Aswath Damodaran

CORPORATE  FINANCE  
LECTURE  NOTE  PACKET  2  
CAPITAL  STRUCTURE,  DIVIDEND  
POLICY  AND  VALUATION  
B40.2302  
Aswath  Damodaran  

1

Aswath Damodaran

2

CAPITAL  STRUCTURE:  THE  
CHOICES  AND  THE  TRADE  OFF  
“Neither  a  borrower  nor  a  lender  be”  
Someone  who  obviously  hated  this  part  of  corporate  finance  

First  principles  
3

Aswath Damodaran

3

The  Choices  in  Financing  
4

¨ 

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  
leY  over  aYer  you  have  made  debt  payments.  

Aswath Damodaran

4

Global  Pa[erns  in  Financing…  
5

Aswath Damodaran

5

And  a  much  greater  dependence  on  bank  loans   outside  the  US…   6 Aswath Damodaran 6 .

  Aracruz  and  Tata  Chemicals   7 Aswath Damodaran 7 .Assessing  the  exis]ng  financing  choices:  Disney.

Moderate. but constrained by infrastructure High. relative to firm value. as projects dry up.Financing Choices across the life cycle Revenues $ Revenues/ Earnings Earnings Time 8 External funding needs High. relative to funding needs High. . relative to funding needs More than funding needs External Financing Owner’s Equity Bank Debt Venture Capital Common Stock Common stock Warrants Convertibles Debt Retire debt Repurchase stock Growth stage Stage 1 Start-up Stage 2 Rapid Expansion Stage 4 Mature Growth Stage 5 Decline Financing Transitions Accessing private equity Inital Public offering Stage 3 High Growth Seasoned equity issue Bond issues Low. Declining. relative to firm value. as a percent of firm value Internal financing Negative or low Negative or low Low.

  When  a  firm  decides  to  go  public.  though.  from  private  to  public   and  subsequent  seasoned  offerings  are  all  mo]vated   primarily  by  the  need  for  capital.  it  has  to  trade  off  the  greater  access   to  capital  markets  against  the  increased  disclosure  requirements  (that   emanate  from  being  publicly  lists).  they  will  demand  their  fair   share  and  more  of  the  ownership  of    the  firm  to  provide  equity.  firms  have  to  consider  issuance   costs  while  managing  their  rela]ons  with  equity  research  analysts  and   rat   Aswath Damodaran 9 .   9 ¨  ¨  The  transi]ons  that  we  see  at  firms  –  from  fully  owned   private  businesses  to  venture  capital.  there  are  costs  incurred  by  the   exis]ng  owners:   ¤  ¤  ¤  When  venture  capitalists  enter  the  firm.   When  making  seasoned  offerings.The  Transi]onal  Phases..  loss  of  control  and  the  transac]ons   costs  of  going  public.     In  each  transi]on.

Measuring  a  firm’s  financing  mix  …   10 ¨  ¨  ¨  The  simplest  measure  of  how  much  debt  and  equity  a   firm  is  using  currently  is  to  look  at  the  propor]on  of  debt   in  the  total  financing.  This  ra]o  is  called  the  debt  to   capital  ra]o:    Debt  to  Capital  Ra]o  =  Debt  /  (Debt  +  Equity)   Debt  includes  all  interest  bearing  liabili]es.  The  resul]ng  debt  ra]os  can  be   very  different.     Equity  can  be  defined  either  in  accoun]ng  terms  (as   book  value  of  equity)  or  in  market  value  terms  (based   upon  the  current  price).   Aswath Damodaran 10 .  short  term  as   well  as  long  term.

 is  there   an  op]mal  mix  of  debt  and  equity?   ¤  If  yes.The  Financing  Mix  Ques]on   11 ¨  In  deciding  to  raise  financing  for  a  business.  what  is  the  trade  off  that  lets  us  determine  this   op]mal  mix?   What  are  the  benefits  of  using  debt  instead  of  equity?   n  What  are  the  costs  of  using  debt  instead  of  equity?   n  ¤  If  not.  why  not?   Aswath Damodaran 11 .

Costs  and  Benefits  of  Debt   12 ¨  Benefits  of  Debt   ¤  Tax  Benefits   ¤  Adds  discipline  to  management   ¨  Costs  of  Debt   ¤  Bankruptcy  Costs   ¤  Agency  Costs   ¤  Loss  of  Future  Flexibility   Aswath Damodaran 12 .

  The  dollar  tax  benefit  from  the  interest  payment  in  any   year  is  a  func]on  of  your  tax  rate  and  the  interest   payment:   ¤  ¨  Tax  benefit  each  year  =  Tax  Rate  *  Interest  Payment         Proposi]on  1:  Other  things  being  equal.  When  you  use  equity.   you  are  not  allowed  to  deduct  payments  to  equity  (such   as  dividends)  to  arrive  at  taxable  income.  This  reduces  your  taxes.  you  are  allowed  to  deduct   interest  expenses  from  your  income  to  arrive  at  taxable   income.  the  higher  the   marginal  tax  rate  of    a  business.Tax  Benefits  of  Debt   13 ¨  ¨  When  you  borrow  money.   Aswath Damodaran 13 .  the  more  debt  it  will   have  in  its  capital  structure.

  You  are  comparing  the  debt  ra]os  of  real  estate   corpora]ons.The  Effects  of  Taxes   14 ¨  a.  which  are  not  taxed.  without  more  informa]on   Aswath Damodaran 14 .  which  pay  the  corporate  tax  rate.  b.  and   real  estate  investment  trusts.  Which  of  these  two   groups  would  you  expect  to  have  the  higher  debt   ra]os?   The  real  estate  corpora]ons   The  real  estate  investment  trusts   Cannot  tell.  c.   but  are  required  to  pay  95%  of  their  earnings  as   dividends  to  their  stockholders.

 and  you   generate  high  income  and  cash  flows  each  year.  you   tend  to  become  complacent.   ¨  Aswath Damodaran 15 .Debt  adds  discipline  to  management   15 If  you  are  managers  of  a  firm  with  no  debt.  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.  The  complacency  can   lead  to  inefficiency  and  inves]ng  in  poor  projects.   There  is  li[le  or  no  cost  borne  by  the  managers     ¨  Forcing  such  a  firm  to  borrow  money  can  be  an   an]dote  to  the  complacency.

  with  an  ac]vist  and  primarily  ins]tu]onal  holding.  none  of  whom   hold  a  large  percent  of  the  stock.  b.  privately   owned  businesses   Conserva]vely  financed.  c.   Conserva]vely  financed.   with  stocks  held  by  millions  of  investors.  publicly  traded  companies.  publicly  traded  companies.  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?   Conserva]vely  financed  (very  li[le  debt).   Aswath Damodaran 16 .Debt  and  Discipline   16 ¨  a.

Bankruptcy  Cost   17 ¨  The  expected  bankruptcy  cost  is  a  func]on  of  two  variables-­‐-­‐   ¤  ¤  ¨  ¨  the  probability  of  bankruptcy.   Aswath Damodaran 17 .  the  less  debt  the  firm  can  afford  to   use  for  any  given  level  of  debt.  the  greater  the   indirect  bankruptcy  cost.   Proposi]on  3:  Other  things  being  equal.  which  will  depend  upon  how  uncertain   you  are  about  future  cash  flows    the  cost  of  going  bankrupt   n  direct  costs:  Legal  and  other  Deadweight  Costs   n  indirect  costs:  Costs  arising  because  people  perceive  you  to  be  in   financial  trouble   Proposi]on  2:  Firms  with  more  vola]le  earnings  and  cash   flows  will  have  higher  probabili]es  of  bankruptcy  at  any  given   level  of  debt  and  for  any  given  level  of  earnings.

  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   Aswath Damodaran 18 .  c.Debt  &  Bankruptcy  Cost   18 ¨  a.  b.

  When  you  lend  money  to  a  business.  the  greater  the  agency  problems   associated  with  lending  to  a  firm.   Proposi]on  4:  Other  things  being  equal.       Aswath Damodaran 19 .  the  clash  of  interests  can  lead  to  stockholders   ¤  ¤  ¨  You  (as  lender)  are  interested  in  gepng  your  money  back   Stockholders  are  interested  in  maximizing  their  wealth   Inves]ng  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.  the  less  debt  the  firm  can  afford  to  use.  because     ¤  ¤  ¨  In  some  cases.  you  are  allowing  the  stockholders  to   use  that  money  in  the  course  of  running  that  business.  It  arises  because  your  interests(as  the  principal)  may  deviate   from  those  of  the  person  you  hired  (as  the  agent).  Stockholders   interests  are  different  from  your  interests.Agency  Cost   19 ¨  ¨  An  agency  cost  arises  whenever  you  hire  someone  else  to  do  something   for  you.

  A  Large  technology  firm     b.Debt  and  Agency  Costs   20 Assume  that  you  are  a  bank.  Which  of  the  following   businesses  would  you  perceive  the  greatest  agency   costs?   a.  A  Large  Regulated  Electric  U]lity   ¨  Why?   ¨  Aswath Damodaran 20 .

  ¨  Aswath Damodaran 21 .Loss  of  future  financing  flexibility   21 When  a  firm  borrows  up  to  its  capacity.  the   more  uncertain  a  firm  is  about  its  future  financing   requirements  and  projects.  the  less  debt  the  firm   will  use  for  financing  current  projects.     ¨  Proposi]on  5:  Other  things  remaining  equal.  it  loses  the   flexibility  of  financing  future  projects  with  debt.

55    4.88    3.What  managers  consider  important  in  deciding   on  how  much  debt  to  carry.55    4.56    2.  Maintain  comparability  with  peer  group Aswath Damodaran  Ranking  (0-­‐5)    4.  Maintain  financial  flexibility   2.   22 ¨  A  survey  of  Chief  Financial  Officers  of  large  U.  Maintain  Predictable  Source  of  Funds 4..  Ensure  long-­‐term  survival     3.  Maintain  financial  independence   6..  Maintain  high  debt  ra]ng     7.05    3.   companies  provided  the  following  ranking  (from  most   important  to  least  important)  for  the  factors  that  they   considered  important  in  the  financing  decisions   Factor         1.S.99    3.  Maximize  Stock  Price     5.47   22 .

Debt:  Summarizing  the  trade  off   23 Aswath Damodaran 23 .

Added discipline Benefits will be high. reinvestment needs. Firm is mature. Low. since physical assets are marketable. Business is Low. Benefits are smaller. Indirect bankruptcy costs should be low. since assets are marketable (timber.99% tax rates It does have significant noninterest tax shields in the form of depreciation.The  Trade  off  for  three  companies. because the voting shares are closely held by insiders. Tata Chemicals mature and is a mature company investment needs are with established well established. Movie and broadcasting businesses have volatile earnings. Although theme park assets are tangible and fairly liquid. Direct costs of bankruptcy are likely to be small. Biggest concern is that debt may be utilized in other (riskier) Tata companies. High. because managers are not large stockholders. but indirect costs can be significant. is much more difficult to monitor movie and broadcasting businesses. The firm has a marginal tax rate of 34%. Aracruz Significant.   24 Item Tax benefits Disney Significant. with fairly stable earnings and cash flows from its chemicals and fertilizer business. Since the Tata family runs the firm.. It does have large depreciation tax shields. The firm has a marginal tax rate of 38%. Low in theme park business but high in media businesses because technological change makes future investment uncertain. Assets are tangible and liquid. Variability in paper prices makes earnings volatile. Tata Chemicals Significant. It does not have very much in noninterest tax shields. the benefits from added discipline are small. 24 . Direct and indirect costs of bankruptcy likely to be moderate. paper plants) Bankruptcy costs Agency costs Flexibility needs Aswath Damodaran Low. as well. The firm has a 33.

 for  your  firm.   ¤  The  poten]al  tax  benefits  of  borrowing   ¤  The  benefits  of  using  debt  as  a  disciplinary  mechanism   ¤  The  poten]al  for  expected  bankruptcy  costs   ¤  The  poten]al  for  agency  costs   ¤  The  need  for  financial  flexibility   Would  you  expect  your  firm  to  have  a  high  debt   ra]o  or  a  low  debt  ra]o?   ¨  Does  the  firm’s  current  debt  ra]o  meet  your   expecta]ons?   ¨  Aswath Damodaran 25 .Applica]on  Test:  Would  you  expect  your  firm  to   gain  or  lose  from  using  a  lot  of  debt?   25 ¨  Considering.

 there  is  no   subterfuge  or  a[empt  to  find  loopholes  in  loan  agreements.   (c)  No  firm  ever  goes  bankrupt   (d)  Equity  investors  are  honest  with  lenders.   (e)  Firms  know  their  future  financing  needs  with  certainty   ¨  What  happens  to  the  trade  off  between  debt  and   equity?  How  much  should  a  firm  borrow?   Aswath Damodaran 26 .A  Hypothe]cal  Scenario   26 Assume  that  you  live  in  a  world  where   (a)  There  are  no  taxes   (b)  Managers  have  stockholder  interests  at  heart  and  do   what’s  best  for  stockholders.

  Aswath Damodaran 27 .The  Miller-­‐Modigliani  Theorem   27 ¨  ¨  In  an  environment.  where  there  are  no  taxes.     If  the  Miller  Modigliani  theorem  holds:   ¤  A  firm's  value  will  be  determined  the  quality  of  its  investments  and  not   by  its  financing  mix.   capital  structure  is  irrelevant.  the  cost  of  equity  will  increase  just  enough  to   offset  any  gains  to  the  leverage.   ¤  The  cost  of  capital  of  the  firm  will  not  change  with  leverage.  default  risk  or  agency  costs.  As  a  firm   increases  its  leverage.

  ¤  Managers  value  control.  with  retained  earnings  being  the  most   preferred  choice  for  financing.  would  you  rather  use  debt  or  equity?   ¤  Aswath Damodaran 28 .   ¤  ¨  With  flexibility  and  control  being  key  factors:   Would  you  rather  use  internal  financing  (retained  earnings)  or   external  financing?   ¤  With  external  financing.  Managers  value  being  able  to  use   capital  (on  new  investments  or  assets)  without  restric]ons  on   that  use  or  having  to  explain  its  use  to  others.  In  par]cular.  followed  by  debt  and  that   new  equity  is  the  least  preferred  choice.What  do  firms  look  at  in  financing?   28 ¨  There  are  some  who  argue  that  firms  follow  a  financing   hierarchy.   Managers  value  flexibility.  Managers  like  being  able  to  maintain   control  of  their  businesses.

42 5 Straight Preferred Stock 2.Preference  rankings  long-­‐term  finance:  Results   of  a  survey   29 Ranking Source Score 1 Retained Earnings 5.88 3 Convertible Debt 3.02 4 External Common Equity 2.72 Aswath Damodaran 29 .61 2 Straight Debt 4.22 6 Convertible Preferred 1.

And  the  unsurprising  consequences.   30 Aswath Damodaran 30 ..

  c.  What  would  you   hypothesize  about  the  health  of  the  company  issuing   these  securi]es?     Nothing   Healthier  than  the  average  firm   In  much  more  financial  trouble  than  the  average   firm   Aswath Damodaran 31 .  offering  to  sell   conver]ble  preferred  stock.  b.Financing  Choices   31 ¨  a.  You  are  reading  the  Wall  Street  Journal  and  no]ce  a   tombstone  ad  for  a  company.

.   .Aswath Damodaran 32 CAPITAL  STRUCTURE:   FINDING  THE  RIGHT  FINANCING   MIX   You  can  have  too  much  debt…  or  too  li[le.

.The  Big  Picture.   33 Aswath Damodaran 33 .

  The  Adjusted  Present  Value  Approach:  The  op]mal  debt  ra]o   is  the  one  that  maximizes  the  overall  value  of  the  firm.   The  Sector  Approach:  The  op]mal  debt  ra]o  is  the  one  that   brings  the  firm  closes  to  its  peer  group  in  terms  of  financing   mix.Pathways  to  the  Op]mal   34 ¨  ¨  ¨  ¨  ¨  The  Cost  of  Capital  Approach:  The  op]mal  debt  ra]o  is  the   one  that  minimizes  the  cost  of  capital  for  a  firm.   The  Life  Cycle  Approach:  The  op]mal  debt  ra]o  is  the  one   that  best  suits  where  the  firm  is  in  its  life  cycle.   The  Enhanced  Cost  of  Capital  approach:  The  op]mal  debt   ra]o  is  the  one  that  generates  the  best  combina]on  of  (low)   cost  of  capital  and  (high)  opera]ng  income.   Aswath Damodaran 34 .

 and   the  cost  of  capital  is  minimized.  the  value  of  the  firm   will  be  maximized.I.   ¨  Aswath Damodaran 35 .  The  Cost  of  Capital  Approach   35 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.

  Cost  of  capital  =  Cost  of  equity  (E/(D+E))  +  AYer-­‐tax  cost  of  debt  (D/(D+E))   Aswath Damodaran 36 .   The  cost  of  capital  is  the  cost  of  each  component  weighted  by  its  rela]ve   market  value.  If  they  are  diversified.  only  the  por]on  of  the  equity  risk   that  cannot  be  diversified  away  (beta  or  betas)  will  be  priced  into  the  cost   of  equity.  reflec]ng  its  credit  risk   (c)  The  firm’s  marginal  tax  rate   ¨  ¨  ¨  The  cost  of  equity  reflects  the  expected  return  demanded  by  marginal   equity  investors.Measuring  Cost  of  Capital   36 ¨  ¨  Recapping  our  discussion  of  cost  of  capital:   The  cost  of  debt  is  the  market  interest  rate  that  the  firm  has  to  pay  on  its   long  term  borrowing  today.  It  will  be  a  func]on  of:   (a)  The  long-­‐term  riskfree  rate   (b)  The  default  spread  for  the  company.  net  of  tax  benefits.

