Corporate Finance: Lecture Note Packet 2

Capital Structure, Dividend Policy & Valuation

Aswath Damodaran
B40.2302.20

Stern School of Business

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 Finding the Right Financing Mix: The
Capital Structure Decision

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 First Principles

 Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
• 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.
• The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm

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 The Choices in Financing

 There are only two ways in which a business can make money.
• The first is debt. The essence of debt is that you promise to make fixed payments in
the future (interest payments and repaying principal). If you fail to make those
payments, you lose control of your business.
• The other is equity. With equity, you do get whatever cash flows are left over after
you have made debt payments.
 The equity can take different forms:
• For very small businesses: it can be owners investing their savings
• For slightly larger businesses: it can be venture capital
• For publicly traded firms: it is common stock
 The debt can also take different forms
• For private businesses: it is usually bank loans
• For publicly traded firms: it can take the form of bonds

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 Financing Choices across the life cycle

Revenues
$ Revenues/
Earnings

Earnings

Time

External funding High, but High, relative Moderate, relative Declining, as a

Low, as projects dry
needs constrained by to firm value. to firm value. percent of firm
up.
infrastructure value

Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs
low low funding needs funding needs

External Owner’s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock
Convertibles

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expansion High Growth Mature Growth Decline

Financing
Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues
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 The Financing Mix Question

 In deciding to raise financing for a business, is there an optimal mix of debt

and equity?
• If yes, what is the trade off that lets us determine this optimal mix?
• If not, why not?

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 Measuring a firm’s financing mix

 The simplest measure of how much debt and equity a firm is using currently
is to look at the proportion of debt in the total financing. This ratio is called
the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
 Debt includes all interest bearing liabilities, short term as well as long term.
 Equity can be defined either in accounting terms (as book value of equity) or
in market value terms (based upon the current price). The resulting debt ratios
can be very different.

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 Costs and Benefits of Debt

 Benefits of Debt
• Tax Benefits
• Adds discipline to management
 Costs of Debt
• Bankruptcy Costs
• Agency Costs
• Loss of Future Flexibility

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 Tax Benefits of Debt

 When you borrow money, you are allowed to deduct interest expenses from
your income to arrive at taxable income. This reduces your taxes. When you
use equity, you are not allowed to deduct payments to equity (such as
dividends) to arrive at taxable income.
 The dollar tax benefit from the interest payment in any year is a function of
your tax rate and the interest payment:
• Tax benefit each year = Tax Rate * Interest Payment
 Proposition 1: Other things being equal, the higher the marginal tax rate of a
business, the more debt it will have in its capital structure.

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 The Effects of Taxes

You are comparing the debt ratios of real estate corporations, which pay the
corporate tax rate, and real estate investment trusts, which are not taxed, but
are required to pay 95% of their earnings as dividends to their stockholders.
Which of these two groups would you expect to have the higher debt ratios?
 The real estate corporations
 The real estate investment trusts
 Cannot tell, without more information

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 Debt adds discipline to management

 If you are managers of a firm with no debt, and you generate high income and
cash flows each year, you tend to become complacent. The complacency can
lead to inefficiency and investing in poor projects. There is little or no cost
borne by the managers
 Forcing such a firm to borrow money can be an antidote to the complacency.
The managers now have to ensure that the investments they make will earn at
least enough return to cover the interest expenses. The cost of not doing so is
bankruptcy and the loss of such a job.

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 Debt and Discipline

Assume that you buy into this argument that debt adds discipline to management.
Which of the following types of companies will most benefit from debt
adding this discipline?
 Conservatively financed (very little debt), privately owned businesses
 Conservatively financed, publicly traded companies, with stocks held by
millions of investors, none of whom hold a large percent of the stock.
 Conservatively financed, publicly traded companies, with an activist and
primarily institutional holding.

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 Bankruptcy Cost

 The expected bankruptcy cost is a function of two variables--

• the cost of going bankrupt
– direct costs: Legal and other Deadweight Costs
– indirect costs: Costs arising because people perceive you to be in financial trouble
• the probability of bankruptcy, which will depend upon how uncertain you are
about future cash flows
 As you borrow more, you increase the probability of bankruptcy and hence
the expected bankruptcy cost.

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 The Bankruptcy Cost Proposition

 Proposition 2: Other things being equal, the greater the indirect bankruptcy
cost and/or probability of bankruptcy in the operating cashflows of the firm,
the less debt the firm can afford to use.

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 Debt & Bankruptcy Cost

Rank the following companies on the magnitude of bankruptcy costs

from most to least, taking into account both explicit and implicit costs:

 A Grocery Store

 An Airplane Manufacturer

 High Technology company

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 Agency Cost

 An agency cost arises whenever you hire someone else to do something for
you. It arises because your interests(as the principal) may deviate from those
of the person you hired (as the agent).
 When you lend money to a business, you are allowing the stockholders to use
that money in the course of running that business. Stockholders interests are
different from your interests, because
• You (as lender) are interested in getting your money back
• Stockholders are interested in maximizing your wealth
 In some cases, the clash of interests can lead to stockholders
• Investing in riskier projects than you would want them to
• Paying themselves large dividends when you would rather have them keep the
cash in the business.
 Proposition 3: Other things being equal, the greater the agency problems
associated with lending to a firm, the less debt the firm can afford to use.

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 Debt and Agency Costs

Assume that you are a bank. Which of the following businesses would

you perceive the greatest agency costs?

 A Large Pharmaceutical company

 A Large Regulated Electric Utility

Why?

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 Loss of future financing flexibility

 When a firm borrows up to its capacity, it loses the flexibility of financing

future projects with debt.
 Proposition 4: Other things remaining equal, the more uncertain a firm is
about its future financing requirements and projects, the less debt the firm will
use for financing current projects.

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 What managers consider important in deciding on how
much debt to carry...

 A survey of Chief Financial Officers of large U.S. companies provided the following
ranking (from most important to least important) for the factors that they considered
important in the financing decisions
Factor Ranking (0-5)
1. Maintain financial flexibility 4.55
2. Ensure long-term survival 4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price 3.99
5. Maintain financial independence 3.88
6. Maintain high debt rating 3.56
7. Maintain comparability with peer group 2.47

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 Debt: Summarizing the Trade Off

Advantages of Borrowing Disadvantages of Borrowing

1. Tax Benefit: 1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost
2. Added Discipline: 2. Agency Cost:
Greater the separation between managers Greater the separation between stock-
and stockholders --> Greater the benefit holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost

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 Application Test: Would you expect your firm to gain or
lose from using a lot of debt?

 Considering, for your firm,

• The potential tax benefits of borrowing
• The benefits of using debt as a disciplinary mechanism
• The potential for expected bankruptcy costs
• The potential for agency costs
• The need for financial flexibility
 Would you expect your firm to have a high debt ratio or a low debt ratio?
 Does the firm’s current debt ratio meet your expectations?

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 A Hypothetical Scenario

 Assume you operate in an environment, where

(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know their future financing needs

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 The Miller-Modigliani Theorem

 In an environment, where there are no taxes, default risk or agency costs,

capital structure is irrelevant.
 The value of a firm is independent of its debt ratio.

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 Implications of MM Theorem

 Leverage is irrelevant. A firm's value will be determined by its project cash

flows.
 The cost of capital of the firm will not change with leverage. As a firm
increases its leverage, the cost of equity will increase just enough to offset
any gains to the leverage

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 What do firms look at in financing?

 Is there a financing hierarchy?

 Argument:
• There are some who argue that firms follow a financing hierarchy, with retained
earnings being the most preferred choice for financing, followed by debt and that
new equity is the least preferred choice.

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 Rationale for Financing Hierarchy

 Managers value flexibility. External financing reduces flexibility more than

internal financing.
 Managers value control. Issuing new equity weakens control and new debt
creates bond covenants.

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 Preference rankings long-term finance: Results of a survey

Ranking Source Score

1 Retained Earnings 5.61
2 Straight Debt 4.88
3 Convertible Debt 3.02
4 External Common Equity 2.42
5 Straight Preferred Stock 2.22
6 Convertible Preferred 1.72

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 Financing Choices

You are reading the Wall Street Journal and notice a

tombstone ad for a company, offering to sell convertible
preferred stock. What would you hypothesize about the
health of the company issuing these securities?
 Nothing
 Healthier than the average firm
 In much more financial trouble than the average firm

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 Pathways to the Optimal

 The Cost of Capital Approach: The optimal debt ratio is the one that
minimizes the cost of capital for a firm.
 The Adjusted Present Value Approach; The optimal debt ratio is the one that
maximizes the overall value of the firm.
 The Sector Approach: The optimal debt ratio is the one that brings the firm
closes to its peer group in terms of financing mix.
 The Life Cycle Approach: The optimal debt ratio is the one that best suits
where the firm is in its life cycle.

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 I. The Cost of Capital Approach

 Value of a Firm = Present Value of Cash Flows to the Firm, discounted back
at the cost of capital.
 If the cash flows to the firm are held constant, and the cost of capital is
minimized, the value of the firm will be maximized.

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 Measuring Cost of Capital

 It will depend upon:

• (a) the components of financing: Debt, Equity or Preferred stock
• (b) the cost of each component
 In summary, the cost of capital is the cost of each component weighted by its
relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))

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 Recapping the Measurement of cost of capital

 The cost of debt is the market interest rate that the firm has to pay on its
borrowing. It will depend upon three components
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate
 The cost of equity is
1. the required rate of return given the risk
2. inclusive of both dividend yield and price appreciation
 The weights attached to debt and equity have to be market value weights, not
book value weights.

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 Costs of Debt & Equity

A recent article in an Asian business magazine argued that equity was cheaper
than debt, because dividend yields are much lower than interest rates on debt.
Do you agree with this statement
 Yes
 No
Can equity ever be cheaper than debt?
 Yes
 No

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 Fallacies about Book Value

1. People will not lend on the basis of market value.

2. Book Value is more reliable than Market Value because it does not change as
much.

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 Issue: Use of Book Value

Many CFOs argue that using book value is more conservative than using
market value, because the market value of equity is usually much
higher than book value. Is this statement true, from a cost of capital
perspective? (Will you get a more conservative estimate of cost of
capital using book value rather than market value?)
 Yes
 No

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 Applying Cost of Capital Approach: The Textbook Example

D/(D+E) ke kd After-tax Cost of Debt WACC

0 10.50% 8% 4.80% 10.50%

10% 11% 8.50% 5.10% 10.41%
20% 11.60% 9.00% 5.40% 10.36%

30% 12.30% 9.00% 5.40% 10.23%

40% 13.10% 9.50% 5.70% 10.14%

50% 14% 10.50% 6.30% 10.15%
60% 15% 12% 7.20% 10.32%

70% 16.10% 13.50% 8.10% 10.50%

80% 17.20% 15% 9.00% 10.64%
90% 18.40% 17% 10.20% 11.02%

100% 19.70% 19% 11.40% 11.40%

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 WACC and Debt Ratios

Weighted Average Cost of Capital and Debt Ratios

11.40%
11.20%
11.00%
10.80%
10.60%
WACC

10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
20%

100%
10%

30%

50%

60%

80%

90%
40%

70%
0

Debt Ratio

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 Current Cost of Capital: Disney

 Equity
• Cost of Equity = Riskfree rate + Beta * Risk Premium
= 7% + 1.25 (5.5%) = 13.85%
• Market Value of Equity = $50.88 Billion
• Equity/(Debt+Equity ) = 82%
 Debt
• After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (7% +0.50) (1-.36) = 4.80%
• Market Value of Debt = $ 11.18 Billion
• Debt/(Debt +Equity) = 18%
 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

50.88/(50.88
+11.18)

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 Mechanics of Cost of Capital Estimation

1. Estimate the Cost of Equity at different levels of debt:

Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt
will increase.
To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest
expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.

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 Process of Ratings and Rate Estimation

 We use the median interest coverage ratios for large manufacturing firms to
develop “interest coverage ratio” ranges for each rating class.
 We then estimate a spread over the long term bond rate for each ratings class,
based upon yields at which these bonds trade in the market place.

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 Medians of Key Ratios : 1993-1995

AAA AA A BBB BB B CCC

Pretax Interest Coverage 13.50 9.67 5.76 3.94 2.14 1.51 0.96
EBITDA Interest Coverage
17.08 12.80 8.18 6.00 3.49 2.45 1.51
Funds from Operations / Total Debt
98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%
(%)
Free Operating Cashflow/ Total
Debt (%) 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%
Pretax Return on Permanent Capital
(%) 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%
Operating Income/Sales (%)
22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%
Long Term Debt/ Capital
13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%
Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%

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 Interest Coverage Ratios and Bond Ratings

If Interest Coverage Ratio is Estimated Bond Rating

> 8.50 AAA
6.50 - 8.50 AA
5.50 - 6.50 A+
4.25 - 5.50 A
3.00 - 4.25 A–
2.50 - 3.00 BBB
2.00 - 2.50 BB
1.75 - 2.00 B+
1.50 - 1.75 B
1.25 - 1.50 B–
0.80 - 1.25 CCC
0.65 - 0.80 CC
0.20 - 0.65 C
< 0.20 D
For more detailed interest coverage ratios and bond ratings, try the ratings.xls spreadsheet on my
web site.

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 Spreads over long bond rate for ratings classes: 1996

Rating Coverage
Spread gt
AAA 0.20%
AA 0.50%
A+ 0.80%
A 1.00%
A- 1.25%
BBB 1.50%
BB 2.00%
B+ 2.50%
B 3.25%
B- 4.25%
CCC 5.00%
CC 6.00%
C 7.50%
D 10.00%

See http://www.bondsonline.com for latest spreads

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 Current Income Statement for Disney: 1996

Revenues 18,739
-Operating Expenses 12,046
EBITDA 6,693
-Depreciation 1,134
EBIT 5,559
-Interest Expense 479
Income before taxes 5,080
-Taxes 847
Income after taxes 4,233

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 Estimating Cost of Equity

1.09 (1+ (1-.36)(10/90) = 1.17

Unlevered Beta = 1.09 (Bottom-up Beta)
Market premium = 5.5% T.Bond Rate = 7.00% t=36%
Debt Ratio D/E Ratio Beta Cost of Equity
0% 0% 1.09 13.00%
10% 11% 1.17 13.43% 7% + 1.17 (5.5%)
20% 25% 1.27 13.96%
30% 43% 1.39 14.65%
40% 67% 1.56 15.56%
50% 100% 1.79 16.85%
60% 150% 2.14 18.77%
70% 233% 2.72 21.97%
80% 400% 3.99 28.95%
90% 900% 8.21 52.14%

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 Disney: Beta, Cost of Equity and D/E Ratio

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 Estimating Cost of Debt

D/(D+E) 0.00% 10.00% Calculation Details Step

D/E 0.00% 11.11% = [D/(D+E)]/( 1 -[D/(D+E)])
$ Debt $0 $6,207 = [D/(D+E)]* Firm Value 1

EBITDA $6,693 $6,693 Kept constant as debt changes.

