Documente Academic
Documente Profesional
Documente Cultură
AswathDamodaran
www.damodaran.com
Everydecisionthatabusinessmakeshasfinancialimplications,and
anydecisionwhichaffectsthefinancesofabusinessisacorporate
financedecision.
Definedbroadly,everythingthatabusinessdoesfitsundertherubric
ofcorporatefinance.
Otherlongtermobligations
Assetswhicharenotphysical,
LongLivedRealAssets
IntangibleAssets
Shorttermliabilitiesofthefirm
Equity
Debt
FixedAssets
Investmentsinsecurities&
FinancialInvestments
CurrentAssets
Current
Debtobligationsoffirm
Equityinvestmentinfirm
ShortlivedAssets
Other
Liabilities
Assets
TheBalanceSheet
likepatents&trademarks
assetsofotherfirms
Liabilties
Liabilities
GrowthAssets
ExpectedValuethatwillbe
FixedClaimoncashflows
Equity
Debt
AssetsinPlace
ResidualClaimoncashflows
ExistingInvestments
Liabilities
Assets
createdbyfutureinvestments
LittleorNoroleinmanagement
SignificantRoleinmanagement
Generatecashflowstoday
FixedMaturity
PerpetualLives
Includeslonglived(fixed)and
TaxDeductible
shortlived(working
capital)assets
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
Intraditionalcorporatefinance,theobjectiveindecisionmakingisto
maximizethevalueofthefirm.
Anarrowerobjectiveistomaximizestockholderwealth.Whenthe
stockistradedandmarketsareviewedtobeefficient,theobjectiveis
tomaximizethestockprice.
Allothergoalsofthefirmareintermediateonesleadingtofirmvalue
maximization,oroperateasconstraintsonfirmvaluemaximization.
LendMoney
Maximize
stockholder
wealth
Managers
Protect
bondholder
Interests
Reveal
information
honestlyand
ontime
NoSocialCosts
SOCIETY
Costscanbe
tracedtofirm
Marketsare
efficientand
assesseffecton
value
FINANCIALMARKETS
BONDHOLDERS
LendMoney
Managersput
theirinterests
abovestockholders
Managers
SignificantSocialCosts
SOCIETY
Bondholderscan
Somecostscannotbe
getrippedoff
tracedtofirm
Delaybad
Marketsmake
newsor
mistakesand
provide
misleading canoverreact
information
FINANCIALMARKETS
10
11
12
Tochooseadifferentmechanismforcorporategovernance
Tochooseadifferentobjectiveforthefirm.
Tomaximizestockprice,butreducethepotentialforconflictand
breakdown:
Makingmanagers(decisionmakers)andemployeesintostockholders
Byprovidinginformationhonestlyandpromptlytofinancialmarkets
13
GermanyandJapandevelopedadifferentmechanismforcorporate
governance,baseduponcorporatecrossholdings.
InGermany,thebanksformthecoreofthissystem.
InJapan,itisthekeiretsus
OtherAsiancountrieshavemodeledtheirsystemafterJapan,withfamily
companiesformingthecoreofthenewcorporatefamilies
Attheirbest,themostefficientfirmsinthegroupworkatbringingthe
lessefficientfirmsuptopar.Theyprovideacorporatewelfaresystem
thatmakesforamorestablecorporatestructure
Attheirworst,theleastefficientandpoorlyrunfirmsinthegrouppull
downthemostefficientandbestrunfirmsdown.Thenatureofthe
crossholdingsmakesitsverydifficultforoutsiders(including
investorsinthesefirms)tofigureouthowwellorbadlythegroupis
doing.
14
Firmscanalwaysfocusonadifferentobjectivefunction.Examples
wouldinclude
maximizingearnings
maximizingrevenues
maximizingfirmsize
maximizingmarketshare
maximizingEVA
Thekeythingtorememberisthattheseareintermediateobjective
functions.
Tothedegreethattheyarecorrelatedwiththelongtermhealthandvalue
ofthecompany,theyworkwell.
Tothedegreethattheydonot,thefirmcanendupwithadisaster
15
Thestrengthofthestockpricemaximizationobjectivefunctionisits
internalselfcorrectionmechanism.Excessesonanyofthelinkages
lead,ifunregulated,tocounteractionswhichreduceoreliminatethese
excesses
Inthecontextofourdiscussion,
managerstakingadvantageofstockholdershasleadtoamuchmore
activemarketforcorporatecontrol.
stockholderstakingadvantageofbondholdershasleadtobondholders
protectingthemselvesatthetimeoftheissue.
firmsrevealingincorrectordelayedinformationtomarketshasleadto
marketsbecomingmoreskepticalandpunitive
firmscreatingsocialcostshasleadtomoreregulations,aswellasinvestor
andcustomerbacklashes.
16
InstitutionalinvestorssuchasCalpersandtheLensFundshave
becomemuchmoreactiveinmonitoringcompaniesthattheyinvestin
anddemandingchangesinthewayinwhichbusinessisdone
IndividualslikeMichaelPricespecializeintakinglargepositionsin
companieswhichtheyfeelneedtochangetheirways(Chase,Dow
Jones,ReadersDigest)andpushforchange
Atannualmeetings,stockholdershavetakentoexpressingtheir
displeasurewithincumbentmanagementbyvotingagainsttheir
compensationcontractsortheirboardofdirectors
17
Boardshavebecomesmallerovertime.Themediansizeofaboardof
directorshasdecreasedfrom16to20inthe1970stobetween9and11
in1998.Thesmallerboardsarelessunwieldyandmoreeffectivethan
thelargerboards.
There are fewer insiders on the board. In contrast to the 6 or more
insidersthatmanyboardshadinthe1970s,onlytwodirectorsinmost
boardsin1998wereinsiders.
Directors are increasingly compensated with stock and options in the
company, instead of cash. In 1973, only 4% of directors received
compensationintheformofstockoroptions,whereas78%didsoin
1998.
Moredirectorsareidentifiedandselectedbyanominatingcommittee
rather than being chosen by the CEO of the firm. In 1998, 75% of
boards had nominating committees; the comparable statistic in 1973
was2%.
18
Occupation
HeadofschoolfortheCenterforEarlyEducation,
CEOandChairmanofConEdison
HeadofDisneyAnimation
CEOofDisney
CEOofPacketDesign(aninternetcompany)
CEOofShamrockHoldings
ChiefOperatingOfficer,Disney
ChiefOperationOfficer,LaOpinion(Spanishnewspaper)
Chairmanoflawfirm(Verner,Liipfert,etal.)
ExCEO,CapitalCitiesABC
ProfessorofTheology,GeorgetownUniversity
Actor,WriterandDirector
SeniorPartnerofRobertA.M.SternArchitectsofNewYork
ChairmanofSotheby'sWestCoast
ChairmanofIrvineCompany(arealestatecorporation)
Chairmanoftheboard,NorthwestAirlines.
19
1.Covenants
2.NewTypes
Managersofpoorly
runfirmsareput
onnotice.
Managers
Firmsare
punished
formisleading
markets
CorporateGoodCitizenConstraints
SOCIETY
1.Morelaws
2.Investor/CustomerBacklash
Investorsand
analystsbecome
moreskeptical
FINANCIALMARKETS
20
21
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedand
thetimingofthesecashflows;theyshouldalsoconsiderbothpositiveand
negativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
22
Sincefinancialresourcesarefinite,thereisahurdlethatprojectshave
tocrossbeforebeingdeemedacceptable.
Thishurdlewillbehigherforriskierprojectsthanforsaferprojects.
Asimplerepresentationofthehurdlerateisasfollows:
Hurdlerate= RisklessRate+RiskPremium
Thetwobasicquestionsthateveryriskandreturnmodelinfinance
triestoanswerare:
Howdoyoumeasurerisk?
Howdoyoutranslatethisriskmeasureintoariskpremium?
23
What is Risk?
Risk,intraditionalterms,isviewedasanegative.Websters
dictionary,forinstance,definesriskasexposingtodangeror
hazard.TheChinesesymbolsforrisk,reproducedbelow,givea
muchbetterdescriptionofrisk
Thefirstsymbolisthesymbolfordanger,whilethesecondisthe
symbolforopportunity,makingriskamixofdangerand
opportunity.
24
25
26
3.Themodeldoesnotworkwell
Ifthemodelisright,thereshouldbe
alinearrelationshipbetweenreturnsandbetas
theonlyvariablethatshouldexplainreturnsisbetas
Therealityisthat
therelationshipbetweenbetasandreturnsisweak
Othervariables(size,price/bookvalue)seemtoexplaindifferencesinreturns
better.
27
TheCAPM,notwithstandingitsmanycriticsandlimitations,has
survivedasthedefaultmodelforriskinequityvaluationandcorporate
finance.Thealternativemodelsthathavebeenpresentedasbetter
models(APM,Multifactormodel..)havemadeinroadsinperformance
evaluationbutnotinprospectiveanalysisbecause:
Thealternativemodels(whicharericher)doamuchbetterjobthanthe
CAPMinexplainingpastreturn,buttheireffectivenessdropsoffwhenit
comestoestimatingexpectedfuturereturns(becausethemodelstendto
shiftandchange).
Thealternativemodelsaremorecomplicatedandrequiremore
informationthantheCAPM.
Formostcompanies,theexpectedreturnsyougetwiththethealternative
modelsisnotdifferentenoughtobeworththeextratroubleofestimating
fouradditionalbetas.
28
Lookingatthebreakdownofstockholdersinyourfirm,consider
whetherthemarginalinvestoris
Aninstitutionalinvestor
b) Anindividualinvestor
c) Aninsider
a)
29
Thecapitalassetpricingmodelyieldsthefollowingexpectedreturn:
ExpectedReturn=RiskfreeRate+Beta*(ExpectedReturnontheMarket
PortfolioRiskfreeRate)
Tousethemodelweneedthreeinputs:
(a) Thecurrentriskfreerate
(b)Theexpectedmarketriskpremium(thepremiumexpectedforinvesting
inriskyassets(marketportfolio)overtherisklessasset)
(c)Thebetaoftheassetbeinganalyzed.
30
Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.
Therefore,thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,i.e.,tohaveanactualreturnbeequal
totheexpectedreturn,twoconditionshavetobemet
Therehastobenodefaultrisk,whichgenerallyimpliesthatthesecurity
hastobeissuedbythegovernment.Note,however,thatnotall
governmentscanbeviewedasdefaultfree.
Therecanbenouncertaintyaboutreinvestmentrates,whichimpliesthat
itisazerocouponsecuritywiththesamematurityasthecashflowbeing
analyzed.
31
Theriskfreerateistherateonazerocoupongovernmentbond
matchingthetimehorizonofthecashflowbeinganalyzed.
Theoretically,thistranslatesintousingdifferentriskfreeratesforeach
cashflowthe1yearzerocouponrateforthecashflowinyear1,the
2yearzerocouponrateforthecashflowinyear2...
Practicallyspeaking,ifthereissubstantialuncertaintyaboutexpected
cashflows,thepresentvalueeffectofusingtimevaryingriskfreerates
issmallenoughthatitmaynotbeworthit.
32
Usingalongtermgovernmentrate(evenonacouponbond)asthe
riskfreerateonallofthecashflowsinalongtermanalysiswillyielda
closeapproximationofthetruevalue.
Forshorttermanalysis,itisentirelyappropriatetouseashortterm
governmentsecurityrateastheriskfreerate.
Theriskfreeratethatyouuseinananalysisshouldbeinthesame
currencythatyourcashflowsareestimatedin.Inotherwords,ifyour
cashflowsareinU.S.dollars,yourriskfreeratehastobeinU.S.
dollarsaswell.
DataSource:YoucangetriskfreeratesfortheUSinanumberofsites.
Tryhttp://www.bloomberg.com/markets.
33
Theriskpremiumisthepremiumthatinvestorsdemandforinvesting
inanaverageriskinvestment,relativetotheriskfreerate.
Asageneralproposition,thispremiumshouldbe
greaterthanzero
increasewiththeriskaversionoftheinvestorsinthatmarket
increasewiththeriskinessoftheaverageriskinvestment
34
35
Ifthiswerethecapitalmarketline,theriskpremiumwouldbea
weightedaverageoftheriskpremiumsdemandedbyeachandevery
investor.
Theweightswillbedeterminedbythemagnitudeofwealththateach
investorhas.Thus,WarrenBuffetsriskaversioncountsmoretowards
determiningtheequilibriumpremiumthanyoursandmine.
Asinvestorsbecomemoreriskaverse,youwouldexpectthe
equilibriumpremiumtoincrease.
36
37
Surveyinvestorsontheirdesiredriskpremiumsandusetheaverage
premiumfromthesesurveys.
Assumethattheactualpremiumdeliveredoverlongtimeperiodsis
equaltotheexpectedpremiumi.e.,usehistoricaldata
Estimatetheimpliedpremiumintodaysassetprices.
38
Surveyingallinvestorsinamarketplaceisimpractical.
However,youcansurveyafewinvestors(especiallythelarger
investors)andusetheseresults.Inpractice,thistranslatesintosurveys
ofmoneymanagersexpectationsofexpectedreturnsonstocksover
thenextyear.
