Please read the following Financial Analysis of Disney by Aswarth Damodaran.

Choose a listed company and follow the steps of the report to write your own
analysis.

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1
 A Corporate Financial Analysis of Disney
June 1997
Aswarth Damodaran

This is a corporate financial analysis of Disney. I do not expect you or

want you to replicate this analysis, but you can use it to get a sense of how I
would answer the project questions. In doing this analysis, I was constrained
because I was looking at only one firm. If you are as a group looking at a number
of firms, I would strongly recommend that you try to integrate your analysis. (In
other words, doing separate reports for each company is not only repetitive, but it
also robs you of some interesting comparisons that you can make across these
companies.) For instance, in the first part, when I have a graph on corporate
governance and show Disney alone, you could show more than one firm on the
same graph. In other parts, where I have tables that compare Disney to the
entertainment industry, expand the tables to include all your firms. In the
discussion parts, focus not only on what is unique about your firm but also on
what it has in common with other companies in the group.
Finally, there will be parts of this analysis where you will have more
information or less information than I do, or where the information you have
from different sources is not consistent. Work with what you have. Be creative,
be bold and do not let yourself be constrained by conventional wisdom. Above
all, have fun. I appreciate the effort .
I. Corporate Governance Analysis
A. Management and Stockholders
Balance of Power:

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 At Disney, the power clearly resides with the incumbent management, and in
particular, with the CEO, Mr. Michael Eisner. This power emanates not from any
stockholdings that Mr. Eisner and other top managers have - they own less than
1% of the outstanding stock - but from the fact that the board of directors is
composed almost entirely of insiders and people who are close to Mr. Eisner.
(See Exhibit 1 for a listing of the directors, and their relationships to Mr. Eisner
or Disney.) Note that
 Insiders (Current or Former executives at Disney) hold seven of the
seventeen positions on the board.
 Of the remaining ten, quite a few have other connections with Mr. Eisner.
For instance, Mr. Irwin Russell happens to be Mr. Eisner’s personal attorney, and
Ms. Bowers, the principal of the school that Mr. Eisner’s child attends.
It is interesting that both Calpers and Fortune, with different ranking
mechanisms, ranked Disney’s board at the very bottom of their lists in terms of
effectiveness, and independence from incumbent management.
Management power is accentuated by the fact that the stockholdings in
Disney are dispersed widely, making it difficult for any one stockholder to exert
pressure on managers to change their ways.
Source: Annual report; Fortune Magazine Rankings of Corporate Boards; New York Times Story on Calpers

Manifestations
The power of incumbent management comes through in a variety of ways. In
particular,
 The top managers of the firm have been compensated extraordinarily well
in the last few years. In the most recent year, for instance, Mr. Eisner earned
$8.25 million in salary and bonus. Over the last 5 years, his total compensation
from Disney has amounted to $ 235.95 million. In addition, has received more
than 8 million options from the firm over the period. (See Exhibit 2 for the
compensation breakdown)
 When Disney parted ways with Mr. Michael Ovitz in 1996, and had to pay
a substantial price (estimated to be $90-100 million) to do so, the board
essentially absolved Mr. Eisner of all responsibility, even though he had brought
Mr. Ovitz into the firm, and their failure to get along precipitated Mr. Ovitz’s
departure.

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Source: Forbes.com/ceo for CEO compensation; WSJ story on Mr. Ovitz

Project Suggestion: If you are analyzing a foreign company, you might not be
able to find much information on who sits on the board of directors or how much
managers are paid. As a rule of thumb, the less information there is available on
these matters, the more likely it is that stockholders have little or no control over
the incumbent managers of the firm.
Managerial Performance
It has to be noted, in management’s favor, that Disney’s earnings and
stock price performance during this period were stellar. Disney’s earnings
increased from $ 816 million in 1992 to $ 1533 million in 1997, and its stock
price increased from $ 35 in 1992 to $ 75.38 in June 1997. On both measures,
Disney did better than other firms in the market.
Stockholder Reaction
Stockholder reaction in the early years was muted to the power that
resided with incumbent management and the efforts of Mr. Eisner to stack the
board. The sheer magnitude of Mr. Eisner’s compensation, and the failure of the
board to hold him accountable for his actions, has lead to an increase in
stockholder activism. This activism has manifested itself in the last year in the
form of significant no votes on re-electing the board and as challenges to
incumbent managers.
Source: WSJ report on Disney Annual Meeting
B. Firm and Financial Markets

Disney is a well-followed firm. Zacks reports at least 24 sell-side analysts

who have made buy, sell or hold recommendations on the firm, providing
estimates of earnings per share and future growth. While the firm provides
substantial amounts of information about itself in the form of earnings reports,
there is a substantial amount of information that is available about the firm from
external sources. Both facts would lead us to expect less bias in the information
that is available about the firm.