Depreciation $1,134 $1,134 "
EBIT $5,559 $5,559
Interest $0 $447 = Interest Rate * $ Debt 2
Taxable Income $5,559 $5,112 = EBIT - Interest
Tax $2,001 $1,840 = Tax Rate * Taxable Income
Net Income $3,558 $3,272 = Taxable Income - Tax

Pre-tax Int. cov ∞ 12.44 = EBIT/Int. Exp 3

Likely Rating AAA AAA Based upon interest coverage 4
Interest Rate 7.20% 7.20% Interest rate for given rating 5
Eff. Tax Rate 36.00% 36.00% See notes on effective tax rate
After-tax kd 4.61% 4.61% =Interest Rate * (1 - Tax Rate)
Firm Value = 50,888+11,180= $62,068

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 The Ratings Table

If Interest Coverage Ratio is Estimated Bond Rating Default spread

> 8.50 AAA 0.20%
6.50 - 8.50 AA 0.50%
5.50 - 6.50 A+ 0.80%
4.25 - 5.50 A 1.00%
3.00 - 4.25 A– 1.25%
2.50 - 3.00 BBB 1.50%
2.00 - 2.50 BB 2.00%
1.75 - 2.00 B+ 2.50%
1.50 - 1.75 B 3.25%
1.25 - 1.50 B– 4.25%
0.80 - 1.25 CCC 5.00%
0.65 - 0.80 CC 6.00%
0.20 - 0.65 C 7.50%
< 0.20 D 10.00%

Aswath Damodaran 48
 A Test: Can you do the 20% level?

D/(D+E) 0.00% 10.00% 20.00% Second Iteration

D/E 0.00% 11.11%
$ Debt $0 $6,207
EBITDA $6,693 $6,693
Depreciation $1,134 $1,134
EBIT $5,559 $5,559
Interest Expense $0 $447
Pre-tax Int. cov ∞ 12.44
Likely Rating AAA AAA
Interest Rate 7.20% 7.20%
Eff. Tax Rate 36.00% 36.00%
Cost of Debt 4.61% 4.61%

Aswath Damodaran 49
 Bond Ratings, Cost of Debt and Debt Ratios

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%
D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%
$ Debt $0 $6,207 $12,414 $18,621 $24,827 $31,034 $37,241 $43,448 $49,655 $55,862
EBITDA $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693
Depreciation $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134
EBIT $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559
Interest $0 $447 $968 $1,536 $2,234 $3,181 $4,469 $5,214 $5,959 $7,262
Taxable Income $5,559 $5,112 $4,591 $4,023 $3,325 $2,378 $1,090 $345 ($400) ($1,703)
Tax $2,001 $1,840 $1,653 $1,448 $1,197 $856 $392 $124 ($144) ($613)
Pre-tax Int. cov ! 12.44 5.74 3.62 2.49 1.75 1.24 1.07 0.93 0.77
Likely Rating AAA AAA A+ A- BB B CCC CCC CCC CC
Interest Rate 7.20% 7.20% 7.80% 8.25% 9.00% 10.25% 12.00% 12.00% 12.00% 13.00%
Eff. Tax Rate 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 33.59% 27.56%
Cost of debt 4.61% 4.61% 4.99% 5.28% 5.76% 6.56% 7.68% 7.68% 7.97% 9.42%

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 Stated versus Effective Tax Rates

 You need taxable income for interest to provide a tax savings

 In the Disney case, consider the interest expense at 70% and 80%
70% Debt Ratio 80% Debt Ratio
EBIT $ 5,559 m $ 5,559 m
Interest Expense $ 5,214 m $ 5,959 m
Tax Savings $ 1,866 m 5559*.36 = $ 2,001m
Effective Tax Rate 36.00% 2001/5959 = 33.59%
Pre-tax interest rate 12.00% 12.00%
After-tax Interest Rate 7.68% 7.97%
 You can deduct only $5,559million of the $5,959 million of the interest
expense at 80%. Therefore, only 36% of $ 5,559 is considered as the tax
savings.

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 Disney’s Cost of Capital Schedule

Debt Ratio Cost of Equity AT Cost of Debt Cost of Capital

0.00% 13.00% 4.61% 13.00%
10.00% 13.43% 4.61% 12.55%
20.00% 13.96% 4.99% 12.17%
30.00% 14.65% 5.28% 11.84%
40.00% 15.56% 5.76% 11.64%
50.00% 16.85% 6.56% 11.70%
60.00% 18.77% 7.68% 12.11%
70.00% 21.97% 7.68% 11.97%
80.00% 28.95% 7.97% 12.17%
90.00% 52.14% 9.42% 13.69%

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 Disney: Cost of Capital Chart

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 Effect on Firm Value

 Firm Value before the change = 50,888+11,180= $ 62,068

WACCb = 12.22% Annual Cost = $62,068 *12.22%= $7,583 million
WACCa = 11.64% Annual Cost = $62,068 *11.64% = $7,226 million
Δ WACC = 0.58% Change in Annual Cost = $ 357 million
 If there is no growth in the firm value, (Conservative Estimate)
• Increase in firm value = $357 / .1164 = $3,065 million
• Change in Stock Price = $3,065/675.13= $4.54 per share
 If there is growth (of 7.13%) in firm value over time,
• Increase in firm value = $357 * 1.0713 /(.1164-.0713) = $ 8,474
• Change in Stock Price = $8,474/675.13 = $12.55 per share
Implied Growth Rate obtained by
Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula
$62,068 = $2,947(1+g)/(.1222-g): Solve for g

Aswath Damodaran 54
 A Test: The Repurchase Price

 Let us suppose that the CFO of Disney approached you about buying back
stock. He wants to know the maximum price that he should be willing to pay
on the stock buyback. (The current price is $ 75.38) Assuming that firm value
will grow by 7.13% a year, estimate the maximum price.

 What would happen to the stock price after the buyback if you were able to
buy stock back at $ 75.38?

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 The Downside Risk

 Doing What-if analysis on Operating Income

• A. Standard Deviation Approach
– Standard Deviation In Past Operating Income
– Standard Deviation In Earnings (If Operating Income Is Unavailable)
– Reduce Base Case By One Standard Deviation (Or More)
• B. Past Recession Approach
– Look At What Happened To Operating Income During The Last Recession. (How Much
Did It Drop In % Terms?)
– Reduce Current Operating Income By Same Magnitude
 Constraint on Bond Ratings

Aswath Damodaran 56
 Disney’s Operating Income: History

Year Operating Income Change in Operating Income

1981 $ 119.35
1982 $ 141.39 18.46%
1983 $ 133.87 -5.32%

1984 $ 142.60 6.5%

1985 $ 205.60 44.2%

1986 $ 280.58 36.5%

1987 $ 707.00 152.0%

1988 $ 789.00 11.6%

1989 $ 1,109.00 40.6%

1990 $ 1,287.00 16.1%
1991 $ 1,004.00 -22.0%

1992 $ 1,287.00 28.2%

1993 $ 1,560.00 21.2%

1994 $ 1,804.00 15.6%

1995 $ 2,262.00 25.4%

1996 $ 3,024.00 33.7%

Aswath Damodaran 57
 Disney: Effects of Past Downturns

Recession Decline in Operating Income

1991 Drop of 22.00%
1981-82 Increased
Worst Year Drop of 26%

 The standard deviation in past operating income is about 39%.

Aswath Damodaran 58
 Disney: The Downside Scenario

Aswath Damodaran 59
 Constraints on Ratings

 Management often specifies a 'desired Rating' below which they do not want
to fall.
 The rating constraint is driven by three factors
• it is one way of protecting against downside risk in operating income (so do not do
both)
• a drop in ratings might affect operating income
• there is an ego factor associated with high ratings
 Caveat: Every Rating Constraint Has A Cost.
• Provide Management With A Clear Estimate Of How Much The Rating Constraint
Costs By Calculating The Value Of The Firm Without The Rating Constraint And
Comparing To The Value Of The Firm With The Rating Constraint.

Aswath Damodaran 60
 Ratings Constraints for Disney

 Assume that Disney imposes a rating constraint of BBB or greater.

 The optimal debt ratio for Disney is then 30% (see next page)
 The cost of imposing this rating constraint can then be calculated as follows:
Value at 40% Debt = $ 70,542 million
- Value at 30% Debt = $ 67,419 million
Cost of Rating Constraint = $ 3,123 million

Aswath Damodaran 61
 Effect of A Ratings Constraint: Disney

Debt Ratio Rating Firm Value

0% AAA $53,172
10% AAA $58,014
20% A+ $62,705
30% A- $67,419
40% BB $70,542
50% B $69,560
60% CCC $63,445
70% CCC $65,524
80% CCC $62,751
90% CC $47,140

Aswath Damodaran 62
 What if you do not buy back stock..

 The optimal debt ratio is ultimately a function of the underlying riskiness of

the business in which you operate and your tax rate
 Will the optimal be different if you invested in projects instead of buying
back stock?
• NO. As long as the projects financed are in the same business mix that the
company has always been in and your tax rate does not change significantly.
• YES, if the projects are in entirely different types of businesses or if the tax rate is
significantly different.

Aswath Damodaran 63
 Analyzing Financial Service Firms

 The interest coverage ratios/ratings relationship is likely to be different for

financial service firms.
 The definition of debt is messy for financial service firms. In general, using all
debt for a financial service firm will lead to high debt ratios. Use only interest-
bearing long term debt in calculating debt ratios.
 The effect of ratings drops will be much more negative for financial service
firms.
 There are likely to regulatory constraints on capital

Aswath Damodaran 64
 Interest Coverage ratios, ratings and Operating income

Interest Coverage Ratio Rating is Spread is Operating Income Decline

< 0.05 D 10.00% -50.00%

0.05 - 0.10 C 7.50% -40.00%

0.10 - 0.20 CC 6.00% -40.00%

0.20 - 0.30 CCC 5.00% -40.00%

0.30 - 0.40 B- 4.25% -25.00%

0.40 - 0.50 B 3.25% -20.00%

0.50 - 0.60 B+ 2.50% -20.00%

0.60 - 0.80 BB 2.00% -20.00%

0.80 - 1.00 BBB 1.50% -20.00%

1.00 - 1.50 A- 1.25% -17.50%

1.50 - 2.00 A 1.00% -15.00%

2.00 - 2.50 A+ 0.80% -10.00%

2.50 - 3.00 AA 0.50% -5.00%

> 3.00 AAA 0.20% 0.00%

Aswath Damodaran 65
 Deutsche Bank: Optimal Capital Structure

Debt Cost of Cost of Debt WACC Firm Value

Ratio Equity

0% 10.13% 4.24% 10.13% DM 124,288.85

10% 10.29% 4.24% 9.69% DM 132,558.74

20% 10.49% 4.24% 9.24% DM 142,007.59

30% 10.75% 4.24% 8.80% DM 152,906.88

40% 11.10% 4.24% 8.35% DM 165,618.31

50% 11.58% 4.24% 7.91% DM 165,750.19

60% 12.30% 4.40% 7.56% DM 162,307.44

70% 13.51% 4.57% 7.25% DM 157,070.00

80% 15.92% 4.68% 6.92% DM 151,422.87

90% 25.69% 6.24% 8.19% DM 30,083.27

Aswath Damodaran 66
 Analyzing Companies after Abnormal Years

 The operating income that should be used to arrive at an optimal debt ratio is
a “normalized” operating income
 A normalized operating income is the income that this firm would make in a
normal year.
• For a cyclical firm, this may mean using the average operating income over an
economic cycle rather than the latest year’s income
• For a firm which has had an exceptionally bad or good year (due to some firm-
specific event), this may mean using industry average returns on capital to arrive at
an optimal or looking at past years
• For any firm, this will mean not counting one time charges or profits

Aswath Damodaran 67
 Analyzing Aracruz Cellulose’s Optimal Debt Ratio

 In 1996, Aracruz had earnings before interest and taxes of only 15 million
BR, and claimed depreciation of 190 million Br. Capital expenditures
amounted to 250 million BR.
 Aracruz had debt outstanding of 1520 million BR. While the nominal rate on
this debt, especially the portion that is in Brazilian Real, is high, we will
continue to do the analysis in real terms, and use a current real cost of debt of
5.5%, which is based upon a real riskfree rate of 5% and a default spread of
0.5%.
 The corporate tax rate in Brazil was estimated to be 32%.
 Aracruz had 976.10 million shares outstanding, trading 2.05 BR per share.
The beta of the stock is estimated, using comparable firms, to be 0.71.

Aswath Damodaran 68
 Current versus Normalized Earnings

 If we use the actual earnings in 1996, a year in which paper prices were low
and earnings were depressed, the optimal debt ratio for Aracruz works out to
0%. The firm is over levered.
 To normalize earnings, we went back to 1995 when Aracruz had earnings
before interest and taxes of 271 million BR. We will use this as our
normalized EBIT.
 Alternative approaches to normaliziing earnings:
• Use average earnings over an economic cycle
• Use normalized price for commodity to estimate earnings
• Use industry-average operating margin to estimate operating income.

Aswath Damodaran 69
 Aracruz’s Optimal Debt Ratio

Debt Beta Cost of Rating Cost of AT Cost Cost of Firm Value

Ratio Equity Debt of Debt Capital
0.00% 0.47 8.51% AAA 5.20% 3.54% 8.51% 2,720 BR
10.00% 0.50 8.78% AAA 5.20% 3.54% 8.25% 2,886 BR
20.00% 0.55 9.11% AA 5.50% 3.74% 8.03% 3,042 BR
30.00% 0.60 9.53% A 6.00% 4.08% 7.90% 3,148 BR
40.00% 0.68 10.10% A- 6.25% 4.25% 7.76% 3,262 BR
50.00% 0.79 10.90% BB 7.00% 4.76% 7.83% 3,205 BR
60.00% 0.95 12.09% B- 9.25% 6.29% 8.61% 2,660 BR
70.00% 1.21 14.08% CCC 10.00% 6.80% 8.98% 2,458 BR
80.00% 1.76 18.23% CCC 10.00% 6.92% 9.18% 2,362 BR
90.00% 3.53 31.46% CCC 10.00% 7.26% 9.68% 2,149 BR

Aswath Damodaran 70
 Analyzing a Private Firm

 The approach remains the same with important caveats

• It is far more difficult estimating firm value, since the equity and the debt of
private firms do not trade
• Most private firms are not rated.
• If the cost of equity is based upon the market beta, it is possible that we might be
overstating the optimal debt ratio, since private firm owners often consider all risk.

Aswath Damodaran 71
 Estimating the Optimal Debt Ratio for a Private Bookstore

 Adjusted EBIT = EBIT + Imputed Interest on Op. Lease Exp.

= $ 2,000,000 + $ 252,000 = $ 2,252,000
 While Bookscape has no debt outstanding, the present value of the operating
lease expenses of $ 3.36 million is considered as debt.
 To estimate the market value of equity, we use a multiple of 22.41 times of
net income. This multiple is the average multiple at which comparable firms
which are publicly traded are valued.
Estimated Market Value of Equity = Net Income * Average PE
= 1,160,000* 22.41 = 26,000,000
 The interest rates at different levels of debt will be estimated based upon a
“synthetic” bond rating. This rating will be assessed using interest coverage
ratios for small firms which are rated by S&P.