Thelimitationsofthisapproachare:
therearenoconstraintsonreasonability(thesurveycouldproduce
negativeriskpremiumsorriskpremiumsof50%)
theyareextremelyvolatile
theytendtobeshortterm;eventhelongestsurveysdonotgobeyondone
year
39
Thisisthedefaultapproachusedbymosttoarriveatthepremiumto
useinthemodel
Inmostcases,thisapproachdoesthefollowing
itdefinesatimeperiodfortheestimation(1926Present,1962Present....)
itcalculatesaveragereturnsonastockindexduringtheperiod
itcalculatesaveragereturnsonarisklesssecurityovertheperiod
itcalculatesthedifferencebetweenthetwo
andusesitasapremiumlookingforward
Thelimitationsofthisapproachare:
itassumesthattheriskaversionofinvestorshasnotchangedina
systematicwayacrosstime.(Theriskaversionmaychangefromyearto
year,butitrevertsbacktohistoricalaverages)
itassumesthattheriskinessoftheriskyportfolio(stockindex)hasnot
changedinasystematicwayacrosstime.
40
AnnualizedStddeviationinStockprices
)
Numberofyearsofhistoricaldata
Beconsistentinyouruseofariskfreerate.
Usearithmeticpremiumsforoneyearestimatesofcostsofequityandgeometric
premiumsforestimatesoflongtermcostsofequity.
DataSource:Checkoutthereturnsbyyearandestimateyourownhistoricalpremiumsby
goingtoupdateddataonmywebsite.
41
HistoricaldataformarketsoutsidetheUnitedStatesisavailablefor
muchshortertimeperiods.Theproblemisevengreaterinemerging
markets.
Thehistoricalpremiumsthatemergefromthisdatareflectsthisand
thereismuchgreatererrorassociatedwiththeestimatesofthe
premiums.
42
RatingsagenciessuchasS&PandMoodysassignratingstocountries
thatreflecttheirassessmentofthedefaultriskofthesecountries.
Theseratingsreflectthepoliticalandeconomicstabilityofthese
countriesandthusprovideausefulmeasureofcountryrisk.In
September2004,forinstance,BrazilhadacountryratingofB2.
Ifacountryissuesbondsdenominatedinadifferentcurrency(say
dollarsoreuros),youcanalsoseehowthebondmarketviewstherisk
inthatcountry.InSeptember2004,BrazilhaddollardenominatedC
Bonds,tradingataninterestrateof10.01%.TheUStreasurybond
ratethatdaywas4%,yieldingadefaultspreadof6.01%forBrazil.
ManyanalystsaddthisdefaultspreadtotheUSriskpremiumtocome
upwithariskpremiumforacountry.Usingthisapproachwouldyield
ariskpremiumof10.85%forBrazil,ifweuse4.84%asthepremium
fortheUS.
43
Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsand
equityriskpremiumsarehighlycorrelated,onewouldexpectequity
spreadstobehigherthandebtspreads.Ifwecancomputehowmuch
moreriskytheequitymarketis,relativetothebondmarket,wecould
usethisinformation.Forexample,
StandardDeviationinBovespa(Equity)=36%
StandardDeviationinBrazilCBond=28.2%
DefaultspreadonCBond=6.01%
CountryRiskPremiumforBrazil=6.01%(36%/28.2%)=7.67%
Notethatthisisontopofthepremiumyouestimateforamature
market.Thus,ifyouassumethattheriskpremiumintheUSis4.84%,
theriskpremiumforBrazilwouldbe12.51%.
44
Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.
Analystsexpectearningstogrow8.5%ayearforthenext5years.
January1,2005
52.85
48.71
44.89
41.37
38.13
In2004,dividends&stock
Afteryear5,wewillassumethat
S&P500isat1211.92
buybackswere2.90%of
earningsontheindexwillgrowat
Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof7.87%onstocks(which
isobtainedbysolvingforrinthefollowingequation)
ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=7.87%4.22%=
3.65%
1211.92 =
38.13 41.37
44.89
48.71
52.85
52.85(1.0422)
+
+
+
+
+
(1+ r) (1+ r) 2 (1+ r) 3 (1 + r) 4 (1+ r) 5 (r .0422)(1+ r) 5
45
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
46
Baseduponourdiscussionofhistoricalriskpremiumssofar,therisk
premiumlookingforwardshouldbe:
a) About7.92%,whichiswhatthearithmeticaveragepremiumhasbeen
since1928,forstocksoverT.Bills
b) About4.84%,whichisthegeometricaveragepremiumsince1928,for
stocksoverT.Bonds
c) About3.7%,whichistheimpliedpremiuminthestockmarkettoday
47
Estimating Beta
Thestandardprocedureforestimatingbetasistoregressstockreturns
(Rj)againstmarketreturns(Rm)
Rj=a+bRm
whereaistheinterceptandbistheslopeoftheregression.
Theslopeoftheregressioncorrespondstothebetaofthestock,and
measurestheriskinessofthestock.
48
Estimating Performance
Theinterceptoftheregressionprovidesasimplemeasureof
performanceduringtheperiodoftheregression,relativetothecapital
assetpricingmodel.
Rj =Rf+b(RmRf)
=Rf(1b) +bRm
Rj =a
+bRm
...........
...........
CapitalAssetPricingModel
RegressionEquation
If
a>Rf(1b).... Stockdidbetterthanexpectedduringregressionperiod
a=Rf(1b).... Stockdidaswellasexpectedduringregressionperiod
a<Rf(1b).... Stockdidworsethanexpectedduringregressionperiod
ThedifferencebetweentheinterceptandRf(1b)isJensen'salpha.If
itispositive,yourstockdidperformbetterthanexpectedduringthe
periodoftheregression.
49
TheRsquared(R2)oftheregressionprovidesanestimateofthe
proportionoftherisk(variance)ofafirmthatcanbeattributedto
marketrisk;
Thebalance(1R2)canbeattributedtofirmspecificrisk.
50
Decideonanestimationperiod
Servicesuseperiodsrangingfrom2to5yearsfortheregression
Longerestimationperiodprovidesmoredata,butfirmschange.
Shorterperiodscanbeaffectedmoreeasilybysignificantfirmspecific
eventthatoccurredduringtheperiod(Example:ITTfor19951997)
Decideonareturnintervaldaily,weekly,monthly
Shorterintervalsyieldmoreobservations,butsufferfrommorenoise.
Noiseiscreatedbystocksnottradingandbiasesallbetastowardsone.
Estimatereturns(includingdividends)onstock
Return=(PriceEndPriceBeginning+DividendsPeriod)/PriceBeginning
Includeddividendsonlyinexdividendmonth
Chooseamarketindex,andestimatereturns(inclusiveofdividends)
ontheindexforeachintervalfortheperiod.
51
Periodused:5years
ReturnInterval=Monthly
MarketIndex:S&P500Index.
Forinstance,tocalculatereturnsonDisneyinDecember1999,
PriceforDisneyatendofNovember1999=$27.88
PriceforDisneyatendofDecember1999=$29.25
Dividendsduringmonth=$0.21(Itwasanexdividendmonth)
Return=($29.25$27.88+$0.21)/$27.88=5.69%
Toestimatereturnsontheindexinthesamemonth
Indexlevel(includingdividends)atendofNovember1999=1388.91
Indexlevel(includingdividends)atendofDecember1999=1469.25
Return=(1469.251388.91)/1388.91=5.78%
52
20.00%
Regressionline
10.00%
Disney
15.00%
0.00%
10.00%
5.00%
0.00%
5.00%
10.00%
15.00%
10.00%
20.00%
30.00%
S&P500
53
Usingmonthlyreturnsfrom1999to2003,weranaregressionof
returnsonDisneystockagainsttheS*P500.Theoutputisbelow:
ReturnsDisney=0.0467%+1.01ReturnsS&P500(Rsquared=29%)
(0.20)
54
Intercept=0.0467%
Thisisaninterceptbasedonmonthlyreturns.Thus,ithastobecompared
toamonthlyriskfreerate.
Between1999and2003,
MonthlyRiskfreeRate=0.313%(baseduponaverageT.Billrate:9903)
RiskfreeRate(1Beta)=0.313%(11.01)=..0032%
TheComparisonisthenbetween
Intercept
versus RiskfreeRate(1Beta)
0.0467%
versus 0.313%(11.01)=0.0032%
JensensAlpha=0.0467%(0.0032%)=0.05%
Disneydid0.05%betterthanexpected,permonth,between1999and
2003.
Annualized,Disneysannualexcessreturn=(1.0005)121=0.60%
55
DisneyhasapositiveJensensalphaof0.60%ayearbetween1999
and2003.Thiscanbeviewedasasignthatmanagementinthefirm
didagoodjob,managingthefirmduringtheperiod.
a) True
b) False
56
SlopeoftheRegressionof1.01isthebeta
Regressionparametersarealwaysestimatedwitherror.Theerroris
capturedinthestandarderrorofthebetaestimate,whichinthecaseof
Disneyis0.20.
AssumethatIaskedyouwhatDisneystruebetais,afterthis
regression.
Whatisyourbestpointestimate?
Whatrangewouldyougiveme,with67%confidence?
Whatrangewouldyougiveme,with95%confidence?
57
Number of Firms
1200
1000
800
600
400
200
0
<.10
.10 - .20
.20 - .30
.30 - .40
.40 -.50
.50 - .75
> .75
58
RSquared=29%
Thisimpliesthat
29%oftheriskatDisneycomesfrommarketsources
71%,therefore,comesfromfirmspecificsources
Thefirmspecificriskisdiversifiableandwillnotberewarded
59
Wouldyouranswerbedifferentifyouwereanundiversifiedinvestor?
60
QuickTime and a
TIFF (LZW) decompressor
are needed to see this picture.
61
Inputstotheexpectedreturncalculation
DisneysBeta=1.01
RiskfreeRate=4.00%(U.S.tenyearT.Bondrate)
RiskPremium=4.82%(Approximatehistoricalpremium:19282003)
ExpectedReturn
=RiskfreeRate+Beta(RiskPremium)
=4.00%+1.01(4.82%)=8.87%
62
Assumenowthatyouareanactiveinvestorandthatyourresearch
suggeststhataninvestmentinDisneywillyield12.5%ayearforthe
next5years.Basedupontheexpectedreturnof8.87%,youwould
a) Buythestock
b) Sellthestock
63
ManagersatDisney
needtomakeatleast8.87%asareturnfortheirequityinvestorstobreak
even.
thisisthehurdlerateforprojects,whentheinvestmentisanalyzedfrom
anequitystandpoint
Inotherwords,Disneyscostofequityis8.87%.
Whatisthecostofnotdeliveringthiscostofequity?
64
UsingyourBloombergriskandreturnprintout,answerthefollowing
questions:
Howwellorbadlydidyourstockdo,relativetothemarket,duringthe
periodoftheregression?(Youcanassumeanannualizedriskfreerateof
4.8%duringtheregressionperiod)
Intercept(4.8%/n)(1Beta)=JensensAlpha
Wherenisthenumberofreturnperiodsinayear(12ifmonthly;52ifweekly)
Whatproportionoftheriskinyourstockisattributabletothemarket?
Whatproportionisfirmspecific?
Whatisthehistoricalestimateofbetaforyourstock?Whatistherange
onthisestimatewith67%probability?With95%probability?
Baseduponthisbeta,whatisyourestimateoftherequiredreturnonthis
stock?
RisklessRate+Beta*RiskPremium
65
A Quick Test
Youareadvisingaveryriskysoftwarefirmontherightcostofequityto
useinprojectanalysis.Youestimateabetaof3.0forthefirmand
comeupwithacostofequityof18.46%.TheCFOofthefirmis
concernedaboutthehighcostofequityandwantstoknowwhether
thereisanythinghecandotolowerhisbeta.
Howdoyoubringyourbetadown?
Shouldyoufocusyourattentiononbringingyourbetadown?
a) Yes
b) No
66
67
IndustryEffects:Thebetavalueforafirmdependsuponthe
sensitivityofthedemandforitsproductsandservicesandofitscosts
tomacroeconomicfactorsthataffecttheoverallmarket.
Cyclicalcompanieshavehigherbetasthannoncyclicalfirms
Firmswhichsellmorediscretionaryproductswillhavehigherbetasthan
firmsthatselllessdiscretionaryproducts
68
Operatingleveragereferstotheproportionofthetotalcostsofthe
firmthatarefixed.
Otherthingsremainingequal,higheroperatingleverageresultsin
greaterearningsvariabilitywhichinturnresultsinhigherbetas.
69
70
Net Sales
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
1987-2003
1996-2003
2877
3438
4594
5844
6182
7504
8529
10055
12112
18739
22473
22976
23435
25418
25172
25329
27061
% Change
in Sales
19.50%
33.62%
27.21%
5.78%
21.38%
13.66%
17.89%
20.46%
54.71%
19.93%
2.24%
2.00%
8.46%
-0.97%
0.62%
6.84%
15.83%
11.73%
EBIT
756
848
1177
1368
1124
1287
1560
1804
2262
3024
3945
3843
3580
2525
2832
2384
2713
% Change
in EBIT
12.17%
38.80%
16.23%
-17.84%
14.50%
21.21%
15.64%
25.39%
33.69%
30.46%
-2.59%
-6.84%
-29.47%
12.16%
-15.82%
13.80%
10.09%
4.42%
71
OperatingLeverage
=%ChangeinEBIT/%ChangeinSales
=10.09%/15.83%=0.64
Thisislowerthantheoperatingleverageforotherentertainmentfirms,
whichwecomputedtobe1.12.ThiswouldsuggestthatDisneyhas
lowerfixedcoststhanitscompetitors.