  Yes   b.  No   ¨  Aswath Damodaran 37 .  Yes   b.Costs  of  Debt  &  Equity   37 An  ar]cle  in  an  Asian  business  magazine  argued  that   equity  was  cheaper  than  debt.  because  dividend   yields  are  much  lower  than  interest  rates  on  debt.  No   ¨  Can  equity  ever  be  cheaper  than  debt?   a.   Do  you  agree  with  this  statement?   a.

Aswath Damodaran 38 .Applying  Cost  of  Capital  Approach:  The   Textbook  Example   38 Assume the firm has $200 million in cash flows. expected to grow 3% a year forever.

The  U-­‐shaped  Cost  of  Capital  Graph…   39 Aswath Damodaran 39 .

 and  based  on  this  ra]ng.  the  aYer-­‐tax  cost  of  debt  for  Disney  is   3.   the  es]mated  pretax  cost  of  debt  for  Disney  is  6%.5%  +  0.  bond   rate  at  that  ]me  was  3.Current  Cost  of  Capital:  Disney   40 ¨  ¨  ¨  The  beta  for  Disney’s  stock  in  May  2009  was  0.  Using  a   marginal  tax  rate  of  38%.  The  T.9011(6%)  =  8.38)  =  3.9011.    AYer-­‐Tax  Cost  of  Debt    =  6.72%   The  cost  of  capital  was  calculated  using  these  costs  and  the   weights  based  on  market  values  of  equity  (45.72%.91%:    Cost  of  Equity  =  3.193)  and  debt   (16.5%.  Using  an  es]mated  equity  risk  premium   of  6%.682):    Cost  of  capital  =     Aswath Damodaran 40 .  we  es]mated  the  cost  of  equity  for  Disney  to  be  8.91%   Disney’s  bond  ra]ng  in  May  2009  was  A.00%  (1  –  0.

 Calculate  the  effect  on  Firm  Value  and  Stock  Price.   Aswath Damodaran 41 .  Es]mate  the  Cost  of  Debt  at  different  levels  of  debt:     Default  risk  will  go  up  and  bond  ra]ngs  will  go  down  as  debt   goes  up  -­‐>  Cost  of  Debt  will  increase.   ¤  Es]ma]on  will  use  levered  beta  calcula]on   ¤  ¨  2.  we  will  use  the  interest  coverage   ra]o  (EBIT/Interest  expense)   ¤  ¨  ¨  3.  Es]mate  the  Cost  of  Capital  at  different  levels  of  debt   4.   ¤  To  es]ma]ng  bond  ra]ngs.  Es]mate  the  Cost  of  Equity  at  different  levels  of  debt:     Equity  will  become  riskier  -­‐>  Beta  will  increase  -­‐>  Cost  of  Equity   will  increase.Mechanics  of  Cost  of  Capital  Es]ma]on   41 ¨  1.

1 93 Equity & # Alterna]vely.9011 = = 0.  we  can  back  to  the  source  and  es]mate  it  from  the  betas  of   the  businesses.7333 " % " % 16.  we  can  start  with  the  levered  beta  (0.t) ' $#1 + (1 -.38) & 45.9011)   and  work  back  to  an  unlevered  beta:    Unlevered  beta  =     ¨  Levered Beta 0.  Es]mate  the  unlevered  beta  for  the  firm   42 ¨  To  get  to  the  unlevered  beta.682 Debt ' $1 + (1 .Laying  the  groundwork:   1.   € Aswath Damodaran 42 .

2.  Get  Disney’s  current  financials…   43 Aswath Damodaran 43 .

I.38) (D/E)) Cost of equity = 3.7333 (1 + (1-.  Cost  of  Equity   44 Levered Beta = 0.5% + Levered Beta * 6% Aswath Damodaran 44 .

00%  10.682  =  $61.00%  Debt  to  capital   D/E      0.1111   $  Debt      $0    $6.422  $8.188    10%  of  $61.875               EBITDA      $8.75%  4.11%  D/E  =  10/90  =  .24  EBIT/  Interest  Expenses   Likely  Ra]ng    AAA  AAA  From  Ra]ngs  table   Pre-­‐tax  cost  of  debt    4.422    Same  as  0%  debt   Deprecia]on    $1.829    $6.75%  Riskless  Rate  +  Spread   Aswath Damodaran 45 .593    $1.00%  11.193  +  $16.  cov    ∞  23.Es]ma]ng  Cost  of  Debt   45 Start  with  the  current  market  value  of  the  firm  =  45.593    Same  as  0%  debt   EBIT      $6.875  million     D/(D+E)      0.829    Same  as  0%  debt   Interest      $0    $294    Pre-­‐tax  cost  of  debt  *  $  Debt               Pre-­‐tax  Int.

The  Ra]ngs  Table   46 T.Bond rate in early 2009 = 3.5% Aswath Damodaran 46 .

188 $12.593     EBIT $6.829     Interest expense $294 $588     Pretax int.375     EBITDA $8.62     Likely rating AAA AAA     Pretax cost of debt 4.422     Depreciation $1.A  Test:  Can  you  do  the  30%  level?   47 D/(D + E) 10.829 $6.593 $1.24 11.422 $8.75% 4.11% 25.00% 20. cov 23.00%     $ Debt $6.00% 30% D/E 11.75%     Aswath Damodaran   47 .

 Cost  of  Debt  and  Debt  Ra]os   48 Aswath Damodaran 48 .Bond  Ra]ngs.

Marginal  tax  rates  and  Taxable  Income…   49 ¨  ¨  You  need  taxable  income  for  interest  to  provide  a  tax  savings.  We   consider  the  tax  benefit  on  the  interest  expenses  up  to  this   amount:   Maximum  Tax  Benefit  =  EBIT  *  Marginal  Tax  Rate  =  $6.  however.518  million.  the  interest  expenses  balloon  to   $7.    At  an  80%  debt   ra]o.52%     Aswath Damodaran 49 .829  million.38  =   $2.  which  is  greater  than  the  EBIT  of  $6.518  =  34.595  million   Adjusted  Marginal  Tax  Rate  =  Maximum  Tax  Benefit/Interest  Expenses  =   $2.829  million  *  0.829  million.829  million.  interest  expenses  remain   fully  tax-­‐deduc]ble  and  earn  the  38%  tax  benefit.     At  a  90%  debt  ra]o.  the  interest  expenses  are  $6.  Note   that  the  EBIT  at  Disney  is  $6.683  million  and  the  tax  benefit   is  therefore  38%  of  this  amount.595/$7.  As  long  as  interest   expenses  are  less  than  $6.

Disney’s  cost  of  capital  schedule…   50 Aswath Damodaran 50 .

Disney:  Cost  of  Capital  Chart   51 Aswath Damodaran 51 .

00%! 70.50%! 13.00%! 11.00%! 40.Disney:  Cost  of  Capital  Chart:  1997   52 Cost of Capital! 14.50%! 12.00%! Note the kink in the cost of capital graph at 60% debt. What is causing it? Debt Ratio! Aswath Damodaran 52 .00%! 30.50%! 0.00%! 20.00%! 10.00%! 11.00%! 50.00%! 12.00%! 60.00%! 10.50%! 90.00%! 13.00%! 80.

  3.  you  should  expect   to  answer  three  ques]ons:   1.68  billion  in  debt.The  cost  of  capital  approach  suggests  that   Disney  should  do  the  following…   53 ¨  ¨  ¨  Disney  currently  has  $16.  Why  should  we  do  it?   What  if  something  goes  wrong?   What  if  we  don’t  want  (or  cannot  )  buy  back  stock  and  want   to  make  investments  with  the  addi]onal  debt  capacity?   Aswath Damodaran 53 .   Given  the  magnitude  of  this  decision.  2.  Disney  has   excess  debt  capacity  of  $  8.   Disney  should  borrow  $  8  billion  and  buy  back  stock.75  billion.  The  op]mal   dollar  debt  (at  40%)  is  roughly  $24.   To  move  to  its  op]mal  and  gain  the  increase  in  value.07  billion.

593     –  Capital  expenditures  =      $1.g) (.199     Step  2:  Back  out  the  implied  growth  rate  in  the  current  market  value   FCFF0 (1 + g) 4.0068  or  0.790  million  (63.0751 .628     –  Change  in  noncash  working  capital      $0   Free  cash  flow  to  the  firm  =      $4.199)  =  0.g) (.0068) = = $63.199(1.875  =  1.0.875  +  4.790)       € Aswath Damodaran 54 .38)  =      $4.665 million   (Cost of Capital .665  –  61.875*  0.875  =     = (Cost of Capital .199(1 + g)  Value  of  firm  =  $  61.234     +  Deprecia]on  and  amor]za]on  =    $1.0068)   The  firm  value  increases  by  $1.g)      Growth  rate  =  (Firm  Value  *  Cost  of  Capital  –  CF  to  Firm)/(Firm  Value  +  CF  to  Firm)        =  (61.0751  –  4199)/(61.Why  should  we  do  it?       Effect  on  Firm  Value  –  Full  Valua]on  Approach   54 Step  1:  Es]mate  the  cash  flows  to  Disney  as  a  firm   EBIT  (1  –  Tax  Rate)  =  6829  (1  –  0.68%     Step  3:  Revalue  the  firm  with  t€he  new  cost  of  capital   Firm  value  =   FCFF0 (1 + g) 4.0732 .

68  million      Change  in  Annual  Cost                            =  $117.51% WACCa  =  7.0068) The  total  number  of  shares  outstanding  before  the  buyback  is  1856.682  =  $61.     € Change  in  Stock  Price  =  $1.g) (0.   ¤  ¤  ¤  Increase  in  firm  value  =   Annual Savings next year $117.95  per  share   Aswath Damodaran 55 .732   million.0732  =  $  4.0732 .  we  start  with  the  current  market  value  and   isolate  the  effect  of  changing  the  capital  structure  on  the  cash  flow   and  the  resul]ng  value.193  +  $16.68%  in  firm  value  over  ]me.875  *  0.875  million     WACCb  =  7.82  million      Annual  Cost  =  61.0751  =  $4.14 = = $1.19% ¨   Annual  Cost  =  61.An  Alternate  Approach   Effect  on  Value:  Capital  Structure  Isola]on…   55 ¨  ¨  In  this  approach.32% Δ WACC  =  0.0.646.763 million (Cost of Capital .529.14  million     If  we  assume  a  perpetual  growth  of  0.875  *  0.732  =  $  0.   Firm  Value  before  the  change  =  45.763/1856.

763/1856.34  +  $0.e.95=  $25.A  Test:  The  Repurchase  Price   56 ¨  ¨  Let  us  suppose  that  the  CFO  of  Disney  approached  you  about   buying  back  stock.34  and  there  are  1856.  i.732    =  $  0.95   New  Stock  Price  =  $24.34?   Aswath Damodaran 56 .29  will  leave  you  as  a  stockholder  indifferent   between  selling  and  not  selling.29   Buying  shares  back  $25.  (The   current  price  is  $  24.  He  wants  to  know  the  maximum  price  that   he  should  be  willing  to  pay  on  the  stock  buyback.732  million  shares   outstanding).   What  would  happen  to  the  stock  price  aYer  the  buyback  if   you  were  able  to  buy  stock  back  at  $  24.  that  the  investor   who  sell  their  shares  back  want  the  same  share  of  firm  value   increase  as  those  who  remain:   ¤  ¤  ¤  ¨  Increase  in  Value  per  Share  =  $1.   If  we  assume  that  investors  are  ra]onal..

Buybacks  and  Stock  Prices   57 ¨  Assume  that  Disney  does  make  a  tender  offer  for   it’s  shares  but  pays  $27  per  share.  b.  What  will  happen   to  the  value  per  share  for  the  shareholders  who  do   not  sell  back?   a.29   Aswath Damodaran 57 .  c.  The  share  price  will  drop  below  the  pre-­‐announcement   price  of  $24.29   The  share  price  will  be  higher  than  $25.34  and  the   es]mated  value  (above)  of  $25.34   The  share  price  will  be  between  $24.

 we  could  require  the  firm  to  have  a   minimum  ra]ng.   Aswath Damodaran 58 .  and   examine  the  op]mal  debt  ra]o  under  each  one.  a  regular   economy  and  an  economy  in  recession.  For  instance.  we  could  look   at  the  op]mal  debt  ra]o  for  a  cyclical  firm  under  a  boom  economy.   tax  rates  and  macro  variables.  based  upon  macro  variables.    Thus.  We  could  focus  on  one  or  two  key  variables  –   opera]ng  income  is  an  obvious  choice  –  and  look  at  history  for  guidance  on   vola]lity  in  that  number  and  ask  what  if  ques]ons.     B.  we  can  put  constraints  on  the  op]mal  debt  ra]o  to  reduce   exposure  to  downside  risk.2.  at  the  op]mal  debt  ra]o  or  to  have  a  book  debt  ra]o  that  is   less  than  a  “specified”  value.  “Economic  Scenario”  Approach    We  can  develop  possible  scenarios.   ¨  Constraint  on  Bond  Ra]ngs/  Book  Debt  Ra]os   Alterna]vely.  What  if  something  goes  wrong?   The  Downside  Risk   58 ¨  Sensi]vity  to  Assump]ons   A.  “What  if”  analysis    The  op]mal  debt  ra]o  is  a  func]on  of  our  inputs  on  opera]ng  income.

Explore  the  past:   Disney’s  Opera]ng  Income  History   59 Key questions: What does a bad year look like for Disney? How much volatility is there in operating income? Recession Decline in Operating Income 2008-09 Drop of about 10% 2002 Drop of 15.00% 1981-82 Increased Aswath Damodaran 59 .82% 1991 Drop of 22.

What  if?   Examining  the  sensi]vity  of  the  op]mal  debt  ra]o..   60 Aswath Damodaran 60 .

  ¤  Managers  should  be  provided  with  an  es]mate  of  the  cost  of  a   specified  ra]ngs  constraint  so  that  they  can  decide  whether  the   benefits  exceed  the  costs.  will  create  a  cost.     Every  ra]ng  constraint.Constraints  on  Ra]ngs   61 ¨  ¨  Management  oYen  specifies  a  'desired  Ra]ng'  below   which  they  do  not  want  to  fall.   ¤  Aswath Damodaran 61 .  if  binding.     The  ra]ng  constraint  is  driven  by  three  factors   it  is  one  way  of  protec]ng  against  downside  risk  in  opera]ng   income   ¤  a  drop  in  ra]ngs  might  affect  opera]ng  income  (indirect   bankruptcy  costs)   ¤  there  is  an  ego  factor  associated  with  high  ra]ngs   ¤  ¨  Caveat:  Every  Ra]ng  Constraint  Has  A  Cost.

651  –  $63.Ra]ngs  Constraints  for  Disney   62 ¨  ¨  At  its  op]mal  debt  ra]o  of  40%.280  million   Aswath Damodaran 62 .651  -­‐  $62.  the  op]mal  debt  ra]o  for   Disney  is  then  30%  and  the  cost  of  the  ra]ngs  constraint  is   fairly  small:   ¤  ¨  Cost  of  AA  Ra]ng  Constraint    =  Value  at  40%  Debt  –  Value  at  30%  Debt          =  $63.  the  op]mal  debt  ra]o   would  drop  to  20%  and  the  cost  of  the  ra]ngs  constraint   would  rise:   ¤  Cost  of  AAA  ra]ng  constraint  =  Value  at  40%  Debt  –  Value  at  20%  Debt          =  $63.371  =  $1.596  =  $55  million     If  managers  insisted  on  a  AAA  ra]ng.   If  managers  insisted  on  a  AA  ra]ng.  Disney  has  an  es]mated   ra]ng  of  A.

  ¤  Yes.  if  the  projects  are  in  en]rely  different  types  of   businesses  or  if  the  tax  rate  is  significantly  different..   63 The  op]mal  debt  ra]o  is  ul]mately  a  func]on  of  the   underlying  riskiness  of  the  business  in  which  you   operate  and  your  tax  rate.   Aswath Damodaran 63 .  What  if  you  do  not  buy  back  stock.3.     ¨  Will  the  op]mal  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.

but it is tough to tell without looking at the rest of the group.Extension  to  a  family  group  company:   Tata  Chemical’s  Op]mal  Capital  Structure   64 Actual Optimal Tata Chemical looks like it is over levered (34% actual versus 10% optimal). Aswath Damodaran 64 .

Applying Aracruz’s average pretax operating margin between 2004 and 2008 of 27.24% to 2008 revenues of $R 3.697 million to get a normalized operating income of R$ 1. an abysmal year. That is the number used in computing the optimal debt ratio in this table. Aswath Damodaran 65 .007 million. yields an optimal debt ratio of 0%.Extension  to  a  firm  with  vola]le  earnings:   Aracruz’s  Op]mal  Debt  Ra]o   65 Cost of debt includes default spread for Brazil. Using Aracruz’s actual operating income in 2008.

Hence.500 * 10 = $15.000 Estimated Market Value of Debt = PV of leases= $9.6 milliion Aswath Damodaran 66 . we estimated value: Estimated Market Value of Equity (in ‘000s) = Net Income for Bookscape * Average PE for Publicly Traded Book Retailers = 1.Extension  to  a  private  business   Op]mal  Debt  Ra]o  for  Bookscape   66 No market value because it is a private firm.

  ¨  It  ignores  indirect  bankruptcy  costs:  The  opera]ng   income  is  assumed  to  stay  fixed  as  the  debt  ra]o   and  the  ra]ng  changes.     ¨  Beta  and  Ra]ngs:  It  is  based  upon  rigid  assump]ons   of  how  market  risk  and  default  risk  get  borne  as  the   firm  borrows  more  money  and  the  resul]ng  costs.  Limita]ons  of  the  Cost  of  Capital  approach   67 It  is  sta]c:  The  most  cri]cal  number  in  the  en]re   analysis  is  the  opera]ng  income.  If  that  changes.  the   op]mal  debt  ra]o  will  change.   ¨  Aswath Damodaran 67 .