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 Source: zacks.com

C. Firms and Society

Disney, as a family-friendly firm, which wants to appeal to the widest

potential audience of customers, is clearly conscious of its image. In the last two
years, it has been forced to make some tough choices. On the one hand, its desire
to be seen as progressive and open has lead it to actions such as granting health
benefits to same-sex partners of employees. At the same time, such actions have
exposed it to criticism from religious groups that view these actions as a betrayal
of the "family" image that Disney tries so hard to propagate. While the boycott
announced by some of the latter has not hurt Disney financially yet, the mix of
businesses that Disney is in (especially the movie and broadcasting divisions) are
likely to create more hard choices in the future.
Disney has also come under criticism for using child labor and accepting
unsafe working conditions in some of the factories at which its toys and clothes
are made overseas. After one such expose on 20/20 (a show on ABC, owned by
Disney), Disney chose to terminate its contract with the company named in the
expose rather than risk the negative publicity.
Finally, the number of pages in Disney’s annual report that are dedicated
to the social good that it does is a good indicator of how much of a role social
concerns play in Disney’s day-to-day decision making.
Source: Annual report; Various news stories;

Project Suggestion: You will not find much information on this aspect of your
firm unless your firm falls into one of the extremes — for example, the tobacco
firms or Exxon, or at the other extreme, companies like Levi Strauss. You can
check out the annual report, and you can see how the company has responded to
public or social criticism.

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II. Stockholder Composition
To analyze Disney’s stockholders, we began with an analysis of who the
stockholders at the firm were at the end of last year. The pie chart breaks down
the stock holdings in Disney into mutual funds, other institutional investors
(pension funds), individual investors and insiders.
Source: Value Line CD-ROM

Most of these investors are still domestic investors, though they may be
diversified into other markets. Finally, Disney’s stockholdings are fairly
dispersed. The largest institutional investor, Investment Company of America,
owns about 1.1% of the outstanding stock. The following table lists out the 10
largest stockholders in Disney.
Holder Shares Owned % of Disney % of Fund
Investment Company of America 5505 1.10% 1.23%
Growth Fund of America 3852 0.77% 2.85%
Vanguard Index 500 3638 0.73% 0.83%
Fidelity Contra fund 2123 0.42% 0.61%
AMCAP Fund 2113 0.42% 4.12%
20th Century Ultra 1970 0.39% 0.84%
Sequoia 1561 0.31% 3.93%
Vanguard Institutional Index 1361 0.27% 0.82%
Fidelity Magellan 1300 0.26% 0.17%
Vanguard Windsor 1293 0.26% 0.58%

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 Source: Value Line

Note that Disney is not a disproportionate share of any of these fund’s total
assets, suggesting that these funds are well diversified. In addition, a comparison
of Disney’s insider and institutional holdings to the other entertainment firms
suggests that Disney has far lower insider holdings and far greater institutional
holdings than other companies in its peer group.
Disney Other Entertainment Companies

Insider Holdings 3.50% 9.73%

Institutional Holdings 57% 37%

Source: Insider and Institutional Holdings Data set on my web site

Conclusions
In conclusion, these facts suggest that:
 The average stockholder in Disney is a domestic institutional investor,
more likely to be a pension fund than a mutual fund.
 Since no stockholder is large enough to dominate the holdings, that the
marginal stockholder is also likely to be a domestic institutional investor, again
more likely to be a pension fund than a mutual fund.
Project Suggestion: The average stockholder may not always be the marginal
stockholder. For instance, in a firm which has a significant insider holding
(Microsoft, Dell etc.), the average investor may be the owner/manager of the
company (Gates, Dell etc.), but the marginal investor (who is the investor who
trades on a regular basis and sets prices) may be a large institutional investor or
individual.