TheacquisitionofCapitalCitiesbyDisneyin1996maybeskewing
theoperatingleverage.Lookingatthechangessincethen:
OperatingLeverage199603=4.42%/11.73%=0.38
LookslikeDisneysoperatingleveragehasdecreasedsince1996.
72
Asfirmsborrow,theycreatefixedcosts(interestpayments)thatmake
theirearningstoequityinvestorsmorevolatile.
Thisincreasedearningsvolatilitywhichincreasestheequitybeta
73
Thebetaofequityalonecanbewrittenasafunctionoftheunlevered
betaandthedebtequityratio
L=u(1+((1t)D/E))
where
L=LeveredorEquityBeta
u=UnleveredBeta
t=Corporatemarginaltaxrate
D=MarketValueofDebt
E=MarketValueofEquity
74
TheregressionbetaforDisneyis1.01.Thisbetaisaleveredbeta
(becauseitisbasedonstockprices,whichreflectleverage)andthe
leverageimplicitinthebetaestimateistheaveragemarketdebtequity
ratioduringtheperiodoftheregression(1999to2003)
Theaveragedebtequityratioduringthisperiodwas27.5%.
TheunleveredbetaforDisneycanthenbeestimated(usingamarginal
taxrateof37.3%)
=CurrentBeta/(1+(1taxrate)(AverageDebt/Equity))
=1.01/(1+(10.373))(0.275))=0.8615
75
Debt/EquityRatio
0.00%
11.11%
25.00%
42.86%
66.67%
100.00%
150.00%
233.33%
400.00%
900.00%
Beta
0.86
0.92
1.00
1.09
1.22
1.40
1.67
2.12
3.02
5.72
EffectofLeverage
0.00
0.06
0.14
0.23
0.36
0.54
0.81
1.26
2.16
4.86
76
Thebetaofaportfolioisalwaysthemarketvalueweightedaverageof
thebetasoftheindividualinvestmentsinthatportfolio.
Thus,
thebetaofamutualfundistheweightedaverageofthebetasofthe
stocksandotherinvestmentinthatportfolio
thebetaofafirmafteramergeristhemarketvalueweightedaverageof
thebetasofthecompaniesinvolvedinthemerger.
77
Thetopdownbetaforafirmcomesfromaregression
Thebottomupbetacanbeestimatedbydoingthefollowing:
Findoutthebusinessesthatafirmoperatesin
Findtheunleveredbetasofotherfirmsinthesebusinesses
Takeaweighted(bysalesoroperatingincome)averageofthese
unleveredbetas
Leverupusingthefirmsdebt/equityratio
Thebottomupbetawillgiveyouabetterestimateofthetruebeta
when
thestandarderrorofthebetafromtheregressionishigh(and)thebetafor
afirmisverydifferentfromtheaverageforthebusiness
thefirmhasreorganizedorrestructureditselfsubstantiallyduringthe
periodoftheregression
whenafirmisnottraded
78
UnleveredBeta
(1 Cash/FirmValue)
Unle vered
Ave rage
beta
Numbe r levered Media n Unle vered Cash/Firm correct ed
for cash
of firms beta
D/E
beta
Value
Business
Comparab le
firms
Medi a
Networks
Rad ia and TV
br oadcasting
companies
24
1.22
Parks an d
Resorts
1.58
11
1.16
27.96%
77
1.06
9.18%
Studio
Movie
Entertainment companies
Consumer
Products
Toy and
apparel
retail ers;
Entertainment
software
20.45%
1.0768
0.75%
1.0850
120.76% 0.8853
2.77%
0.9105
0.9824
14.08%
1.1435
0.9981
12.08%
1.1353
79
Business
MediaNetworks
ParksandResorts
Studio
Entertainment
ConsumerProducts
Disney
Disneys
Revenues
$10,941
$6,412
$7,364
$2,344
$27,061
Estimated
EV/Sales
Value
3.41
$37,278.62
2.37
$15,208.37
2.63
1.63
$19,390.14
$3,814.38
$75,691.51
FirmValue
Proportion
49.25%
20.09%
Unlevered
beta
1.0850
0.9105
25.62%
5.04%
100.00%
1.1435
1.1353
1.0674
80
Business
Medi a Networks
Parksan d
Resorts
Studio
Entertainment
Consumer
Products
Disn e y
D/E
UnleveredBeta Ratio
1.08 5 0
26.6 2 %
Lever e d
Beta
1.26 6 1
Costof
Equit y
10.1 0 %
0.91 0 5
26.6 2 %
1.06 2 5
9.12%
1.14 3 5
26.6 2 %
1.33 4 4
10.4 3 %
1.13 5 3
1.06 7 4
26.6 2 %
26.6 2 %
1.32 4 8
1.24 5 6
10.3 9 %
10.0 0 %
81
Discussion Issue
IfyouwerethechieffinancialofficerofDisney,whatcostofequity
wouldyouuseincapitalbudgetinginthedifferentdivisions?
a) ThecostofequityforDisneyasacompany
b) ThecostofequityforeachofDisneysdivisions?
82
Theconventionalapproachesofestimatingbetasfromregressionsdo
notworkforassetsthatarenottraded.
Therearetwowaysinwhichbetascanbeestimatedfornontraded
assets
usingcomparablefirms
usingaccountingearnings
83
84
Sincethedebt/equityratiosusedaremarketdebtequityratios,andthe
onlydebtequityratiowecancomputeforBookscapeisabookvalue
debt equity ratio, we have assumed that Bookscape is close to the
industryaveragedebttoequityratioof20.33%.
Using a marginal tax rate of 40% (based upon personal income tax
rates)forBookscape,wegetaleveredbetaof0.82.
LeveredbetaforBookscape=0.7346(1+(1.40)(.2033))=0.82
Usingariskfreerateof4%(UStreasurybondrate)andahistorical
riskpremiumof4.82%:
CostofEquity=4%+0.82(4.82%)=7.95%
85
Theownersofmostprivatefirmsarenotdiversified.Betameasures
theriskaddedontoadiversifiedportfolio.Therefore,usingbetato
arriveatacostofequityforaprivatefirmwill
a) Underestimatethecostofequityfortheprivatefirm
b) Overestimatethecostofequityfortheprivatefirm
c) Couldunderoroverestimatethecostofequityfortheprivatefirm
86
Adjustthebetatoreflecttotalriskratherthanmarketrisk.This
adjustmentisarelativelysimpleone,sincetheRsquaredofthe
regressionmeasurestheproportionoftheriskthatismarketrisk.
TotalBeta=MarketBeta/Correlationofthesectorwiththemarket
IntheBookscapeexample,wherethemarketbetais0.82andthe
averageRsquaredofthecomparablepubliclytradedfirmsis16%,
MarketBeta
Rsquared
0.82
.16
= 2.06
TotalCostofEquity=4%+2.06(4.82%)=13.93%
87
Baseduponthebusinessorbusinessesthatyourfirmisinrightnow,
anditscurrentfinancialleverage,estimatethebottomupunlevered
betaforyourfirm.
DataSource:Youcangetalistingofunleveredbetasbyindustryon
mywebsitebygoingtoupdateddata.
88
Thecostofcapitalisacompositecosttothefirmofraisingfinancing
tofunditsprojects.
Inadditiontoequity,firmscanraisecapitalfromdebt
89
What is debt?
GeneralRule:Debtgenerallyhasthefollowingcharacteristics:
Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrol
ofthefirmtothepartytowhompaymentsaredue.
Asaconsequence,debtshouldinclude
Anyinterestbearingliability,whethershorttermorlongterm.
Anyleaseobligation,whetheroperatingorcapital.
90
Ifthefirmhasbondsoutstanding,andthebondsaretraded,theyield
tomaturityonalongterm,straight(nospecialfeatures)bondcanbe
usedastheinterestrate.
Ifthefirmisrated,usetheratingandatypicaldefaultspreadonbonds
withthatratingtoestimatethecostofdebt.
Ifthefirmisnotrated,
andithasrecentlyborrowedlongtermfromabank,usetheinterestrate
ontheborrowingor
estimateasyntheticratingforthecompany,andusethesyntheticratingto
arriveatadefaultspreadandacostofdebt
Thecostofdebthastobeestimatedinthesamecurrencyasthecostof
equityandthecashflowsinthevaluation.
91
Theratingforafirmcanbeestimatedusingthefinancial
characteristicsofthefirm.Initssimplestform,theratingcanbe
estimatedfromtheinterestcoverageratio
InterestCoverageRatio=EBIT/InterestExpenses
Forafirm,whichhasearningsbeforeinterestandtaxesof$3,500
millionandinterestexpensesof$700million
InterestCoverageRatio=3,500/700=5.00
In2003,Bookscapehadoperatingincomeof$2millionafterinterest
expensesof500,000.Theresultinginterestcoverageratiois4.00.
Interestcoverageratio=2,000,000/500,000=4.00
92
Rating
AAA
AA
A+
A
A
BBB
BB+
BB
B+
B
B
CCC
CC
C
D
Typicaldefaultspread
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
93
Ratingbasedoninterestcoverageratio=BBB
DefaultSpreadbaseduponrating=1.50%
Pretaxcostofdebt=RiskfreeRate+DefaultSpread=4%+1.50%=
5.50%
Aftertaxcostofdebt=Pretaxcostofdebt(1taxrate)=5.50%
(1.40)=3.30%
94
Forthethreepubliclytradedfirmsinoursample,wewillusethe
actualbondratingstoestimatethecostsofdebt:
S&PRating
Disney
BBB+
DeutscheBank AA
Aracruz
B+
RiskfreeRate
4%($)
4.05%(Eu)
4%($)
Default
Spread
1.25%
1.00%
3.25%
Costof
Debt
5.25%
5.05%
7.25%
Tax Aftertax
Rate CostofDebt
37.3% 3.29%
38% 3.13%
34% 4.79%
WecomputedthesyntheticratingsforDisneyandAracruzusingthe
interestcoverageratios:
Disney:Coverageratio=2,805/758=3.70
Syntheticrating=A
Aracruz:Coverageratio=888/339=2.62
Syntheticrating=BBB
Disneyssyntheticratingisclosetoitsactualrating.Aracruzhastwo
ratingsoneforitslocalcurrencyborrowingsofBBBandoneforits
dollarborrowingsofB+.
95
Baseduponyourfirmscurrentearningsbeforeinterestandtaxes,its
interestexpenses,estimate
Aninterestcoverageratioforyourfirm
Asyntheticratingforyourfirm(usetheinterestcoveragetable)
Apretaxcostofdebtforyourfirm
Anaftertaxcostofdebtforyourfirm
96
Theweightsusedinthecostofcapitalcomputationshouldbemarket
values.
Therearethreespeciousargumentsusedagainstmarketvalue
Book value is more reliable than market value because it is not as
volatile: While it is true that book value does not change as much as
marketvalue,thisismoreareflectionofweaknessthanstrength
Using book value rather than market value is a more conservative
approach to estimating debt ratios: For most companies, using book
valueswillyieldalowercostofcapitalthanusingmarketvalueweights.
Since accounting returns are computed based upon book value,
consistency requires the use of book value in computing cost of capital:
While it may seem consistent to use book values for both accounting
returnandcostofcapitalcalculations,itdoesnotmakeeconomicsense.
97
MarketValueofEquityshouldincludethefollowing
MarketValueofSharesoutstanding
MarketValueofWarrantsoutstanding
MarketValueofConversionOptioninConvertibleBonds
MarketValueofDebtismoredifficulttoestimatebecausefewfirms
haveonlypubliclytradeddebt.Therearetwosolutions:
Assumebookvalueofdebtisequaltomarketvalue
Estimatethemarketvalueofdebtfromthebookvalue
ForDisney,withbookvalueof13,100million,interestexpensesof$666
million,acurrentcostofborrowingof5.25%andanweightedaverage
maturityof11.53years.
(1
13,100
(1.0525)11.53
666
+
= $12, 915million
EstimatedMVofDisneyDebt=
.0525
(1.0525)11.53
98
Thedebtvalueofoperatingleasesisthepresentvalueofthelease
payments,ataratethatreflectstheirrisk.
Ingeneral,thisratewillbeclosetoorequaltotherateatwhichthe
companycanborrow.
99
100
Estimatethe
MarketvalueofequityatyourfirmandBookValueofequity
Marketvalueofdebtandbookvalueofdebt(Ifyoucannotfindthe
averagematurityofyourdebt,use3years):Remembertocapitalizethe
valueofoperatingleasesandaddthemontoboththebookvalueandthe
marketvalueofdebt.
Estimatethe
Weightsforequityanddebtbaseduponmarketvalue
Weightsforequityanddebtbaseduponbookvalue
101
Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=4%+1.25(4.82%)=10.00%
MarketValueofEquity=
$55.101Billion
Equity/(Debt+Equity)=
79%
Debt
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
102
Costof
Equity
MediaNetworks
10.10%
ParksandResorts
9.12%
StudioEntertainment 10.43%
ConsumerProducts 10.39%
Disney
10.00%
Aftertax
costofdebt
3.29%
3.29%
3.29%
3.29%
3.29%
E/(D+E)
D/(D+E)
Costofcapital
78.98%
78.98%
78.98%
78.98%
78.98%
21.02%
21.02%
21.02%
21.02%
21.02%
8.67%
7.90%
8.93%
8.89%
8.59%
103
Usingthebottomupunleveredbetathatyoucomputedforyourfirm,
andthevaluesofdebtandequityyouhaveestimatedforyourfirm,
estimateabottomupleveredbetaandcostofequityforyourfirm.