Aswath Damodaran 72
 Interest Coverage Ratios, Spreads and Ratings: Small Firms

Interest Coverage Ratio Rating Spread over T Bond Rate

> 12.5 AAA 0.20%
9.50-12.50 AA 0.50%
7.5 - 9.5 A+ 0.80%
6.0 - 7.5 A 1.00%
4.5 - 6.0 A- 1.25%
3.5 - 4.5 BBB 1.50%
3.0 - 3.5 BB 2.00%
2.5 - 3.0 B+ 2.50%
2.0 - 2.5 B 3.25%
1.5 - 2.0 B- 4.25%
1.25 - 1.5 CCC 5.00%
0.8 - 1.25 CC 6.00%
0.5 - 0.8 C 7.50%
< 0.5 D 10.00%

Aswath Damodaran 73
 Optimal Debt Ratio for Bookscape

Debt Ratio Beta Cost of Equity Bond Rating Interest Rate AT Cost of Debt Cost of Capital Firm Value
0% 1.03 12.65% AA 7.50% 4.35% 12.65% $26,781
10% 1.09 13.01% AA 7.50% 4.35% 12.15% $29,112
20% 1.18 13.47% BBB 8.50% 4.93% 11.76% $31,182
30% 1.28 14.05% B+ 9.50% 5.51% 11.49% $32,803
40% 1.42 14.83% B- 11.25% 6.53% 11.51% $32,679
50% 1.62 15.93% CC 13.00% 7.54% 11.73% $31,341
60% 1.97 17.84% CC 13.00% 7.96% 11.91% $30,333
70% 2.71 21.91% C 14.50% 10.18% 13.70% $22,891
80% 4.07 29.36% C 14.50% 10.72% 14.45% $20,703
90% 8.13 51.72% C 14.50% 11.14% 15.20% $18,872

Aswath Damodaran 74
 Determinants of Optimal Debt Ratios

 Firm Specific Factors

• 1. Tax Rate
• Higher tax rates - - > Higher Optimal Debt Ratio
• Lower tax rates - - > Lower Optimal Debt Ratio
• 2. Pre-Tax CF on Firm = EBITDA / MV of Firm
• Higher Pre-tax CF - - > Higher Optimal Debt Ratio
• Lower Pre-tax CF - - > Lower Optimal Debt Ratio
• 3. Variance in Earnings [ Shows up when you do 'what if' analysis]
• Higher Variance - - > Lower Optimal Debt Ratio
• Lower Variance - - > Higher Optimal Debt Ratio
 Macro-Economic Factors
• 1. Default Spreads
Higher - - > Lower Optimal Debt Ratio
Lower - - > Higher Optimal Debt Ratio

Aswath Damodaran 75
  Application Test: Your firm’s optimal financing mix

 Using the optimal capital structure spreadsheet provided:

• Estimate the optimal debt ratio for your firm
• Estimate the new cost of capital at the optimal
• Estimate the effect of the change in the cost of capital on firm value
• Estimate the effect on the stock price
 In terms of the mechanics, what would you need to do to get to the optimal
immediately?

Aswath Damodaran 76
 II. The APV Approach to Optimal Capital Structure

 In the adjusted present value approach, the value of the firm is written as the
sum of the value of the firm without debt (the unlevered firm) and the effect
of debt on firm value
 Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected
Bankruptcy Cost from the Debt)
 The optimal dollar debt level is the one that maximizes firm value

Aswath Damodaran 77
 Implementing the APV Approach

 Step 1: Estimate the unlevered firm value. This can be done in one of two
ways:
1. Estimating the unlevered beta, a cost of equity based upon the unlevered beta and
valuing the firm using this cost of equity (which will also be the cost of capital,
with an unlevered firm)
2. Alternatively, Unlevered Firm Value = Current Market Value of Firm - Tax
Benefits of Debt (Current) + Expected Bankruptcy cost from Debt
 Step 2: Estimate the tax benefits at different levels of debt. The simplest
assumption to make is that the savings are perpetual, in which case
• Tax benefits = Dollar Debt * Tax Rate
 Step 3: Estimate a probability of bankruptcy at each debt level, and multiply
by the cost of bankruptcy (including both direct and indirect costs) to
estimate the expected bankruptcy cost.

Aswath Damodaran 78
 Estimating Expected Bankruptcy Cost

 Probability of Bankruptcy
• Estimate the synthetic rating that the firm will have at each level of debt
• Estimate the probability that the firm will go bankrupt over time, at that level of
debt (Use studies that have estimated the empirical probabilities of this occurring
over time - Altman does an update every year)
 Cost of Bankruptcy
• The direct bankruptcy cost is the easier component. It is generally between 5-10%
of firm value, based upon empirical studies
• The indirect bankruptcy cost is much tougher. It should be higher for sectors where
operating income is affected significantly by default risk (like airlines) and lower
for sectors where it is not (like groceries)

Aswath Damodaran 79
 Ratings and Default Probabilities: Results from Altman
study of bonds

Rating Default Risk

AAA 0.01%
AA 0.28%
A+ 0.40%
A 0.53%
A- 1.41%
BBB 2.30%
BB 12.20%
B+ 19.28%
B 26.36%
B- 32.50%
CCC 46.61%
CC 52.50%
C 60%
D 75%

Aswath Damodaran 80
 Disney: Estimating Unlevered Firm Value

Current Value of the Firm = 50,888 + 11,180 = $62,068

- Tax Benefit on Current Debt = 11,180 * .36 = $4,025
+ Expected Bankruptcy Cost = 0.28% of .25*(62,068-4025) = $41
Unlevered Value of Firm = $58,084

Cost of Bankruptcy for Disney = 25% of firm value

Probability of Bankruptcy = 0.28%, based on firm’s current rating of AA
Tax Rate = 36%
Market Value of Equity = $ 50,888
Market Value of Debt = $ 11,180

Aswath Damodaran 81
 Disney: APV at Debt Ratios

D/ $ Debt Tax Rate Unlevered Tax Rating Prob. Exp Value of

(D+E) Firm Value Benefit Default Bk Cst Firm
0% $0 36.00% $58,084 $0 AAA 0.01% $2 $58,083
10% $6,207 36.00% $58,084 $2,234 AAA 0.01% $2 $60,317
20% $12,414 36.00% $58,084 $4,469 A+ 0.40% $62 $62,491
30% $18,621 36.00% $58,084 $6,703 A- 1.41% $219 $64,569
40% $24,827 36.00% $58,084 $8,938 BB 12.20% $1,893 $65,129
50% $31,034 36.00% $58,084 $11,172 B 26.36% $4,090 $65,166
60% $37,241 36.00% $58,084 $13,407 CCC 50.00% $7,759 $63,732
70% $43,448 36.00% $58,084 $15,641 CCC 50.00% $7,759 $65,967
80% $49,655 33.59% $58,084 $16,677 CCC 50.00% $7,759 $67,003
90% $55,862 27.56% $58,084 $15,394 CC 65.00% $10,086 $63,392
Exp. Bk. Cst: Expected Bankruptcy cost

Aswath Damodaran 82
 III. Relative Analysis

I. Industry Average with Subjective Adjustments

 The “safest” place for any firm to be is close to the industry average
 Subjective adjustments can be made to these averages to arrive at the right
debt ratio.
• Higher tax rates -> Higher debt ratios (Tax benefits)
• Lower insider ownership -> Higher debt ratios (Greater discipline)
• More stable income -> Higher debt ratios (Lower bankruptcy costs)
• More intangible assets -> Lower debt ratios (More agency problems)

Aswath Damodaran 83
 Disney’s Comparables

Company Name Market Debt Ratio Book Debt Ratio

Disney (Walt) 18.19% 43.41%
Time Warner 29.39% 68.34%
Westinghouse Electric 26.98% 51.97%
Viacom Inc. 'A' 48.14% 46.54%
Gaylord Entertainm. 'A' 13.92% 41.47%
Belo (A.H.) 'A' Corp. 23.34% 63.04%
Evergreen Media 'A' 16.77% 39.45%
Tele-Communications Intl Inc 23.28% 34.60%
King World Productions 0.00% 0.00%
Jacor Communications 30.91% 57.91%
LIN Television 19.48% 71.66%
Regal Cinemas 4.53% 15.24%
Westwood One 11.40% 60.03%
United Television 4.51% 15.11%
Average of Large Firms 19.34% 43.48%

Aswath Damodaran 84
 Getting past simple averages: Using Statistics

 Step 1: Run a regression of debt ratios on the variables that you believe
determine debt ratios in the sector. For example,
Debt Ratio = a + b (Tax Rate) + c (Earnings Variability) + d (EBITDA/Firm
Value)
 Step 2: Estimate the proxies for the firm under consideration. Plugging into
the crosssectional regression, we can obtain an estimate of predicted debt
ratio.
 Step 3: Compare the actual debt ratio to the predicted debt ratio.

Aswath Damodaran 85
 Applying the Regression Methodology: Entertainment Firms

 Using a sample of 50 entertainment firms, we arrived at the following

regression:
Debt Ratio = - 0.1067 + 0.69 Tax Rate+ 0.61 EBITDA/Value- 0.07 σOI
(0.90) (2.58) (2.21) (0.60)
 The R squared of the regression is 27.16%. This regression can be used to
arrive at a predicted value for Disney of:
Predicted Debt Ratio = - 0.1067 + 0.69 (.4358) + 0.61 (.0837) - 0.07 (.2257) =
.2314
 Based upon the capital structure of other firms in the entertainment industry,
Disney should have a market value debt ratio of 23.14%.

Aswath Damodaran 86
 Extending to the entire market: 1996 Data

 Using 1996 data for 2929 firms listed on the NYSE, AMEX and NASDAQ
data bases. The regression provides the following results –
DFR =0.1906 - 0.0552 PRVAR -.1340 CLSH - 0.3105 CPXFR + 0.1447 FCP
(37.97a) (2.20a) (6.58a) (8.52a) (12.53a)
where,
DFR = Debt / ( Debt + Market Value of Equity)
PRVAR = Variance in Firm Value
CLSH = Closely held shares as a percent of outstanding shares
CPXFR = Capital Expenditures / Book Value of Capital
FCP = Free Cash Flow to Firm / Market Value of Equity
 While the coefficients all have the right sign and are statistically significant,
the regression itself has an R-squared of only 13.57%.

Aswath Damodaran 87
 An Aggregated Regression

 One way to improve the predictive power of the regression is to aggregate the
data first and then do the regression. To illustrate with the 1994 data, the firms
are aggregated into two-digit SIC codes, and the same regression is re-run.
DFR =0.2370- 0.1854 PRVAR +.1407 CLSH + 1.3959 CPXF -.6483 FCP
(6.06a) (1.96b) (1.05a) (5.73a) (3.89a)
 The R squared of this regression is 42.47%.

Data Source: For the latest regression, go to updated data on my web site and
click on the debt regression.

Aswath Damodaran 88
 Applying the Regression

Lets check whether we can use this regression. Disney had the following values
for these inputs in 1996. Estimate the optimal debt ratio using the debt
regression.
Variance in Firm Value = .04
Closely held shares as percent of shares outstanding = 4% (.04)
Capital Expenditures as fraction of firm value = 6.00%(.06)
Free Cash Flow as percent of Equity Value = 3% (.03)
Optimal Debt Ratio
=0.2370- 0.1854 ( ) +.1407 ( ) + 1.3959( ) -.6483 ( )
What does this optimal debt ratio tell you?

Why might it be different from the optimal calculated using the weighted
average cost of capital?

Aswath Damodaran 89
 IV. The Debt-Equity Trade off and Life Cycle
Stage 1 Stage 2 Stage 3 Stage 4 Stage 5
Start-up Rapid Expansion High Growth Mature Growth Decline

Revenues
$ Revenues/
Earnings

Earnings

Time

Zero, if Low, as earnings Increase, with High High, but

Tax Benefits losing money are limited earnings declining

Added Disceipline Low, as owners Low. Even if Increasing, as High. Managers are Declining, as firm
of Debt run the firm public, firm is managers own less separated from does not take many
closely held. of firm owners new investments

Bamkruptcy Cost Very high. Firm has Very high. High. Earnings are Declining, as earnings Low, but increases as
no or negative Earnings are low increasing but still from existing assets existing projects end.
earnings. and volatile volatile increase.

Very high, as firm High. New High. Lots of new Declining, as assets
Agency Costs has almost no investments are investments and in place become a Low. Firm takes few
assets difficult to monitor unstable risk. larger portion of firm. new investments

Very high, as firm High. Expansion High. Expansion Low. Firm has low Non-existent. Firm has no
Need for Flexibility looks for ways to needs are large and needs remain and more predictable new investment needs.
establish itself unpredicatble unpredictable investment needs.

Costs exceed benefits Costs still likely Debt starts yielding Debt becomes a more Debt will provide
Net Trade Off Minimal debt to exceed benefits. net benefits to the attractive option. benefits.
Mostly equity firm
Aswath Damodaran 90
 Summarizing for Disney

Approach Used Optimal

1a. Cost of Capital unconstrained 40%
1b. Cost of Capital w/ lower EBIT 30%
1c. Cost of Capital w/ Rating constraint 30%
II. APV Approach 40-50%
IIIa. Entertainment Sector Regression 23%
IIIb. Market Regression 30%
IV. Life Cycle Approach Mature Growth

Actual Debt Ratio 18%

Aswath Damodaran 91
 A Framework for Getting to the Optimal

Is the actual deb t ratio greater than or lesser than the op timal deb t ratio?

Actual > Op timal Actual < Op timal

Overlevered Underlevered

Is the firm under b ankrup tcy threat? Is the firm a takeover target?

Yes No Yes No

Reduce Deb t quickly Increase leverage

1. Equity for Deb t swap Does the firm have good quickly Does the firm have good
2. Sell Assets; use cash p rojects? 1. Deb t/Equity swap s p rojects?
to p ay off deb t ROE > C ost of Equity 2. Borrow money& ROE > C ost of Equity
3. Renegotiate with lenders ROC > C ost of C ap ital b uy shares. ROC > C ost of C ap ital

Yes No
Yes No
Take good p rojects with 1. Pay off deb t with retained
new equity or with retained earnings. Take good p rojects with
earnings. 2. Reduce or eliminate dividends. deb t.
3. Issue new equity and p ay off Do your stockholders like
deb t. dividends?

Yes
Pay Dividends No
Buy b ack stock
Aswath Damodaran 92
 Disney: Applying the Framework

Is the actual deb t ratio greater than or lesser than the op timal deb t ratio?

Actual > Op timal Actual < Optimal

Overlevered Underlevered

Is the firm under b ankrup tcy threat? Is the firm a takeover target?