II.  As  the  ra]ng  of  the  firm  declines.  you  can  draw  from  a   distribu]on  of  opera]ng  income  (thus  allowing  for   different  outcomes).   suppliers  and  investors  react.       ¨  Aswath Damodaran 68 .  Enhanced  Cost  of  Capital  Approach   68 Distress  cost  affected  opera]ng  income:  In  the   enhanced  cost  of  capital  approach.   ¨  Dynamic  analysis:  Rather  than  look  at  a  single   number  for  opera]ng  income.  the  indirect  costs   of  bankruptcy  are  built  into  the  expected  opera]ng   income.  the   opera]ng  income  is  adjusted  to  reflect  the  loss  in   opera]ng  income  that  will  occur  when  customers.

Es]ma]ng  the  Distress  Effect-­‐  Disney   69 Ra]ng   A-­‐  or  higher A-­‐   BBB   BB+   B-­‐   CCC   D   Aswath Damodaran  Drop  in  EBITDA      No  effect      2.00%      20. 69 .00%      10.00%      50.and then start becoming larger as the rating drops below investment grade. when the rating drops to A.00%      40.00%   Indirect bankruptcy costs manifest themselves.00%      25.

The  Op]mal  Debt  Ra]o  with  Indirect   Bankruptcy  Costs   70 The optimal debt ratio drops to 30% from the original computation of 40%. Aswath Damodaran 70 .

Extending  this  approach  to  analyzing  Financial  
Service  Firms  
71

¨ 

¨ 

¨ 

Interest  coverage  ra]o  spreads,  which  are  cri]cal  in  determining  
the  bond  ra]ngs,  have  to  be  es]mated  separately  for  financial  
service  firms;  applying  manufacturing  company  spreads  will  result  
in  absurdly  low  ra]ngs  for  even  the  safest  banks  and  very  low  
op]mal  debt  ra]os.    
It  is  difficult  to  es]mate  the  debt  on  a  financial  service  company’s  
balance  sheet.  Given  the  mix  of  deposits,  repurchase  agreements,  
short-­‐term  financing,  and  other  liabili]es  that  may  appear  on  a  
financial  service  firm’s  balance  sheet,  one  solu]on  is  to  focus  only  
on  long-­‐term  debt,  defined  ]ghtly,  and  to  use  interest  coverage  
ra]os  defined  using  only  long-­‐term  interest  expenses.    
Financial  service  firms  are  regulated  and  have  to  meet  capital  
ra]os  that  are  defined  in  terms  of  book  value.  If,  in  the  process  of  
moving  to  an  op]mal  market  value  debt  ra]o,  these  firms  violate  
the  book  capital  ra]os,  they  could  put  themselves  in  jeopardy.    

Aswath Damodaran

71

An  alterna]ve  approach  based  on  Regulatory  
Capital  
72

¨ 

¨ 

Rather  than  try  to  bend  the  cost  of  capital  approach  to  breaking  
point,  we  will  adopt  a  different  approach  for  financial  service  firms  
where  we  es]mate  debt  capacity  based  on  regulatory  capital.  
Consider  a  bank  with  $  100  million  in  loans  outstanding  and  a  book  
value  of  equity  of  $  6  million.  Furthermore,  assume  that  the  
regulatory  requirement  is  that  equity  capital  be  maintained  at  5%  
of  loans  outstanding.  Finally,  assume  that  this  bank  wants  to  
increase  its  loan  base  by  $  50  million  to  $  150  million  and  to  
augment  its  equity  capital  ra]o  to  7%  of  loans  outstanding.    
Loans  outstanding  aYer  Expansion
 
 =  $  150  million  
*  Equity/Capital  ra]o  desired    
 =  7%  
=  Equity  aYer  expansion  
 
 
 =  $10.5  million  
Exis]ng  Equity  
 
 
 
 =  $    6.0  million  
New  Equity  needed    
 
 =  $  4.5  million  
¤  This  can  come  from  retained  earnings  or  from  new  equity  issues.  

Aswath Damodaran

72

Financing  Strategies  for  a  financial  ins]tu]on  
73

¨ 

¨ 

¨ 

The  Regulatory  minimum  strategy:  In  this  strategy,  financial  service  
firms  try  to  stay  with  the  bare  minimum  equity  capital,  as  required  
by  the  regulatory  ra]os.  In  the  most  aggressive  versions  of  this  
strategy,  firms  exploit  loopholes  in  the  regulatory  framework  to  
invest  in  those  businesses  where  regulatory  capital  ra]os  are  set  
too  low  (rela]ve  to  the  risk  of  these  businesses).    
The  Self-­‐regulatory  strategy:  The  objec]ve  for  a  bank  raising  equity  
is  not  to  meet  regulatory  capital  ra]os  but  to  ensure  that  losses  
from  the  business  can  be  covered  by  the  exis]ng  equity.  In  effect,  
financial  service  firms  can  assess  how  much  equity  they  need  to  
hold  by  evalua]ng  the  riskiness  of  their  businesses  and  the  
poten]al  for  losses.    
Combina]on  strategy:  In  this  strategy,  the  regulatory  capital  ra]os  
operate  as  a  floor  for  established  businesses,  with  the  firm  adding  
buffers  for  safety  where  needed..    

Aswath Damodaran

73

Deutsche  Bank’s  Financing  Mix  
74

¨ 

¨ 

¨ 

Deutsche  Bank  has  generally  been  much  more  
conserva]ve  in  its  use  of  equity  capital.  In  October  2008,  
it  raised  its  Tier  1  Capital  Ra]o  to  10%,  well  above  the  
Basel  1  regulatory  requirement  of  6%.    
While  its  loss  of  4.8  billion  Euros  in  the  last  quarter  of  
2008  did  reduce  equity  capital,  Deutsche  Bank  was  
confident  (at  least  as  of  the  first  part  of  2009)  that  it  
could  survive  without  fresh  equity  infusions  or  
government  bailouts.  In  fact,  Deutsche  Bank  reported  
net  income  of  1.2  billion  Euros  for  the  first  quarter  of  
2009  and  a  Tier  1  capital  ra]o  of  10.2%.  
If  the  capital  ra]o  had  dropped  below  10%,  the  firm  
would  have  had  to  raise  fresh  equity.  

Aswath Damodaran

74

Determinants  of  the  Op]mal  Debt  Ra]o:  
1.  The  marginal  tax  rate  
75

¨ 

The  primary  benefit  of  debt  is  a  tax  benefit.  The  
higher  the  marginal  tax  rate,  the  greater  the  benefit  
to  borrowing:  

Aswath Damodaran

75

 growth  firms  will  have  lower  cash  flows.875   million  in  the  base  case.   Cash  flow  poten]al  =  EBITDA/  (Market  value  of  equity  +  Debt)   ¨  Disney.  Pre-­‐tax  Cash  flow  Return   76 Firms  that  have  more  in  opera]ng  income  and  cash  flows.   rela]ve  to  firm  value  (in  market  terms).   which  is  11%  of  the  market  value  of  the  firm  of  $61.829  million.  and  an  op]mal  debt  ra]o  of  40%.  as  a   percent  of  firm  value.2.   ¨  Aswath Damodaran 76 .     ¨  In  general.  We  can  measure  opera]ng  income  with   EBIT  and  opera]ng  cash  flow  with  EBITDA.  has  opera]ng  income  of  $6.  for  example.  and  lower  op]mal  debt  ra]os.  should  have  higher   op]mal  debt  ra]os.   Increasing  the  opera]ng  income  to  15%  of  the  firm  value  will   increase  the  op]mal  debt  ra]o  to  60%.

 The  ra]ngs   are  based  upon  normalized  income.  Opera]ng  Risk   77 ¨  ¨  Firms  that  face  more  risk  or  uncertainty  in  their   opera]ons  (and  more  variable  opera]ng  income  as  a   consequence)  will  have  lower  op]mal  debt  ra]os  than   firms  that  have  more  predictable  opera]ons.  debt  will  magnify   this  already  large  risk  and  push  up  costs  of  equity  much  more   steeply.  As  they  borrow.   Opera]ng  risk  enters  the  cost  of  capital  approach  in  two   places:   Unlevered  beta:  Firms  that  face  more  opera]ng  risk  will  tend  to   have  higher  unlevered  betas.3.   ¤  Bond  ra]ngs:  For  any  given  level  of  opera]ng  income.   ¤  Aswath Damodaran 77 .  firms  that   face  more  risk  in  opera]ons  will  have  lower  ra]ngs.

 The  only  macro  determinant:   Equity  vs  Debt  Risk  Premiums   78 Aswath Damodaran 78 .4.

 what  would  you  need  to   do  to  get  to  the  op]mal  immediately?   Aswath Damodaran 79 .  2.  3.  4.  6  Applica]on  Test:  Your  firm’s  op]mal   financing  mix   79 ¨  Using  the  op]mal  capital  structure  spreadsheet   provided:   1.  ¨  Es]mate  the  op]mal  debt  ra]o  for  your  firm   Es]mate  the  new  cost  of  capital  at  the  op]mal   Es]mate  the  effect  of  the  change  in  the  cost  of  capital  on   firm  value   Es]mate  the  effect  on  the  stock  price   In  terms  of  the  mechanics.

III.  the  value  of   the  firm  is  wri[en  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  op]mal  dollar  debt  level  is  the  one  that   maximizes  firm  value   Aswath Damodaran 80 .  The  APV  Approach  to  Op]mal  Capital   Structure   80 ¨  In  the  adjusted  present  value  approach.

 This  can  be  done  in  one   of  two  ways:   ¤  ¤  ¨  Step  2:  Es]mate  the  tax  benefits  at  different  levels  of  debt.  in   which  case   ¤  ¨  Es]ma]ng  the  unlevered  beta.   Aswath Damodaran 81 .  with  an  unlevered  firm)   Alterna]vely.Implemen]ng  the  APV  Approach   81 ¨  Step  1:  Es]mate  the  unlevered  firm  value.  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.  and   mul]ply  by  the  cost  of  bankruptcy  (including  both  direct  and   indirect  costs)  to  es]mate  the  expected  bankruptcy  cost.  The   simplest  assump]on  to  make  is  that  the  savings  are  perpetual.  Unlevered  Firm  Value  =  Current  Market  Value  of  Firm  -­‐  Tax   Benefits  of  Debt  (Current)  +  Expected  Bankruptcy  cost  from  Debt   Tax  benefits  =  Dollar  Debt  *  Tax  Rate   Step  3:  Es]mate  a  probability  of  bankruptcy  at  each  debt  level.

 at   that  level  of  debt  (Use  studies  that  have  es]mated  the  empirical   probabili]es  of  this  occurring  over  ]me  -­‐  Altman  does  an  update  every   year)   Cost  of  Bankruptcy   ¤  ¤  The  direct  bankruptcy  cost  is  the  easier  component.  based  upon  empirical  studies   The  indirect  bankruptcy  cost  is  much  tougher.  It  should  be  higher  for   sectors  where  opera]ng  income  is  affected  significantly  by  default  risk   (like  airlines)  and  lower  for  sectors  where  it  is  not  (like  groceries)   Aswath Damodaran 82 .Es]ma]ng  Expected  Bankruptcy  Cost   82 ¨  Probability  of  Bankruptcy   ¤  ¤  ¨  Es]mate  the  synthe]c  ra]ng  that  the  firm  will  have  at  each  level  of   debt   Es]mate  the  probability  that  the  firm  will  go  bankrupt  over  ]me.  It  is  generally   between  5-­‐10%  of  firm  value.

54%     years prior and then examining the    16.60%        0.00%     Aswath Damodaran 83 .66%     Altman estimated these probabilities by    2.00%     over the ten years.    36.51%        0.07%        0.63%     proportion of these bonds that defaulted    25.00%        100.50%     looking at bonds in each ratings class ten    7.00%        59.00%        85.Ra]ngs  and  Default  Probabili]es:  Results  from   Altman  study  of  bonds   83 Ra]ng AAA AA A+ A A-­‐ BBB BB B+ B B-­‐ CCC CC C D  Likelihood  of  Default        0.01%        70.80%        45.

339      +  Expected  Bankruptcy  Cost  =  0.Disney:  Es]ma]ng  Unlevered  Firm  Value   84 Current  Market  Value  of  the  Firm  =  =  $45.875    -­‐  Tax  Benefit  on  Current  Debt  =  $16.638   ¤  Cost  of  Bankruptcy  for  Disney  =  25%  of  firm  value   ¤  Probability  of  Bankruptcy  =  0.682  =  $  61.193  +  $16.682  *  0.66%  *  (0.66%.25  *  61.  based  on  firm’s  current   ra]ng  of  A   ¤  Tax  Rate  =  38%   Aswath Damodaran 84 .38      =  $      6.875)    =  $            102   Unlevered  Value  of  Firm  =        =  $  55.

Aswath Damodaran 85 .Disney:  APV  at  Debt  Ra]os   85 The optimal debt ratio is 50%. which is the point at which firm value is maximized.

 Rela]ve  Analysis   86 The  “safest”  place  for  any  firm  to  be  is  close  to  the   industry  average   ¨  Subjec]ve  adjustments  can  be    made  to  these   averages  to  arrive  at  the  right  debt  ra]o.   ¨  ¤  Higher  tax  rates  -­‐>  Higher  debt  ra]os  (Tax  benefits)   ¤  Lower  insider  ownership  -­‐>  Higher  debt  ra]os  (Greater   discipline)   ¤  More  stable  income  -­‐>  Higher  debt  ra]os  (Lower   bankruptcy  costs)   ¤  More  intangible  assets  -­‐>  Lower  debt  ra]os  (More  agency   problems)   Aswath Damodaran 86 .IV.

Comparing  to  industry  averages   87 Aswath Damodaran 87 .

 we  can  obtain  an  es]mate  of  predicted  debt   ra]o.   Step  3:  Compare  the  actual  debt  ra]o  to  the  predicted   debt  ra]o.Gepng  past  simple  averages   88 Step  1:  Run  a  regression  of  debt  ra]os  on  the  variables  that   you  believe  determine  debt  ra]os  in  the  sector.   Aswath Damodaran 88 .   Debt  Ra]o  =  a  +  b  (Tax  rate)  +  c  (Earnings  Variability)  +  d  (EBITDA/ Firm  Value)   Check  this  regression  for  sta]s]cal  significance  (t  sta]s]cs)   and  predic]ve  ability  (R  squared)   Step  2:  Es]mate  the  values  of  the  proxies  for  the  firm   under  considera]on.  For   example.  Plugging  into  the  cross  sec]onal   regression.

 Disney  should  have  a  market   value  debt  ra]o  of  37.372)  +  0.1%.049  +  0.3710  or  37.Applying  the  Regression  Methodology:   Entertainment  Firms     89 ¨  ¨  ¨  ¨  Using  a  sample  of  80  entertainment  firms.  we  arrived  at   the  following  regression:   The  R  squared  of  the  regression  is  40%.1735)  =  0.692   (0.543  (0.   Aswath Damodaran 89 .10%     Based  upon  the  capital  structure  of  other  firms  in  the   entertainment  industry.  This  regression   can  be  used  to  arrive  at  a  predicted  value  for  Disney  of:   Predicted  Debt  Ra]o  =  0.

16a)    (2.026  E/V  –  0.  The  regression  provides  the  following  results  –    DFR  =  0.   Aswath Damodaran 90 .6a)     where.    DFR    =  Debt  /  (  Debt  +  Market  Value  of  Equity)    Intangible  %  =  Intangible  Assets/  Total  Assets  (in  book  value  terms)    CLSH  =  Closely  held  shares  as  a  percent  of  outstanding  shares    E/V  =  EBITDA/  (Market  Value  of  Equity  +  Debt-­‐  Cash)    GEPS  =  Expected  growth  rate  in  EPS   ¨  The  regression  has  an  R-­‐squared  of  13%.25)          (12.878  GEPS      (25.064  Intangible  %  –  0.45a)  (2.327      -­‐  0.88a)              (1.138  CLSH  +  0.  Extending  to  the  en]re  market   90 ¨  Using  2008  data  for  firms  listed  on  the  NYSE.  AMEX  and  NASDAQ   data  bases.

0.878  (0.91%     ¨  What  does  this  op]mal  debt  ra]o  tell  you?     ¨  ¨   Why  might  it  be  different  from  the  op]mal  calculated  using  the  weighted   average  cost  of  capital?     Aswath Damodaran 91 .138  (0.077)  +  0.26  (0.7%   ¤    EBITDA/Value  =  17.2891  or  28.5%   Op]mal  Debt  Ra]o     =  0.065)   =  0.327      -­‐  0.Applying  the  Regression   91 Disney    had  the  following  values  for  these  inputs  in  2008.1735)  –  0.35%   ¤    Expected  growth  in  EPS  =  6.   ¤    Intangible  Assets  =  24%   ¤    Closely  held  shares  as  percent  of  shares  outstanding  =  7.  Es]mate  the   op]mal  debt  ra]o  using  the  debt  regression.064  (0.24)  –  0.

Summarizing  the  op]mal  debt  ra]os…   92 Aswath Damodaran 92 .

 Or  perhaps  not…   93 ..Aswath Damodaran GETTING  TO  THE  OPTIMAL:   TIMING  AND  FINANCING   CHOICES   You  can  take  it  slow.

Big  Picture…   94 Aswath Damodaran 94 .

.   What  next?   95 ¨  At  the  end  of  the  analysis  of  financing  mix  (using   whatever  tool  or  tools  you  choose  to  use).  the  right  kind  of  financing  to  use  in   making  this  adjustment   Aswath Damodaran 95 .  2.  you  can   come  to  one  of  three  conclusions:   1.  And  an  actual.  ¨  The  firm  has  the  right  financing  mix   It  has  too  li[le  debt  (it  is  under  levered)   It  has  too  much  debt  (it  is  over  levered)   The  next  step  in  the  process  is   ¤  Deciding  how  much  quickly  or  gradually  the  firm  should   move  to  its  op]mal   ¤  Assuming  that  it  does.Now  that  we  have  an  op]mal.  3..