Baseduponthecostsofequityanddebtthatyouhaveestimated,and
theweightsforeach,estimatethecostofcapitalforyourfirm.
Howdifferentwouldyourcostofcapitalhavebeen,ifyouusedbook
valueweights?
104
Eitherthecostofequityorthecostofcapitalcanbeusedasahurdle
rate,dependinguponwhetherthereturnsmeasuredaretoequity
investorsortoallclaimholdersonthefirm(capital)
Ifreturnsaremeasuredtoequityinvestors,theappropriatehurdlerate
isthecostofequity.
Ifreturnsaremeasuredtocapital(orthefirm),theappropriatehurdle
rateisthecostofcapital.
105
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedand
thetimingofthesecashflows;theyshouldalsoconsiderbothpositiveand
negativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
106
Showmethemoney
JerryMaguire
107
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflows
generatedandthetimingofthesecashflows;theyshouldalso
considerbothpositiveandnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
108
PrinciplesGoverningAccountingEarningsMeasurement
AccrualAccounting:Showrevenueswhenproductsandservicesaresold
orprovided,notwhentheyarepaidfor.Showexpensesassociatedwith
theserevenuesratherthancashexpenses.
OperatingversusCapitalExpenditures:Onlyexpensesassociatedwith
creatingrevenuesinthecurrentperiodshouldbetreatedasoperating
expenses.Expensesthatcreatebenefitsoverseveralperiodsarewritten
offovermultipleperiods(asdepreciationoramortization)
Togetfromaccountingearningstocashflows:
youhavetoaddbacknoncashexpenses(likedepreciation)
youhavetosubtractoutcashoutflowswhicharenotexpensed(suchas
capitalexpenditures)
youhavetomakeaccrualrevenuesandexpensesintocashrevenuesand
expenses(byconsideringchangesinworkingcapital).
109
Usecashflowsratherthanearnings.Youcannotspendearnings.
Useincrementalcashflowsrelatingtotheinvestmentdecision,i.e.,
cashflowsthatoccurasaconsequenceofthedecision,ratherthantotal
cashflows.
Usetimeweightedreturns,i.e.,valuecashflowsthatoccurearlier
morethancashflowsthatoccurlater.
TheReturnMantra:Timeweighted,IncrementalCashFlow
Return
110
ThethemeparkstobebuiltnearBangkok,modeledonEuroDisneyin
Paris,willincludeaMagicKingdomtobeconstructed,beginning
immediately,andbecomingoperationalatthebeginningofthesecond
year,andasecondthemeparkmodeledonEpcotCenteratOrlandoto
beconstructedinthesecondandthirdyearandbecomingoperational
atthebeginningofthefifthyear.
TheearningsandcashflowsareestimatedinnominalU.S.Dollars.
111
Earnings on Project
MagicKing d om
Seco n d The m e Pa rk
Resort&Prop e rties
TotalRevenues
Magic Kingdom:Operating
Expenses
EpcotII:Operating
Expenses
Resort&Prop e rty:
OperatingExpenses
Depreciation&Amortization
AllocatedG&ACosts
OperatingIncome
Taxes
OperatingIncom
e aft e r
Taxes
Now(0)1
$0
$0
$0
$0
2
3
4
5
6
7
8
9
10
$1,0 0 0 $1,4 0 0 $1,7 0 0 $2,0 0 0 $2,2 0 0 $2,4 2 0 $2,6 6 2 $2,9 2 8 $2,9 8 7
$0
$0
$300 $500 $550 $605 $666 $732 $747
$250 $350 $500 $625 $688 $756 $832 $915 $933
$1,2 5 0 $1,7 5 0 $2,5 0 0 $3,1 2 5 $3,4 3 8 $3,7 8 1 $4,1 5 9 $4,5 7 5 $4,6 6 7
$0
$0
$0
$0
$0
$0
$0
$0
$188
$537
$188
$262
$98
$263
$508
$263
$123
$46
$375
$430
$375
$120
$45
$164 $77
$75
$469
$359
$469
$329
$1 23
$516
$357
$516
$399
$149
$567
$358
$567
$473
$177
$624
$361
$624
$554
$206
$6 86
$366
$686
$641
$239
$700
$369
$700
$657
$245
112
Year
1
2
3
4
5
6
7
8
9
10
After -tax
Operating
Income
$0
-$165
-$77
$75
$206
$251
$297
$347
$402
$412
$175
BV of
Capital:
Beginning
$2,500
$3,500
$4,294
$4,616
$4,524
$4,484
$4,464
$4,481
$4,518
$4,575
BV of
Capital:
Ending
$3,500
$4,294
$4,616
$4,524
$4,484
$4,464
$4,481
$4,518
$4,575
$4,617
Ave rage BV
of Capital
$3,000
$3,897
$4,455
$4,570
$4,504
$4,474
$4,472
$4,499
$4,547
$4,596
$4,301
ROC
NA
-4.22%
-1.73%
1.65%
4.58%
5.60%
6.64%
7.72%
8.83%
8.97%
4.23%
113
Theexchangerateriskshouldbediversifiablerisk(andhenceshould
notcommandapremium)if
thecompanyhasprojectsisalargenumberofcountries(or)
theinvestorsinthecompanyaregloballydiversified.
ForDisney,thisriskshouldnotaffectthecostofcapitalused.Consequently,
wewouldnotadjustthecostofcapitalforDisneysinvestmentsinother
maturemarkets(Germany,UK,France)
Thesamediversificationargumentcanalsobeappliedagainstpolitical
risk,whichwouldmeanthatittooshouldnotaffectthediscountrate.
Itmay,however,affectthecashflows,byreducingtheexpectedlife
orcashflowsontheproject.
ForDisney,thisistheriskthatweareincorporatingintothecostof
capitalwhenitinvestsinThailand(oranyotheremergingmarket)
114
Wedidestimateacostofequityof9.12%fortheDisneythemepark
businessinthelastchapter,usingabottomupleveredbetaof1.0625
forthebusiness.
This cost of equity may not adequately reflect the additional risk
associatedwiththethemeparkbeinginanemergingmarket.
Tocounterthisrisk,wecomputethecostofequityforthethemepark
using a risk premium that includes a country risk premium for
Thailand:
The rating for Thailand is Baa1 and the default spread for the country bond
is 1.50%. Multiplying this by the relative volatility of 2.2 of the equity
market in Thailand (strandard deviation of equity/standard devaiation of
country bond) yields a country risk premium of 3.3%.
CostofEquityinUS$=4%+1.0625(4.82%+3.30%)=12.63%
CostofCapitalinUS$=12.63%(.7898)+3.29%(.2102)=10.66%
115
Donotinvestinthispark.Thereturnoncapitalof4.23%islower
thanthecostofcapitalforthemeparksof10.66%;Thiswould
suggestthattheprojectshouldnotbetaken.
Giventhatwehavecomputedtheaverageoveranarbitraryperiodof
10years,whilethethemeparkitselfwouldhavealifegreaterthan10
years,wouldyoufeelcomfortablewiththisconclusion?
a) Yes
b) No
116
Justasacomparisonofprojectreturnoncapitaltothecostofcapital
yieldsameasureofwhethertheprojectisacceptable,acomparison
canbemadeatthefirmlevel,tojudgewhethertheexistingprojectsof
thefirmareaddingordestroyingvalue.
Disney,in2003,hadearningsbeforeinterestandtaxesof$2,713
million,hadabookvalueofequityof$23,879millionandabook
valueofdebtof14,130million.Withataxrateof37.3%,weget
ReturnonCapital=2713(1.373)/(23879+14130)=4.48%
CostofCapitalforDisney=8.59%
ExcessReturn=4.48%8.59%=4.11%
Thiscanbeconvertedintoadollarfigurebymultiplyingbythecapital
invested,inwhichcaseitiscalledeconomicvalueadded
EVA=(..0448.0859)(23879+14130)=$1,562million
117
Forthemostrecentperiodforwhichyouhavedata,computethe
returnspreadearnedbyyourfirm:
ReturnSpread=AftertaxROCCostofCapital
Forthemostrecentperiod,computetheEVAearnedbyyourfirm
EVA=ReturnSpread*((BVofdebt+BVofEquity) previousyear
118
2
-$165
$537
$1,269
$63
-$960
3
-$77
$508
$805
$25
-$399
4
$75
$430
$301
$38
$166
5
$206
$359
$287
$31
$247
6
$251
$357
$321
$16
$271
Togetfromincometocashflow,we
addedbackallnoncashchargessuchasdepreciation
subtractedoutthecapitalexpenditures
subtractedoutthechangeinnoncashworkingcapital
119
OperatingIncomeafterTaxes
Now(0)
$2,500 $1,000 $1,269 $805 $301 $287 $321 $358 $379 $403 $406
$0
+ Non
-incrementa
l Allocated
Expense
(1-t)
+ Sun
k Costs
Cashflow to Firm
2
3
4
5
6
7
8
9
10
-$165 -$77 $75 $206 $251 $297 $347 $402 $412
$0
$63
$25
$5
$0
$78
500
-$2,000 -$1,000 -$880 -$289 $324 $443 $486 $517 $571 $631 $663
2/3rdofallocatedG&Aisfixed.
Addbackthisamount(1t)
Togetfromcashflowtoincrementalcashflows,we
Takenoutofthesunkcostsfromtheinitialinvestment
Addedbackthenonincrementalallocatedcosts(inaftertaxterms)
120
Incrementalcashflowsintheearlieryearsareworthmorethan
incrementalcashflowsinlateryears.
Infact,cashflowsacrosstimecannotbeaddedup.Theyhavetobe
broughttothesamepointintimebeforeaggregation.
Thisprocessofmovingcashflowsthroughtimeis
discounting,whenfuturecashflowsarebroughttothepresent
compounding,whenpresentcashflowsaretakentothefuture
Thediscountingandcompoundingisdoneatadiscountratethatwill
reflect
Expectedinflation:HigherInflation>HigherDiscountRates
Expectedrealrate:Higherrealrate>HigherDiscountrate
Expecteduncertainty:Higheruncertainty>HigherDiscountRate
121
3.GrowingAnnuity
DiscountingFormula
CFn/(1+r)n
CompoundingFormula
CF (1+r)n
0
1
n
(1+ r)
A
(1 + g)n
1
(1 + r)n
A(1 + g)
r g
(1
+ r) 1
A
4.Perpetuity
A/r
5.GrowingPerpetuity ExpectedCashflownextyear/(rg)
122
NetPresentValue(NPV):Thenetpresentvalueisthesumofthe
presentvaluesofallcashflowsfromtheproject(includinginitial
investment).
NPV=Sumofthepresentvaluesofallcashflowsontheproject,including
theinitialinvestment,withthecashflowsbeingdiscountedatthe
appropriatehurdlerate(costofcapital,ifcashflowiscashflowtothe
firm,andcostofequity,ifcashflowistoequityinvestors)
DecisionRule:AcceptifNPV>0
InternalRateofReturn(IRR):Theinternalrateofreturnisthe
discountratethatsetsthenetpresentvalueequaltozero.Itisthe
percentagerateofreturn,baseduponincrementaltimeweightedcash
flows.
DecisionRule:AcceptifIRR>hurdlerate
123
Inaprojectwithafiniteandshortlife,youwouldneedtocomputea
salvagevalue,whichistheexpectedproceedsfromsellingallofthe
investmentintheprojectattheendoftheprojectlife.Itisusuallyset
equaltobookvalueoffixedassetsandworkingcapital
Inaprojectwithaninfiniteorverylonglife,wecomputecashflows
forareasonableperiod,andthencomputeaterminalvalueforthis
project,whichisthepresentvalueofallcashflowsthatoccurafterthe
estimationperiodends..
Assumingtheprojectlastsforever,andthatcashflowsafteryear9
grow2%(theinflationrate)forever,thepresentvalueattheendof
year10ofcashflowsafterthatcanbewrittenas:
TerminalValueinyear10=CFinyear11/(CostofCapitalGrowthRate)
=663(1.02)/(.1066.02)=$7,810million
124
Annual
Cashflo w
-$2,000
-$1,000
-$880
-$289
$324
$443
$486
$517
$571
$631
$663
Terminal
Value
$7,810
Present
Value
-$2,000
-$904
-$719
-$213
$216
$267
$265
$254
$254
$254
$3,076
$749
125
Theprojectshouldbeaccepted.Thepositivenetpresentvalue
suggeststhattheprojectwilladdvaluetothefirm,andearnareturnin
excessofthecostofcapital.
Bytakingtheproject,Disneywillincreaseitsvalueasafirmby$749
million.
126
$3,000.00
$2,000.00
InternalRateofReturn
$1,000.00
NPV
$0.00
8%
9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
$1,000.00
$2,000.00
$3,000.00
DiscountRate
127
Theprojectisagoodone.Usingtimeweighted,incrementalcash
flows,thisprojectprovidesareturnof11.97%.Thisisgreaterthanthe
costofcapitalof10.66%.
TheIRRandtheNPVwillyieldsimilarresultsmostofthetime,
thoughtherearedifferencesbetweenthetwoapproachesthatmay
causeprojectrankingstovarydependingupontheapproachused.