Yes No Yes No

Reduce Deb t quickly Increase leverage

1. Equity for Deb t swap Does the firm have good quickly Does the firm have good
2. Sell Assets; use cash p rojects? 1. Deb t/Equity swap s p rojects?
to p ay off deb t ROE > C ost of Equity 2. Borrow money& ROE > C ost of Equity
3. Renegotiate with lenders ROC > C ost of C ap ital b uy shares. ROC > C ost of C ap ital

Yes No
Yes No
Take good p rojects with 1. Pay off deb t with retained
new equity or with retained earnings. Take good p rojects with
earnings. 2. Reduce or eliminate dividends. deb t.
3. Issue new equity and p ay off Do your stockholders like
deb t. dividends?

Yes
Pay Dividends No
Buy b ack stock
Aswath Damodaran 93
  Application Test: Getting to the Optimal

 Based upon your analysis of both the firm’s capital structure and investment
record, what path would you map out for the firm?
 Immediate change in leverage
 Gradual change in leverage
 No change in leverage
 Would you recommend that the firm change its financing mix by
 Paying off debt/Buying back equity
 Take projects with equity/debt

Aswath Damodaran 94
 Designing Debt: The Fundamental Principle

 The objective in designing debt is to make the cash flows on debt match up as
closely as possible with the cash flows that the firm makes on its assets.
 By doing so, we reduce our risk of default, increase debt capacity and
increase firm value.

Aswath Damodaran 95
 Firm with mismatched debt

Aswath Damodaran 96
 Firm with matched Debt

Aswath Damodaran 97
 Design the perfect financing instrument

 The perfect financing instrument will

• Have all of the tax advantages of debt
• While preserving the flexibility offered by equity

Start with the

Cash Flows Cyclicality &
Growth Patterns Other Effects
on Assets/ Duration Currency Effect of Inflation
Projects Uncertainty about Future

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
* More floating rate Convertible on Debt Catastrophe Notes
Duration/ Currency
Define Debt - if CF move with - Convertible if - Options to make
Maturity Mix
Characteristics inflation cash flows low cash flows on debt
- with greater uncertainty now but high match cash flows
on future exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed

Aswath Damodaran 98
 Ensuring that you have not crossed the line drawn by the tax
code

 All of this design work is lost, however, if the security that you have designed
does not deliver the tax benefits.
 In addition, there may be a trade off between mismatching debt and getting
greater tax benefits.

Deductibility of cash flows Differences in tax rates

Overlay tax for tax purposes across different locales Zero Coupons
preferences
If tax advantages are large enough, you might override results of previous step

Aswath Damodaran 99
 While keeping equity research analysts, ratings agencies and
regulators applauding

 Ratings agencies want companies to issue equity, since it makes them safer.
Equity research analysts want them not to issue equity because it dilutes
earnings per share. Regulatory authorities want to ensure that you meet their
requirements in terms of capital ratios (usually book value). Financing that
leaves all three groups happy is nirvana.

Consider Analyst Concerns Ratings Agency Regulatory Concerns

ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?

Aswath Damodaran 100

 Debt or Equity: The Strange Case of Trust Preferred

 Trust preferred stock has

• A fixed dividend payment, specified at the time of the issue
• That is tax deductible
• And failing to make the payment can cause ? (Can it cause default?)
 When trust preferred was first created, ratings agencies treated it as equity. As
they have become more savvy, ratings agencies have started giving firms only
partial equity credit for trust preferred.

Aswath Damodaran 101

 Debt, Equity and Quasi Equity

 Assuming that trust preferred stock gets treated as equity by ratings agencies,
which of the following firms is the most appropriate firm to be issuing it?
 A firm that is under levered, but has a rating constraint that would be violated
if it moved to its optimal
 A firm that is over levered that is unable to issue debt because of the rating
agency concerns.

Aswath Damodaran 102

 Soothe bondholder fears

 There are some firms that face skepticism from bondholders when they go out
to raise debt, because
• Of their past history of defaults or other actions
• They are small firms without any borrowing history
 Bondholders tend to demand much higher interest rates from these firms to
reflect these concerns.
Observability of Cash Flows Type of Assets financed
by Lenders - Tangible and liquid assets Existing Debt covenants Convertibiles
Factor in agency - Less observable cash flows create less agency problems - Restrictions on Financing Puttable Bonds
conflicts between stock lead to more conflicts Rating Sensitive
and bond holders Notes
If agency problems are substantial, consider issuing convertible bonds LYONs

Aswath Damodaran 103

 And do not lock in market mistakes that work against you

 Ratings agencies can sometimes under rate a firm, and markets can under
price a firm’s stock or bonds. If this occurs, firms should not lock in these
mistakes by issuing securities for the long term. In particular,
• Issuing equity or equity based products (including convertibles), when equity is
under priced transfers wealth from existing stockholders to the new stockholders
• Issuing long term debt when a firm is under rated locks in rates at levels that are far
too high, given the firm’s default risk.
 What is the solution
• If you need to use equity?
• If you need to use debt?

Aswath Damodaran 104

 Designing Debt: Bringing it all together

Start with the Cyclicality &

Cash Flows Duration Currency Effect of Inflation
Growth Patterns Other Effects
on Assets/ Uncertainty about Future
Projects

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
Duration/ Currency * More floating rate Convertible on Debt Catastrophe Notes
Define Debt Maturity Mix - if CF move with - Convertible if - Options to make
Characteristics inflation
- with greater uncertainty
cash flows low
now but high
cash flows on debt
match cash flows
on future exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed

Deductibility of cash flows Differences in tax rates

Overlay tax for tax purposes across different locales Zero Coupons
preferences
If tax advantages are large enough, you might override results of previous step

Consider Analyst Concerns Ratings Agency Regulatory Concerns

ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?

Observability of Cash Flows Type of Assets financed

by Lenders - Tangible and liquid assets Existing Debt covenants Convertibiles
Factor in agency - Less observable cash flows create less agency problems - Restrictions on Financing Puttable Bonds
conflicts between stock lead to more conflicts Rating Sensitive
and bond holders Notes
If agency problems are substantial, consider issuing convertible bonds LYONs

Consider Information Uncertainty about Future Cashflows Credibility & Quality of the Firm
Asymmetries - When there is more uncertainty, it - Firms with credibility problems
may be better to use short term debt will issue more short term debt
Aswath Damodaran 105
 Approaches for evaluating Asset Cash Flows

 I. Intuitive Approach
• Are the projects typically long term or short term? What is the cash flow pattern on
projects?
• How much growth potential does the firm have relative to current projects?
• How cyclical are the cash flows? What specific factors determine the cash flows on
projects?
 II. Project Cash Flow Approach
• Project cash flows on a typical project for the firm
• Do scenario analyses on these cash flows, based upon different macro economic
scenarios
 III. Historical Data
• Operating Cash Flows
• Firm Value

Aswath Damodaran 106

 I. Intuitive Approach - Disney

Business Project Cash Flow Characteristics Type of Financing

Creative Projects are likely to Debt should be
Content 1. be short term 1. short term
2. have cash outflows are primarily in dollars (but cash inflows 2. primarily dollar
could have a substantial foreign currency component 3. if possible, tied to the
3. have net cash flows which are heavily driven by whether the success of movies.
movie or T.V series is a “hit”
Retailing Projects are likely to be Debt should be in the form
1. medium term (tied to store life) of operating leases.
2. primarily in dollars (most in US still)
3. cyclical
Broadcasting Projects are likely to be Debt should be
1. short term 1. short term
2. primarily in dollars, though foreign component is growing 2. primarily dollar debt
3. driven by advertising revenues and show success 3. if possible, linked to
network ratings.
Aswath Damodaran 107
 Financing Details: Other Divisions

Theme Parks Projects are likely to be Debt should be

1. very long term 1. long term

2. primarily in dollars, but a significant proportion of revenues 2. mix of currencies, based

come from foreign tourists. upon tourist make up.

3. affected by success of movie and broadcasting divisions.

Real Estate Projects are likely to be Debt should be

1. long term 1. long term

2. primarily in dollars. 2. dollars

3. affected by real estate values in the area 3. real-estate linked

(Mortgage Bonds)

Aswath Damodaran 108

  Application Test: Choosing your Financing Type

 Based upon the business that your firm is in, and the typical investments that
it makes, what kind of financing would you expect your firm to use in terms of
• Duration (long term or short term)
• Currency
• Fixed or Floating rate
• Straight or Convertible

Aswath Damodaran 109

 II. Project Specific Financing

 With project specific financing, you match the financing choices to the project
being funded. The benefit is that the the debt is truly customized to the project.
 Project specific financing makes the most sense when you have a few large,
independent projects to be financed. It becomes both impractical and costly
when firms have portfolios of projects with interdependent cashflows.

Aswath Damodaran 110

 Duration of Disney Theme Park

Year FCFF Terminal Value Total FCFF PV of FCFF PV * t

1 ($39,078 Bt) ($39,078 Bt) (31,180 Bt) -31180.4
2 ($36,199 Bt) ($36,199 Bt) (23,046 Bt) -46092.4
3 ($11,759 Bt) ($11,759 Bt) (5,973 Bt) -17920
4 16,155 Bt 16,155 Bt 6,548 Bt 26193.29
5 21,548 Bt 21,548 Bt 6,969 Bt 34844.55
6 33,109 Bt 33,109 Bt 8,544 Bt 51264.53
7 46,692 Bt 46,692 Bt 9,614 Bt 67299.02
8 58,169 Bt 58,169 Bt 9,557 Bt 76454.39
9 70,423 Bt 838,720 Bt 909,143 Bt 119,182 Bt 1072635
Sum 100,214 Bt 1,233,498
Duration of the Project = 1,233,498/100,214 = 12.30 years

Aswath Damodaran 111

 The perfect theme park debt…

 The perfect debt for this theme park would have a duration of roughly 12.30
years and be in a mix of Asian currencies, reflecting where the visitors to the
park are coming from.
 If possible, you would tie the interest payments on the debt to the number of
visitors at the park.

Aswath Damodaran 112

 III. Firm-wide financing

Rather than look at individual projects, you could consider the firm to be a
portfolio of projects. The firm’s past history should then provide clues as to
what type of debt makes the most sense. In particular, you can look at
1. Operating Cash Flows
l The question of how sensitive a firm’s asset cash flows are to a variety of factors, such
as interest rates, inflation, currency rates and the economy, can be directly tested by
regressing changes in the operating income against changes in these variables.
l This analysis is useful in determining the coupon/interest payment structure of the debt.
2. Firm Value
l The firm value is clearly a function of the level of operating income, but it also
incorporates other factors such as expected growth & cost of capital.
l The firm value analysis is useful in determining the overall structure of the debt,
particularly maturity.

Aswath Damodaran 113

 Disney: Historical Data

Year Firm Value % Change Operating Income % Change

1981 $ 1,707 $ 119.35
1982 $ 2,108 23.46% $ 141.39 18.46%
1983 $ 1,817 -13.82% $ 133.87 -5.32%
1984 $ 2,024 11.4% $ 142.60 6.5%
1985 $ 3,655 80.6% $ 205.60 44.2%
1986 $ 5,631 54.1% $ 280.58 36.5%
1987 $ 8,371 48.7% $ 707.00 152.0%
1988 $ 9,195 9.8% $ 789.00 11.6%
1989 $ 16,015 74.2% $ 1,109.00 40.6%
1990 $ 14,963 -6.6% $ 1,287.00 16.1%
1991 $ 17,122 14.4% $ 1,004.00 -22.0%
1992 $ 24,771 44.7% $ 1,287.00 28.2%
1993 $ 25,212 1.8% $ 1,560.00 21.2%
1994 $ 26,506 5.1% $ 1,804.00 15.6%
1995 $ 33,858 27.7% $ 2,262.00 25.4%
1996 $ 39,561 16.8% $ 3,024.00 33.7%

Aswath Damodaran 114

 The Macroeconomic Data

Long Bond Rate

Change in Interest RateReal GNP GNP Growth Weighted DollarChange in DollarInflation Rate Change in Inflation Rate
13.98% 3854 115.65 8.90%
10.47% -3.51% 3792 -1.6% 123.14 6.48% 3.80% -5.10%
11.80% 1.33% 4047 6.7% 128.65 4.47% 3.80% 0.00%
11.51% -0.29% 4216 4.2% 138.89 8.0% 4.00% 0.20%
8.99% -2.52% 4350 3.2% 125.95 -9.3% 3.80% -0.20%
7.22% -1.77% 4431 1.9% 112.89 -10.4% 1.20% -2.60%
8.86% 1.64% 4633 4.6% 95.88 -15.1% 4.40% 3.20%
9.14% 0.28% 4789 3.4% 95.32 -0.6% 4.40% 0.00%
7.93% -1.21% 4875 1.8% 102.26 7.3% 4.60% 0.20%
8.07% 0.14% 4895 0.4% 96.25 -5.9% 6.10% 1.50%
6.70% -1.37% 4894 0.0% 98.82 2.7% 3.10% -3.00%
6.69% -0.01% 5061 3.4% 104.58 5.8% 2.90% -0.20%
5.79% -0.90% 5219 3.1% 105.22 0.6% 2.70% -0.20%
7.82% 2.03% 5416 3.8% 98.6 -6.3% 2.70% 0.00%
5.57% -2.25% 5503 1.6% 95.1 -3.5% 2.50% -0.20%
6.42% 0.85% 5679 3.2% 101.5 6.7% 3.30% 0.80%

Aswath Damodaran 115

 I. Sensitivity to Interest Rate Changes

 How sensitive is the firm’s value and operating income to changes in the level
of interest rates?
 The answer to this question is important because it
• it provides a measure of the duration of the firm’s projects
• it provides insight into whether the firm should be using fixed or floating rate debt.

Aswath Damodaran 116

 Firm Value versus Interest Rate Changes

 Regressing changes in firm value against changes in interest rates over this
period yields the following regression –
Change in Firm Value = 0.22 - 7.43 ( Change in Interest Rates)
(3.09) (1.69)
T statistics are in brackets.
 The coefficient on the regression (-7.43) measures how much the value of
Disney as a firm changes for a unit change in interest rates.

Aswath Damodaran 117

 Why the coefficient on the regression is duration..

 The duration of a straight bond or loan issued by a company can be written in

terms of the coupons (interest payments) on the bond (loan) and the face
value of the bond to be –
"t = N t * Coupon %
t + N * Face Value
dP/P
$
$#
! (1 + r) t
(1 + r) N
'
'&
Duration of Bond = = t =1 t =N
dr/r " Coupont Face Value %
$ !
$# t =1 (1 + r)
t +
(1 + r) N '&
'

 The duration of a bond measures how much the price of the bond changes for
a unit change in interest rates.
 Holding other factors constant, the duration of a bond will increase with the
maturity of the bond, and decrease with the coupon rate on the bond.