" Is the firm a takeover target?" Yes" Increase leverage" quickly" 1. Pay off debt with retained" new equity or with retained" earnings. Reduce or eliminate dividends. Debt/Equity swaps" 2." earnings." No" Does the firm have good " projects?" ROE > Cost of Equity" ROC > Cost of Capital" Yes" Take good projects with" debt." 2. Sell Assets.A  Framework  for  Gepng  to  the  Op]mal   96 Is the actual debt ratio greater than or lesser than the optimal debt ratio?" Actual > Optimal" Overlevered" Actual < Optimal" Underlevered" Is the firm under bankruptcy threat?" Yes" No" Reduce Debt quickly" 1. Borrow money&" buy shares. Renegotiate with lenders" Does the firm have good " projects?" ROE > Cost of Equity" ROC > Cost of Capital" Yes" No" Take good projects with" 1. Issue new equity and pay off " debt." No" Do your stockholders like" dividends?" Yes" Pay Dividends" Aswath Damodaran No" Buy back stock" 96 ." 3. Equity for Debt swap" 2. use cash" to pay off debt" 3.

Large mkt cap & positive Jensen’s α! Yes" Increase leverage" quickly" 1. Reduce or eliminate dividends." 3.Disney:  Applying  the  Framework   97 Is the actual debt ratio greater than or lesser than the optimal debt ratio?" Actual > Optimal" Overlevered" Actual < Optimal! Actual (26%) < Optimal (40%)! Is the firm under bankruptcy threat?" Yes" No" Reduce Debt quickly" 1. Equity for Debt swap" 2." Is the firm a takeover target?" No. Renegotiate with lenders" Does the firm have good " projects?" ROE > Cost of Equity" ROC > Cost of Capital" Yes" No" Take good projects with" 1. Borrow money&" buy shares. Sell Assets. ROC > Cost of capital" Take good projects! With debt.! No" Do your stockholders like" dividends?" Yes" Pay Dividends" Aswath Damodaran No" Buy back stock" 97 ." 2. Debt/Equity swaps" 2." earnings. Issue new equity and pay off " debt." Does the firm have good " projects?" ROE > Cost of Equity" ROC > Cost of Capital" Yes. use cash" to pay off debt" 3. Pay off debt with retained" new equity or with retained" earnings.

  No  change  in  leverage   ¨  Would  you  recommend  that  the  firm  change  its   financing  mix  by     a.6  Applica]on  Test:  Gepng  to  the  Op]mal   98 Based  upon  your  analysis  of  both  the  firm’s  capital   structure  and  investment  record.  Immediate  change  in  leverage   b.  what  path  would   you  map  out  for  the  firm?   a.  Paying  off  debt/Buying  back  equity   b.  Take  projects  with  equity/debt   ¨  Aswath Damodaran 98 .  Gradual  change  in  leverage   c.

Liabilities Debt Opearing Assets in place Growth Assets Sell operating assets and use cash to buy back stock or pay or special dividend Equity Borrow money and buy back stock or pay a large special dividend To increase the debt ratio Aswath Damodaran 99 . Assets Cash Issue new stock to retire debt or get debt holders to accept equity in the firm.The  Mechanics  of  Changing  Debt  Ra]o  over   ]me…  quickly…   99 To decrase the debt ratio Sell operating assets and use cash to pay down debt.

 you  use  the  same  mix   of  tools  that  you  used  to  change  debt  ra]os  gradually:   Dividends  and  stock  buybacks:  Dividends  and  stock  buybacks   will  reduce  the  value  of  equity.   ¤  Debt  repayments:  will  reduce  the  value  of  debt.     If  equity  is  fairly  valued  today.   ¤  ¨  The  complica]on  of  changing  debt  ra]os  over  ]me  is   that  firm  value  is  itself  a  moving  target.  in  conjunc]on  as  firm  value   changes.   ¤  Aswath Damodaran 100 .The  mechanics  of  changing  debt  ra]os  over   ]me…  gradually…   100 ¨  To  change  debt  ra]os  over  ]me.  the  equity  value  should  change   over  ]me  to  reflect  the  expected  price  apprecia]on:   ¤  Expected  Price  apprecia]on  =  Cost  of  equity  –  Dividend  Yield   ¤  Debt  will  also  change  over  ]me.

Designing  Debt:  The  Fundamental  Principle   101 The  objec]ve  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.   ¨  Aswath Damodaran 101 .  we  reduce  our  risk  of  default.  increase   debt  capacity  and  increase  firm  value.   ¨  By  doing  so.

Firm  with  mismatched  debt   102 Firm Value Value of Debt Aswath Damodaran 102 .

Firm  with  matched  Debt   103 Firm Value Value of Debt Aswath Damodaran 103 .

if CF move with inflation . Floating Rate * More floating rate .Convertible if cash flows low now but high exp.Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Aswath Damodaran 104 .Design  the  perfect  financing  instrument   104 ¨  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 on Assets/ Projects Define Debt Characteristics Duration Duration/ Maturity Currency Currency Mix Effect of Inflation Uncertainty about Future Fixed vs. growth Cyclicality & Other Effects Special Features on Debt .with greater uncertainty on future Growth Patterns Straight versus Convertible .

Ensuring  that  you  have  not  crossed  the  line   drawn  by  the  tax  code   105 All  of  this  design  work  is  lost.  if  the   security  that  you  have  designed  does  not  deliver  the   tax  benefits.   ¨  Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough.  there  may  be  a  trade  off  between   mismatching  debt  and  gepng  greater  tax  benefits.  however. you might override results of previous step Aswath Damodaran 105 .     ¨  In  addi]on.

 since  it   makes  them  safer.   Consider ratings agency & analyst concerns Analyst Concerns .Value relative to comparables Ratings Agency .  ra]ngs   agencies  and  regulators  applauding   106 ¨  ¨  ¨  ¨  Ra]ngs  agencies  want  companies  to  issue  equity.Effect on EPS .     Regulatory  authori]es  want  to  ensure  that  you  meet  their   requirements  in  terms  of  capital  ra]os  (usually  book  value).     Equity  research  analysts  want  them  not  to  issue  equity   because  it  dilutes  earnings  per  share.Ratios relative to comparables Regulatory Concerns .Effect on Ratios .Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Aswath Damodaran 106 .While  keeping  equity  research  analysts.     Financing  that  leaves  all  three  groups  happy  is  nirvana.

 ra]ngs  agencies  have  started  giving   firms  only  par]al  equity  credit  for  trust  preferred.  As  they  have  become   more  savvy.Debt  or  Equity:  The  Strange  Case  of  Trust   Preferred   107 ¨  Trust  preferred  stock  has   ¤  A  fixed  dividend  payment.  ra]ngs   agencies  treated  it  as  equity.  specified  at  the  ]me  of  the   issue   ¤  That  is  tax  deduc]ble   ¤  And  failing  to  make  the  payment  can  give  these   shareholders  vo]ng  rights     ¨  When  trust  preferred  was  first  created.   Aswath Damodaran 107 .

  b.  but  has  a  ra]ng  constraint   that  would  be  violated  if  it  moved  to  its  op]mal   A  firm  that  is  over  levered  that  is  unable  to  issue  debt   because  of  the  ra]ng  agency  concerns.   Aswath Damodaran 108 .Debt.  which  of  the  following   firms  is  the  most  appropriate  firm  to  be  issuing  it?   a.  Equity  and  Quasi  Equity   108 ¨  Assuming  that  trust  preferred  stock  gets  treated  as   equity  by  ra]ngs  agencies.  A  firm  that  is  under  levered.

Less observable cash flows lead to more conflicts Type of Assets financed .   because   ¤  Of  their  past  history  of  defaults  or  other  ac]ons   ¤  They  are  small  firms  without  any  borrowing  history   ¨  Bondholders  tend  to  demand  much  higher  interest   rates  from  these  firms  to  reflect  these  concerns. consider issuing convertible bonds Aswath Damodaran Convertibiles Puttable Bonds Rating Sensitive Notes LYONs 109 .   Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders .Tangible and liquid assets create less agency problems Existing Debt covenants .Restrictions on Financing If agency problems are substantial.Soothe  bondholder  fears   109 ¨  There  are  some  firms  that  face  skep]cism  from   bondholders  when  they  go  out  to  raise  debt.

 and   markets  can  under  price  a  firm’s  stock  or  bonds.     Issuing  equity  or  equity  based  products  (including  conver]bles).   when  equity  is  under  priced  transfers  wealth  from  exis]ng   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.  In  par]cular.   ¤  ¨  What  is  the  solu]on   If  you  need  to  use  equity?   ¤  If  you  need  to  use  debt?   ¤  Aswath Damodaran 110 .  firms  should  not  lock  in  these  mistakes  by  issuing   securi]es  for  the  long  term.  If  this   occurs.And  do  not  lock  in  market  mistakes  that  work   against  you   110 ¨  Ra]ngs  agencies  can  some]mes  under  rate  a  firm.

Less observable cash flows lead to more conflicts Type of Assets financed .Convertible if cash flows low now but high exp. Floating Rate * More floating rate .Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders .Effect on EPS . consider issuing convertible bonds Consider Information Aswath Damodaran Asymmetries Uncertainty about Future Cashflows .if CF move with inflation .Value relative to comparables Ratings Agency .Restrictions on Financing If agency problems are substantial.Firms with credibility problems will issue more short term debt Convertibiles Puttable Bonds Rating Sensitive Notes LYONs 111 .Effect on Ratios . growth Special Features on Debt .with greater uncertainty on future Cyclicality & Other Effects Growth Patterns Straight versus Convertible .Designing  Debt:  Bringing  it  all  together   111 Start with the Cash Flows on Assets/ Projects Define Debt Characteristics Duration Currency Effect of Inflation Uncertainty about Future Duration/ Maturity Currency Mix Fixed vs.When there is more uncertainty. you might override results of previous step Analyst Concerns .Tangible and liquid assets create less agency problems Existing Debt covenants . it may be better to use short term debt Credibility & Quality of the Firm .Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Overlay tax preferences Consider ratings agency & analyst concerns Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough.Ratios relative to comparables Regulatory Concerns .

Approaches  for  evalua]ng  Asset  Cash  Flows   112 I.  Historical  Data   ¤  ¤  Opera]ng  Cash  Flows   Firm  Value   Aswath Damodaran 112 .  based  upon  different  macro   economic  scenarios   III.  Intui]ve  Approach   ¤  ¤  ¤  Are  the  projects  typically  long  term  or  short  term?  What  is  the  cash   flow  pa[ern  on  projects?     How  much  growth  poten]al  does  the  firm  have  rela]ve  to  current   projects?   How  cyclical  are  the  cash  flows?  What  specific  factors  determine  the   cash  flows  on  projects?   II.  Project  Cash  Flow  Approach   ¤  ¤  Es]mate  expected  cash  flows  on  a  typical  project  for  the  firm   Do  scenario  analyses  on  these  cash  flows.

I.    Intui]ve  Approach  -­‐  Disney   113 Aswath Damodaran 113 .

 what  kind  of   financing  would  you  expect  your  firm  to  use  in  terms   of   a.  Dura]on  (long  term  or  short  term)   Currency   Fixed  or  Floa]ng  rate   Straight  or  Conver]ble   Aswath Damodaran 114 .  c.  b.  d.  and  the   typical  investments  that  it  makes.6    Applica]on  Test:  Choosing  your  Financing   Type   114 ¨  Based  upon  the  business  that  your  firm  is  in.

 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.  you  match  the   financing  choices  to  the  project  being  funded.  independent  projects  to   be  financed.  It  becomes  both  imprac]cal  and  costly   when  firms  have  por}olios  of  projects  with   interdependent  cashflows.II.   ¨  Aswath Damodaran 115 .  Project  Specific  Financing   115 With  project  specific  financing.

29 years Aswath Damodaran 116 .Dura]on  of  Disney  Theme  Park   116 Duration of the Project = 58.877 = 20.375/2.

  ¨  If  possible.The  perfect  theme  park  debt…   117 The  perfect  debt  for  this  theme  park  would  have  a   dura]on  of  roughly  20  years  and  be  in  a  mix  of  La]n   American  currencies  (since  it  is  located  in  Brazil).   reflec]ng  where  the  visitors  to  the  park  are  coming   from.   ¨  Aswath Damodaran 117 .  you  would  ]e  the  interest  payments  on   the  debt  to  the  number  of  visitors  at  the  park.

 currency  rates  and  the   economy.III.   n  ¨   Firm  Value   The  firm  value  is  clearly  a  func]on  of  the  level  of  opera]ng  income.  you  could  consider  the  firm  to  be  a   por}olio  of  projects.  such  as  interest  rates.   n  This  analysis  is  useful  in  determining  the  coupon/interest  payment   structure  of  the  debt.  The  firm’s  past  history  should  then  provide  clues  as  to   what  type  of  debt  makes  the  most  sense.     n  The  firm  value  analysis  is  useful  in  determining  the  overall  structure  of   the  debt.  can  be  directly  tested  by  regressing  changes  in  the  opera]ng   income  against  changes  in  these  variables.  Firm-­‐wide  financing   118 ¨  ¨  Rather  than  look  at  individual  projects.  infla]on.   n  Aswath Damodaran 118 .  but   it  also  incorporates  other  factors  such  as  expected  growth  &  cost  of   capital.     Opera]ng  Cash  Flows    The  ques]on  of  how  sensi]ve  a  firm’s  asset  cash  flows  are  to  a  variety   of  factors.  par]cularly  maturity.

Disney:  Historical  Data   119 Aswath Damodaran 119 .

The  Macroeconomic  Data   120 Aswath Damodaran 120 .

  Aswath Damodaran 121 .I.  Sensi]vity  to  Interest  Rate  Changes   121 How  sensi]ve  is  the  firm’s  value  and  opera]ng   income  to  changes  in  the  level  of  interest  rates?   ¨  The  answer  to  this  ques]on  is  important  because  it     ¨  ¤  it  provides  a  measure  of  the  dura]on  of  the  firm’s  projects   ¤  it  provides  insight  into  whether  the  firm  should  be  using   fixed  or  floa]ng  rate  debt.

94)  measures   how  much  the  value  of  Disney  as  a  firm  changes  for   a  unit  change  in  interest  rates.   Aswath Damodaran 122 .89)  (0.94  (Change  in  Interest  Rates)        (2.   ¨   The  coefficient  on  the  regression  (-­‐2.Firm  Value  versus  Interest  Rate  Changes   122 ¨  Regressing  changes  in  firm  value  against  changes  in   interest  rates  over  this  period  yields  the  following   regression  –   Change  in  Firm  Value  =  0.50)   T  sta]s]cs  are  in  brackets.1949  -­‐  2.

.Why  the  coefficient  on  the  regression  is   dura]on.   123 ¨      ¨  ¨  The  dura]on  of  a  straight  bond  or  loan  issued  by  a  company   can  be  wri[en  in  terms  of  the  coupons  (interest  payments)   on  the  bond  (loan)  and  the  face  value  of  the  bond  to  be  –     " t=N t*Coupon N*Face Value % t + $∑ ' t (1+r)N dP/P # t=1 (1+r) & Duration of Bond = = t=N " Coupon Face Value % dr/r t + $∑ ' t (1+r)N & # t=1 (1+r) The  dura]on  of  a  bond  measures  how  much  the  price  of  the   bond  changes  for  a  unit  change  in  interest  rates.  and  decrease  with   the  coupon  rate  on  the  bond.  the  dura]on  of  a  bond  will   increase  with  the  maturity  of  the  bond.   Holding  other  factors  constant.   Aswath Damodaran 123 .

Past project cash flows are similar to future project cash flows. Changes in market value reflect changes in the value of the firm. Projected Cash Flows Assumes: 1. Cash Flows are unaffected by changes in interest rates 2. 124 . Relationship between cash flows and interest rates is stable. 3. Changes in interest rates are small. Historical data on changes in firm value (market) and interest rates Assumes: 1. Aswath Damodaran δP/δr= Percentage Change in Value for a percentage change in Interest Rates Regression: δP = a + b (δr) Uses: 1. 2.Dura]on:  Comparing  Approaches   124 Traditional Duration Measures Uses: 1.

  ¨  Generally  speaking.   Aswath Damodaran 125 .74)    +  6.Opera]ng  Income  versus  Interest  Rates   125 ¨  Regressing  changes  in  opera]ng  cash  flow  against   changes  in  interest  rates  over  this  period  yields  the   following  regression  –   Change  in  Opera]ng  Income  =  0.1958      (2.59  (Change  in  Interest  Rates)  (1.  unlike  its   firm  value.  has  moved  with  interest  rates.06)       Conclusion:  Disney’s  opera]ng  income.  the  opera]ng  cash  flows  are   smoothed  out  more  than  the  value  and  hence  will   exhibit  lower  dura]on  that  the  firm  value.

 or  add  special  features  to  the   debt  to  ]e  cash  flows  on  the  debt  to  the  firm’s  cash   flows.   Aswath Damodaran 126 .II.  Sensi]vity  to  Changes  in  GDP/  GNP   126 ¨  ¨  How  sensi]ve  is  the  firm’s  value  and  opera]ng  income   to  changes  in  the  GNP/GDP?   The  answer  to  this  ques]on  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.  the  firm  will  either  have  to   issue  less  debt  overall.   ¤  ¨  If  the  cash  flows  and  firm  value  are  sensi]ve  to   movements  in  the  economy.