128
Theanalysiswasdoneindollars.Wouldtheconclusionshavebeen
anydifferentifwehaddonetheanalysisinThaiBaht?
a) Yes
b) No
129
Bt/$inyear1=42.09(1.10/1.02)=45.39
Year
0
1
2
3
4
5
6
7
8
9
10
Cashflow ($)
-2000
-1000
-880
-289
324
443
486
517
571
631
8474
Bt/$
42.09
45.39
48.95
52.79
56.93
61.40
66.21
71.40
77.01
83.04
89.56
NPV=31,542Bt/42.09Bt=$749Million
NPVisequaltoNPVindollarterms
130
Ourconclusionsonaprojectareclearlyconditionedonalargenumber
ofassumptionsaboutrevenues,costsandothervariablesoververy
longtimeperiods.
Tothedegreethattheseassumptionsarewrong,ourconclusionscan
alsobewrong.
Onewaytogainconfidenceintheconclusionsistochecktoseehow
sensitivethedecisionmeasure(NPV,IRR..)istochangesinkey
assumptions.
131
Mostprojectsconsideredbyanybusinesscreatesidecostsand
benefitsforthatbusiness.
Thesidecostsincludethecostscreatedbytheuseofresourcesthatthe
businessalreadyowns(opportunitycosts)andlostrevenuesforother
projectsthatthefirmmayhave.
Thebenefitsthatmaynotbecapturedinthetraditionalcapital
budgetinganalysisincludeprojectsynergies(wherecashflowbenefits
mayaccruetootherprojects)andoptionsembeddedinprojects
(includingtheoptionstodelay,expandorabandonaproject).
Thereturnsonaprojectshouldincorporatethesecostsandbenefits.
132
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflows
generatedandthetimingofthesecashflows;theyshouldalso
considerbothpositiveandnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
133
134
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
135
Growthstage
Stage2
Time
Stage1
Stage4
Stage5
External
OwnersEquity
Earnings
Revenues
VentureCapital
Retiredebt
Debt
Externalfunding
High,but
High,relative
Moderate,relative
Declining,asa
Low,asprojectsdry
Internalfinancing
Commonstock
Stage3
Low,relativeto
High,relativeto
Financing
Bondissues
Seasonedequityissue
InitalPublicoffering
Accessingprivateequity
Morethanfundingneeds
$Revenues/
Negativeor
FinancingChoicesacrossthelifecycle
RapidExpansion
Startup
MatureGrowth
Decline
Financing
BankDebt
CommonStock
Repurchasestock
needs
constrainedby
tofirmvalue.
percentoffirm
up.
Warrants
HighGrowth
low
fundingneeds
Transitions
Earnings
136
Thesimplestmeasureofhowmuchdebtandequityafirmisusing
currentlyistolookattheproportionofdebtinthetotalfinancing.This
ratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswellaslong
term.
Equitycanbedefinedeitherinaccountingterms(asbookvalueof
equity)orinmarketvalueterms(baseduponthecurrentprice).The
resultingdebtratioscanbeverydifferent.
137
DisadvantagesofBorrowing
1.TaxBenefit:
1.BankruptcyCost:
Highertaxrates>Highertaxbenefit
Higherbusinessrisk>HigherCost
2.AddedDiscipline:
2.AgencyCost:
Greatertheseparationbetweenmanagers
Greatertheseparationbetweenstock
andstockholders>Greaterthebenefit
holders&lenders>HigherCost
3.LossofFutureFinancingFlexibility:
Greatertheuncertaintyaboutfuture
financingneeds>HigherCost
138
A Hypothetical Scenario
Assumeyouoperateinanenvironment,where
(a)therearenotaxes
(b)thereisnoseparationbetweenstockholdersandmanagers.
(c)thereisnodefaultrisk
(d)thereisnoseparationbetweenstockholdersandbondholders
(e)firmsknowtheirfuturefinancingneeds
139
Inanenvironment,wheretherearenotaxes,defaultriskoragency
costs,capitalstructureisirrelevant.
Thevalueofafirmisindependentofitsdebtratio.
140
Implications of MM Theorem
Leverageisirrelevant.Afirm'svaluewillbedeterminedbyitsproject
cashflows.
Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm
increasesitsleverage,thecostofequitywillincreasejustenoughto
offsetanygainstotheleverage
141
TheCostofCapitalApproach:Theoptimaldebtratioistheonethat
minimizesthecostofcapitalforafirm.
TheSectorApproach:Theoptimaldebtratioistheonethatbringsthe
firmclosestoitspeergroupintermsoffinancingmix.
142
ValueofaFirm=PresentValueofCashFlowstotheFirm,
discountedbackatthecostofcapital.
Ifthecashflowstothefirmareheldconstant,andthecostofcapitalis
minimized,thevalueofthefirmwillbemaximized.
143
ke
kd
AftertaxCostofDebt WACC
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%
144
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
11.40%
11.20%
11.00%
10.80%
10.60%
10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
0
WACC
WeightedAverageCostofCapitalandDebtRatios
DebtRatio
145
Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=4%+1.25(4.82%)=10.00%
MarketValueofEquity=
$55.101Billion
Equity/(Debt+Equity)=
79%
Debt
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
146
2.EstimatetheCostofDebtatdifferentlevelsofdebt:
Defaultriskwillgoupandbondratingswillgodownasdebtgoesup>Cost
ofDebtwillincrease.
Toestimatingbondratings,wewillusetheinterestcoverageratio
(EBIT/Interestexpense)
3.EstimatetheCostofCapitalatdifferentlevelsofdebt
4.CalculatetheeffectonFirmValueandStockPrice.
147
148
EBITDA
$3,882
$3,882
Sameas0%debt
Depreciation
$1,077
$1,077
Sameas0%debt
EBIT
$2,805
$2,805
Sameas0%debt
Interest
$0
$303
Pretaxcostofdebt*$Debt
PretaxInt.cov
9.24
EBIT/InterestExpenses
LikelyRating
AAA
AAA
FromRatingstable
Pretaxcostofdebt
4.35%
4.35%
RisklessRate+Spread
149
Typical de fault
spread
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
150
0.00%
10.00%
D/E
$Debt
EBITDA
Depreciation
EBIT
Interest
PretaxInt.cov
LikelyRating
Costofdebt
0.00%
$0
$3,882
$1,077
$2,805
$0
AAA
4.35%
11.11%
$6,977
25.00%
$13,954
$3,882
$1,077
$2,805
$303
$3,882
$1,077
$2,805
$606 .0485*13954=676
9.24
AAA
4.35%
4.62
2805/676=4.15
A
A
4.85% 5.00%
151
Interest
Interest Coverage
Debt expense Ratio
$0
$0
$6,977 $303
9.24
$13,954 $698
4.02
$20,931 $1,256
2.23
$27,908 $3,349
0.84
$34,885 $5,582
0.50
$41,861 $6,698
0.42
$48,838 $7,814
0.36
$55,815 $8,930
0.31
$62,792 $10,047
0.28
Interest
Bond rate on
debt
Rating
AAA
4.35%
AAA
4.35%
A5.00%
BB+
6.00%
CCC
12.00%
C
16.00%
C
16.00%
C
16.00%
C
16.00%
C
16.00%
Cost of
Tax
Debt
Rate (after -tax)
37.30% 2.73%
37.30% 2.73%
37.30% 3.14%
37.30% 3.76%
31.24% 8.25%
18.75% 13.00%
15.62% 13.50%
13.39% 13.86%
11.72% 14.13%
10.41% 14.33%
152
Youneedtaxableincomeforinteresttoprovideataxsavings
IntheDisneycase,considertheinterestexpenseat30%and40%
30%DebtRatio
40%DebtRatio
EBIT
$2,805m
$2,805m
InterestExpense
$1,256m
$3,349m
TaxSavings
$1,256*.373=468 2,805*.373=$1,046
TaxRate
37.30%
1,046/3,349=31.2%
Pretaxinterestrate
6.00%
12.00%
AftertaxInterestRate 3.76%
8.25%
Youcandeductonly$2,805millionofthe$3,349millionofthe
interestexpenseat40%.Therefore,only37.3%of$2,805millionis
consideredasthetaxsavings.
153
CostofEquity
9.15%
9.50%
9.95%
10.53%
11.50%
13.33%
15.66%
19.54%
27.31%
50.63%
CostofDebt(aftertax)
2.73%
2.73%
3.14%
3.76%
8.25%
13.00%
13.50%
13.86%
14.13%
14.33%
CostofCapital
9.15%
8.83%
8.59%
8.50%
10.20%
13.16%
14.36%
15.56%
16.76%
17.96%
154
20.00%
18.00%
50.00%
16.00%
14.00%
40.00%
Costofequity
climbsas
leveredbeta
increases
OptimalDebtratioisatthispoint
12.00%
30.00%
10.00%
8.00%
Costsofdebtandequity
20.00%
CostofCapital
6.00%
4.00%
10.00%
Aftertaxcostofdebtincreasesas
interestcoverageratiodeteriorates
andwithitthesyntheticrating.
0.00%
2.00%
0.00%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
DebtRatio
CostofEquity
AftertaxCostofDebt
CostofCapital
155
FirmValuebeforethechange=55,101+14,668=$69,769
WACCb=8.59%
WACCa=8.50%
WACC=0.09%
AnnualCost=$69,769*8.59%=$5,993million
AnnualCost=$69,769*8.50%=$5,930million
ChangeinAnnualCost
=$63million
Ifthereisnogrowthinthefirmvalue,(ConservativeEstimate)
Increaseinfirmvalue=$63/.0850=$741million
ChangeinStockPrice=$741/2047.6=$0.36pershare
Ifweassumeaperpetualgrowthof4%infirmvalueovertime,
Increaseinfirmvalue=$63/(.0850.04)=$1,400million
ChangeinStockPrice=$1,400/2,047.6=$0.68pershare
ImpliedGrowthRateobtainedby
FirmvalueToday=FCFF(1+g)/(WACCg):Perpetualgrowthformula
$69,769=$1,722(1+g)/(.0859g):Solveforg>Impliedgrowth=5.98%
156
LetussupposethattheCFOofDisneyapproachedyouaboutbuying
backstock.Hewantstoknowthemaximumpricethatheshouldbe
willingtopayonthestockbuyback.(Thecurrentpriceis$26.91)
Assumingthatfirmvaluewillgrowby4%ayear,estimatethe
maximumprice.
Whatwouldhappentothestockpriceafterthebuybackifyouwere
abletobuystockbackat$26.91?
157
DoingWhatifanalysisonOperatingIncome
A.StandardDeviationApproach
StandardDeviationInPastOperatingIncome
StandardDeviationInEarnings(IfOperatingIncomeIsUnavailable)
ReduceBaseCaseByOneStandardDeviation(OrMore)
B.PastRecessionApproach
LookAtWhatHappenedToOperatingIncomeDuringTheLastRecession.
(HowMuchDidItDropIn%Terms?)
ReduceCurrentOperatingIncomeBySameMagnitude
ConstraintonBondRatings
158
EBIT
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
756
848
1177
1368
1124
1287
1560
1804
2262
3024
3945
3843
3580
2525
2832
2384
2713
% Change
in EBIT
12.17%
38.80%
16.23%
-17.84%
14.50%
21.21%
15.64%
25.39%
33.69%
30.46%
-2.59%
-6.84%
-29.47%
12.16%
-15.82%
13.80%
159
DeclineinOperatingIncome
Dropof15.82%
Dropof22.00%
Increased
Dropof29.47%
Thestandarddeviationinpastoperatingincomeisabout20%.
160
EBIT
OptimalDebtRatio
0%
$2,805
30%
5%
$2,665
20%
10%
$2,524
20%
15%
$2385
20%
20%
$2,245
20%
161
Constraints on Ratings
Managementoftenspecifiesa'desiredRating'belowwhichtheydo
notwanttofall.
Theratingconstraintisdrivenbythreefactors
itisonewayofprotectingagainstdownsideriskinoperatingincome(so
donotdoboth)
adropinratingsmightaffectoperatingincome
thereisanegofactorassociatedwithhighratings
Caveat:EveryRatingConstraintHasACost.
ProvideManagementWithAClearEstimateOfHowMuchTheRating
ConstraintCostsByCalculatingTheValueOfTheFirmWithoutThe
RatingConstraintAndComparingToTheValueOfTheFirmWithThe
RatingConstraint.
162
163
Rating
AAA
AAA
A
BB+
CCC
C
C
C
C
C
FirmValue
$62,279
$66,397
$69,837
$71,239
$51,661
$34,969
$30,920
$27,711
$25,105
$22,948
164
Theoptimaldebtratioisultimatelyafunctionoftheunderlying
riskinessofthebusinessinwhichyouoperateandyourtaxrate.
Willtheoptimalbedifferentifyouinvestedinprojectsinsteadof
buyingbackstock?
No.Aslongastheprojectsfinancedareinthesamebusinessmixthatthe
companyhasalwaysbeeninandyourtaxratedoesnotchange
significantly.
Yes,iftheprojectsareinentirelydifferenttypesofbusinessesorifthetax
rateissignificantlydifferent.
165
Theinterestcoverageratios/ratingsrelationshipislikelytobedifferent
forfinancialservicefirms.
Thedefinitionofdebtismessyforfinancialservicefirms.Ingeneral,
usingalldebtforafinancialservicefirmwillleadtohighdebtratios.
Useonlyinterestbearinglongtermdebtincalculatingdebtratios.
Theeffectofratingsdropswillbemuchmorenegativeforfinancial
servicefirms.