Aswath Damodaran 118

 Duration: Comparing Approaches

!P/!r=
Traditional Duration Percentage Change Regression:
Measures in Value for a !P = a + b (!r)
percentage change in
Interest Rates

Uses: Uses:
1. Projected Cash Flows 1. Historical data on changes in
Assumes: firm value (market) and interest
1. Cash Flows are unaffected by rates
changes in interest rates Assumes:
2. Changes in interest rates are 1. Past project cash flows are
small. similar to future project cash
flows.
2. Relationship between cash
flows and interest rates is
stable.
3. Changes in market value
reflect changes in the value of
the firm.

Aswath Damodaran 119

 Operating Income versus Interest Rates

 Regressing changes in operating cash flow against changes in interest rates

over this period yields the following regression –
Change in Operating Income = 0.31 - 4.99 ( Change in Interest Rates)
(2.90) (0.78)
• Conclusion: Disney’s operating income, like its firm value, has been very sensitive
to interest rates, which confirms our conclusion to use long term debt.
 Generally speaking, the operating cash flows are smoothed out more than the
value and hence will exhibit lower duration that the firm value.

Aswath Damodaran 120

 II. Sensitivity to Changes in GNP

 How sensitive is the firm’s value and operating income to changes in the
GNP/GDP?
 The answer to this question is important because
• it provides insight into whether the firm’s cash flows are cyclical and
• whether the cash flows on the firm’s debt should be designed to protect against
cyclical factors.
 If the cash flows and firm value are sensitive to movements in the economy,
the firm will either have to issue less debt overall, or add special features to
the debt to tie cash flows on the debt to the firm’s cash flows.

Aswath Damodaran 121

 Regression Results

 Regressing changes in firm value against changes in the GNP over this period
yields the following regression –
Change in Firm Value = 0.31 - 1.71 ( GNP Growth)
(2.43) (0.45)
• Conclusion: Disney is only mildly sensitive to cyclical movements in the
economy.
 Regressing changes in operating cash flow against changes in GNP over this
period yields the following regression –
Change in Operating Income = 0.17 + 4.06 ( GNP Growth)
(1.04) (0.80)
• Conclusion: Disney’s operating income is slightly more sensitive to the economic
cycle. This may be because of the lagged effect of GNP growth on operating
income.

Aswath Damodaran 122

 III. Sensitivity to Currency Changes

 How sensitive is the firm’s value and operating income to changes in

exchange rates?
 The answer to this question is important, because
• it provides a measure of how sensitive cash flows and firm value are to changes in
the currency
• it provides guidance on whether the firm should issue debt in another currency that
it may be exposed to.
 If cash flows and firm value are sensitive to changes in the dollar, the firm
should
• figure out which currency its cash flows are in;
• and issued some debt in that currency

Aswath Damodaran 123

 Regression Results

 Regressing changes in firm value against changes in the dollar over this
period yields the following regression –
Change in Firm Value = 0.26 - 1.01 ( Change in Dollar)
(3.46) (0.98)
• Conclusion: Disney’s value has not been very sensitive to changes in the dollar
over the last 15 years.
 Regressing changes in operating cash flow against changes in the dollar over
this period yields the following regression –
Change in Operating Income = 0.26 - 3.03 ( Change in Dollar)
(3.14) (2.59)
• Conclusion: Disney’s operating income has been much more significantly
impacted by the dollar. A stronger dollar seems to hurt operating income.

Aswath Damodaran 124

 IV. Sensitivity to Inflation

 How sensitive is the firm’s value and operating income to changes in the
inflation rate?
 The answer to this question is important, because
• it provides a measure of whether cash flows are positively or negatively impacted
by inflation.
• it then helps in the design of debt; whether the debt should be fixed or floating rate
debt.
 If cash flows move with inflation, increasing (decreasing) as inflation
increases (decreases), the debt should have a larger floating rate component.

Aswath Damodaran 125

 Regression Results

 Regressing changes in firm value against changes in inflation over this period
yields the following regression –
Change in Firm Value = 0.26 - 0.22 (Change in Inflation Rate)
(3.36) (0.05)
• Conclusion: Disney’s firm value does not seem to be affected too much by
changes in the inflation rate.
 Regressing changes in operating cash flow against changes in inflation over
this period yields the following regression –
Change in Operating Income = 0.32 + 10.51 ( Change in Inflation Rate)
(3.61) (2.27)
• Conclusion: Disney’s operating income seems to increase in periods when inflation
increases. However, this increase in operating income seems to be offset by the
increase in discount rates leading to a much more muted effect on value.

Aswath Damodaran 126

 Summarizing…

 Looking at the four macroeconomic regressions, we would conclude that

• Disney’s assets have a duration of 7.43 years
• Disney is not a cyclical firm
• Disney is hurt by a stronger dollar
• Disney’s operating income tends to move with inflation
 All of the regression coefficients have substantial standard errors associated
with them. One way to reduce the error (a la bottom up betas) is to use sector-
wide averages for each of the coefficients.

Aswath Damodaran 127

 Bottom-up Estimates
Business Comparable Firms Division Weight Duration Cyclicality Inflation Currency
Creative Content Motion Picture and TV program producers 35.71% -3.34 1.39 2.30 -1.86
Retailing High End Specialty Retailers 3.57% -5.50 2.63 2.10 -0.75
Broadcasting TV Broadcasting companies 30.36% -4.50 0.70 3.03 -1.15
Theme Parks Theme Park and Entertainment Complexes 26.79% -10.47 0.22 0.72 -2.54
Real Estate REITs specializing in hotel and vacation propertiers 3.57% -8.46 0.89 -0.08 0.97
Disney 100.00% -5.86 0.89 2.00 -1.69

Aswath Damodaran 128

 Analyzing Disney’s Current Debt

Description Amount Duration Non-US $ Floating Rate

Commercial paper $4,185 0.50 0 0
US $ notes & debentures $4,399 14.00 0 0
Dual Currency notes $1,987 1.20 1000 0
Senior notes $1,099 2.50 0 0
Other $672 5.00 0 0
Total $12,342 5.85 1000 0

Aswath Damodaran 129

 Financing Recommendations

 The duration of the debt is almost exactly the duration estimated using the
bottom-up approach, though it is lower than the duration estimated from the
firm-specific regression.
 Less than 10% of the debt is non-dollar debt and it is primarily in Japanese
yen, Australian dollars and Italian lire, and little of the debt is floating rate
debt.
 Based on our analysis, we would recommend more non-dollar debt issues,
with a shift towards floating rate debt, at least in those sectors where Disney
retains significant pricing power.

Aswath Damodaran 130

 Returning Cash to the Owners: Dividend
Policy

Aswath Damodaran 131

 First Principles

 Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
• 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.
• The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm

Aswath Damodaran 132

 Steps to the Dividend Decision…

How much did you borrow?

Cashflows to Debt
(Principal repaid,
Interest
Expenses)
How good are your investment choices?

Cashflow Reinvestment back

from into the business
Operations
What is a reasonable cash balance?
Cashflows from
Operations to Cash held back
Equity Investors by the company

Cash available
for return to What do your
stockholders stockholders prefer?

Stock Buybacks

Cash Paid out

Dividends

Aswath Damodaran 133

 I. Dividends are sticky

Aswath Damodaran 134

 II. Dividends tend to follow earnings

Aswath Damodaran 135

 III. More and more firms are buying back stock, rather than
pay dividends...

Aswath Damodaran 136

 IV. But the change in dividend tax law in 2003 may cause a
shift back to dividends

Aswath Damodaran 137

 Measures of Dividend Policy

 Dividend Payout:
• measures the percentage of earnings that the company pays in dividends
• = Dividends / Earnings
 Dividend Yield :
• measures the return that an investor can make from dividends alone
• = Dividends / Stock Price

Aswath Damodaran 138

 Dividend Payout Ratios: January 2005

Aswath Damodaran 139

 Dividend Yields in the United States: January 2005

Aswath Damodaran 140

 Three Schools Of Thought On Dividends

 1. If
• (a) there are no tax disadvantages associated with dividends
• (b) companies can issue stock, at no cost, to raise equity, whenever needed
• Dividends do not matter, and dividend policy does not affect value.
 2. If dividends have a tax disadvantage,
• Dividends are bad, and increasing dividends will reduce value
 3. If stockholders like dividends, or dividends operate as a signal of future prospects,
• Dividends are good, and increasing dividends will increase value

Aswath Damodaran 141

 The balanced viewpoint

 If a company has excess cash, and few good investment opportunities

(NPV>0), returning money to stockholders (dividends or stock repurchases) is
GOOD.
 If a company does not have excess cash, and/or has several good investment
opportunities (NPV>0), returning money to stockholders (dividends or stock
repurchases) is BAD.

Aswath Damodaran 142

 Why do firms pay dividends?

 The Miller-Modigliani Hypothesis: Dividends do not affect value

 Basis:
• If a firm's investment policy (and hence cash flows) don't change, the value of the
firm cannot change with dividend policy. If we ignore personal taxes, investors
have to be indifferent to receiving either dividends or capital gains.
 Underlying Assumptions:
• (a) There are no tax differences between dividends and capital gains.
• (b) If companies pay too much in cash, they can issue new stock, with no flotation
costs or signaling consequences, to replace this cash.
• (c) If companies pay too little in dividends, they do not use the excess cash for bad
projects or acquisitions.

Aswath Damodaran 143

 The Classic Tax Response: Until 2003, dividends were
taxed much more heavily than capital gains…

Aswath Damodaran 144

 Gauging the tax effect by looking at Price Behavior on Ex-
Dividend Date

Let Pb= Price before the stock goes ex-dividend

Pa=Price after the stock goes ex-dividend
D = Dividends declared on stock
to, tcg = Taxes paid on ordinary income and capital gains respectively

$ Pb $Pa
______________|_______Ex-Dividend Day_______________|

Aswath Damodaran 145

 Cashflows from Selling around Ex-Dividend Day

 The cash flows from selling before then are-

Pb - (Pb - P) tcg
 The cash flows from selling after the ex-dividend day are-
Pa - (Pa - P) tcg + D(1-to)
Since the average investor should be indifferent between selling before the ex-
dividend day and selling after the ex-dividend day -
Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)
Moving the variables around, we arrive at the following:

Aswath Damodaran 146

 Price Change, Dividends and Tax Rates

Pb − Pa (1- t o)
=
D (1 − t cg )

If P b - Pa = D then to = tcg
P b - Pa < D then to > tcg
P b - Pa > D then to < tcg

Aswath Damodaran 147

 The Evidence on Ex-Dividend Day Behavior

Ordi nary I nco me Capit al Gai ns ( Pb - Pa)/ D

Bef ore 1981 70 % 28 % 0. 78 ( 1966- 69)

1981- 85 50 % 20 % 0. 85
1986- 1990 28 % 28 % 0. 90
1991- 1993 33 % 28 % 0. 92
1994.. 39. 6 % 28 % 0.90

Aswath Damodaran 148

 Dividend Arbitrage

 Assume that you are a tax exempt investor, and that you know that the price
drop on the ex-dividend day is only 90% of the dividend. How would you
exploit this differential?
 Invest in the stock for the long term
 Sell short the day before the ex-dividend day, buy on the ex-dividend day
 Buy just before the ex-dividend day, and sell after.
 ______________________________________________

Aswath Damodaran 149

 Example of dividend capture strategy with tax factors

 XYZ company is selling for $50 at close of trading May 3. On May 4, XYZ
goes ex-dividend; the dividend amount is $1. The price drop (from past
examination of the data) is only 90% of the dividend amount.
 The transactions needed by a tax-exempt U.S. pension fund for the arbitrage
are as follows:
• 1. Buy 1 million shares of XYZ stock cum-dividend at $50/share.
• 2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 - 1* 0.90)
• 3. Collect dividend on stock.
 Net profit = - 50 million + 49.10 million + 1 million = $0.10 million

Aswath Damodaran 150

 The wrong reasons for paying dividends
1. The bird in the hand fallacy

 Argument: Dividends now are more certain than capital gains later. Hence
dividends are more valuable than capital gains.
 Counter: The appropriate comparison should be between dividends today
and price appreciation today. (The stock price drops on the ex-dividend day.)

Aswath Damodaran 151

 2. We have excess cash this year…

 Argument: The firm has excess cash on its hands this year, no investment
projects this year and wants to give the money back to stockholders.
 Counter: So why not just repurchase stock? If this is a one-time
phenomenon, the firm has to consider future financing needs. Consider the
cost of issuing new stock:

Aswath Damodaran 152

 The Cost of Raising Capital

Aswath Damodaran 153

 Are firms perverse to pay dividends?

Aswath Damodaran 154

 Evidence from Canadian Firms

Company Premium for Cash dividend over

Stock Dividend Shares
Consolidated Bathurst 19.30%
Donfasco 13.30%
Dome Petroleum 0.30%
Imperial Oil 12.10%
Newfoundland Light &Power 1.80%
Royal Trustco 17.30%
Stelco 2.70%
TransAlta 1.10%
Average 7.54%

Aswath Damodaran 155

 A clientele based explanation

 Basis: Investors may form clienteles based upon their tax brackets. Investors
in high tax brackets may invest in stocks which do not pay dividends and
those in low tax brackets may invest in dividend paying stocks.
 Evidence: A study of 914 investors' portfolios was carried out to see if their
portfolio positions were affected by their tax brackets. The study found that
• (a) Older investors were more likely to hold high dividend stocks and
• (b) Poorer investors tended to hold high dividend stocks

Aswath Damodaran 156

 Results from Regression: Clientele Effect

Dividend Yieldt = a + b βt + c Aget + d Incomet + e Differential Tax Ratet + εt

Variable Coefficient Implies
Constant 4.22%
Beta Coefficient -2.145 Higher beta stocks pay lower dividends.
Age/100 3.131 Firms with older investors pay higher
dividends.
Income/1000 -3.726 Firms with wealthier investors pay lower
dividends.
Differential Tax Rate -2.849 If ordinary income is taxed at a higher rate
than capital gains, the firm pays less
dividends.

Aswath Damodaran 157

 Dividend Policy and Clientele

 Assume that you run a phone company, and that you have historically paid
large dividends. You are now planning to enter the telecommunications and
media markets. Which of the following paths are you most likely to follow?
 Courageously announce to your stockholders that you plan to cut dividends
and invest in the new markets.
 Continue to pay the dividends that you used to, and defer investment in the
new markets.
 Continue to pay the dividends that you used to, make the investments in the
new markets, and issue new stock to cover the shortfall
 Other

Aswath Damodaran 158

 Increases in dividends are signals… of good news..

Aswath Damodaran 159

 An Alternative Story..Dividends as Negative Signals

Aswath Damodaran 160

 The Wealth Transfer Hypothesis

EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES

0.5

0
t:- -12 -9 -6 -3 0 3 6 9 12 15
-0.5 15 CAR (Div Up)
CAR
-1 CAR (Div down)

-1.5

-2
Day (0: Announcement date)

Aswath Damodaran 161

 Assessing Dividend Policy

 Approach 1: The Cash/Trust Nexus

• Assess how much cash a firm has available to pay in dividends, relative what it
returns to stockholders. Evaluate whether you can trust the managers of the
company as custodians of your cash.
 Approach 2: Peer Group Analysis
• Pick a dividend policy for your company that makes it comparable to other firms in
its peer group.