0826      (0.30)       Conclusion:  Disney’s  opera]ng  income  is  sensi]ve  to   economic  growth  as  well.36)    Conclusion:  Disney  is  sensi]ve  to  economic  growth   ¨  Regressing  changes  in  opera]ng  cash  flow  against   changes  in  GDP  over  this  period  yields  the  following   regression  –        Change  in  Opera]ng  Income  =  0.   Aswath Damodaran 127 .06  (GDP  Growth)                  (0.Regression  Results   127 ¨  Regressing  changes  in  firm  value  against  changes  in  the   GDP  over  this  period  yields  the  following  regression  –   Change  in  Firm  Value  =  0.65)    +  8.22)      (1.04  +  6.89  (GDP  Growth)    (2.

 the  firm  should   ¤  figure  out  which  currency  its  cash  flows  are  in.   ¨  If  cash  flows  and  firm  value  are  sensi]ve  to  changes   in  the  dollar.III.   ¤  and  issued  some  debt  in  that  currency   Aswath Damodaran 128 .  because   ¨  ¤  it  provides  a  measure  of  how  sensi]ve  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.  Sensi]vity  to  Currency  Changes   128 How  sensi]ve  is  the  firm’s  value  and  opera]ng   income  to  changes  in  exchange  rates?   ¨  The  answer  to  this  ques]on  is  important.

73)     Conclusion:  Disney’s  opera]ng  income  is  also  impacted  by  the   dollar.42)      (1.80)   Conclusion:  Disney’s  value  is  sensi]ve  to  exchange  rate   changes.04  (Change  in  Dollar)      (2.Regression  Results   129 ¨  Regressing  changes  in  firm  value  against  changes  in  the  dollar   over  this  period  yields  the  following  regression  –   Change  in  Firm  Value  =          0.19  -­‐1.57(  Change  in  Dollar)          (2.   Aswath Damodaran 129 .63)  (0.   ¨  Regressing  changes  in  opera]ng  cash  flow  against  changes  in   the  dollar  over  this  period  yields  the  following  regression  –   Change  in  Opera]ng  Income  =  0.  A  stronger  dollar  seems  to  hurt  opera]ng  income.17    -­‐2.  decreasing  as  the  dollar  strengthens.

  ¤  it  then  helps  in  the  design  of  debt.   Aswath Damodaran 130 .  Sensi]vity  to  Infla]on   130 How  sensi]ve  is  the  firm’s  value  and  opera]ng   income  to  changes  in  the  infla]on  rate?   ¨  The  answer  to  this  ques]on  is  important.  whether  the  debt   should  be  fixed  or  floa]ng  rate  debt.  increasing   (decreasing)  as  infla]on  increases  (decreases).  because   ¨  ¤  it  provides  a  measure  of  whether  cash  flows  are  posi]vely   or  nega]vely  impacted  by  infla]on.   ¨   If  cash  flows  move  with  infla]on.  the   debt  should  have  a  larger  floa]ng  rate  component.IV.

80)    Conclusion:  Disney’s  firm  value  does  seem  to  increase  with   infla]on.40)   Conclusion:  Disney’s  opera]ng  income  seems  to  increase  in   periods  when  infla]on  increases.Regression  Results   131 ¨  Regressing  changes  in  firm  value  against  changes  in  infla]on   over  this  period  yields  the  following  regression  –   Change  in  Firm  Value  =          0.  sugges]ng  that  Disney  does   have  pricing  power.71  (Change  in  Infla]on  Rate)    (2.90)  (0.  but  not  by  much  (sta]s]cal  significance  is  low)   ¨  Regressing  changes  in  opera]ng  cash  flow  against  changes  in   infla]on  over  this  period  yields  the  following  regression  –   Change  in  Opera]ng  Income  =  0.18    +  2.   Aswath Damodaran 131 .79  (  Change  in  Infla]on  Rate)                (3.22    +8.28)    (2.

  Aswath Damodaran 132 .  we   would  conclude  that     ¤  Disney’s  assets  collec]vely  have  a  dura]on  of  about  3   years   ¤  Disney  is  increasingly  affected  by  economic  cycles   ¤  Disney  is  hurt  by  a  stronger  dollar   ¤  Disney’s  opera]ng  income  tends  to  move  with  infla]on   ¨  All  of  the  regression  coefficients  have  substan]al   standard  errors  associated  with  them.Summarizing…   132 ¨  Looking  at  the  four  macroeconomic  regressions.  One  way  to   reduce  the  error  (a  la  bo[om  up  betas)  is  to  use   sector-­‐wide  averages  for  each  of  the  coefficients.

Bo[om-­‐up  Es]mates   133 These weights reflect the estimated values of the businesses Aswath Damodaran 133 .

 As  its  broadcas]ng   businesses  expand  into  La]n  America.  Based  upon  2008  numbers  at   least.   Aswath Damodaran 134 .   A  significant  por]on  of  the  debt  should  be  floa]ng  rate  debt.   reflec]ng  Disney’s  capacity  to  pass  infla]on  through  to  its   customers  and  the  fact  that  opera]ng  income  tends  to  increase  as   interest  rates  go  up.Recommenda]ons  for  Disney   134 ¨  ¨  ¨  The  debt  issued  should  be  long  term  and  should  have  dura]on  of   about  5  years.   Given  Disney’s  sensi]vity  to  a  stronger  dollar.  this  would  indicate  that  about  20%  of  the  debt  should  be  in   Euros  and  about  10%  of  the  debt  in  Japanese  Yen  reflec]ng   Disney’s  larger  exposures  in  Europe  and  Asia.  it  may  want  to  consider   using  either  Mexican  Peso  or  Brazilian  Real  debt  as  well.  The  specific  currency  used   and  the  magnitude  of  the  foreign  currency  debt  should  reflect   where  Disney  makes  its  revenues.  a  por]on  of  the   debt  should  be  in  foreign  currencies.

  Aswath Damodaran 135 .     Of  the  debt.  Based  on  our  analysis.   Disney  has  no  conver]ble  debt  and  about  24%  of  its  debt  is   floa]ng  rate  debt.  which  is  appropriate  given  its  status  as  a   mature  company  with  significant  pricing  power.  we   would  argue  for  increasing  the  floa]ng  rate  por]on  of  the   debt  to  about  40%.  In  fact.38  years.  this  would   indicate  that  Disney’s  debt  is  of  the  right  maturity.  Allowing  for  the  fact  that  the   maturity  of  debt  is  higher  than  the  dura]on.  about  10%  is  yen  denominated  debt  but  the  rest   is  in  US  dollars.  we  would  suggest  that   Disney  increase  its  propor]on  of  debt  in  other  currencies  to   about  20%  in  Euros  and  about  5%  in  Chinese  Yuan.Analyzing  Disney’s  Current  Debt   135 ¨  ¨  ¨  Disney  has  $16  billion  in  debt  with  a  face-­‐value  weighted   average  maturity  of  5.

 its  debt  matching  will   become  be[er  at  the  company  level.Adjus]ng  Debt  at  Disney   136 ¨  ¨  It  can  swap  some  of  its  exis]ng  fixed  rate.  it  can  use   primarily  floa]ng  rate.     Aswath Damodaran 136 .  Given  Disney’s   standing  in  financial  markets  and  its  large  market   capitaliza]on.  dollar  debt  for   floa]ng  rate.  either  to  get  to  a   higher  debt  ra]o  or  to  fund  new  investments.  this  should  not  be  difficult  to  do.   If  Disney  is  planning  new  debt  issues.  Although  it  may  be  mismatching   the  funding  on  these  investments.  foreign  currency  debt  to  fund   these  new  investments.  foreign  currency  debt.

Debt  Design  for  other  firms..   137 Aswath Damodaran 137 .

Aswath Damodaran 138 RETURNING  CASH  TO  THE   OWNERS:  DIVIDEND  POLICY   “Companies  don’t  have  cash.  They  hold  cash  for   their  stockholders.”   .

First  Principles   139 Aswath Damodaran 139 .

Steps  to  the  Dividend  Decision…   140 How much did you borrow? Cashflows to Debt (Principal repaid. Interest Expenses) Cashflow from Operations How good are your investment choices? Reinvestment back into the business What is a reasonable cash balance? Cashflows from Operations to Equity Investors Cash held back by the company Cash available for return to stockholders What do your stockholders prefer? Stock Buybacks Cash Paid out Dividends Aswath Damodaran 140 .

 Dividends  are  s]cky   141 Aswath Damodaran 141 .I.

 Number  of  S&P  500  companies  that…   142 Quarter Dividend Increase Dividend initiated Dividend decrease Dividend suspensions Q1 2007 102 1 1 1 Q2 2007 63 1 1 5 Q3 2007 59 2 2 0 Q4 2007 63 7 4 2 Q1 2008 93 3 7 4 Q2 2008 65 0 9 0 Q3 2008 45 2 6 8 Q4 2008 32 0 17 10 Aswath Damodaran 142 ..The  last  quarter  of  2008  put  s]ckiness  to  the   test.

 Dividends  tend  to  follow  earnings   143 Aswath Damodaran 143 .II.

    .  101   had  insider  holdings  in   excess  of  20%  of  the   outstanding  stock.   ¨  Of  these  companies.  233   companies  paid  out  $31   billion  in  dividends.  Are  affected  by  tax  laws…   In  2003   In  the  last  quarter  of  2012   ¨  As  the  possibility  of  tax   rates  rever]ng  back  to   pre-­‐2003  levels  rose.II.

  rather  than  pay  dividends.  More  and  more  firms  are  buying  back  stock.IV...   145 Aswath Damodaran 145 .

V.  And  there  are  differences  across  countries…   146 Aswath Damodaran 146 .

Measures  of  Dividend  Policy   147 ¨  Dividend  Payout  =  Dividends/  Net  Income   ¤  Measures  the  percentage  of  earnings  that  the  company   pays  in  dividends   ¤  If  the  net  income  is  nega]ve.   Aswath Damodaran 147 .  the  payout  ra]o  cannot  be   computed.     ¨  Dividend  Yield  =  Dividends  per  share/  Stock  price   ¤  Measures  the  return  that  an  investor  can  make  from   dividends  alone   ¤  Becomes  part  of  the  expected  return  on  the  investment.

Dividend  Payout  Ra]os   148 Aswath Damodaran 148 .

Dividend  Yields:  January  2013   149 Aswath Damodaran 149 .

150 Aswath Damodaran .

Dividend  Yields  and  Payout  Ra]os:  Growth   Classes   151 Aswath Damodaran 151 .

 Tata.Dividend  Policy:  Disney.  Aracruz  and   Deutsche  Bank   152 Aswath Damodaran 152 .

 and  increasing  dividends  will  reduce  value   3.   2.   whenever  needed   Dividends  do  not  ma[er.  If  dividends  create  a  tax  disadvantage  for  investors   (rela]ve  to  capital  gains)   Dividends  are  bad.  and  increasing  dividends  will  increase  value   Aswath Damodaran 153 .   Dividends  are  good.  at  no  cost.  and  dividend  policy  does  not  affect  value.  to  raise  equity.  If  stockholders  like  dividends  or  dividends  operate  as  a   signal  of  future  prospects.Three  Schools  Of  Thought  On  Dividends   153 1.  If       (a)  there  are  no  tax  disadvantages  associated  with   dividends   (b)  companies  can  issue  stock.

The  balanced  viewpoint   154 If  a  company  has  excess  cash.   ¨  Aswath Damodaran 154 .   ¨  If  a  company  does  not  have  excess  cash.  and/or  has   several  good  investment  opportuni]es  (NPV>0).  and  few  good   investment  opportuni]es  (NPV>0).  returning  money   to  stockholders  (dividends  or  stock  repurchases)  is   good.   returning  money  to  stockholders  (dividends  or  stock   repurchases)  is  bad.

  Aswath Damodaran 155 .  it  will  have  to  issue  new  equity  to  fund  the  same   projects.   (c)  If  companies  pay  too  li[le  in  dividends.   (b)  If  companies  pay  too  much  in  cash.  to  replace  this  cash.  By  doing  so.  they  do  not  use  the  excess  cash  for  bad   projects  or  acquisi]ons.  they  can  issue  new  stock.  it  will  reduce  expected  price  apprecia]on  on  the  stock  but  it   will  be  offset  by  a  higher  dividend  yield.     If  a  firm  pays  more  in  dividends.   Underlying  Assump]ons:   (a)  There  are  no  tax  differences  to  investors  between  dividends  and  capital  gains.The  Dividends  don’t  ma[er  school   The  Miller  Modigliani  Hypothesis   155 ¨  ¨  The  Miller-­‐Modigliani  Hypothesis:  Dividends  do  not  affect  value   Basis:   ¤  ¤  ¤  ¨  If  a  firm's  investment  policies  (and  hence  cash  flows)  don't  change.  investors  have  to  be  indifferent  to  receiving  either   dividends  or  capital  gains.  the  value  of  the   firm  cannot  change  as  it  changes  dividends.   If  we  ignore  personal  taxes.  with  no  flota]on  costs   or  signaling  consequences.

 The  Dividends  are  “bad”  school:  And  the   evidence  to  back  them  up…   156 Aswath Damodaran 156 .II.

 tcg  =  Taxes  paid  on  ordinary  income  and  capital  gains  respec]vely   Aswath Damodaran 157 .What  do  investors  in  your  stock  think  about   dividends?  Clues  on  the  ex-­‐dividend  day!   157 ¨  Assume  that  you  are  the  owner  of  a  stock  that  is  approaching  an  ex-­‐ dividend  day  and  you  know  that  dollar  dividend  with  certainty.  assume  that  you  have  owned  the  stock  for  several  years.     Initial buy At $P Pb Pa Ex-dividend day Dividend = $ D P  =  Price  at  which  you  bought  the  stock  a  “while”  back   Pb=  Price  before  the  stock  goes  ex-­‐dividend   Pa=Price  aYer  the  stock  goes  ex-­‐dividend   D  =  Dividends  declared  on  stock   to.  In   addi]on.

Cashflows  from  Selling  around  Ex-­‐Dividend  Day   158 ¨  The  cash  flows  from  selling  before  ex-­‐dividend  day  are:   Pb  -­‐  (Pb  -­‐  P)  tcg     ¨  The  cash  flows  from  selling  aYer  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   aYer  the  ex-­‐dividend  day  -­‐   Pb  -­‐  (Pb  -­‐  P)  tcg  =  Pa  -­‐  (Pa  -­‐  P)  tcg  +  D(1-­‐to)   ¨  Some  basic  algebra  leads  us  to  the  following:   Pb − Pa 1− t o = D 1− t cg Aswath Damodaran 158 .

Intui]ve  Implica]ons   159 ¨  The  rela]onship  between  the  price  change  on  the  ex-­‐ dividend  day  and  the  dollar  dividend  will  be  determined  by   the  difference  between  the  tax  rate  on  dividends  and  the  tax   rate  on  capital  gains  for  the  typical  investor  in  the  stock.   Tax Rates Ex-dividend day behavior If dividends and capital gains are taxed equally Price change = Dividend If dividends are taxed at a higher rate than capital gains Price change < Dividend If dividends are taxed at a lower rate than capital gains Price change > Dividend Aswath Damodaran 159 .

78   1981-­‐1985   1966-­‐1969   160 •  Ordinary   tax  rate  =   28%   •  Capital   gains  rate   =  28%   •  Price  chg/   Dividend  =   0.The  empirical  evidence…   Aswath Damodaran •  Ordinary   tax  rate  =   50%   •  Capital   gains  rate   =  20%   •  Price  chg/   Dividend  =   0.85   1986-­‐1990   •  Ordinary   tax  rate  =   70%   •  Capital   gains  rate   =  28%   •  Price  chg/   Dividend  =   0.90   160 .

 How  would  you  exploit   this  differen]al?   a.  c.  b.  and  that   you  know  that  the  price  drop  on  the  ex-­‐dividend  day   is  only  90%  of  the  dividend.  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.   ______________________________________________   Aswath Damodaran 161 .Dividend  Arbitrage   161 ¨  Assume  that  you  are  a  tax  exempt  investor.  d.  and  sell  aYer.

 Buy  1  million  shares  of  XYZ  stock  cum-­‐dividend  at  $50/share.  Wait  ]ll  stock  goes  ex-­‐dividend.10  million  +  1  million  =   $0.  pension   fund  for  the  arbitrage  are  as  follows:   1.90)   ¤  3.  Collect  dividend  on  stock.10  million   Aswath Damodaran 162 .  XYZ  goes  ex-­‐dividend.  the  dividend  amount  is   $1.     The  transac]ons  needed  by  a  tax-­‐exempt  U.   ¤  ¨  Net  profit  =  -­‐  50  million  +  49.10/share   (50  -­‐  1*  0.Example  of  dividend  capture  strategy  with  tax   factors   162 ¨  ¨  XYZ  company  is  selling  for  $50  at  close  of  trading  May  3.   On  May  4.S.   ¤  2.  Sell  stock  for  $49.  The  price  drop  (from  past  examina]on  of  the  data)  is   only  90%  of  the  dividend  amount.

 Stocks  that  pay   dividends  will  therefore  be  more  highly  valued  than   stocks  that  do  not.Two  bad  reasons  for  paying  dividends   1.   ¨  Counter:  The  appropriate  comparison  should  be   between  dividends  today  and  price  apprecia]on   today.  Hence  dividends  are  more   valuable  than  capital  gains.   ¨  Aswath Damodaran 163 .  The  bird  in  the  hand  fallacy   163 Argument:  Dividends  now  are  more  certain  than   capital  gains  later.  The  stock  price  drops  on  the  ex-­‐dividend  day.

 no  investment  projects  this  year  and  wants  to   give  the  money  back  to  stockholders.  We  have  excess  cash  this  year…   164 Argument:  The  firm  has  excess  cash  on  its  hands  this   year.      The  cost  of  raising  new   financing  in  future  years.  can  be  staggering.   ¨  Counter:  So  why  not  just  repurchase  stock?  If  this  is   a  one-­‐]me  phenomenon.2.   ¨  Aswath Damodaran 164 .  the  firm  has  to  consider   future  financing  needs.  especially  by  issuing  new   equity.