Therearelikelytoregulatoryconstraintsoncapital
166
167
Debt
Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Beta
0.44
0.47
0.50
0.55
0.62
0.71
0.84
1.07
1.61
3.29
Costof
Equity
6.15%
6.29%
6.48%
6.71%
7.02%
7.45%
8.10%
9.19%
11.83%
19.91%
Bond
Interest
Tax CostofDebt
Firm
Rating rateondebt Rate (aftertax) WACC Value(G)
AAA
4.75% 38.00% 2.95%
6.15% $111,034
AAA
4.75% 38.00% 2.95%
5.96% $115,498
AAA
4.75% 38.00% 2.95%
5.77% $120,336
AAA
4.75% 38.00% 2.95%
5.58% $125,597
AAA
4.75% 38.00% 2.95%
5.39% $131,339
A+
5.30% 38.00% 3.29%
5.37% $118,770
A
5.45% 38.00% 3.38%
5.27% $114,958
A
5.45% 38.00% 3.38%
5.12% $119,293
BB+
8.30% 32.43% 5.61%
6.85% $77,750
BB
8.80% 27.19% 6.41%
7.76% $66,966
168
FirmSpecificFactors
1.TaxRate
Highertaxrates
>HigherOptimalDebtRatio
Lowertaxrates
>LowerOptimalDebtRatio
2.PreTaxCFonFirm=EBITDA/MVofFirm
HigherPretaxCF >HigherOptimalDebtRatio
LowerPretaxCF >LowerOptimalDebtRatio
3.VarianceinEarnings[Showsupwhenyoudo'whatif'analysis]
HigherVariance >LowerOptimalDebtRatio
LowerVariance
>HigherOptimalDebtRatio
MacroEconomicFactors
1.DefaultSpreads
Higher
Lower
>LowerOptimalDebtRatio
>HigherOptimalDebtRatio
169
Usingtheoptimalcapitalstructurespreadsheetprovided:
Estimatetheoptimaldebtratioforyourfirm
Estimatethenewcostofcapitalattheoptimal
Estimatetheeffectofthechangeinthecostofcapitalonfirmvalue
Estimatetheeffectonthestockprice
Intermsofthemechanics,whatwouldyouneedtodotogettothe
optimalimmediately?
170
Highertaxrates>Higherdebtratios(Taxbenefits)
Lowerinsiderownership>Higherdebtratios(Greaterdiscipline)
Morestableincome>Higherdebtratios(Lowerbankruptcycosts)
Moreintangibleassets>Lowerdebtratios(Moreagencyproblems)
171
PaperandPulp(Emerging
Market)
27.71%
49.00%
172
No
Yes
No
Take good projects with
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
No
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital
Yes
Take good projects with
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
173
No
Yes
No
Take good projects with
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
No
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital
Yes
Take good projects with
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
174
Baseduponyouranalysisofboththefirmscapitalstructureand
investmentrecord,whatpathwouldyoumapoutforthefirm?
Immediatechangeinleverage
Gradualchangeinleverage
Nochangeinleverage
Wouldyourecommendthatthefirmchangeitsfinancingmixby
Payingoffdebt/Buyingbackequity
Takeprojectswithequity/debt
175
Theobjectiveindesigningdebtistomakethecashflowsondebt
matchupascloselyaspossiblewiththecashflowsthatthefirm
makesonitsassets.
Bydoingso,wereduceourriskofdefault,increasedebtcapacityand
increasefirmvalue.
176
Theperfectfinancinginstrumentwill
Haveallofthetaxadvantagesofdebt
Whilepreservingtheflexibilityofferedbyequity
CommodityBonds
EffectofInflation
Duration
Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced
Cyclicality&
GrowthPatterns
DefineDebt
Duration/
Currency
Fixedvs.FloatingRate
Straightversus
SpecialFeatures
Startwiththe
UncertaintyaboutFuture
OtherEffects
Characteristics
Maturity
Mix
*Morefloatingrate
Convertible
onDebt
CashFlows
CatastropheNotes
ifCFmovewith
Convertibleif
Optionstomake
onAssets/
inflation
cashflowslow
cashflowsondebt
Projects
withgreateruncertainty
nowbuthigh
matchcashflows
onfuture
exp.growth
onassets
177
Allofthisdesignworkislost,however,ifthesecuritythatyouhave
designeddoesnotdeliverthetaxbenefits.
Inaddition,theremaybeatradeoffbetweenmismatchingdebtand
gettinggreatertaxbenefits.
Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
Overlaytax
ZeroCoupons
Deductibilityofcashflows
Differencesintaxrates
preferences
fortaxpurposes
acrossdifferentlocales
178
Ratingsagencieswantcompaniestoissueequity,sinceitmakesthem
safer.Equityresearchanalystswantthemnottoissueequitybecauseit
dilutesearningspershare.Regulatoryauthoritieswanttoensurethat
youmeettheirrequirementsintermsofcapitalratios(usuallybook
value).Financingthatleavesallthreegroupshappyisnirvana.
Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?
OperatingLeases
Consider
AnalystConcerns
RatingsAgency
RegulatoryConcerns
MIPs
ratingsagency
EffectonEPS
EffectonRatios
Measuresused
SurplusNotes
&analystconcerns
Valuerelativetocomparables
Ratiosrelativetocomparables
179
Trustpreferredstockhas
Afixeddividendpayment,specifiedatthetimeoftheissue
Thatistaxdeductible
Andfailingtomakethepaymentcancause?(Canitcausedefault?)
Whentrustpreferredwasfirstcreated,ratingsagenciestreateditas
equity.Astheyhavebecomemoresavvy,ratingsagencieshave
startedgivingfirmsonlypartialequitycreditfortrustpreferred.
180
Assumingthattrustpreferredstockgetstreatedasequitybyratings
agencies,whichofthefollowingfirmsisthemostappropriatefirmto
beissuingit?
Afirmthatisunderlevered,buthasaratingconstraintthatwouldbe
violatedifitmovedtoitsoptimal
Afirmthatisoverleveredthatisunabletoissuedebtbecauseofthe
ratingagencyconcerns.
181
Therearesomefirmsthatfaceskepticismfrombondholderswhen
theygoouttoraisedebt,because
Oftheirpasthistoryofdefaultsorotheractions
Theyaresmallfirmswithoutanyborrowinghistory
Bondholderstendtodemandmuchhigherinterestratesfromthese
firmstoreflecttheseconcerns.
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds
Convertibiles
Factorinagency
ObservabilityofCashFlows
TypeofAssetsfinanced
ExistingDebtcovenants
PuttableBonds
conflictsbetweenstock
byLenders
Tangibleandliquidassets
RestrictionsonFinancing
RatingSensitive
andbondholders
Lessobservablecashflows
createlessagencyproblems
leadtomoreconflicts
Notes
LYONs
182
Ratingsagenciescansometimesunderrateafirm,andmarketscan
underpriceafirmsstockorbonds.Ifthisoccurs,firmsshouldnot
lockinthesemistakesbyissuingsecuritiesforthelongterm.In
particular,
Issuingequityorequitybasedproducts(includingconvertibles),when
equityisunderpricedtransferswealthfromexistingstockholderstothe
newstockholders
Issuinglongtermdebtwhenafirmisunderratedlocksinratesatlevels
thatarefartoohigh,giventhefirmsdefaultrisk.
Whatisthesolution
Ifyouneedtouseequity?
Ifyouneedtousedebt?
183
CashFlows
onAssets/
Projects
DefineDebt
Characteristics
Duration
Currency
EffectofInflation
UncertaintyaboutFuture
Duration/
Maturity
Currency
Mix
Fixedvs.FloatingRate
*Morefloatingrate
ifCFmovewith
inflation
withgreateruncertainty
onfuture
Cyclicality&
OtherEffects
GrowthPatterns
Straightversus
Convertible
Convertibleif
cashflowslow
nowbuthigh
exp.growth
SpecialFeatures
onDebt
Optionstomake
cashflowsondebt
matchcashflows
onassets
CommodityBonds
CatastropheNotes
Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced
Overlaytax
preferences
Consider
ratingsagency
&analystconcerns
Deductibilityofcashflows
fortaxpurposes
Differencesintaxrates
acrossdifferentlocales
ZeroCoupons
Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
AnalystConcerns
EffectonEPS
Valuerelativetocomparables
RatingsAgency
EffectonRatios
Ratiosrelativetocomparables
RegulatoryConcerns
Measuresused
OperatingLeases
MIPs
SurplusNotes
Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?
Factorinagency
conflictsbetweenstock
andbondholders
ObservabilityofCashFlows
byLenders
Lessobservablecashflows
leadtomoreconflicts
TypeofAssetsfinanced
Tangibleandliquidassets
createlessagencyproblems
ExistingDebtcovenants
RestrictionsonFinancing
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds
ConsiderInformation
Asymmetries
UncertaintyaboutFutureCashflows
Whenthereismoreuncertainty,it
maybebettertouseshorttermdebt
Credibility&QualityoftheFirm
Firmswithcredibilityproblems
willissuemoreshorttermdebt
Convertibiles
PuttableBonds
RatingSensitive
Notes
LYONs
184
Broadcasting
ProjectCashFlowCharacteristics
Projectsarelikelyto
1. Be short term
2. Have cash outflows primaril
y in dollars (sinceDisneymakesmostof
its movies in theU.S.) but cashinflows could havea substantial
foreign currency component (becausef overseas
o
sales)
3. Have net cash flows thatear
heavily driven by whether the movie is a
hit, which is often difficul t to predict.
Projects are likel
y to be
1. Short term
2. Primarily in dollars, though foreign componentis growing
3. Driven by advertising revenuesandshowsuccess
TypeofFinancing
Debt should be
1. Short term
2. Primarily dollar debt.
3. If possible,tied to the success
of movies.(Lion King or
Nemo Bonds)
Debt should be
1. Short term
2. Primarily dollar debt
3. If possible,linked to network
ratings.
Theme Parks
Projects are likel
y to be
Debt should be
1. Very long term
1. Long term
2. Primarily in dollars, but a significant proportion of revenues come 2. Mix of currencies,basedupon
from foreign tourists, who are likely to stay away if the dollar
tourist make up.
strengthens
3. Affected by success of movie and
broadcast
ing divisions.
Consumer Products Projectsare likely to be shor
t to mediumterm and linked to the success ofDebt should be
the movie division. Most of Disneys product offerings are derived from a. Medium term
their movieproductions.
b. Dollar debt.
185
186
Itcanswapsomeofitsexistinglongterm,fixedrate,dollardebtwith
shorter term, floating rate, foreign currency debt. Given Disneys
standing in financial markets and its large market capitalization, this
shouldnotbedifficulttodo.
If Disney is planning new debt issues, either to get to a higher debt
ratio or to fund new investments, it can use primarily short term,
floating rate, foreign currency debt to fund these new investments.
While it may be mismatching the funding on these investments, its
debtmatchingwillbecomebetteratthecompanylevel.
187
188
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
189
190
191
50.00
40.00
30.00
Earnings
Dividends
20.00
10.00
0.00
192
$250,000.00
$200,000.00
$150,000.00
$100,000.00
$50,000.00
$
1988
1989
1990
1991
1992
1993
1994
1995
StockBuybacks
1996
1997
1998
1999
2000
2001
2002
Dividends
193
194
DividendPayout:
measuresthepercentageofearningsthatthecompanypaysindividends
=Dividends/Earnings
DividendYield
measuresthereturnthataninvestorcanmakefromdividendsalone
=Dividends/StockPrice
195
250
200
150
100
50
0
010%
1020%
2030%
3040%
4050%
5060%
6070%
7080%
8090%
90100%
>100%
196
100
80
60
40
20
0
0
02 0.4 0.6
0.2% 0.4% 0.6% 0.8%
0.8
1%
1
1.2 1.4 1.6
1.2% 1.4% 1.6% 1.8%
1.8
2%
2
2.2 2.4 2.6
2.2% 2.4% 2.6% 2.8%
2.8
3%
3
3.5%
3.5
4%
4
4.5%
4.5
5%
>5%
197
1.If
(a)therearenotaxdisadvantagesassociatedwithdividends
(b)companiescanissuestock,atnocost,toraiseequity,whenever
needed
Dividendsdonotmatter,anddividendpolicydoesnotaffectvalue.
2.Ifdividendshaveataxdisadvantage,
Dividendsarebad,andincreasingdividendswillreducevalue
3.Ifstockholderslikedividends,ordividendsoperateasasignaloffutureprospects,
Dividendsaregood,andincreasingdividendswillincreasevalue
198
Ifacompanyhasexcesscash,andfewgoodinvestmentopportunities
(NPV>0),returningmoneytostockholders(dividendsorstock
repurchases)isgood.
Ifacompanydoesnothaveexcesscash,and/orhasseveralgood
investmentopportunities(NPV>0),returningmoneytostockholders
(dividendsorstockrepurchases)isbad.
199
Approach1:TheCash/TrustNexus
Assesshowmuchcashafirmhasavailabletopayindividends,relative
whatitreturnstostockholders.Evaluatewhetheryoucantrustthe
managersofthecompanyascustodiansofyourcash.
Approach2:PeerGroupAnalysis
Pickadividendpolicyforyourcompanythatmakesitcomparableto
otherfirmsinitspeergroup.
200
Step1:Howmuchcouldthecompanyhavepaidoutduringtheperiod
underquestion?
Step2:Howmuchdidthethecompanyactuallypayoutduringthe
periodinquestion?
Step3:HowmuchdoItrustthemanagementofthiscompanywith
excesscash?
