receding a very good sign.4 As long-term interest rates declined in 1992 and 1993, companies and investors began to show renewed interest in very long-term maturities. The Tennessee Valley Authority (a government-owned hydroelectric power company) sold a 50-year bond in April 1992. Ford,
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* This case was revised by Jonathan M. Karpoff. It is revised from HBS case #9-294-038, prepared by Professor Carliss Y. Baldwin. Copyright 1994. Quoted by Thomas T. Vogel, Credit Markets: Disney Amazes Investors with Sale of 100-Year Bonds, The Wall Street Journal, July 21, 1993. 2 Quoted by Anne Michaud, Disney Co. Goes the Distance, The Los Angeles Times, July 22, 1993. 3 Ibid. 4 Thomas D. Lauricella and Constance Mitchell, Credit Markets: Coca-Cola Joins Disney at the Very Long End with a Sale of $150 Million of 100-Year Bonds, The Wall Street Journal, July 23, 1993.

2 Boeing, Texaco and Conrail followed with their own 50-year issues (irreverently dubbed Methuselah bonds) in 1993. The Disney bonds were the first 100-year bonds to be issued since 1954, when the Chicago & Eastern Railroad (a subsidiary of Union Pacific) issued 5% bonds due in 2054. However, the award for longest lasting liability went to the Canadian Pacific Corporation, which was paying 4% on a 1000-year bond, issued by the Toronto Grey and Bruce Railway in 1883, and due to be repaid in 2883!5 The idea for the 100-year bond came from an institutional investor. As reported in the Wall Street Journal, an institution approached Morgan Stanley with a request for a 100-year corporate bond to balance its short-term holdings and lengthen the duration of its portfolio. Thus, according to one reporter, the 100-year bonds were conceived by quantitative analysts tucked away in cramped rooms crowded with computer screens.6 The issue was priced on July 20, 1993 to yield 0.95% (95 basis points) over the benchmark 30-year Treasury Bond. Analysts estimated that this was .15% to .20% more than Disney would have paid had it issued 30-year bonds. And Disney had the right to call the bonds after 30 years for 103.02% of face value. Thus thirty years hence, the company had the best of both worlds. If prevailing interest rates were low, it could call the bonds and replace them with a cheaper issue. But if interest rates were high, the bonds could remain out, continuing to pay 7.55%, for seventy more years! Demand was so brisk that the company doubled the size of the issue from $150 million to $300 million. Merrill Lynch, co-manager of the Disney offering, perceived an overflow of interest for very-long-maturity bonds. According to Grant Kvalheim, a managing director at Merrill Lynch & Co., We went to Coke and showed them the [Disney] bonds.7 Three days later Coca-Cola Co. went to market with its own 100-year issue of $150 million. The Coke 100year bonds were priced to yield 7.455% or just 80 basis point over the benchmark Treasury, but, unlike the Disney bonds, were not callable. The primary buyers of both the Disney and Coca-Cola bonds were large institutions, especially insurance companies and pension funds. There was also speculation that some Wall Street houses would break up the bonds into their component parts and sell the pieces separately. At the end of the week, professionals were still divided over whether the two 100-year bond issues were indicators of a trend and (as Greenspan claimed) evidence of confidence in the economy, or merely two novelty items that enlivened a dull week in July, before everyone headed off on vacation!

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Michaud, op. cit. Bernice Napach, Century Bonds Appealing to a Select Few, Investors Daily, July 29, 1993. 7 Ibid.

3 Case preparation questions: 1. What are the cash payments associated with the Sleeping Beauties? Who gets how much and when, per $100 of bonds issued? 2. Open the Sleeping Beauty Excel Workbook, which contains a number of worksheets. Open the Basic Spreadsheet. It contains a list of years and payments made each year on the Sleeping Beauties. (For simplicity, we are ignoring the fact that US debentures, by convention, pay interest semiannually.) The NPV function in Excel calculates values of cash flow streams for given interest rates. Cell G6 titled "Present Values" contains the formula, and shows the resulting price of the bonds. Why is the price higher than $100 (which is the face value)? 3. Suppose on the day after the Sleeping Beauties were sold, the prevailing interest rate increased one percentage point, i.e., from 7.55% to 8.55%. What would be the new price of the Sleeping Beauties? If the interest rate dropped by one percentage point, what would the price of the Sleeping Beauties become? 4. What is the formula for the present value of a single cash flow received n years from today? In the space provided (column E) use this formula to calculate the present value of each years cash flow from the Sleeping Beauty bonds. 5. Use the Excel Chart function (Insert; Chart; As a new sheet) to create pictures of: The raw cash flows from the Sleeping Beauty bond in years 1 through 100; The present values of the individual cash flows from the Sleeping Beauty bond from years 1 through 100. (We call this picture the present value pattern of the bond. We will use present value patterns as an aid to reasoning throughout the course.)