00% 15.00% Under $1 mil $1.9 mil $20-49.9 mil $50 mil and over Size of Issue Cost of Issuing bonds Aswath Damodaran Cost of Issuing Common Stock 165 .9 mil $10-19.The  Cost  of  Raising  Capital   165 Issuance Costs for Stocks and Bonds 25.00% 10.00% 5.00% Cost as % of funds raised 20.0-4.9 mil $2.0-$9.9 mil $5.00% 0.0-1.

Three  “good”  reasons  for  paying  dividends…  
166

Clientele  Effect:  The  investors  in  your  company  like  
dividends.  
¨  The  Signalling  Story:  Dividends  can  be  signals  to  the  
market  that  you  believe  that  you  have  good  cash  
flow  prospects  in  the  future.  
¨  The  Wealth  Appropria]on  Story:  Dividends  are  one  
way  of  transferring  wealth  from  lenders  to  equity  
investors  (this  is  good  for  equity  investors  but  bad  
for  lenders)  
¨ 

Aswath Damodaran

166

1.  The  Clientele  Effect  
The  “strange  case”  of  Ci]zen’s  U]lity  
167

Aswath Damodaran

Class A
shares pay
cash
dividend

Class B
shares offer
the same
amount as a
stock
dividend &
can be
converted to
class A
shares
167

Evidence  from  Canadian  firms  
168

Company

Premium for cash 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 across companies

+ 7.54%

Aswath Damodaran

168

A  clientele  based  explana]on  
169

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'  por}olios  was  
carried  out  to  see  if  their  por}olio  posi]ons  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

169

Results  from  Regression:  Clientele  Effect  
D  i  v  i  d  e  n  d    Y  
  ie  
  l  d  t    =  
   a  
   +  
   b  
   β  
  t    +  
   c  
   A  
  g  e  t    +  
   d  
   I  n  
  c  o  m  e  t    +  
   e  
   D  
  i  f  f  e  r  e  n  t  i  a  l    T  
  a  x    R  a  
  t  e  t    +  
   ε  
  t  
V  a  r  i  a  b  l  e  

C  oe  
  f  f  i  c  i  e  n  t  

I  mp  
  l  i  e  s  

C  o  n  s  t  a  n  t  

4  .  2  2  %  

B  e  t  a    C  o  
  e  f  f  i  c  i  e  n  t  

-­‐  2  .  1  4  5  

H  i  g  h  e  r    b  
  e  t  a    s  
  t  o  c  k  s    p  
  a  y    l    o  w  e  r    d  
  i  v  i  d  e  n  d  s  .  

A  g  e  /  1  0  0  

3  .  1  3  1  

F  i  r  m  s    w  
  i  t  h    o  
  l  d  e  r    i    n  v  e  s  t  o  r  s    p  
  a  y    h  
  i  g  h  e  r  
d  i  v  i  d  e  n  d  s  .  

I  n  c  o  m  e  /  1  0  0  0  

-­‐  3  .  7  2  6  

F  i  r  m  s    w  
  i  t  h    w  
  e  a  l  t  h  i  e  r    i    n  v  e  s  t  o  r  s    p  
  a  y    l    o  w  e  r  
d  i  v  i  d  e  n  d  s  .  

D  i  f  f  e  r  e  n  t  i  a  l    T  
  a  x    R  a  
  t  e  

-­‐  2  .  8  4  9  

I  f    o  
  r  d  i  n  a  r  y    i    n  c  o  m  e    i    s    t  
 a  x  e  d    a  
  t    a  
   h  
  i  g  h  e  r    r  
  a  t  e  
t  h  a  n    c  
  a  p  i  t  a  l    g  
  a  i  n  s  ,    t  
 h  e    f  
  i  r  m    p  
  a  y  s    l    e  s  s  
d  i  v  i  d  e  n  d  s  .  

  Con]nue  to  pay  the  dividends  that  you  used  to.  make  the   investments  in  the  new  markets.  b.  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.Dividend  Policy  and  Clientele   171 ¨  a.  Assume  that  you  run  a  phone  company.  c.  d.  and  issue  new  stock  to   cover  the  shor}all   Other   Aswath Damodaran 171 .  You  are  now  planning  to   enter  the  telecommunica]ons  and  media  markets.  and  that  you  have   historically  paid  large  dividends.  and  defer   investment  in  the  new  markets.   Con]nue  to  pay  the  dividends  that  you  used  to.

  172 Aswath Damodaran 172 .2..  Dividends  send  a  signal”   Increases  in  dividends  are  good  news.

An  Alterna]ve  Story..Increasing  dividends  is  
bad  news…  

Both  dividend  increases  and  decreases  are  
becoming  less  informa]ve…  

3.  Dividend  increases  may  be  good  for  
stocks…  but  bad  for  bonds..  
EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES!
0.5!
0!
t:-! -12! -9! -6! -3!
-0.5!15!

0!

3!

6!

9! 12! 15!

CAR!

CAR (Div Up)!
CAR (Div down)!

-1!
-1.5!
-2!
Day (0: Announcement date)!

What  managers  believe  about  dividends…  
176

Aswath Damodaran

176

Aswath Damodaran

ASSESSING  DIVIDEND  POLICY:  
OR  HOW  MUCH  CASH  IS  TOO  
MUCH?  
It  is  my  cash  and  I  want  it  now…  

177

The  Big  Picture…   178 Aswath Damodaran 178 .

Assessing  Dividend  Policy   179 ¨  Approach  1:  The  Cash/Trust  Nexus   ¤  Assess  how  much  cash  a  firm  has  available  to  pay  in   dividends.   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 179 .  rela]ve  what  it  returns  to  stockholders.

 The  Cash/Trust  Assessment   180 Step  1:  How    much  did  the  the  company  actually  pay   out  during  the  period  in  ques]on?   Step  2:  How  much  could  the  company  have  paid  out   during  the  period  under  ques]on?   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   ques]on?   ¤  How  well  has  my  stock  performed  during  the  period  in   ques]on?   Aswath Damodaran 180 .I.

 for  the  four  companies  we  are   analyzing  the  cash  returned  looked  as  follows.   ¨  Aswath Damodaran 181 .How  much  has  the  company  returned  to   stockholders?   181 As  firms  increasing  use  stock  buybacks.   ¨  For  instance.  we  have  to   measure  cash  returned  to  stockholders  as  not  only   dividends  but  also  buybacks.

  Net  Income    +  Deprecia]on  &  Amor]za]on        =  Cash  flows  from  Opera]ons  to  Equity  Investors    -­‐  Preferred  Dividends    -­‐  Capital  Expenditures      -­‐  Working  Capital  Needs    -­‐  Principal  Repayments    +  Proceeds  from  New  Debt  Issues        =  Free  Cash  flow  to  Equity   Aswath Damodaran 182 .A  Measure  of  How  Much  a  Company  Could  have   Afforded  to  Pay  out:  FCFE   182 ¨  The  Free  Cashflow  to  Equity  (FCFE)  is  a  measure  of  how  much   cash  is  leY  in  the  business  aYer  non-­‐equity  claimholders   (debt  and  preferred  stock)  have  been  paid.  and  aYer  any   reinvestment  needed  to  sustain  the  firm’s  assets  and  future   growth.

Disney’s  FCFE   183 Aswath Damodaran 183 .

Comparing  Payout  Ra]os  to  Cash  Returned   Ra]os.  Disney   184 Aswath Damodaran 184 ..

Es]ma]ng  FCFE  when  Leverage  is  Stable   185 Net  Income   -­‐  (1-­‐  δ)    (Capital  Expenditures  -­‐  Deprecia]on)   -­‐  (1-­‐  δ)  Working  Capital  Needs   =  Free  Cash  flow  to  Equity   δ  =  Debt/Capital  Ra]o   Proceeds  from  new  debt  issues    =  Principal   Repayments  +  δ  (Capital  Expenditures  -­‐  Deprecia]on  +   Working  Capital  Needs)   Aswath Damodaran 185 .

176  -­‐  (494  -­‐  480)  (1-­‐0)  $  2.  In   1996.127  Million      -­‐  $  35  (1-­‐0)   186 .An  Example:  FCFE  Calcula]on   186 ¨  Consider  the  following  inputs  for  MicrosoY  in  1996.176  Million   ¤  Capital  Expenditures  =  $494  Million   ¤  Deprecia]on  =  $  480  Million   ¤  Change  in  Non-­‐Cash  Working  Capital  =  $  35  Million   ¤  Debt  Ra]o(DR)  =  0%   ¤  FCFE  =    Net  Income  -­‐  (Cap  ex  -­‐  Depr)  (1-­‐DR)  -­‐  Chg  WC  (1-­‐DR)            =          =   Aswath Damodaran  $  2.  MicrosoY’s  FCFE  was:   Net  Income  =  $2.

 MicrosoY  could  have  paid  $  2.127   Million  in  dividends/stock  buybacks  in  1996.     ¨  Where  will  the  $2.MicrosoY:  Dividends?   187 By  this  es]ma]on.127  million  show  up  in   MicrosoY’s  balance  sheet?   ¨  Aswath Damodaran 187 .  They   paid  no  dividends  and  bought  back  no  stock.

000)*  (.  Assume  that   the  bank  wants  to  maintain  its  exis]ng  capital  ra]o  of  7.075)  =  $75  million   If  this  bank  wants  to  increase  its  regulatory  capital  ra]o  to  8%  (for   precau]onary  purposes)  while  increasing  its  loan  base  to  $  11  billion   FCFE  =  $  150  million  –  ($  880  -­‐  $750)  =  $20  million   Aswath Damodaran 188 .  we  redefine  reinvestment  as  investment   in  regulatory  capital.  intends  to   grow  its  loan  base  by  10%  (to  $11  billion)  and  expects  to  generate  $  150   million  in  net  income  next  year.FCFE  for  a  Bank?   188 ¨  ¨  ¨  To  es]mate  the  FCFE  for  a  bank.000-­‐10.  consider  a  bank  with  $  10  billion  in  loans   outstanding  and  book  equity  (Tier  1  capital)  of  $  750  million.      FCFE  =  $150  million  –  (11.5%.  Since  any  dividends  paid  deplete  equity  capital  and   retained  earnings  increase  that  capital.  the  FCFE  is:   FCFEBank=  Net  Income  –  Increase  in  Regulatory  Capital  (Book  Equity)   As  a  simple  example.

Deutsche  Bank’s  FCFE   189 Aswath Damodaran 189 .

Dividends  versus  FCFE:  Cash  Deficit  versus   Buildup   190 Aswath Damodaran 190 .

000 Cash Balance Cash Flow $6.000 $0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 ($500) $1.000 $2.000 $4.000 $2.The  Consequences  of  Failing  to  pay  FCFE   191 Chrysler: FCFE.000 $8.500 $7.000 $500 $2.500 $5.000 $0 Year = Free CF to Equity Aswath Damodaran = Cash to Stockholders Cumulated Cash 191 .000 $1. Dividends and Cash Balance $3.000 $9.000 $3.000 $1.

6    Applica]on  Test:  Es]ma]ng  your  firm’s  FCFE  
192

¨ 

In  General,  

 

 

Net  Income  
 
 
+  Deprecia]on  &  Amor]za]on  
-­‐  Capital  Expenditures  
 
-­‐  Change  in  Non-­‐Cash  Working  Capital
-­‐  Preferred  Dividend  
 
-­‐  Principal  Repaid
 
 
+  New  Debt  Issued
 
 
 
 
 
 
=  FCFE
 
 
 
¨ 

 If  cash  flow  statement  used  
 Net  Income  
 +  Deprecia]on  &  Amor]za]on  
 +  Capital  Expenditures  
 +  Changes  in  Non-­‐cash  WC  
 +  Preferred  Dividend  
 +  Increase  in  LT  Borrowing  
 +  Decrease  in  LT  Borrowing  
 +  Change  in  ST  Borrowing  
 =  FCFE  

Compare  to  
Dividends  (Common)
+  Stock  Buybacks  

Aswath Damodaran

 
 

 
 

 Common  Dividend      
 Stock  Buybacks    

192

A  Prac]cal  Framework  for  Analyzing  Dividend  
Policy  
193

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

Firm pays out too little"
FCFE > Dividends"

Firm pays out too much"
FCFE < Dividends"

Do you trust managers in the company with!
your cash?!
Look at past project choice:"
Compare" ROE to Cost of Equity"
ROC to WACC"

Aswath Damodaran

What investment opportunities does the !
firm have?!
Look at past project choice:"
Compare" ROE to Cost of Equity"
ROC to WACC"

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

Firm has history"
of poor project "
choice"

Firm has good "
projects"

Give managers the "
flexibility to keep "
cash and set "
dividends"

Force managers to "
justify holding cash "
or return cash to "
stockholders"

Firm should "
cut dividends "
and reinvest "
more "

Firm has poor "
projects"

Firm should deal "
with its investment "
problem first and "
then cut dividends"

193

A  Dividend  Matrix  
194

Quality of projects taken: ROE versus Cost of Equity
Poor projects
Good projects

Aswath Damodaran

Cash Surplus + Poor
Projects
Significant pressure to
pay out more to
stockholders as
dividends or stock
buybacks

Cash Surplus + Good
Projects
Maximum flexibility in
setting dividend policy

Cash Deficit + Poor
Projects
Cut out dividends but
real problem is in
investment policy.

Cash Deficit + Good
Projects
Reduce cash payout, if
any, to stockholders

194

More  on  MicrosoY  
195

¨ 

MicrosoY  had  accumulated  a  cash  balance  of  $  43  billion  by  
2003  by  paying  out  no  dividends  while  genera]ng  huge  FCFE.  
At  the  end  of  2003,  there  was  no  evidence  that  
¤ 
¤ 

¨ 

¨ 

MicrosoY  was  being  penalized  for  holding  such  a  large  cash  balance  
Stockholders  were  becoming  res]ve  about  the  cash  balance.  There  
was  no  hue  and  cry  demanding  more  dividends  or  stock  buybacks.  

Why?  
In  2004,  MicrosoY  announced  a  huge  special  dividend  of  $  33  
billion  and  made  clear  that  it  would  try  to  return  more  cash  
to  stockholders  in  the  future.  What  do  you  think  changed?  

Aswath Damodaran

195

Case  1:  Disney  in  2003  
196

¨ 

FCFE  versus  Dividends  
¤ 
¤ 

¨ 

Cash  Balance  
¤ 

¨ 

Between  1994  &  2003,  Disney  generated  $969  million  in  FCFE  each  
year.    
Between  1994  &  2003,  Disney  paid  out  $639  million  in  dividends  and  
stock  buybacks  each  year.  
Disney  had  a  cash  balance  in  excess  of  $  4  billion  at  the  end  of  2003.  

Performance  measures  
¤ 

¤ 
¤ 

Between  1994  and  2003,  Disney  has  generated  a  return  on  equity,  on  
it’s  projects,  about  2%  less  than  the  cost  of  equity,  on  average  each  
year.  
Between  1994  and  2003,  Disney’s  stock  has  delivered  about  3%  less  
than  the  cost  of  equity,  on  average  each  year.  
The  underperformance  has  been  primarily  post  1996  (aYer  the  Capital  
Ci]es  acquisi]on).  

Aswath Damodaran

196

  the  CEO  for  the  last  10  years  and  the  ini]ator  of  the  Cap   Ci]es  acquisi]on  have  an  effect  on  your  decision.  would  you  be   comfortable  with  Disney’s  dividend  policy?   Yes   No   Does  the  fact  that  the  company  is  run  by  Michael  Eisner.  ¨  a.  b.   Yes   No   Aswath Damodaran 197 .Can  you  trust  Disney’s  management?   197 ¨  a.  Given  Disney’s  track  record  between  1994  and  2003.  if   you  were  a  Disney  stockholder.  b.

 its  ac]ons  over  that   decade  have  fri[ered  away  this  flexibility.com).  Expect  to  face  relentless  pressure  to   pay  out  more  dividends.   While  the  company  may  have  flexibility  to  set  its   dividend  policy  a  decade  ago.   It  chose  not  to.   Bo[om  line:  Large  cash  balances  would  not  be  tolerated   in  this  company.The  Bo[om  Line  on  Disney  Dividends  in  2003   198 ¨  ¨  ¨  ¨  Disney  could  have  afforded  to  pay  more  in  dividends   during  the  period  of  the  analysis.   Aswath Damodaran 198 .  and  used  the  cash  for  acquisi]ons   (Capital  Ci]es/ABC)  and  ill  fated  expansion  plans   (Go.

  would  you  be  more  recep]ve?   Yes   No   Aswath Damodaran 199 .   It’s  stock  price  performance  improved  (posi]ve  Jensen’s  alpha)   It’s  project  choice  improved  (ROC  moved  from  being  well  below  cost   of  capital  to  above)   The  firm  also  shiYed  from  cash  returned  <  FCFE  to  cash   returned  >  FCFE  and  avoided  making  large  acquisi]ons.  Bob  Iger.  with  a  new  CEO.  b.  who  at   least  on  the  surface  seemed  to  be  more  recep]ve  to  stockholder   concerns.   If  you  were  a  stockholder  in  2009  and  Iger  made  a  plea  to   retain  cash  in  Disney  to  pursue  investment  opportuni]es.  Michael  Eisner.Following  up:  Disney  in  2009   199 ¨  Between  2004  and  2008.  It  replaced  its  CEO.  Disney  made  significant  changes:   ¤  ¤  ¤  ¨  ¨  a.