Howwelldidtheymakeinvestmentsduringtheperiodinquestion?
Howwellhasmystockperformedduringtheperiodinquestion?
201
TheFreeCashflowtoEquity(FCFE)isameasureofhowmuchcash
isleftinthebusinessafternonequityclaimholders(debtandpreferred
stock)havebeenpaid,andafteranyreinvestmentneededtosustain
thefirmsassetsandfuturegrowth.
NetIncome
+Depreciation&Amortization
=CashflowsfromOperationstoEquityInvestors
PreferredDividends
CapitalExpenditures
WorkingCapitalNeeds
PrincipalRepayments
+ProceedsfromNewDebtIssues
=FreeCashflowtoEquity
202
203
ConsiderthefollowinginputsforMicrosoftin1996.In1996,
MicrosoftsFCFEwas:
NetIncome=$2,176Million
CapitalExpenditures=$494Million
Depreciation=$480Million
ChangeinNonCashWorkingCapital=$35Million
DebtRatio=0%
FCFE= NetIncome(CapexDepr)(1DR)ChgWC(!DR)
= $2,176
(494480)(10)
= $2,127Million
$35(10)
204
Microsoft: Dividends?
Bythisestimation,Microsoftcouldhavepaid$2,127Millionin
dividends/stockbuybacksin1996.Theypaidnodividendsandbought
backnostock.Wherewillthe$2,127millionshowupinMicrosofts
balancesheet?
205
250
200
150
100
50
206
$9,000
$8,000
$2,500
$7,000
$2,000
$6,000
$1,500
$5,000
$1,000
$4,000
$3,000
$500
$2,000
$0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
($500)
$1,000
$0
= Free CF to Equity
= Cash to Stockholders
Cumulated Cash
207
Compareto
Dividends(Common)
+StockBuybacks
Ifcashflowstatementused
NetIncome
+Depreciation&Amortization
+CapitalExpenditures
+ChangesinNoncashWC
+PreferredDividend
+IncreaseinLTBorrowing
+DecreaseinLTBorrowing
+ChangeinSTBorrowing
=FCFE
CommonDividend
DecreaseinCapitalStock
+IncreaseinCapitalStock
208
Force managers to
justify holding cash
or return cash to
stockholders
Firm should
cut dividends
and reinvest
more
209
A Dividend Matrix
real out
setting
pay
any,
problem
to stockholders
dividend
more istoinpolicy
investment policy.
stockholders
as
dividends or stock
210
Net
Capital
Income Depreciation Expend
itures
$1,110.40 $1,608.30 $1,026.11
$1,380.10 $1,853.00
$896.50
$1,214.00 $3,944.00 $13,464.00
$1,966.00 $4,958.00 $1,922.00
$1,850.00 $3,323.00 $2,314.00
$1,300.00 $3,779.00 $2,134.00
$920.00 $2,195.00 $2,013.00
($158.00) $1,754.00 $1,795.00
$1,236.00 $1,042.00 $1,086.00
$1,267.00 $1,077.00 $1,049.00
$2,769.96
Changein
FCFE
FCFE
non-cash
(befor
e
Net CF
(after
WC
debtCF)
fromDebt DebtCF)
$654.10 $1,038.49 $551.10 $1,589.59
($270.70
)
$2,607.30 $14.20 $2,621.50
$617.00 ($8,923.00) $8,688.00 ($235.00)
($174.00) $5,176.00 ($1,641.00)$3,535.00
$939.00 $1,920.00 $618.00 $2,538.00
($363.00) $3,308.00 ($176.00) $3,132.00
($1,184.00) $2,286.00 ($2,118.00) $168.00
$244.00 ($443.00)
$77.00 ($366.00)
$27.00
$1,165.00 $1,892.00 $3,057.00
($264.00) $1,559.00 ($1,145.00) $414.00
$22.54
$969.38
$676.03 $1,645.41
211
Disney
Year
Dividends(in$)
EquityRepurchases(in
$)
CashtoEquity
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
$153
$180
$271
$342
$412
$0
$434
$438
$428
$429
$571
$349
$462
$633
$30
$19
$166
$1,073
$0
$0
$724
$529
$733
$975
$442
$19
$600
$1,511
$428
$429
Average
$308.70
$330.30
$639
212
Disneypaidout$330millionlessindividends(andstockbuybacks)
thanitcouldaffordtopayout(Dividendsandstockbuybackswere
$639million;FCFEbeforenetdebtissueswas$969million).How
muchcashdoyouthinkDisneyaccumulatedduringtheperiod?
213
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
20.00%
30.00%
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
214
GivenDisneystrackrecordoverthelast10years,ifyouwerea
Disneystockholder,wouldyoubecomfortablewithDisneysdividend
policy?
Yes
No
215
Disneycouldhaveaffordedtopaymoreindividendsduringthe
periodoftheanalysis.
Itchosenotto,andusedthecashforacquisitions(CapitalCities/ABC)
andillfatedexpansionplans(Go.com).
Whilethecompanymayhaveflexibilitytosetitsdividendpolicya
decadeago,itsactionsoverthatdecadehavefritteredawaythis
flexibility.
Bottomline:Largecashbalanceswillnotbetoleratedinthis
company.Expecttofacerelentlesspressuretopayoutmore
dividends.
216
Year
1998
1999
2000
2001
2002
2003
Net
Income
$3.45
$90.77
$201.71
$18.11
$111.91
$148.09
Average $95.67
Change in FCFE
Capital
non-cash (before net Net Debt
DepreciationExpenditures WC
Debt CF) Cashflow
$152.80
$88.31
$76.06
($8.11)
$174.27
$158.83
$56.47
$2.18
$190.95 ($604.48)
$167.96
$219.37
$12.30
$138.00 ($292.07)
$162.57
$421.49
($56.76) ($184.06) $318.24
$171.50
$260.70
($5.63)
$28.34
$36.35
$162.57
$421.49
($7.47)
($103.37) $531.20
$162.70
$244.64
$3.45
$10.29
$27.25
FCFE
(after net
Debt CF)
$166.16
($413.53)
($154.07)
$134.19
$64.69
$427.83
$37.54
217
Year
1998
1999
2000
2001
2002
2003
1998
2003
Net IncomeDividendsPayout Ra
tio
$3.45
$90.77
$201.71
$18.11
$111.91
$148.09
$574.04
$24.39
$18.20
$57.96
$63.17
$73.80
$109.31
$346.83
FCFE
Cash retur
nedto Cash Returned/FCFE
Stockholders
707.51% $166.16
$50.79
30.57%
20.05% ($413.53)
$18.20
NA
28.74% ($154.07)
$80.68
NA
348.87% $134.19
$63.17
47.08%
65.94%
$64.69
$75.98
117.45%
73.81%
$427.83
$112.31
26.25%
60.42%
$225.27
$401.12
178.07%
218
30.00%
20.00%
10.00%
0.00%
10.00%
20.00%
1998
1999
2000
ROE
2001
Returnonstock
2002
2003
19982003
CostofEquity
219
AssumethatyouarealargestockholderinAracruz.Theyhavebeen
payingmoreindividendsthantheyhaveavailableinFCFE.Their
projectchoicehasbeenacceptableandyourstockhasperformedwell
overtheperiod.Wouldyouacceptacutindividends?
Yes
No
220
Therearemanycountrieswherecompaniesaremandatedtopayouta
certainportionoftheirearningsasdividends.Givenourdiscussionof
FCFE,whattypesofcompanieswillbehurtthemostbytheselaws?
Largecompaniesmakinghugeprofits
Smallcompanieslosingmoney
Highgrowthcompaniesthatarelosingmoney
Highgrowthcompaniesthataremakingmoney
221
10
$712.00
$947.00
$1,256.00
$2,076.00
(Cap.ExpDepr)*(1DR) $1,499.00
$580.00
WorkingCapital*(1DR)
$369.50
($286.50)
$678.50
=FreeCFtoEquity
($612.50)
$631.50
$1,940.50 $1,022.00
Dividends
$831.00
$949.00
$1,079.00 $1,314.00
$1,391.00
$831.00
$949.00
$1,079.00 $1,314.00
$1,391.00
66.16%
58.36%
$82.00
($2,268.00) ($984.50)
$429.50
$1,047.50
($77.00)
($305.00) ($415.00)
($528.50)
$262.00
+EquityRepurchases
=CashtoStockholders
DividendRatios
PayoutRatio
CashPaidas%ofFCFE
135.67%
46.73%
119.67%
67.00%
91.64%
68.69%
64.32%
296.63%
177.93%
36.96%
101.06%
643.13%
PerformanceRatios
1.AccountingMeasure
ROE
9.58%
12.14%
19.82%
9.25%
12.43%
15.60%
21.47%
19.93%
4.27%
7.66%
Requiredrateofreturn
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%
222
Summaryofcalculations
Average
StandardDeviation
$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
11.49%
20.90%
21.59%
FreeCFtoEquity
DividendPayoutRatio
84.77%
CashPaidas%ofFCFE
262.00%
ROERequiredreturn
1.67%
Maximum Minimum
223
224
StandardDeviation
Maximum Minimum
FreeCFtoEquity
($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
DividendPayoutRatio
18.59%
19.07%
29.26%
19.84%
CashPaidas%ofFCFE 119.52%
ROERequiredreturn
1.69%
225
226
Summing up
Figure11.5:AnalyzingDividendPolicy
PoorProjects
GoodProjects
Increasepayout
Flexibilityto
ReduceInvestment
accumulate
cash
Disney
CashReturned<FCFE
Microsoft
Aracruz
CashReturned>FCFE
Cutpayout
Cutpayout
ReduceInvestment
InvestinProjects
ROECostofEquity
227
Valuation
AswathDamodaran
228
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
229
where,
n=Lifeoftheasset
CFt=Cashflowinperiodt
r=Discountratereflectingtheriskinessoftheestimatedcashflows
230
Equity Valuation
Thevalueofequityisobtainedbydiscountingexpectedcashflowsto
equity,i.e.,theresidualcashflowsaftermeetingallexpenses,tax
obligationsandinterestandprincipalpayments,atthecostofequity,
i.e.,therateofreturnrequiredbyequityinvestorsinthefirm.
t=n
CFtoEquity t
(1+ k e )t
t=1
ValueofEquity =
where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity
Thedividenddiscountmodelisaspecializedcaseofequityvaluation,
andthevalueofastockisthepresentvalueofexpectedfuture
dividends.
231
Firm Valuation
Thevalueofthefirmisobtainedbydiscountingexpectedcashflowsto
thefirm,i.e.,theresidualcashflowsaftermeetingalloperating
expensesandtaxes,butpriortodebtpayments,attheweighted
averagecostofcapital,whichisthecostofthedifferentcomponents
offinancingusedbythefirm,weightedbytheirmarketvalue
proportions.
t=n
CFtoFirm t
t
t=1 (1+ WACC)
ValueofFirm =
where,
CFtoFirmt=ExpectedCashflowtoFirminperiodt
WACC=WeightedAverageCostofCapital
232
VALUATION
233
Estimating Inputs:
I. Discount Rates
Criticalingredientindiscountedcashflowvaluation.Errorsin
estimatingthediscountrateormismatchingcashflowsanddiscount
ratescanleadtoseriouserrorsinvaluation.
Atanintuitivelevel,thediscountrateusedshouldbeconsistentwith
boththeriskinessandthetypeofcashflowbeingdiscounted.
Thecostofequityistherateatwhichwediscountcashflowstoequity
(dividendsorfreecashflowstoequity).Thecostofcapitalistherate
atwhichwediscountfreecashflowstothefirm.
234
Business
Medi a Networks
Parksan d
Resorts
Studio
Entertainment
Consumer
Products
Disn e y
D/E
UnleveredBeta Ratio
1.08 5 0
26.6 2 %
Lever e d
Beta
1.26 6 1
Costof
Equit y
10.1 0 %
0.91 0 5
26.6 2 %
1.06 2 5
9.12%
1.14 3 5
26.6 2 %
1.33 4 4
10.4 3 %
1.13 5 3
1.06 7 4
26.6 2 %
26.6 2 %
1.32 4 8
1.24 5 6
10.3 9 %
10.0 0 %
DisneysCostofDebt(baseduponrating)=5.25%
Disneystaxrate=37.3%
235
Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=4%+1.25(4.82%)=10.00%
MarketValueofEquity=
$55.101Billion
Equity/(Debt+Equity)=
79%
Debt
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
236
237
EBIT=$2,805Million
Taxrate=37.30%
Capitalspending=$1,735Million
Depreciation=$1,254Million
IncreaseinNoncashWorkingcapital=$454Million
EstimatingFCFF
EBIT*(1taxrate)
NetCapitalExpenditures
ChangeinWorkingCapital
FreeCashflowtoFirm
$1,759
$481
$454
$824
:2805(1.373)
:(17351254)
TotalReinvestment=NetCapEx+ChangeinWC=481+454=935
ReinvestmentRate=935/1759=53.18%
238
239
Webeginbyestimatingthereinvestmentrateandreturnoncapitalfor
Disney in 2003, using the numbers from the latest financial
statements.Wedidconvertoperatingleasesintodebtandadjustedthe
operatingincomeandcapitalexpenditureaccordingly.