Aswath Damodaran 162

 I. The Cash/Trust Assessment

 Step 1: How much could the company have paid out during the period under
question?
 Step 2: How much did the the company actually pay out during the period in
question?
 Step 3: How much do I trust the management of this company with excess
cash?
• How well did they make investments during the period in question?
• How well has my stock performed during the period in question?

Aswath Damodaran 163

 A Measure of How Much a Company Could have Afforded
to Pay out: FCFE

 The Free Cashflow to Equity (FCFE) is a measure of how much cash is left in
the business after non-equity claimholders (debt and preferred stock) have
been paid, and after any reinvestment needed to sustain the firm’s assets and
future growth.
Net Income
+ Depreciation & Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs
- Principal Repayments
+ Proceeds from New Debt Issues
= Free Cash flow to Equity

Aswath Damodaran 164

 Estimating FCFE when Leverage is Stable

Net Income
- (1- δ) (Capital Expenditures - Depreciation)
- (1- δ) Working Capital Needs
= Free Cash flow to Equity
δ = Debt/Capital Ratio
For this firm,
• Proceeds from new debt issues = Principal Repayments + δ (Capital Expenditures -
Depreciation + Working Capital Needs)

Aswath Damodaran 165

 An Example: FCFE Calculation

 Consider the following inputs for Microsoft in 1996. In 1996, Microsoft’s

FCFE was:
• Net Income = $2,176 Million
• Capital Expenditures = $494 Million
• Depreciation = $ 480 Million
• Change in Non-Cash Working Capital = $ 35 Million
• Debt Ratio = 0%
 FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (!-DR)
= $ 2,176 - (494 - 480) (1-0) - $ 35 (1-0)
= $ 2,127 Million

Aswath Damodaran 166

 Microsoft: Dividends?

 By this estimation, Microsoft could have paid $ 2,127 Million in

dividends/stock buybacks in 1996. They paid no dividends and bought back
no stock. Where will the $2,127 million show up in Microsoft’s balance sheet?

Aswath Damodaran 167

 Dividends versus FCFE: U.S.

Aswath Damodaran 168

 The Consequences of Failing to pay FCFE

Chrysler: FCFE, Dividends and Cash Balance

$3,000 $9,000

$8,000
$2,500

$7,000

$2,000
$6,000

Cash Balance
$1,500
Cash Flow

$5,000

$4,000
$1,000

$3,000
$500

$2,000

$0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 $1,000

($500) $0
Year

= Free CF to Equity = Cash to Stockholders Cumulated Cash

Aswath Damodaran 169

  Application Test: Estimating your firm’s FCFE

In General, If cash flow statement used

Net Income Net Income
+ Depreciation & Amortization + Depreciation & Amortization
- Capital Expenditures + Capital Expenditures
- Change in Non-Cash Working Capital + Changes in Non-cash WC
- Preferred Dividend + Preferred Dividend
- Principal Repaid + Increase in LT Borrowing
+ New Debt Issued + Decrease in LT Borrowing
+ Change in ST Borrowing
= FCFE = FCFE
Compare to
Dividends (Common) -Common Dividend
+ Stock Buybacks - Decrease in Capital Stock
+ Increase in Capital Stock

Aswath Damodaran 170

 A Practical Framework for Analyzing Dividend Policy

How much did the firm pay out? How much could it have afforded to pay out?
What it could have p aid out What it actually p aid out
Net Income Dividends
- (Cap Ex - Depr’n) (1-DR) + Equity Repurchase
- Chg Working Capital (1-DR)
= FCFE

Firm pays out too little Firm pays out too much
FCFE > Dividends FCFE < Dividends

Do you trust managers in the comp any with What investment op p ortunities does the
your cash? firm have?
Look at past project choice: Look at past project choice:
Compare ROE to Cost of Equity Compare ROE to Cost of Equity
ROC to WACC ROC to WACC

Firm has history of Firm has history Firm has good Firm has poor
good project choice of poor project projects projects
and good projects in choice
the future

Give managers the Force managers to Firm should Firm should deal
flexibility to keep justify holding cash cut dividends with its investment
cash and set or return cash to and reinvest problem first and
dividends stockholders more then cut dividends

Aswath Damodaran 171

 A Dividend Matrix

Quality of projects taken: ROE versus Cost of Equity

Poor projects Good projects

Cash Surplus + Poor Cash Surplus + Good

Projects Projects
Significant pressure to Maximum flexibility in
pay out more to setting dividend policy
stockholders as
dividends or stock
buybacks

Cash Deficit + Poor Cash Deficit + Good

Projects Projects
Cut out dividends but Reduce cash payout, if
real problem is in any, to stockholders
investment policy.

Aswath Damodaran 172

 Disney: An analysis of FCFE from 1992-1996

Year Net Income (Cap Ex- Depr) Chg in WC FCFE

(1- Debt Ratio) (1-Debt Ratio)
1992 $817 $173 ($81) $725
1993 $889 $328 $160 $402
1994 $1,110 $469 $498 $143
1995 $1,380 $325 $206 $849
1996* $1,214 $466 ($470) $1,218
Avge $1,082 $352 $63 $667
(The numbers for 1996 are reported without the Capital Cities Acquisition)
The debt ratio used to estimate the free cash flow to equity was estimated as
follows = Net Debt Issues/(Net Cap Ex + Change in Non-cash WC)

Aswath Damodaran 173

 Disney’s Dividends and Buybacks from 1992 to 1996

Year FCFE Dividends + Stock Buybacks

1992 $725 $105
1993 $402 $160
1994 $143 $724
1995 $849 $529
1996 $1,218 $733
Average $667 $450

Aswath Damodaran 174

 Disney: Dividends versus FCFE

 Disney paid out $ 217 million less in dividends (and stock buybacks) than it
could afford to pay out. How much cash do you think Disney accumulated
during the period?

Aswath Damodaran 175

 Can you trust Disney’s management?

 During the period 1992-1996, Disney had

• an average return on equity of 21.07% on projects taken
• earned an average return on 21.43% for its stockholders
• a cost of equity of 19.09%
 Disney has taken good projects and earned above-market returns for its
stockholders during the period.
 If you were a Disney stockholder, would you be comfortable with Disney’s
dividend policy?
 Yes
 No

Aswath Damodaran 176

 Disney: Return Performance Trends

Returns on Equity, Stock and Required Returns - Disney

60.00%

50.00%

40.00%

30.00%
ROE
Returns on Stock
Required Return
20.00%

10.00%

0.00%
1992 1993 1994 1995 1996

-10.00%
Year

Aswath Damodaran 177

 The Bottom Line on Disney Dividends

 Disney could have afforded to pay more in dividends during the period of the
analysis.
 It chose not to, and used the cash for the ABC acquisition.
 The excess returns that Disney earned on its projects and its stock over the
period provide it with some dividend flexibility. The trend in these returns,
however, suggests that this flexibility will be rapidly depleted.
 The flexibility will clearly not survive if the ABC acquisition does not work
out.

Aswath Damodaran 178

 Aracruz: Dividends and FCFE: 1994-1996

1994 1995 1996

Net Income BR248.21 BR326.42 BR47.00
- (Cap. Exp - Depr)*(1-DR) BR174.76 BR197.20 BR14.96
- ∂ Working Capital*(1-DR) (BR47.74) BR15.67 (BR23.80)
= Free CF to Equity BR121.19 BR113.55 BR55.84

Dividends BR80.40 BR113.00 BR27.00

+ Equity Repurchases BR 0.00 BR 0.00 BR 0.00
= Cash to Stockholders BR80.40 BR113.00 BR27.00

Aswath Damodaran 179

 Aracruz: Investment Record

1994 1995 1996

Project Performance Measures
ROE 19.98% 16.78% 2.06%
Required rate of return 3.32% 28.03% 17.78%
Difference 16.66% -11.25% -15.72%
Stock Performance Measure
Returns on stock 50.82% -0.28% 8.65%
Required rate of return 3.32% 28.03% 17.78%
Difference 47.50% -28.31% -9.13%

Aswath Damodaran 180

 Aracruz: Its your call..

 Assume that you are a large stockholder in Aracruz. They have a history of
paying less in dividends than they have available in FCFE and have
accumulated a cash balance of roughly 1 billion BR (25% of the value of the
firm). Would you trust the managers at Aracruz with your cash?
 Yes
 No

Aswath Damodaran 181

 Mandated Dividend Payouts

 There are many countries where companies are mandated to pay out a certain
portion of their earnings as dividends. Given our discussion of FCFE, what
types of companies will be hurt the most by these laws?
 Large companies making huge profits
 Small companies losing money
 High growth companies that are losing money
 High growth companies that are making money

Aswath Damodaran 182

 BP: Dividends- 1983-92

1 2 3 4 5 6 7 8 9 10
Net Income $1,256.00 $1,626.00 $2,309.00 $1,098.00 $2,076.00 $2,140.00 $2,542.00 $2,946.00 $712.00 $947.00
- (Cap. Exp - Depr)*(1-DR) $1,499.00 $1,281.00 $1,737.50 $1,600.00 $580.00 $1,184.00 $1,090.50 $1,975.50 $1,545.50 $1,100.00
∂ Working Capital*(1-DR) $369.50 ($286.50) $678.50 $82.00 ($2,268.00) ($984.50) $429.50 $1,047.50 ($305.00) ($415.00)
= Free CF to Equity ($612.50) $631.50 ($107.00) ($584.00) $3,764.00 $1,940.50 $1,022.00 ($77.00) ($528.50) $262.00

Dividends $831.00 $949.00 $1,079.00 $1,314.00 $1,391.00 $1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00
+ Equity Repurchases
= Cash to Stockholders $831.00 $949.00 $1,079.00 $1,314.00 $1,391.00 $1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00

Dividend Ratios
Payout Ratio 66.16% 58.36% 46.73% 119.67% 67.00% 91.64% 68.69% 64.32% 296.63% 177.93%
Cash Paid as % of FCFE -135.67% 150.28% -1008.41% -225.00% 36.96% 101.06% 170.84% -2461.04% -399.62% 643.13%

Performance Ratios
1. Accounting Measure
ROE 9.58% 12.14% 19.82% 9.25% 12.43% 15.60% 21.47% 19.93% 4.27% 7.66%
Required rate of return 19.77% 6.99% 27.27% 16.01% 5.28% 14.72% 26.87% -0.97% 25.86% 7.12%
Difference -10.18% 5.16% -7.45% -6.76% 7.15% 0.88% -5.39% 20.90% -21.59% 0.54%

Aswath Damodaran 183

 BP: Summary of Dividend Policy

Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity $571.10 $1,382.29 $3,764.00 ($612.50)
Dividends $1,496.30 $448.77 $2,112.00 $831.00
Dividends+Repurchases $1,496.30 $448.77 $2,112.00 $831.00

Dividend Payout Ratio 84.77%

Cash Paid as % of FCFE 262.00%

ROE - Required return -1.67% 11.49% 20.90% -21.59%

Aswath Damodaran 184

 BP: Just Desserts!

Aswath Damodaran 185

 The Limited: Summary of Dividend Policy: 1983-1992

Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity ($34.20) $109.74 $96.89 ($242.17)
Dividends $40.87 $32.79 $101.36 $5.97
Dividends+Repurchases $40.87 $32.79 $101.36 $5.97

Dividend Payout Ratio 18.59%

Cash Paid as % of FCFE -119.52%

ROE - Required return 1.69% 19.07% 29.26% -19.84%

Aswath Damodaran 186

 Growth Firms and Dividends

 High growth firms are sometimes advised to initiate dividends because its
increases the potential stockholder base for the company (since there are some
investors - like pension funds - that cannot buy stocks that do not pay
dividends) and, by extension, the stock price. Do you agree with this
argument?
 Yes
 No
Why?

Aswath Damodaran 187

  Application Test: Assessing your firm’s dividend policy

 Compare your firm’s dividends to its FCFE, looking at the last 5 years of
information.

 Based upon your earlier analysis of your firm’s project choices, would you
encourage the firm to return more cash or less cash to its owners?

 If you would encourage it to return more cash, what form should it take
(dividends versus stock buybacks)?

Aswath Damodaran 188

 II. The Peer Group Approach

Company Price Dividend Dividend Earnings Expected

Name Yield Payout Stability Growth

Belo (A.H.). $ 44.50 0.99% 22.11% 55.00 2.50%

King World $ 40.13 0.00% 0.00% 95.00 6.50%

Gaylord 'A' $ 23.50 1.70% 45.98% 40.00 9.50%

Disney (Walt) $ 79.56 0.67% 19.78% 80.00 15.00%

Chris-Craft $ 50.00 0.00% 0.00% 30.00 19.00%

Clear Channel $ 68.25 0.00% 0.00% 55.00 24.00%

Viacom 'A' $ 31.63 0.00% 0.00% 5.00 24.00%

Westinghouse $ 26.31 0.76% 10.50% 20.00 4.85%

Average 0.51% 12.30% 47.50 13.17%%

Aswath Damodaran 189

 Going beyond averages…

 Regressing dividend yield and payout against expected growth yields:

Dividend Payout Ratio = 0.24 - 0.89 (Expected growth rate) R2 = 21.37%
(1.28)
Dividend Yield = 0.0107 - 0.043 (Expected growth rate) R2 = 33.65%
(1.74)
 Plugging in the values for Disney
Predicted Dividend Payout for Disney = 0.24 - 0.89 (.15)= 0.1066 or 10.66%
Predicted Dividend Yield for Disney = 0.0107 - 0.043(.15)= 0.0044 or .44%

Aswath Damodaran 190

 Other Actions that affect Stock Prices

 In the case of dividends and stock buybacks, firms change the value of the
assets (by paying out cash) and the number of shares (in the case of buybacks).
 There are other actions that firms can take to change the value of their
stockholder’s equity.
• Divestitures: They can sell assets to another firm that can utilize them more
efficiently, and claim a portion of the value.
• Spin offs: In a spin off, a division of a firm is made an independent entity. The
parent company has to give up control of the firm.
• Equity carve outs: In an ECO, the division is made a semi-independent entity. The
parent company retains a controlling interest in the firm.
• Tracking Stock: When tracking stock are issued against a division, the parent
company retains complete control of the division. It does not have its own board of
directors.

Aswath Damodaran 191

 Differences in these actions

Aswath Damodaran 192

 Valuation

Aswath Damodaran

Aswath Damodaran 193

 First Principles

 Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
• 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.
• The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm

Aswath Damodaran 194

 Discounted Cashflow Valuation: Basis for Approach

t = n CF
Value = ! t
t
t = 1 (1 + r)
• where,
• n = Life of the asset
• CFt = Cashflow in period t
• r = Discount rate reflecting the riskiness of the estimated cashflows

Aswath Damodaran 195

 Equity Valuation

 The value of equity is obtained by discounting expected cashflows to equity,

i.e., the residual cashflows after meeting all expenses, tax obligations and
interest and principal payments, at the cost of equity, i.e., the rate of return
required by equity investors in the firm.
t=n CF to Equity
t
Value of Equity = ! t
t=1 (1+ k e )

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
 The dividend discount model is a specialized case of equity valuation, and
the value of a stock is the present value of expected future dividends.