 Aracruz’s  stock  has  delivered  about   2%  more  than  the  cost  of  equity.  Aracruz  generated  $37  million  in  FCFE   each  year.Case  2:  Aracruz  Celulose  -­‐  Assessment  of   dividends  paid  in  2003   200 ¨  FCFE  versus  Dividends   Between  1999  and  2003.   ¤  ¨  Performance  measures   Between  1999  and  2003.  on  average  each  year.  Aracruz  has  generated  a  return  on   equity.   ¤  Between  1999  and  2003.5%  more  than  the  cost  of   equity.  on  average  each  year.  about  1.     ¤  Between  1999  and  2003.   ¤  Aswath Damodaran 200 .  Aracruz  paid  out  $80  million  in   dividends  and  stock  buybacks  each  year.  on  it’s  projects.

  b.  Are  you  likely  to  go  along?   a.  However.  the  preferred  shares  get  vo]ng   rights.  Aracruz  has  two  classes   of  shares  -­‐  common  shares  with  vo]ng  rights  and  preferred  shares   without  vo]ng  rights.  Aracruz  has  commi[ed  to  paying   out  35%  of  its  earnings  as  dividends  to  the  preferred  stockholders..  If  you  own  the  preferred  shares.   201 ¨  Aracruz’s  managers  have  asked  you  for  permission  to  cut   dividends  (to  more  manageable  levels).  b.  would  your  answer  to  the   ques]on  above  change?   a.  Yes   No   Aswath Damodaran 201 .Aracruz:  Its  your  call.   If  they  fail  to  meet  this  threshold.  ¨  Yes   No   The  reasons  for  Aracruz’s  dividend  problem  lie  in  it’s  equity   structure.  Like  most  Brazilian  companies.

 what  types  of  companies  will  be  hurt   the  most  by  such  a  mandate?   Large  companies  making  huge  profits   Small  companies  losing  money   High  growth  companies  that  are  losing  money   High  growth  companies  that  are  making  money   What  if  the  government  mandates  a  cap  on  the  dividend   payout  ra]o  (and  a  requirement  that  all  companies   reinvest  a  por]on  of  their  profits)?   Aswath Damodaran 202 .  b.  d.  c.  Given  our   discussion  of  FCFE.  ¨  Assume  now  that  the  government  decides  to  mandate  a   minimum  dividend  payout  for  all  companies.Mandated  Dividend  Payouts   202 ¨  a.

  In  2008.  The  reason  for  the  losses.  was  specula]on  on  the  part  of  the   company’s  managers  on  currency  deriva]ves.   though.  with  losses   in  excess  of  a  billion.Aracruz:  Ready  to  reassess?   203 ¨  a.  The   FCFE  in  2008  was  -­‐$1.   would  you  reassess  your  unwillingness  to  accept   dividend  cuts  now?   Yes   No     Aswath Damodaran 203 .226  billion  but  the  company   s]ll  had  to  pay  out  $448  million  in  dividends.  As   owners  of  the  non-­‐vo]ng.  Aracruz  had  a  catastrophic  year.  dividend  receiving  shares.  b.

50) $1.29 $3.00 11.496.382.00 ($612.112.77 $2.10 $1.00 $831.00% ROE .30 $448.59% Free CF to Equity Dividends Dividend Payout Ratio 84.90% -21.00 Dividends+Repurchases $1.67% 204 .Required return Aswath Damodaran -1.77 $2.00 $831.30 $448.496.77% Cash Paid as % of FCFE 262.49% 20.764.112.Case  3:  BP:  Summary  of  Dividend  Policy:   1982-­‐1991   204 Summary of calculations Average Standard Deviation Maximum Minimum $571.

BP:  Just  Desserts!   205 Aswath Damodaran 205 .

Managing  changes  in  dividend  policy   206 Aswath Damodaran 206 .

69% 207 .59% 19.17) Dividends $40.36 $5.79 $101.07% 29.36 $5.97 Dividends+Repurchases $40.74 $96.89 ($242.52% ROE .84% Cash Paid as % of FCFE -119.20) $109.97 Dividend Payout Ratio 18.Required return Aswath Damodaran 1.26% -19.87 $32.Case  4:  The  Limited:  Summary  of  Dividend   Policy:  1983-­‐1992   207 Summary of calculations Average Standard Deviation Maximum Minimum Free CF to Equity ($34.79 $101.87 $32.

  the  stock  price.  Yes   b.  No   ¨  Why?   ¨  Aswath Damodaran 208 .  by  extension.Growth  Firms  and  Dividends   208 High  growth  firms  are  some]mes  advised  to  ini]ate   dividends  because  its  increases  the  poten]al   stockholder  base  for  the  company  (since  there  are   some  investors  -­‐  like  pension  funds  -­‐  that  cannot  buy   stocks  that  do  not  pay  dividends)  and.  Do  you  agree  with  this  argument?   a.

 Tata  Chemicals:  The  Cross  Holding  Effect:   2009   209 Aswath Damodaran Much of the cash held back was invested in other Tata companies. 209 .5.

Summing  up…   210 Aswath Damodaran 210 .

 would  you  encourage  the  firm  to  return  more   cash  or  less  cash  to  its  owners?   If  you  would  encourage  it  to  return  more  cash.   Based  upon  your  earlier  analysis  of  your  firm’s  project   choices.Applica]on  Test:  Assessing  your  firm’s  dividend   policy   211 ¨  ¨  ¨  Compare  your  firm’s  dividends  to  its  FCFE.  looking  at   the  last  5  years  of  informa]on.  what   form  should  it  take  (dividends  versus  stock  buybacks)?   Aswath Damodaran 211 .

II.  The  Peer  Group  Approach  -­‐  Disney   212 Aswath Damodaran 212 .

Peer  Group  Approach:  Deutsche  Bank   213 Aswath Damodaran 213 .

Peer  Group  Approach:  Aracruz  and  Tata   Chemicals   214 Aswath Damodaran 214 .

Going  beyond  averages…  Looking  at  the  market   215 ¨  Regressing  dividend  yield  and  payout  against  expected  growth  across  all   US  companies  in  January  2009  yields:   PYT  =  Dividend  Payout  Ra]o  =  Dividends/Net  Income   YLD  =  Dividend  Yield  =  Dividends/Current  Price   ROE  –  Return  on  Equity   EGR  =  Expected  growth  rate  in  earnings  over  next  5  years  (analyst  es]mates)   STD  =  Standard  devia]on  in  equity  values   INS  =  Insider  holdings  as  a  percent  of  outstanding  stock   Aswath Damodaran 215 .

67%  and  a   payout  ra]o  of  approximately  20%  is  paying  too  li[le  in  dividends.  we  es]mate  a  predicted  payout  ra]o:   ¤  ¤  ¨  Insider  holdings  at  Disney  (as  %  of  outstanding  stock)  =  7.Using  the  market  regression  on  Disney   216 ¨  To  illustrate  the  applicability  of  the  market  regression  in  analyzing  the   dividend  policy  of  Disney.1930)  –  0.30%   Disney’s  ROE          =  13.1305)  -­‐1.  This   analysis.313  (.4069     Predicted  Yield  =  0.  however.     Aswath Damodaran 216 .039  (.05%   Expected  growth  in  earnings  per  share  (Analyst  es]mates)  =  14.07  (.  fails  to  factor  in  the  huge  stock  buybacks  made  by   Disney  over  the  last  few  years.50%   Predicted  Payout  =  0.145)  =0.077)  –  0.093  (.  Disney  with  its  dividend  yield  of  1.  we  es]mate  the  values  of  the  independent   variables  in  the  regressions  for  the  firm.   ¤  ¤  ¤  ¤  ¨  Subs]tu]ng  into  the  regression  equa]ons  for  the  dividend  payout  ra]o   and  dividend  yield.1930)  –  0.039  –  0.70%   Standard  Devia]on  in  Disney  stock  prices      =  19.185  (.010  (.0172   Based  on  this  analysis.683    –  0.145)  =    .

  Oscar  Wilde   ..Aswath Damodaran 217 VALUATION   Cynic:  A  person  who  knows  the  price  of  everything  but  the  value  of  nothing.

First  Principles   218 Aswath Damodaran 218 .

 the  value  can   be  es]mated  using  op]on  pricing  models.   Aswath Damodaran 219 .  this  takes  the  form  of  value  or  price  mul]ples   and  comparing  firms  within  the  same  business.   In  general.   Con]ngent  claim  valua]on:  When  the  cash  flows  on  an   asset  are  con]ngent  on  an  external  event.  discounted  cash  flow  models  are  used  to   es]mate  intrinsic  value.   Rela]ve  valua]on:  The  value  of  an  asset  is  es]mated   based  upon  what  investors  are  paying  for  similar  assets.  In   general.  growth  and  risk.Three  approaches  to  valua]on   219 ¨  ¨  ¨  Intrinsic  valua]on:  The  value  of  an  asset  is  a  func]on  of   its  fundamentals  –  cash  flows.

Discounted  Cashflow  Valua]on:  Basis  for   Approach   220 t=n Expected Cash flow in period t Value of an asset= ∑ (1+r)t t=1 where.   n  =  Life  of  the  asset   r  =  Discount  rate  reflec]ng  the  riskiness  of  the  es]mated   cashflows   Aswath Damodaran 220 .

 the  residual  cashflows  aYer  mee]ng  all  expenses.  i.e..  the  rate  of  return  required  by  equity  investors  in  the   firm.e.Equity  Valua]on   221 ¨  The  value  of  equity  is  obtained  by  discoun]ng  expected  cashflows   to  equity.   tax  obliga]ons  and    interest  and  principal  payments.   Aswath Damodaran 221 .  at  the  cost  of   equity.    CF  to  Equity  t  =  Expected  Cashflow  to  Equity  in  period  t    ke  =  Cost  of  Equity   ¨  The  dividend  discount  model  is  a  specialized  case  of  equity   valua]on.  i..    and  the  value  of  a  stock  is  the  present  value  of  expected   future  dividends.     t=n CF to Equity t (1+k e )t t=1 Value of Equity= ∑ where.

 but  prior  to  debt   payments.  weighted  by  their  market  value  propor]ons.Firm  Valua]on   222 ¨  The  value  of  the  firm  is  obtained  by  discoun]ng  expected   cashflows  to  the  firm.  the  residual  cashflows  aYer   mee]ng  all  opera]ng  expenses  and  taxes.    CF  to  Firm  t  =  Expected  Cashflow  to  Firm  in  period  t    WACC  =  Weighted  Average  Cost  of  Capital   Aswath Damodaran 222 .e.  i..  at  the  weighted  average  cost  of  capital.   t=n CF to Firm t t t=1 (1+WACC) Value of Firm= ∑ where.  which  is   the  cost  of  the  different  components  of  financing  used  by  the   firm.

 For  Aracruz.   If  a  firm’s  debt  ra]o  is  not  expected  to  change  over   ]me.  we  will  discount   free  cash  flows  to  equity.  For  financial  service  firms.   If  a  firm’s  debt  ra]o  might  change  over  ]me.  it  is  difficult  to   es]mate  free  cash  flows.   we  would  discount  free  cash  flows  to  the  firm.  free  cash   flows  to  equity  become  cumbersome  to  es]mate.Choosing  a  Cash  Flow  to  Discount   223 ¨  ¨  ¨  When  you  cannot  es]mate  the  free  cash  flows  to  equity   or  the  firm.  Here.  For   Disney.  For  Deutsche  Bank.   Aswath Damodaran 223 .  we  will  be   discoun]ng  dividends.  the  free  cash  flows  to  equity  can  be  discounted  to   yield  the  value  of  equity.  we  will  discount  the  free  cash  flow  to  the  firm.  the  only  cash  flow  that  you  can  discount  is   dividends.

The  Ingredients  that  determine  value.   224 Aswath Damodaran 224 .

I.  Es]ma]ng  Cash  Flows   225 Aswath Damodaran 225 .

  In  early  2009.  To  forecast  future  dividends.  Deutsche  Bank  paid  out  dividends  of  2.  Deutsche  Bank’s  dividend   policy  was  in  flux.146  million  Euros  on  net   income  of  6.  In  early  2008.Dividends  and  Modified  Dividends  for  Deutsche   Bank   226 ¨  ¨  In  2007.  The  net  income  had  plummeted  and  capital  ra]os  were   being  reassessed.510  million  Euros.  we  valued  Deutsche  Bank   using  the  dividends  it  paid  in  2007.  we  first  forecast  net   income  (ROE*  Asset  Base)  and  then  es]mated  the  investments  in   regulatory  capital:   Aswath Damodaran 226 .  We  are  assuming  the  dividends  are   not  only  reasonable  but  sustainable.  in  the  aYermath  of  the  crisis.

Es]ma]ng  FCFE  :  Tata  Chemicals   227   Aswath Damodaran     227 .

Es]ma]ng  FCFF:  Disney   228 ¨    Aswath Damodaran     228 .

    ¨  The  cost  of  equity  is  the  rate  at  which  we  discount   cash  flows  to  equity  (dividends  or  free  cash  flows  to   equity).II.   Errors  in  es]ma]ng  the  discount  rate  or   mismatching  cashflows  and  discount  rates  can  lead   to  serious  errors  in  valua]on.   ¨  Aswath Damodaran 229 .     ¨  At  an  intui]ve  level.  the  discount  rate  used  should   be  consistent  with  both  the  riskiness  and  the  type  of   cashflow  being  discounted.    Discount  Rates   229 Cri]cal  ingredient  in  discounted  cashflow  valua]on.  The  cost  of  capital  is  the  rate  at  which  we   discount  free  cash  flows  to  the  firm.

50%  (the  mature  market   risk  premium  in  early  2008).6%  and  the   equity  risk  premium  had  risen  to  6%  for  mature  markets:   Cost  of  equity  Jan  2009  =  Riskfree  Rate  Jan  2009  +  Beta  (Equity  Risk  Premium)      =  3.Cost  of  Equity:  Deutsche  Bank   2008  versus  2009   230 ¨  In  early  2008.23%.572%   Aswath Damodaran 230 .162  (4.   which  used  in  conjunc]on  with  the  Euro  risk-­‐free  rate  of  4%  (in   January  2008)  and  a  risk  premium  of  4.00%  +  1.  We  could  have  looked   at  the  betas  for  banks  in  early  2008  and  used  that  number  instead)   ¨  In  early  2009.6%  +  1.162  (6%)  =  10.5%)  =  9.  we  es]mated  a  beta  of  1.   Cost  of  Equity  Jan  2008  =  Riskfree  Rate  Jan  2008  +  Beta*  Mature  Market  Risk   Premium      =  4.162  for  Deutsche  Bank.  the  Euro  riskfree  rate  had  dropped  to  3.  yielded  a  cost  of  equity  of  9.23%   (We  used  the  same  beta  for  early  2008  and  early  2009.

Cost  of  Equity:  Tata  Chemicals   231 We  will  be  valuing  Tata  Chemicals  in  rupee  terms.945  for   Tata  Chemical’s  opera]ng  assets  .945  (10.   (That  is  a  choice.51%)  =  13.93%.51%  for  India  (also  es]mated  in   Chapter  4).  we  es]mated  a  beta  for  equity  of  0.  we  arrive  at  a  cost  of  equity  of  13.93%   ¨  Aswath Damodaran 231 .   ¨  Earlier.    Cost  of  Equity  =  4%  +  0.  Any  company  can  be  valued  in  any   currency).  With  a  nominal   rupee  risk-­‐free  rate  of  4  percent  and  an  equity  risk   premium  of  10.

 we  es]mated  the  cost  of  equity  for  Disney  to  be  8.682):   45.Current  Cost  of  Capital:  Disney   232 The  beta  for  Disney’s  stock  in  May  2009  was  0.193 16.682 + 45.193)  and  debt   (16.72%   ¨  The  cost  of  capital  was  calculated  using  these  costs  and  the   weights  based  on  market  values  of  equity  (45.   the  es]mated  pretax  cost  of  debt  for  Disney  is  6%.193) 232 .  and  based  on  this  ra]ng.91% + 3.72%.  Using  a   marginal  tax  rate  of  38%.51% ¨  (16.682 + 45.  bond   rate  at  that  ]me  was  3.5%  +  0.91%:    Cost  of  Equity  =  3.91%   ¨  Disney’s  bond  ra]ng  in  May  2009  was  A.193) Aswath Damodaran € (16.72% = 7.  Using  an  es]mated  equity  risk  premium   of  6%.9011(6%)  =  8.38)  =  3.  The  T.9011.5%.    AYer-­‐Tax  Cost  of  Debt    =  6.682 Cost  of  capital  =     8.  the  aYer-­‐tax  cost  of  debt  for  Disney  is   3.00%  (1  –  0.

But  costs  of  equity  and  capital  can  and  should   change  over  ]me…   233 Aswath Damodaran 233 .

 Expected  Growth   234 Expected Growth Net Income Retention Ratio= 1 .III.Dividends/Net Income Aswath Damodaran X Return on Equity Net Income/Book Value of Equity Operating Income Reinvestment Rate = (Net Cap Ex + Chg in WC/EBIT(1-t) X Return on Capital = EBIT(1-t)/Book Value of Capital 234 .

146 = 67.45% Book Value of Equity 33.     6.510  Return  on  Equity  =     Net Income = = 19.475  billion  Euros  at  the  start  of  the  year  (end  of  2006).146 = 45.   from  2003  to  2007:   Average Net Income 3.475      Reten]on  Ra]o  =     1 − Dividends = 1 −2.03% 2007 2006 € ¨  ¨  Net Income 6.954 Expected  Growth  Rate  Normalized  Fundamentals  =  0.  Deutsche  Bank  reported  net  income  of  6.4572  *  0.146  billion  Euros  as  dividends.1181  =  5.  and  paid   out  2.475 = 11.1945  =  13.Es]ma]ng  growth  in  EPS:  Deutsche  Bank  in   January  2008   235 ¨  In  2007.81%  Normalized  Reten]on  Ra]o  =     1 − Dividends = 1 −2.6703  *  0.40%   2003-07 2006 € € Aswath Damodaran 235 .04%   If  we  replace  the  net  income  in  2007  with  average  net  income  of  $3.72% Net Income 3.510 If  Deutsche  Bank  maintains  the  return  on  equity  (ROE)  and  reten]on  ra]o  that  it   delivered  in  2007  for  t€he  long  run:    Expected  Growth  Rate  Exis]ng  Fundamentals  =  0.954  Normalized  Return  on  Equity  =     Book Value of Equity = 33.954  million.51  billion  Euros  on  a  book  value   of  equity  of  33.