ReinvestmentRate2003=(CapExDepreciation+ChginnoncashWC)/
EBIT(1t)=(17351253+454)/(2805(1.373))=53.18%
Returnoncapital2003 =EBIT(1t)2003/(BVofDebt2002+BVofEquity2002)
=2805(1.373)/(15,883+23,879)=4.42%
ExpectedGrowthRatefromexistingfundamentals= 53.18%*4.42%=
2.35%
WewillassumethatDisneywillbeabletoearnareturnoncapitalof
12% on its new investments and that the reinvestment rate will be
53.18%fortheimmediatefuture.
Expected Growth Rate in operating income = Return on capital *
ReinvestmentRate=12%*.5318=6.38%
240
Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueis
thereforethepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)
Sincewecannotestimatecashflowsforever,weestimatecashflows
foragrowthperiodandthenestimateaterminalvalue,tocapture
thevalueattheendoftheperiod:
CF
t
Value =
t
(1 + r)
241
Whenafirmscashflowsgrowataconstantrateforever,the
presentvalueofthosecashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate
Thisconstantgrowthrateiscalledastablegrowthrateandcannot
behigherthanthegrowthrateoftheeconomyinwhichthefirm
operates.
Whilecompaniescanmaintainhighgrowthratesforextendedperiods,
theywillallapproachstablegrowthatsomepointintime.
Whentheydoapproachstablegrowth,thevaluationformulaabove
canbeusedtoestimatetheterminalvalueofallcashflowsbeyond.
242
Growth Patterns
Akeyassumptioninalldiscountedcashflowmodelsistheperiodof
highgrowth,andthepatternofgrowthduringthatperiod.Ingeneral,
wecanmakeoneofthreeassumptions:
thereisnohighgrowth,inwhichcasethefirmisalreadyinstablegrowth
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdroptothestablegrowthrate(2stage)
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdeclinegraduallytoastablegrowthrate(3stage)
Theassumptionofhowlonghighgrowthwillcontinuewilldepend
uponseveralfactorsincluding:
thesizeofthefirm(largerfirm>shorterhighgrowthperiods)
currentgrowthrate(ifhigh>longerhighgrowthperiod)
barrierstoentryanddifferentialadvantages(ifhigh>longergrowth
period)
243
HighGrowthFirmstendto
beaboveaveragerisk
paylittleornodividends
havehighnetcapex
earnhighROC(excessreturn)
havelittleornodebt
StableGrowthFirmstendto
beaveragerisk
payhighdividends
havelownetcapex
earnROCclosertoWACC
higherleverage
244
Startwiththefundamentals:
Profitabilitymeasuressuchasreturnonequityandcapital,instable
growth,canbeestimatedbylookingat
industryaveragesforthesemeasure,inwhichcaseweassumethatthisfirmin
stablegrowthwilllookliketheaveragefirmintheindustry
costofequityandcapital,inwhichcaseweassumethatthefirmwillstop
earningexcessreturnsonitsprojectsasaresultofcompetition.
Leverageisatoughercall.Whileindustryaveragescanbeusedhereas
well,itdependsuponhowentrenchedcurrentmanagementisandwhether
theyarestubbornabouttheirpolicyonleverage(Iftheyare,usecurrent
leverage;iftheyarenot;useindustryaverages)
Usetherelationshipbetweengrowthandfundamentalstoestimate
payoutandnetcapitalexpenditures.
245
Thebetaforthestockwilldroptoone,reflectingDisneysstatusasamature
company.Thiswilllowerthecostofequityforthefirmto8.82%.
CostofEquity=RiskfreeRate+Beta*RiskPremium=4%+4.82%=8.82%
ThedebtratioforDisneywillriseto30%.Thisistheoptimalwecomputed
for Disney earlier and we are assuming that investor pressure will be the
impetus for this change. Since we assume that the cost of debt remains
unchangedat5.25%,thiswillresultinacostofcapitalof7.16%
Costofcapital=8.82%(.70)+5.25%(1.373)(.30)=7.16%
ThereturnoncapitalforDisneywilldropfromitshighgrowthperiodlevelof
12% to a stable growth return of 10%. This is still higher than the cost of
capitalof7.16%butthecompetitiveadvantagesthatDisneyhasareunlikely
todissipatecompletelybytheendofthe10thyear.Theexpectedgrowthratein
stable growth will be 4%. In conjunction with the return on capital of 10%,
thisyieldsastableperiodreinvestmentrateof40%:
ReinvestmentRate=GrowthRate/ReturnonCapital=4%/10%=40%
246
HighGrowthPhase
TransitionPhase
5years
5years
LengthofPeriod
TaxRate
37.3%
ReturnonCapital
12% (lastyearsreturno
StableGrowthPhase
Foreverafter10years
37.3%
37.3%
n Declineslinearlyto10%
StableROCof10%
capitalwas4.42%)
ReinvestmentRate
53.18%
(Last
(NetCapEx+WorkingCapita l reinvestmentrate)
growthratesdrop:
income, estimatedfromstabl e
Investments/EBIT)
ReinvestmentRate=g/ROC
= Linear
declinet
Stable 4%:Settoriskfreerate
12%*0.5318=6.38%
GrowthRateof4%
Debt/CapitalRatio
21%(Existingdebtratio)
Increaseslinearlyto30%
RiskParameters
Beta=1.25,ke=10%
CostofDebt=5.25%
Costofdebtstaysat5.25%
Costofdebtstaysat5.25%
Costofcapital=8.59%
Costofcapitaldropsto7.16%
Costofcapital=7.16%
Stabledebtratioof30%
247
Year
Current
1
2
3
4
5
6
7
8
9
10
Expected
Growth
6.38 %
6.38 %
6.38 %
6.38 %
6.38 %
5.90 %
5.43 %
4.95 %
4.48 %
4.00 %
EBIT
$2,805
$2,984
$3,174
$3,377
$3,592
$3,822
$4,047
$4,267
$4,478
$4,679
$4,866
EBIT (1t)
$1,871
$1,990
$2,117
$2,252
$2,396
$2,538
$2,675
$2,808
$2,934
$3,051
Reinvestment
Rate
Reinvestment
53.18 %
53.18 %
53.18 %
53.18 %
53.18 %
50.54 %
47.91 %
45.27 %
42.64 %
40.00 %
$994.92
$1,058.41
$1,125.94
$1,197.79
$1,274.23
$1,282.59
$1,281.71
$1,271.19
$1,250.78
$1,220.41
FCFF
$876.06
$931.96
$991.43
$1,054.70
$1,122.00
$1,255.13
$1,393.77
$1,536.80
$1,682.90
$1,830.62
248
Year
Cost of c apital
FCFF
1
8.59 %
$876.06
2
8.59 %
$931.96
3
8.59 %
$991.43
4
8.59 %
$1,054.70
5
8.59 %
$1,122.00
6
8.31 %
$1,255.13
7
8.02 %
$1,393.77
8
7.73 %
$1,536.80
9
7.45 %
$1,682.90
10
7.16 %
$1,830.62
PV of cashflows during high growth =
PV of FCFF
$806.74
$790.31
$774.21
$758.45
$743.00
$767.42
$788.91
$807.42
$822.90
$835.31
$7,894.66
249
TerminalValue
FCFF11=EBIT11(1t)(1ReinvestmentRateStableGrowth)/
=4866(1.04)(1.40)=$1,903.84million
TerminalValue=FCFF11/(CostofcapitalStableGrowthg)
=1903.84/(.0716.04)=$60,219.11million
Valueoffirm
PVofcashflowsduringthehighgrowthphase
=$7,894.66
PVofterminalvalue
=$27,477.81
+CashandMarketableSecurities
=$1,583.00
+NonoperatingAssets(Holdingsinothercompanies)=$1,849.00
Valueofthefirm
=$38,804.48
250
Thefirstthingyouhavetosubtractoutisthedebtthatyoucomputed(and
usedinestimatingthecostofcapital).Ifyouhavecapitalizedoperatingleases,
youshouldcontinuetotreatoperatingleasesasdebtinthisstageinthe
process.
Thisisalsoyourlastchancetoconsiderotherpotentialliabilitiesthatmaybe
facedbythefirmincluding
Expected liabilities on lawsuits: You could be analyzing a firm that is the defendant
in a lawsuit, where it potentially could have to pay tens of millions of dollars in
damages. You should estimate the probability that this will occur and use this
probability to estimate the expected liability.
Unfunded Pension and Health Care Obligations: If a firm has significantly under
funded a pension or a health plan, it will need to set aside cash in future years to
meet these obligations. While it would not be considered debt for cost of capital
purposes, it should be subtracted from firm value to arrive at equity value.
Deferred Tax Liability: The deferred tax liability that shows up on the financial
statements of many firms reflects the fact that firms often use strategies that reduce
their taxes in the current year while increasing their taxes in the future years.
251
Whentherearewarrantsandemployeeoptionsoutstanding,the
estimatedvalueoftheseoptionshastobesubtractedfromthevalueof
theequity,beforewedividebythenumberofsharesoutstanding.
Therearetwoalternativeapproachesthatareusedinpractice:
Oneistodividethevalueofequitybythefullydilutednumberofshares
outstanding rather than by the actual number. This approach will
underestimatethevalueoftheequity,becauseitfailstoconsiderthecash
proceedsfromoptionexercise.
Theothershortcut,whichiscalledthetreasurystockapproach,addsthe
expected proceeds from the exercise of the options (exercise price
multipliedbythenumberofoptionsoutstanding)tothenumeratorbefore
dividing by the number of shares outstanding. While this approach will
yieldamorereasonableestimatethanthefirstone,itdoesnotincludethe
timevalueoftheoptionsoutstanding.
252
Attheendof2003,Disneyhad219millionoptionsoutstanding,with
aweightedaverageexercisepriceof$26.44andweightedaveragelife
of6years.
Using the current stock price of $26.91, an estimated standard
deviationof40,adividendyieldof1.21%.ariskfreerateof4%and
the BlackScholes option pricing model we arrived at a value of
$2,129million.
Since options expenses are taxdeductible, we used the tax rate of
37.30%toestimatethevalueoftheemployeeoptions:
Valueofemployeeoptions=2129(1.373)=$1334.67million
253
254
Intransitionphase,
Current
Growthdropsto4%
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
RiskfreeRate
Beta
M
X
UnleveredBetafor
FirmsD/E
ReinvestmentRate
ReturnonCapital
TermYr
Disneywastradingatabout
EBIT(1t)
Cashflows
aturemarket
Assets
ofGrowth
Equity
Debt
Cashflow
Value
atGrowth
35,373
Cost
$1,871
: =
of1,904/(.0716-.04)
to
Capital
$1,990
Firm $2,117
(WACC)
$2,252
==10.00%
60,219
$2,396(.79)
$2,538
+ 3.29%
$2,675 (0.21)
$2,808 =$2,934
8.59 $3,051
10
+
Disney:Valuation
EBIT(1-t)
in
g
(4.00%+1.25%)(1-.373)
E
+Cash:
RiskfreeRate=4%
1.2456
premium
Sectors:1.0674
Ratio:24.77%
53.18%%
12%
3089
$26atthetimeofthis
debtratioincreasesto30%andcost
Reinvestment
10%
==EBIT
4%;
79%(1-t)
Beta
D: = $995
3,432
21%
= 1.00;$1,058
1,759$1,126 $1,198 $1,274 $1,283 $1,282 $1,271 $1,251 $1,220
255
CostFinancing
Current
The
Investment
Return
Reinvestment
Expected
Existing
New
Financing
Investment
Dividend
Investments
of on
capital
EBIT
Growth
Mix
Choices
Capital
decision
(1-t)
Rate
Decision
=Decision
10%
Decision
Rate
affects
(.79)
= Financing
12%
+risk
3.29%
* 53.18%
of assets
(.21)
being
= 8.59%
finance
andFirm
financing
decision affects hurdle rate
Disney:
Corporate
Decisiions
and
Value
$ you
Invest
If
Choose
12%
53.18%
=
Investments
D=21%;
Fxed
1,759
6.38%
rate
cannot
in aE=
projects
US
financing
79%
find
$ that
investments
mix
earn
thata that earn
256
Year
Expected
EBIT
E
BIT
Reinvestment
Growth
(1-t)
Reinvestment
FCFF
Cost
PV
of
Rate
of
cap
FC
Current$5,327
1
7.98%
$5,752
$3,606
53.18%
$1,918
$1,688
8.40%
$1,558
2
7.98%
$6,211
$3,894
53.18%
$2,071
$1,823
8.40%
$1,551
3
7.98%
$6,706
$4,205
53.18%
$2,236
$1,969
8.40%
$1,545
4
7.98%
$7,241
$4,540
53.18%
$2,414
$2,126
8.40%
$1,539
5
7.98%
$7,819
$4,902
53.18%
$2,607
$2,295
8.40%
$1,533
6
7.18%
$8,380
$5,254
50.54%
$2,656
$2,599
8.16%
$1,605
7
6.39%
$8,915
$5,590
47.91%
$2,678
$2,912
7.91%
$1,667
8
5.59%
$9,414
$5,902
45.27%
$2,672
$3,230
7.66%
$1,717
9
4.80%
$9,865
$6,185
42.64%
$2,637
$3,548
7.41%
$1,756
104.00%
$10,260
$6,433
40.00%
$2,573
$3,860
7.16%
$1,783
Terminal Value
$126,967
$58,64
Value
of
$74,90
Oper
+
Cash
$3,432
&
No
Value
of
$78,33
firm
Debt
$14,64
Options
$1,335
Value
of
$62,34
equit
Value per
sha
$30.45
257
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
258