Aswath Damodaran 196

 Firm Valuation

 The value of the firm is obtained by discounting expected cashflows to the

firm, i.e., the residual cashflows after meeting all operating expenses and
taxes, but prior to debt payments, at the weighted average cost of capital,
which is the cost of the different components of financing used by the firm,
weighted by their market value proportions.

t=n
CF to Firm t
Value of Firm = ! (1+ WACC)t
t=1
where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital

Aswath Damodaran 197

 Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

Aswath Damodaran 198

 Estimating Inputs:
I. Discount Rates

 Critical ingredient in discounted cashflow valuation. Errors in estimating the

discount rate or mismatching cashflows and discount rates can lead to serious
errors in valuation.
 At an intutive level, the discount rate used should be consistent with both the
riskiness and the type of cashflow being discounted.
 The cost of equity is the rate at which we discount cash flows to equity
(dividends or free cash flows to equity). The cost of capital is the rate at
which we discount free cash flows to the firm.

Aswath Damodaran 199

 Estimating Aracruz’s Cost of Equity

 Average Unlevered Beta for Paper and Pulp firms is 0.61

 Aracruz has a cash balance which was 20% of the market value in 1997,
which is much higher than the typical cash balance at other paper and pulp
firms. The beta of cash is zero.
Unlevered Beta for Aracruz = (0.8) ( 0.61) + 0.2 (0) = 0.488
 Using Aracruz’s gross debt equity ratio of 66.67% and a tax rate of 33%:
Levered Beta for Aracruz = 0.49 (1+ (1-.33) (.6667)) = 0.71
 Cost of Equity for Aracruz = Real Riskfree Rate + Beta(Premium)
= 5% + 0.71 (7.5%) = 10.33%
Real Riskfree Rate = 5% (Long term Growth rate in Brazilian economy)
Risk Premium = 7.5% (U.S. Premium + Brazil Risk (from rating))

Aswath Damodaran 200

 Estimating Cost of Equity: Deutsche Bank

 Deutsche Bank is in two different segments of business - commercial banking

and investment banking.
 To estimate its commercial banking beta, we will use the average beta of
commercial banks in Germany.
 To estimate the investment banking beta, we will use the average bet of
investment banks in the U.S and U.K.
Comparable Firms Average Beta Weight
Commercial Banks in Germany 0.90 90%
U.K. and U.S. investment banks 1.30 10%
 Beta for Deutsche Bank = 0.9 (.90) + 0.1 (1.30)= 0.94
 Cost of Equity for Deutsche Bank (in DM) = 7.5% + 0.94 (5.5%)
= 12.67%

Aswath Damodaran 201

 Reviewing Disney’s Costs of Equity & Debt

Business Unlevered D/E Ratio Levered Riskfree Risk Cost of

Beta Beta Rate Premium Equity
Creative Content 1.25 20.92% 1.42 7.00% 5.50% 14.80%
Retailing 1.50 20.92% 1.70 7.00% 5.50% 16.35%
Broadcasting 0.90 20.92% 1.02 7.00% 5.50% 12.61%
Theme Parks 1.10 20.92% 1.26 7.00% 5.50% 13.91%
Real Estate 0.70 59.27% 0.92 7.00% 5.50% 12.31%
Disney 1.09 21.97% 1.25 7.00% 5.50% 13.85%

 Disney’s Cost of Debt (based upon rating) = 7.50%

Aswath Damodaran 202

 Estimating Cost of Capital: Disney

 Equity
• Cost of Equity = 13.85%
• Market Value of Equity = $50.88 Billion
• Equity/(Debt+Equity ) = 82%
 Debt
• After-tax Cost of debt = 7.50% (1-.36) = 4.80%
• Market Value of Debt = $ 11.18 Billion
• Debt/(Debt +Equity) = 18%
 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

Aswath Damodaran 203

 II. Estimating Cash Flows

Cash Flows

To Equity To Firm

The Strict View The Broader View EBIT (1-t)

Dividends + Net Income - ( Cap Ex - Depreciation)
Stock Buybacks - Net Cap Ex (1-Debt Ratio) - Change in Working Capital
- Chg WC (1 - Debt Ratio) = Free Cashflow to Firm
= Free Cashflow to Equity

Aswath Damodaran 204

 Estimating FCFE next year: Aracruz

All inputs are per share numbers:

Earnings BR 0.222
- (CapEx-Depreciation)*(1-DR) BR 0.042
-Chg. Working Capital*(1-DR) BR 0.018
Free Cashflow to Equity BR 0.170
 Earnings: Since Aracruz’s 1996 earnings are “abnormally” low, I used the
average earnings per share from 1992 to 1996.
 Capital Expenditures per share next year = 0.24 BR/share
 Depreciation per share next year = 0.18 BR/share
 Change in Working Capital = 0.03 BR/share
 Debt Ratio = 39%

Aswath Damodaran 205

 Estimating FCFF: Disney

 EBIT = $5,559 Million

 Capital spending = $ 1,746 Million
 Depreciation = $ 1,134 Million
 Increase in Non-cash Working capital = $ 617 Million
 Estimating FCFF
EBIT (1-t) $ 3,558
+ Depreciation $ 1,134
- Capital Expenditures $ 1,746
- Change in WC $ 617
= FCFF $ 2,329 Million

Aswath Damodaran 206

  Application Test: Estimating your firm’s FCFF

 Estimate the FCFF for your firm in its most recent financial year:
In general, If using statement of cash flows
EBIT (1-t) EBIT (1-t)
+ Depreciation + Depreciation
- Capital Expenditures + Capital Expenditures
- Change in Non-cash WC + Change in Non-cash WC
= FCFF = FCFF
Estimate the dollar reinvestment at your firm:
Reinvestment = EBIT (1-t) - FCFF

Aswath Damodaran 207

 Choosing a Cash Flow to Discount

 When you cannot estimate the free cash fllows to equity or the firm, the only
cash flow that you can discount is dividends. For financial service firms, it is
difficult to estimate free cash flows. For Deutsche Bank, we will be
discounting dividends.
 If a firm’s debt ratio is not expected to change over time, the free cash flows
to equity can be discounted to yield the value of equity. For Aracruz, we will
discount free cash flows to equity.
 If a firm’s debt ratio might change over time, free cash flows to equity
become cumbersome to estimate. Here, we would discount free cash flows to
the firm. For Disney, we will discount the free cash flow to the firm.

Aswath Damodaran 208

 III. Expected Growth

Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)

Aswath Damodaran 209

 Expected Growth in EPS

gEPS = Retained Earningst-1/ NIt-1 * ROE

= Retention Ratio * ROE
= b * ROE
• Proposition 1: The expected growth rate in earnings for a company
cannot exceed its return on equity in the long term.

Aswath Damodaran 210

 Estimating Expected Growth in EPS: Disney, Aracruz and
Deutsche Bank

Company ROE Retention Exp. Forecast Retention Exp

Ratio Growth ROE Ratio Growth
Disney 24.95% 77.68% 19.38% 25% 77.68% 19.42%
Aracruz 2.22% 65.00% 1.44% 13.91% 65.00% 9.04%
Deutsche Bank 7.25% 39.81% 2.89% 14.00% 45.00% 6.30%
ROE: Return on Equity for most recent year
Forecasted ROE = Expected ROE for the next 5 years
• For Disney, forecasted ROE is expected to be close to current ROE
• For Aracruz, the average ROE between 1994 and 1996 is used, since 1996 was a
abnormally bad year
• For Deutsche Bank, the forecast ROE is set equal to the average ROE for German
banks

Aswath Damodaran 211

 ROE and Leverage

 ROE = ROC + D/E (ROC - i (1-t))

where,
ROC = (EBIT (1 - tax rate)) / Book Value of Capital
= EBIT (1- t) / Book Value of Capital
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / Book Value of Debt
t = Tax rate on ordinary income
 Note that BV of Capital = BV of Debt + BV of Equity.

Aswath Damodaran 212

 Decomposing ROE: Disney in 1996

 Return on Capital
= (EBIT(1-tax rate) / (BV: Debt + BV: Equity)
= 5559 (1-.36)/ (7663+11668) = 18.69%
 Debt Equity Ratio
= Book Value of Debt/ Book Value of Equity= 45%
 Interest Rate on Debt = 7.50%
 Expected Return on Equity = ROC + D/E (ROC - i(1-t))
= 18.69 % + .45 (18.69% - 7.50(1-.36)) = 24.95%

Aswath Damodaran 213

 Expected Growth in EBIT And Fundamentals

 Reinvestment Rate and Return on Capital

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
 Proposition 2: No firm can expect its operating income to grow over time
without reinvesting some of the operating income in net capital expenditures
and/or working capital.
 Proposition 3: The net capital expenditure needs of a firm, for a given growth
rate, should be inversely proportional to the quality of its investments.

Aswath Damodaran 214

 Estimating Growth in EBIT: Disney

Actual reinvestment rate in 1996 = (Net Cap Ex+ Chg in WC)/ EBIT (1-t)
• Net Cap Ex in 1996 = (1745-1134)
• Change in Working Capital = 617
• EBIT (1- tax rate) = 5559(1-.36)
• Reinvestment Rate = (1745-1134+617)/(5559*.64)= 34.5%
 Forecasted Reinvestment Rate = 50%
 Return on Capital =20% (Higher than this year’s 18.69%)
 Expected Growth in EBIT =.5(20%) = 10%
 The forecasted reinvestment rate is much higher than the actual reinvestment
rate in 1996, because it includes projected acquisition. Between 1992 and
1996, adding in the Capital Cities acquisition to all capital expenditures
would have yielded a reinvestment rate of roughly 50%.

Aswath Damodaran 215

  Application Test: Estimating Expected Growth

 Estimate the following:

• The reinvestment rate for your firm
• The after-tax return on capital
• The expected growth in operating income, based upon these inputs

Aswath Damodaran 216

 IV. Getting Closure in Valuation

 A publicly traded firm potentially has an infinite life. The value is therefore
the present value of cash flows forever.
t = ! CFt
Value = "
t
t = 1 (1+ r)

 Since we cannot estimate cash flows forever, we estimate cash flows for a
“growth period” and then estimate a terminal value, to capture the value at the
end of the period:

t = N CFt Terminal Value

Value = ! +
t (1 + r)N
t = 1 (1 + r)

Aswath Damodaran 217

 Stable Growth and Terminal Value

 When a firm’s cash flows grow at a “constant” rate forever, the present value
of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
 This “constant” growth rate is called a stable growth rate and cannot be higher
than the growth rate of the economy in which the firm operates.
 While companies can maintain high growth rates for extended periods, they
will all approach “stable growth” at some point in time.
 When they do approach stable growth, the valuation formula above can be
used to estimate the “terminal value” of all cash flows beyond.

Aswath Damodaran 218

 Growth Patterns

 A key assumption in all discounted cash flow models is the period of high
growth, and the pattern of growth during that period. In general, we can make
one of three assumptions:
• there is no high growth, in which case the firm is already in stable growth
• there will be high growth for a period, at the end of which the growth rate will
drop to the stable growth rate (2-stage)
• there will be high growth for a period, at the end of which the growth rate will
decline gradually to a stable growth rate(3-stage)
 The assumption of how long high growth will continue will depend upon
several factors including:
• the size of the firm (larger firm -> shorter high growth periods)
• current growth rate (if high -> longer high growth period)
• barriers to entry and differential advantages (if high -> longer growth period)

Aswath Damodaran 219

 Length of High Growth Period

 Assume that you are analyzing two firms, both of which are enjoying high
growth. The first firm is Earthlink Network, an internet service provider,
which operates in an environment with few barriers to entry and extraordinary
competition. The second firm is Biogen, a bio-technology firm which is
enjoying growth from two drugs to which it owns patents for the next decade.
Assuming that both firms are well managed, which of the two firms would
you expect to have a longer high growth period?
 Earthlink Network
 Biogen
 Both are well managed and should have the same high growth period

Aswath Damodaran 220

 Choosing a Growth Pattern: Examples

Company Valuation in Growth Period Stable Growth

Disney Nominal U.S. $ 10 years 5%(long term
Firm (3-stage) nominal growth rate
in the U.S. economy
Aracruz Real BR 5 years 5%: based upon
Equity: FCFE (2-stage) expected long term
real growth rate for
Brazilian economy
Deutsche Bank Nominal DM 0 years 5%: set equal to
Equity: Dividends nominal growth rate
in the world
economy

Aswath Damodaran 221

 Firm Characteristics as Growth Changes

Variable High Growth Firms tend to Stable Growth Firms tend to

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

Aswath Damodaran 222

 Estimating Stable Growth Inputs

 Start with the fundamentals:

• Profitability measures such as return on equity and capital, in stable growth, can be
estimated by looking at
– industry averages for these measure, in which case we assume that this firm in stable
growth will look like the average firm in the industry
– cost of equity and capital, in which case we assume that the firm will stop earning excess
returns on its projects as a result of competition.
• Leverage is a tougher call. While industry averages can be used here as well, it
depends upon how entrenched current management is and whether they are
stubborn about their policy on leverage (If they are, use current leverage; if they
are not; use industry averages)
 Use the relationship between growth and fundamentals to estimate payout and
net capital expenditures.

Aswath Damodaran 223

 Estimating Stable Period Net Cap Ex

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC

= Reinvestment Rate * ROC
 Moving terms around,
Reinvestment Rate = gEBIT / Return on Capital
 For instance, assume that Disney in stable growth will grow 5% and that its
return on capital in stable growth will be 16%. The reinvestment rate will then
be:
Reinvestment Rate for Disney in Stable Growth = 5/16 = 31.25%
 In other words,
• the net capital expenditures and working capital investment each year during the
stable growth period will be 31.25% of after-tax operating income.

Aswath Damodaran 224

 Valuation: Deutsche Bank

 Sustainable growth at Deutsche Bank = ROE * Retention Ratio

= 14% (.45) = 6.30% { I used the normalized numbers for this]
 Cost of equity = 7.5% + 0.94 (5.5%) = 12.67%.
 Current Dividends per share = 2.61 DM
 Model Used:
• Stable Growth (Large firm; Growth is close to stable growth already)
• Dividend Discount Model (FCFE is tough to estimate)
 Valuation
• Expected Dividends per Share next year = 2.61 DM (1.063) = 2.73 DM
• Value per Share = 2.73 DM / (.1267 - .063) = 42.89 DM
 Deutsche Bank was trading for 119 DM on the day of this analysis.

Aswath Damodaran 225

 What does the valuation tell us?