Es]ma]ng  growth  in  Net  Income:  Tata   Chemicals   236 Normalized  Equity  Reinvestment  Rate  =     Equity Reinvestment Total 2004-08 19.62% Net IncomeTotal 2004-08 31.992      Expected  Growth  in   € Net  Income  =  63.744 = = 63.34%  =  11.03%   Total 2004-08 Total 2004-08 Aswath Damodaran 236 .033 = = 17.34% Normalized  Return  on  Equity  =     Book Value of Equity 178.033 €     Net Income 31.62%  *  17.

   ROC  =  (EBIT  (1  -­‐  tax  rate))  /  (Book  Value  of  Capital)    BV  of  Capital  =  BV  of  Debt  +  BV  of  Equity  -­‐  Cash    D/E  =  Debt/  Equity  ra]o      i  =  Interest  rate  on  debt    t  =  Tax  rate  on  ordinary  income.ROE  and  Leverage   237 A  high  ROE.  other  things  remaining  equal.   ¨  Aswath Damodaran 237 .     ¨  The  ROE  for  a  firm  is  a  func]on  of  both  the  quality  of  its   investments  and  how  much  debt  it  uses  in  funding  these   investments.  should  yield  a   higher  expected  growth  rate  in  equity  earnings.  In  par]cular   ROE  =  ROC  +  D/E  (ROC  -­‐  i  (1-­‐t))   where.

 an  aYer-­‐tax  cost  of  debt  of  5%  and  a  book  debt  to   equity  ra]o  of  100%.   Now  assume  that  another  company  in  the  same  sector  has   the  same  ROE  as  the  company  that  you  have  just  analyzed   but  no  debt.Decomposing  ROE   238 ¨  ¨  ¨  Assume  that  you  are  analyzing  a  company  with  a  15%  return   on  capital.  Will  these  two  firms  have  the  same  growth  rates   in  earnings  per  share  if  they  have  the  same  dividend  payout   ra]o?   Will  they  have  the  same  equity  value?   Aswath Damodaran 238 .  Es]mate  the  ROE  for  this  company.

5   billion  to  buy  Capital  Ci]es  in  1996.  but  this  is  a  vola]le  item.030 (1-.  we  es]mate  an  average  annual   value  of  $1.5  billion  to  buy  Pixar  in  2006  and  $  11.  but  it  does  so   infrequently  -­‐  $  7.38) Aswath Damodaran 239 .030 (1-.  Averaging  out   acquisi]ons  from  1994-­‐2008.939.1.72%  Reinvestment  Rate  Normalized  =     7.761  million  for  acquisi]ons  over  this  period:   (3.752.839+ 241) = 26.Es]ma]ng  Growth  in  EBIT:  Disney   The  Reinvestment  Rate   239 ¨  We  begin  by  es]ma]ng  the  reinvestment  rate  and  return  on   capital  for  Disney  in  2008  using  the  numbers  from  the  latest   financial  statements.1.  Disney  does   not  make  large  acquisi]ons  every  year.839+ 241) = 53.      Reinvestment  Rate2008  =     (2.38) ¨  We  include  $516  million  in  acquisi]ons  made  during  2008  in   capital  expenditures.48% 7.

 its  growth  rate  will  be   5.72%  *  9.72%  and  return  on  capital  of   9.32%   Aswath Damodaran 240 .91%  =  5.892 .670) € If  Disney  maintains   its  2008  normalized   reinvestment  rate  of  53.030 (1 -.91%  for  the  next  few  years.3.38) = = 9.  using  opera]ng   income  in  2008  and  capital  invested  at  the  start  of   2008  (end  of  2007):   EBIT (1 .753 + 16.       Expected  Growth  Rate  =  53.32  percent.Es]ma]ng  Growth  in  Disney   ROC  and  Expected  Growth   240 ¨  We  compute  the  return  on  capital.t) 7.91% Return  on  Capital2008  =     ¨  (BV of Equity + BV of Debt .Cash) (30.

 to  capture  the  value   at  the  end  of  the  period:   t=N CF t + Terminal Value Value = ∑ N t (1+r) (1+r) t=1 ¨  When  a  firm’s  cash  flows  grow  at  a  “constant”  rate  forever.   ¨  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.IV.    r  =  Discount  rate  (Cost  of  Equity  or  Cost  of  Capital)    g  =  Expected  growth  rate  forever.  the  present   value  of  those  cash  flows  can  be  wri[en  as:   Value  =  Expected  Cash  Flow  Next  Period  /  (r  -­‐  g)   where.   Aswath Damodaran 241 .  we  es]mate  cash  flows  for  a   “growth  period”  and  then  es]mate  a  terminal  value.  Gepng  Closure  in  Valua]on   241 ¨  Since  we  cannot  es]mate  cash  flows  forever.

 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.  we  can  make  one  of  three  assump]ons:   ¤  ¤  ¤  ¨  there  is  no  high  growth.Gepng  to  stable  growth…   242 ¨  A  key  assump]on  in  all  discounted  cash  flow  models  is  the  period   of  high  growth.  at  the  end  of  which  the  growth  rate   will  decline  gradually  to  a  stable  growth  rate(3-­‐stage)   The  assump]on  of  how  long  high  growth  will  con]nue  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  differen]al  advantages  (if  high  -­‐>  longer  growth   period)   Aswath Damodaran 242 .  in  which  case  the  firm  is  already  in  stable  growth   there  will  be  high  growth  for  a  period.  and  the  pa[ern  of  growth  during  that  period.  In   general.

Choosing  a  Growth  Period:  Examples   243 Aswath Damodaran 243 .

38)  (.73%.  Since  we  assume  that  the  cost  of  debt  remains   unchanged  at  6%.33%   Adjust  risk  and  cost  of  capital:  The  beta  for  the  stock  will  drop  to  one.95%  but  the  compe]]ve  advantages   that  Disney  has  are  unlikely  to  dissipate  completely  by  the  end  of  the  10th  year.  reflec]ng   Disney’s  status  as  a  mature  company.733)  +  6%  (1-­‐.Es]ma]ng  Stable  Period  Inputs:  Disney   244 ¨  ¨  ¨  Respect  the  cap:  The  growth  rate  forever  is  assumed  to  be  3%.   Think  about  stable  period  excess  returns:  The  return  on  capital  for  Disney  will   drop  from  its  high  growth  period  level  of  9.33%:   ¤  ¨  Reinvestment  Rate  =  Growth  Rate  /  Return  on  Capital    =  3%  /9%  =  33.     ¤  ¤  ¤  Cost  of  Equity  =  Riskfree  Rate  +  Beta  *  Risk  Premium  =  3.  This  is  set  lower   than  the  riskfree  rate  (3.5%).  this  yields  a  stable  period   reinvestment  rate  of  33.5%   The  debt  ra]o  for  Disney  will  stay  at  26.91%  to  a  stable  growth  return  of  9%.267)  =  7.  this  will  result  in  a  cost  of  capital  of  7.95%   Cost  of  capital  =  9.5%  (.5%  +  6%  =  9.     Reinvest  to  grow:  The  expected  growth  rate  in  stable  growth  will  be  3%.95%   Aswath Damodaran 244 .  In   conjunc]on  with  the  return  on  capital  of  9%.   This  is  s]ll  higher  than  the  cost  of  capital  of  7.

V. Discount aggregate FCFF at the cost of capital PV = Value of operating assets + Cash & Near Cash investments + Value of minority cross holdings - Debt outstanding = Value of equity - Value of equity options =Value of equity in common stock / Number of shares Aswath Damodaran 245 .  From  firm  value  to  equity  value  per  share   245 Approach used To get to equity value per share Discount dividends per share at the cost of equity Present value is value of equity per share Discount aggregate FCFE at the cost of equity Present value is value of aggregate equity. Subtract the value of equity options given to managers and divide by number of shares.

28%   ¤  Expected  growth  rate  =  (1-­‐.954  million  Euros)  and  the  dividends  in  2008  (2.  We  assumed  that  the  payout  ra]o  and  ROE.  we  started  with  the  normalized  income  over  the   previous  five  years  (3.054  or  5.4%     ¤  Cost  of  equity  =  9.1181  =  0.5428)  *  .146   million  Euros).146/3954  =  54.23%   Aswath Damodaran 246 .Valuing  Deutsche  Bank  in  early  2008   246 ¨  To  value  Deutsche  Bank.  based  on   these  numbers  will  con]nue  for  the  next  5  years:   ¤  Payout  ra]o  =  2.

318 million Euros Terminal Value n 62.   Aswath Damodaran 247 .2  Stock  was  trading  at  89  Euros  per  share  at  the  ]me  of  the  analysis.71%     Expected  Dividends  in  Year  6  =  Expected  Net  Income5  *(1+gStable)*  Stable  Payout  Ra]o      =  €5.88 Euros/share # Shares 474.732  million  Euros   Value  of  equity  per  share=     Value of Equity = 49.085  =  0.03/0.6471  or  64.6471  =  €3.5%  (as  the  beta  moves  to  1)  and  that  the  return  on   equity  also  drops  to  8.085-.Deutsche  Bank  in  stable  growth   247 ¨  At  the  end  of  year  5.03)  *  0.079  =  €49.   Stable  Period  Payout  Ra]o  =  1  –  g/ROE  =  1  –  0.03) = 62. 079 mil Euros (1+Cost of Equity High growth )n (1.247     (Cost of Equity-g) PV  of  Terminal  Value  =         ¨  ¨    = (.0923)5 Value  of  equity  =  €9.143  (1.5  (to  equal  the  cost  of  equity).  the  firm  is  in  stable  growth.427  million   Terminal  Value  =     Expected Dividends6 3.732 = 104.318 = = 40.  We  assume  that  the  cost   of  equity  drops  to  8.653+  €40.

 The  FCFE  could  have  been   significantly  lower  than  the  dividends  paid.     ¨  Aswath Damodaran 248 .  given   our  es]mates  of  expected  growth  and  risk.   ¨  Es]mates  of  growth  and  risk  are  wrong:  It  is  also   possible  that  we  have  over  es]mated  growth  or   under  es]mated  risk  in  the  model.  thus  reducing  our   es]mate  of  value.   ¨  Dividends  may  not  reflect  the  cash  flows  generated   by  Deutsche  Bank.What  does  the  valua]on  tell  us?  One  of  three   possibili]es…   248 Stock  is    under  valued:  This  valua]on  would  suggest   that  Deutsche  Bank  is  significantly  overvalued.

62%  *  17.717  *.03%   We  assume  that  the  current  cost  of  equity  (see  earlier  page)  of   13.193  million   (We  removed  interest  income  from  cash  to  arrive  at  the  normalized  return  on   equity)   ¨  ¨  We  use  the  average  equity  reinvestment  rate  of  63.34%  to  es]mate  growth:    Expected  Growth  in  Net  Income  =  63.       Aswath Damodaran 249 .Valuing  Tata  Chemicals  in  early  2009:   The  high  growth  period   249 ¨  We  used  the  normalized  return  on  equity  of  17.62  percent  and   the  normalized  return  on  equity  of  17.93%  will  hold  for  the  next  5  years.  6.717  million)  to   es]mate  net  income:    Normalized  Net  Income  =  35.34%  (see  earlier   table)  and  the  current  book  value  of  equity  (Rs  35.1734  =  Rs.34%  =  11.

5%  (which  is  also  the  cost  of  equity).13935  +1.04)(1  –  0.  we  will  assume  that  the  beta  will  increase  to  1  and  that   the  equity  risk  premium  will  decline  to  7.    Cost  of  Equity  in  Stable  Growth  =  4%  +  1(7.5  percent.5  percent  (we  assumed  India   country  risk  would  drop).5%)  =  11.5%   We  will  assume  that  the  growth  in  net  income  will  drop  to  4%  and  that   the  return  on  equity  will  rise  to  11.433  +  94.  about   20%  higher  than  the  stock  price  of  Rs  222  per  share.5%  =  34.Stable  growth  and  value….78%     FCFE  in  Year  6  =  10.087  million     Terminal  Value  of  Equity  =  7.   250 ¨  ¨  AYer  year  five.759  =  Rs  61.449(1.3478)  =  Rs  7.  The  resul]ng  cost  of  equity  is  11.423  million   ¤  Dividing  by  235.087/(0.   Aswath Damodaran 250 .17  million  shares  yields  a  value  of  equity  per  share  of  Rs  261.497/1.04)  =  Rs  94.497  million   ¨  To  value  equity  in  the  firm  today   Value  of  equity  =  PV  of  FCFE  during  high  growth  +  PV  of  terminal  value  +  Cash      =  10.     Equity  Reinvestment  Rate  Stable  Growth  =  4%/11.115  –  0.

Disney:  Inputs  to  Valua]on   251 Aswath Damodaran 251 .

0795-. Reinvestment Rate=3/9=33.Reinvestment $2. Beta = 1.91% Reinvestment Rate 53.91% On June 1.882 $2.574 -Options 528 Value/Share $ 28.0532 5.Debt 16.283 $4.5%)(1-.95% Cost of Equity 8.795 + Non op inv 1.90 Unlevered Beta for Sectors: 0.238 Expected Growth in EBIT (1-t) .72% (0.736 $2.32% 3 $5.7333 Weights E = 73% D = 27% X Risk Premium 6% D/E=36.33% Terminal Value10 = 4704/(.91% Riskfree Rate: Riskfree rate = 3.185 $2.284 + Cash: 3.466 FCFF $2.73) + 3.03) = 94.682 .27) = 7.941 $2.5% 252 Aswath Damodaran Cost of Debt (3.91% (0.Disney . Assets 65.357 4 $5.359 .52% Cost of capital gradually increases to 7. Cost of capital =7.344 =Equity 73.38)= 4.591 .364 $2.667 $3.5%+2.Minority int 1.818 $3.Status Quo in 2009 Current Cashflow to Firm EBIT(1-t)= 7030(1-.95% ROC= 9%.650 $2.017 Reinvestment Rate = 2342/4359 =53.366 8 $6. Disney was trading at $24.835 $2.761 9 $6.72% Return on capital = 9.428 $2.5372*.924 $2.72% Based on actual A rating + Beta 0.488 $4.598 $2.035 $2.125 2 $4.72% Op.0991=.850 $2.928 Growth decreases gradually to 3% First 5 years Return on Capital 9.650 $3.567 Term Yr 7055 2351 4704 Cost of Capital (WACC) = 8.16 Year 1 EBIT (1-t) $4.Nt CpX= 2.101 .38) = 3.983 Stable Growth g = 3%.763 .00.162 10 $6.482 5 $5.91% 7 $6.Chg WC 241 = FCFF 2.615 6 $5.34 /share .093 $2. 2009.

253 Aswath Damodaran .

Operating risk of the company . but after taxes and reinvestment to maintain exising assets Are you building on your competitive advantages? Are you using the right amount and kind of debt for your firm? Aswath Damodaran Growth from new investments Growth created by making new investments.Mix of debt and equity used in financing 254 .Ways  of  changing  value…   254 Are you investing optimally for future growth? How well do you manage your existing investments/assets? Cashflows from existing assets Cashflows before debt payments. this is a function of .Sustainability of competitive advantages Cost of capital to apply to discounting cashflows Determined by .Default risk of the company .Magnitude of competitive advantages . with no or very limited excess returns Length of the high growth period Since value creating growth requires excess returns. function of amount and quality of investments Efficiency Growth Growth generated by using existing assets better Expected Growth during high growth period Is there scope for more efficient utilization of exsting assets? Stable growth firm.

Nt CpX= 2.939 $2.45% Stable Growth g = 3%.147 Expected Growth in EBIT (1-t) .19% ROC= 9%.60) + 3.Minority int 1.016 $3.359 .Disney .Restructured Current Cashflow to Firm EBIT(1-t)= 7030(1-.757 6 $6.33% Cost of capital gradually decreases to 7.795 + Non op inv 1.164 $2.5372*.74% Riskfree Rate: Riskfree rate = 3.344 =Equity 68621 -Options 528 Value/Share $ 36.74% (0.12=.Debt 16.866 $4.5%)(1-.33% Terminal Value10 = 5067/(.72% Year 1 EBIT (1-t) $4.5%+2.67% On June 1.101 .300 $3.127 $3.34 /share .460 $4.957 $3.72% (0.763 .67 Return on Capital 12% 2 $4.484 10 $7.653 $2.089 + Cash: 3.492 FCFF $2. Assets 81.017 Reinvestment Rate = 2342/4359 =53.40) = 7.043 9 $7.72% Based on synthetic A rating + Beta 1.603 8 $6.682 .72% Return on capital = 9.590 5 $5. Beta = 1.Reinvestment $2.200 $2.7333 255 Aswath Damodaran X Weights E = 60% D = 40% Risk Premium 6% D/E=66.596 $3.03) = 120.38)= 4.0645 6. Reinvestment Rate=3/9=33.286 3 $5. Cost of capital =7.619 $3.172 7 $6.38) = 3.5% Cost of Debt (3.680 $4.00.04 Unlevered Beta for Sectors: 0.19% Cost of Equity 9.824 $2.909 $2.919 Term Yr 7600 2533 5067 Cost of Capital (WACC) = 9.Chg WC 241 = FCFF 2.982 Growth decreases gradually to 3% First 5 years Op.433 4 $5.257 $2.91% Reinvestment Rate 53. 2009.0719-.379 $2.640 . Disney was trading at $24.006 $2.

First  Principles   256 Aswath Damodaran 256 .