Compare the two pictures. Do they look as you expect? Could you have drawn them freehand ahead of time? 6. Column F is labeled "Interest Rates." It contains a list of interest rates ranging from 2% to 1000%. Use the NPV function in Excel to calculate the value of the Sleeping Beauties for each of the interest rates shown.

4 7. The next sheet in the Workbook is called "Maturity." The first three columns are identical to the Basic Spreadsheet. The next column (D) contains cash flows for a bond that is just like Sleeping Beauty, but lasts only 10 years (Napping Beauty). Column F contains the same list of interest rates as in the Basic Spreadsheet, excluding the very high ones and including 7.55%. Columns G and H contain present values for the Sleeping and Napping bonds that correspond to the different interest rates. (You can check your answers to Questions 6 against the values in Column G.) Compare the prices of the Sleeping Beauty and Napping bonds at the initial interest rate of 7.55%. Why are they the same? What does this say about the expected price path of the Sleeping Beauties as time passes, if interest rates remain around 7.55%? Suppose interest rates fluctuate wildly during the next two years and then stabilize again at around 7.55%. What do you predict would happen to the price of each of the bonds?

8. Use the Excel Chart function to create a picture of the present value pattern of the 10-year bond. 9. Compare the value of the Sleeping and Napping bonds for interest rates greater than 7.55%. Which is more? Why? Do the same for interest rates below 7.55%. Which bond is more sensitive to interest rate fluctuations? Why? Flip to the next sheet of the Workbook, called Chart, to see the graphed values for the Sleeping and Napping bonds.

10. The next sheet in the Workbook is called Additional bonds. It shows the cash flows to a 30-year bond in Column C, and the present value of each years cash flow for this bond (at a 7.55% interest rate) in Column D. Column G contains all zeros, except in year 30. The cash flow in that year is the value of $100 compounded forward for 30 years at 7.55%. This is known as a zero-coupon bond. Column H shows the present value of each years cash flow for this bond.

5 At 7.55%, what is the price of the 30-year zero-coupon bond per $100 face value? How will the price of the 30-year zero-coupon bond change over time if interest rates remain at 7.55%?

11. Use the Excel Chart function to create separate pictures of the present value patterns of each 30-year bond. Compare these pictures to the present value patterns of the Sleeping Beauty bond and the 10-year, Napping Beauty bond, which you constructed in Questions 5 and 8 above. For each bond, what is the mid-point of the present value pattern? That is, in what year is there approximately as much present value weight on the left side of the pattern as on the right. Eyeballing the charts, estimates this average year for each of the four bonds (100-year, 10-year, 30-year, 30-year zero).

12. The next sheet is called Duration. For each of the four bonds, it shows the present value of cash flows received in Columns G, I, K, and M. (The cash flows themselves are in Columns C-F.) For each bond, in the column to the right of its present values, multiply the relative year in which a cash flow is received (Column B) times the present value of the cash flow. Now, in the boxed and yellowed cells at the top of each column, sum these values and divide the sum by 100 (the value of each bond). You have calculated the Duration of each bond, a kind of present-valueweighted average of the times at which the bonds make payments. What is the duration of each bond? Compare these calculated durations to your eyeball estimates from the present value patterns. How close were you? Are you surprised that the Sleeping Beauties have a shorter duration than the 30-year zeros?

6 13. Suppose interest rates go up 1% to 8.55%. Calculate the values of the four bonds at this new interest rate. (The information in columns P-T should make this very easy to do!) Which bond is the most sensitive to an interest rate change? Which is least sensitive? Calculate the percent change in value for each bond: (New Value-Old Value) / Old Value. The Old Value was 100, also known as "par." Now suppose interest rates fall to 6.55% calculate the values and the percent change in value for the four bonds at this interest rate.

14. If your calculations on the previous spreadsheets were correct, the Duration expressed in years should be close to the percentage changes (ignore the minus signs). This relationship can be used to hedge portfolios. With a little practice, you can learn to eyeball the duration from a present value pattern, or even from a mental picture of the cash flows. Knowing the duration lets you know the interest rate sensitivity of the asset, which is an important parameter of risk for debt securities.