 Stock is tremendously overvalued: This valuation would suggest that

Deutsche Bank is significantly overvalued, given our estimates of expected
growth and risk.
 Dividends may not reflect the cash flows generated by Deutsche Bank.
TheFCFE could have been significantly higher than the dividends paid.
 Estimates of growth and risk are wrong: It is also possible that we have
underestimated growth or overestimated risk in the model, thus reducing our
estimate of value.

Aswath Damodaran 226

 Valuation: Aracruz Cellulose

 The current earnings per share for Aracruz Cellulose is 0.044 BR.
 These earnings are abnormally low. To normalize earnings, we use the
average earnings per share between 1994 and 1996 of 0.204 BR per share as a
measure of the normalized earnings per share.
 Model Used:
• Real valuation (since inflation is still in double digits)
• 2-Stage Growth (Firm is still growing in a high growth economy)
• FCFE Discount Model (Dividends are lower than FCFE: See Dividend section)

Aswath Damodaran 227

 Aracruz Cellulose: Inputs for Valuation

High Growth Phase Stable Growth Phase

Length 5 years Forever, after year 5
Expected Growth Retention Ratio * ROE 5% (Real Growth Rate in Brazil)
= 0.65 * 13.91%= 8.18%
Cost of Equity 5% + 0.71 (7.5%) = 10.33% 5% + 1(7.5%) = 12.5%
(Beta =0.71; Rf =5%) (Assumes beta moves to 1)
Net Capital Expenditures Net capital ex grows at same Capital expenditures are assumed
rate as earnings. Next year, to be 120% of depreciation
capital ex will be 0.24 BR
and depreciation will be 0.18 BR.
Working Capital 32.15% of Revenues; 32.15% of Revenues;
Revenues grow at same rate as earnings in both periods.
Debt Ratio 39.01% of net capital ex and working capital investments come
from debt.

Aswath Damodaran 228

 Aracruz: Estimating FCFE for next 5 years

1 2 3 4 5 Terminal
Earnings BR 0.222 BR 0.243 BR 0.264 BR 0.288 BR 0.314 BR 0.330
- (CapEx-Depreciation)*(1-DR) BR 0.042 BR 0.046 BR 0.050 BR 0.055 BR 0.060 BR 0.052
-Chg. Working Capital*(1-DR) BR 0.010 BR 0.011 BR 0.012 BR 0.013 BR 0.014 BR 0.008
Free Cashflow to Equity BR 0.170 BR 0.186 BR 0.202 BR 0.221 BR 0.241 BR 0.269
Present Value BR 0.154 BR 0.152 BR 0.150 BR 0.149 BR 0.147

The present value is computed by discounting the FCFE at the current cost of
equity of 10.33%.

Aswath Damodaran 229

 Aracruz: Estimating Terminal Price and Value per share

 The terminal value at the end of year 5 is estimated using the FCFE in the
terminal year.
• The FCFE in year 6 reflects the drop in net capital expenditures after year 5.
• Terminal Value = 0.269/(.125-.05) = 3.59 BR
• Value per Share = 0.154 + 0.152 + 0.150 + 0.149 + 0.147 + 3.59/1.10335 = 2.94 BR
 The stock was trading at 2.40 BR in September 1997.
 The value per share is based upon normalized earnings. To the extent that it
will take some time to get to normal earnings, discount this value per share
back to the present at the cost of equity of 10.33%.

Aswath Damodaran 230

 Disney Valuation

 Model Used:
• Cash Flow: FCFF (since I think leverage will change over time)
• Growth Pattern: 3-stage Model (even though growth in operating income is only
10%, there are substantial barriers to entry)

Aswath Damodaran 231

 Disney: Inputs to Valuation

High Growth Phase Transition Phase Stable Growth Phase

Length of Period 5 years 5 years Forever after 10 years
Revenues Current Revenues: $ 18,739; Continues to grow at same rate Grows at stable growth rate
Expected to grow at same rate a as operating earnings
operating earnings
Pre-tax Operating Margin 29.67% of revenues, based upon Increases gradually to 32% of Stable margin is assumed to be
1996 EBIT of $ 5,559 million. revenues, due to economies of 32%.
scale.
Tax Rate 36% 36% 36%
Return on Capital 20% (approximately 1996 level) Declines linearly to 16% Stable ROC of 16%
Working Capital 5% of Revenues 5% of Revenues 5% of Revenues
Reinvestment Rate 50% of after-tax operating Declines to 31.25% as ROC and 31.25% of after-tax operating
(Net Cap Ex + Working Capital income; Depreciation in 1996 is growth rates drop: income; this is estimated from
Investments/EBIT) $ 1,134 million, and is assumed Reinvestment Rate = g/ROC the growth rate of 5%
to grow at same rate as earnings Reinvestment rate = g/ROC
Expected Growth Rate in EBIT ROC * Reinvestment Rate = Linear decline to Stable Growth 5%, based upon overall nominal
20% * .5 = 10% Rate economic growth
Debt/Capital Ratio 18% Increases linearly to 30% Stable debt ratio of 30%
Risk Parameters Beta = 1.25, ke = 13.88% Beta decreases linearly to 1.00; Stable beta is 1.00.
Cost of Debt = 7.5% Cost of debt stays at 7.5% Cost of debt stays at 7.5%
(Long Term Bond Rate = 7%)
Aswath Damodaran 232
 Disney: FCFF Estimates

Base 1 2 3 4 5 6 7 8 9 10

Expected Growth 10% 10% 10% 10% 10% 9% 8% 7% 6% 5%

Revenues $ 18,739 $ 20,613 $ 22,674 $ 24,942 $ 27,436 $ 30,179 $ 32,895 $ 35,527 $ 38,014 $ 40,295 $ 42,310

Oper. Margin 29.67% 29.67% 29.67% 29.67% 29.67% 29.67% 30.13% 30.60% 31.07% 31.53% 32.00%

EBIT $ 5,559 $ 6,115 $ 6,726 $ 7,399 $ 8,139 $ 8,953 $ 9,912 $ 10,871 $ 11,809 $ 12,706 $ 13,539

EBIT (1-t) $ 3,558 $ 3,914 $ 4,305 $ 4,735 $ 5,209 $ 5,730 $ 6,344 $ 6,957 $ 7,558 $ 8,132 $ 8,665

+ Depreciation $ 1,134 $ 1,247 $ 1,372 $ 1,509 $ 1,660 $ 1,826 $ 2,009 $ 2,210 $ 2,431 $ 2,674 $ 2,941

- Capital Exp. $ 1,754 $ 3,101 $ 3,411 $ 3,752 $ 4,128 $ 4,540 $ 4,847 $ 5,103 $ 5,313 $ 5,464 $ 5,548

- Change in WC $ 94 $ 94 $ 103 $ 113 $ 125 $ 137 $ 136 $ 132 $ 124 $ 114 $ 101

= FCFF $ 1,779 $ 1,966 $ 2,163 $ 2,379 $ 2,617 $ 2,879 $ 3,370 $ 3,932 $ 4,552 $ 5,228 $ 5,957

ROC 20% 20% 20% 20% 20% 20% 19.2% 18.4% 17.6% 16.8% 16%

Reinv. Rate 50% 50% 50% 50% 50% 46.875% 43.48% 39.77% 35.71% 31.25%

Aswath Damodaran 233

 Disney: Costs of Capital

Year 1 2 3 4 5 6 7 8 9 10

Cost of Equity 13.88% 13.88% 13.88% 13.88% 13.88% 13.60% 13.33% 13.05% 12.78% 12.50%

Cost of Debt 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80%

Debt Ratio 18.00% 18.00% 18.00% 18.00% 18.00% 20.40% 22.80% 25.20% 27.60% 30.00%

Cost of Capital 12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran 234

 Disney: Terminal Value

 The terminal value at the end of year 10 is estimated based upon the free cash
flows to the firm in year 11 and the cost of capital in year 11.
 FCFF11 = EBIT (1-t) - EBIT (1-t) Reinvestment Rate
= $ 13,539 (1.05) (1-.36) - $ 13,539 (1.05) (1-.36) (.3125)
= $ 6,255 million
 Note that the reinvestment rate is estimated from the cost of capital of 16%
and the expected growth rate of 5%.
 Cost of Capital in terminal year = 10.19%
 Terminal Value = $ 6,255/(.1019 - .05) = $ 120,521 million

Aswath Damodaran 235

 Disney: Present Value

Year 1 2 3 4 5 6 7 8 9 10

FCFF $ 1,966 $ 2,163 $ 2,379 $ 2,617 $ 2,879 $ 3,370 $ 3,932 $ 4,552 $ 5,228 $ 5,957

Term Value 120,521

Present Value $ 1,752 $ 1,717 $ 1,682 $1,649 $1,616 $ 1,692 $1,773 $ 1,849 $ 1,920 42,167

Cost of Capital 12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran 236

 Present Value Check

 The FCFF and costs of capital are provided for all 10 years. Confirm the
present value of the FCFF in year 7.

Aswath Damodaran 237

 Disney: Value Per Share

Value of the Firm = $ 57,817 million

+ Value of Cash = $ 0 (almost no non-operating cash)
- Value of Debt = $ 11,180 million
= Value of Equity = $ 46,637 million
/ Number of Shares 675.13
Value Per Share = $ 69.08

Aswath Damodaran 238

 Disney: A Valuation
Reinvestment Rate Return on Capital
50.00% Expected Growth 20%
Cashflow to Firm in EBIT (1-t)
EBIT(1-t) : 3,558 Stable Growth
.50*.20 = .10 g = 5%; Beta = 1.00;
- Nt CpX 612 10.00 %
- Chg WC 617 D/(D+E) = 30%; ROC=16%
= FCFF 2,329 Reinvestment Rate=31.25%

Terminal Value 10 = 6255/(.1019-.05) = 120,521

ROC drops to 16%
57,817 Reinv. rate drops to 31.25%
- 11,180= 46,637 1,966 2,163 2,379 2,617 2,879 3,370 3,932 4,552 5,228 5,957
Per Share: 69.08
Forever
Discount at Cost of Capital (WACC) = 13.85% (0.82) + 4.8% (0.18) = 12.22%
Transition
Beta drops to 1.00
Debt ratio rises to 30%

Cost of Equity Cost of Debt

13.85% (7%+ 0.50%)(1-.36) Weights
= 4.80% E = 82% D = 18%

Riskfree Rate :
Government Bond Risk Premium
Rate = 7% Beta 5.5%
+ 1.25 X

Unlevered Beta for Firm’s D/E Historical US Country Risk

Sectors: 1.09 Ratio: 21.95% Premium Premium
5.5% 0%
Aswath Damodaran 239
 Determine the business risk of the firm (Beta, Default Risk)

The Investment Decision The Dividend Decision The Financing Decision

Invest in projects that yield a return If there are not enough Choose a financing mix that
greater than the minimum acceptable investments that earn the maximizes the value of the projects
hurdle rate hurdle rate, return the cash to taken, and matches the assets being
the owners financed.

Return on Capital Reinvestment Rate

20.00% 50% Equity: Debt::
Beta=1.25 Default Risk

Cost of Capital
Current Expected Growth = ROC * RR 12.22%
EBIT(1-t) = = .50 * 20%= 10%
$3,558 million

Year EBIT(1-t) Reinvestment FCFF Terminal Value PV

1 $ 3,914 $ 1,947 $ 1,966 $ 1,752
2 $ 4,305 $ 2,142 $ 2,163 $ 1,717
3 $ 4,735 $ 2,356 $ 2,379 $ 1,682
4 $ 5,209 $ 2,343 $ 2,866 $ 1,649
5 $ 5,730 $ 2,851 $ 2,879 $ 1,616
6 $ 6,344 $ 2,974 $ 3,370 $ 1,692
7 $ 6,957 $ 2,762 $ 4,196 $ 1,773
Transition to 8 $ 7,558 $ 3,006 $ 4,552 $ 1,849 In stable growth:
stable growth 9 $ 8,132 $ 2,904 $ 5,228 $ 1,920 Reinvestment Rate=31.67%
inputs 10 $ 8,665 $ 2,708 $ 5,957 $ 120,521 $ 42,167 Return on Capital = 16%
Value of Disney = $ 57,817 Beta = 1.00
- Value of Debt = $11,180 Debt Ratio = 30.00%
= Value of Equity $ 46,637
Aswath Damodaran Cost of Capital = 10.19% 240
Value of Disney/share = $ 69.08
 Relative Valuation

 In relative valuation, the value of an asset is derived from the pricing of

'comparable' assets, standardized using a common variable such as earnings,
cashflows, book value or revenues. Examples include --
• Price/Earnings (P/E) ratios
– and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios
– and variants (Tobin's Q)
• Price/Sales ratios

Aswath Damodaran 241

 Multiples and Fundamenals

DPS1
P0 =
r ! gn
 Gordon Growth Model:
 Dividing both sides
P0 by the Payout
earnings,
Ratio * (1 + g n )
= PE =
EPS0 r-gn

 Dividing both sides

P
by theROE
book value of equity,
* Payout Ratio * (1 + g )
0 n
= PBV =
BV 0 r-g n

 If the return on equity is written in terms of the retention ratio and the
expected growth rate
P0 ROE - gn
= PBV =
BV 0 r-gn
 Dividing by the Sales per share,

P0 Profit Margin * Payout Ratio * (1 + g n )

= PS =
Sales 0 r-g n

Aswath Damodaran 242

 Disney: Relative Valuation

Company PE Expected Growth PEG

King World Productions 10.4 7.00% 1.49
Aztar 11.9 12.00% 0.99
Viacom 12.1 18.00% 0.67
All American Communications 15.8 20.00% 0.79
GC Companies 20.2 15.00% 1.35
Circus Circus Enterprises 20.8 17.00% 1.22
Polygram NV ADR 22.6 13.00% 1.74
Regal Cinemas 25.8 23.00% 1.12
Walt Disney 27.9 18.00% 1.55
AMC Entertainment 29.5 20.00% 1.48
Premier Parks 32.9 28.00% 1.18
Family Golf Centers 33.1 36.00% 0.92
CINAR Films 48.4 25.00% 1.94
Average 22.19 18.56% 1.20

Aswath Damodaran 243

 Is Disney fairly valued?

 Based upon the PE ratio, is Disney under, over or correctly valued?

 Under Valued
 Over Valued
 Correctly Valued
 Based upon the PEG ratio, is Disney under valued?
 Under Valued
 Over Valued
 Correctly Valued
 Will this valuation give you a higher or lower valuation than the discounted
CF valutaion?
 Higher
 Lower

Aswath Damodaran 244

 Relative Valuation Assumptions

 Assume that you are reading an equity research report where a buy
recommendation for a company is being based upon the fact that its PE ratio
is lower than the average for the industry. Implicitly, what is the underlying
assumption or assumptions being made by this analyst?
 The sector itself is, on average, fairly priced
 The earnings of the firms in the group are being measured consistently
 The firms in the group are all of equivalent risk
 The firms in the group are all at the same stage in the growth cycle
 The firms in the group are of equivalent risk and have similar cash flow
patterns
 All of the above

Aswath Damodaran 245

 First Principles

 Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
• 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.
• The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm

Aswath Damodaran 246