7
III. Risk Profile
Overall Risk Profile

To

analyze the risk profile for Disney, we begin with a plot of Disney monthly
stock prices and quarterly earnings over the last 5 years. Both Disney’s stock
prices and earnings have been on an upward path over the period, though there
is considerable volatility in the stock prices, as evidenced by the standard
deviation in stock prices, which was 21.26% on an annualized basis during
this period.
Source: Bloomberg for prices over last 5 years and annual earnings per share.

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A Market Analysis of Risk and Return
To analyze how much of this volatility can be attributed to market forces,
we ran a regression of Disney stock prices against the S&P 500:

Source: Bloomberg Beta Page

In terms of the diagnostics on this regression, we concluded the following:

(a) Slope of the regression = 1.40. This is Disney's beta, based on returns from
1992 to 1996. Using a different time period for the regression or different return
intervals (weekly or daily) for the same period can result in a different beta.
(b) Intercept of the regression = -0.01%. This is a measure of Disney's
performance, when it is compared with Rf (1-). The monthly risk-free rate
(since the returns used in the regression are monthly returns) between 1992 and
1996 averaged 0.4%, resulting in the following estimate for the performance:
Rf (1-) = 0.4% (1-1.40) = -0.16%
Intercept - Rf (1-) =-0.01% - (-0.16%) = 0.15%

This analysis suggests that Disney performed 0.15% better than expected,
when expectations are based on the CAPM, on a monthly basis between January

9
1992 and December 1996. This results in an annualized excess return of
approximately 1.81%.
Annualized Excess Return = (1 + Monthly Excess Return)12 - 1
= 1.001512 -1 = 1.0181 - 1 = 0.0181 or 1.81%

By this measure of performance, Disney did slightly better than expected

during the period of the regression. Note, however, that this does not imply that
Disney would be a good investment looking forward. It also does not provide a
breakdown of how much of this excess return can be attributed to ‘industry-wide’
effects, and how much is specific to the firm. To make that breakdown, the
excess returns would have to be computed over the same period for other firms in
the entertainment industry and compared with Disney’s excess return. The
difference would be then attributable to firm-specific actions. In this case, for
instance, the average annualized excess return on other entertainment firms
between 1992 and 1996 was 3.5%, suggesting that the firm-specific component
of performance for Disney is actually -1.7%. (Firm-specific Jensen’s alpha =
1.8% - 3.5%)
Source: The monthly riskfree rate can be obtained by adding up the T.Bill rates each year
for the last 5 years (available in the Historical returns dataset on my web site), averaging
them out, and then dividing by 5.For 1993-97, you can use 0.4% a month.

(c) R squared of the regression = 32.41%. This statistic suggests that 32.41% of
the risk (variance) in Disney comes from market sources (interest rate risk,
inflation risk etc.), and that the balance of 67.59% of the risk comes from firm-
specific components. The latter risk should be diversifiable, and therefore
unrewarded in the CAPM.
We also compared Disney’s regression statistics to those of the market
over the same period, and came up with the following estimates:

  Disney Entertainment Companies

Beta 1.40 0.91
Jensen’s Alpha 1.81% 3.51%
R Squared of Regression 32% 47%

Source: Industry Regression Statistics (My web site/new stuff)

10
 Disney seems riskier than the comparable firms, and has done less well
these firms in recent periods. It also gets a smaller portion of its risk from market
factors (which are not diversifiable).
Project Suggestion: If you are comparing these statistics across multiple
companies, you can consign the scatter plot (from Bloomberg or your own
regression to the end of the report, and focus on only the output from the
regression in this part of the report. Thus, the table shown above for Disney and
entertainment firms can be expanded to include the other companies that you are
analyzing.
A Bottom-up Beta Estimate
While the regression of Disney on the S&P 500 suggests a beta of 1.40, I would
be concerned about using this beta because of
 the high standard error on the estimate (the standard error of 0.26 suggests
a wide range for the true beta of Disney
 the changing business mix of Disney over the period, with its acquisition
of Cap Cities in 1995
 the changing financial leverage at Disney over the period, with the $10
billion borrowed in 1995
To estimate a bottom-up beta for Disney, we broke it up into five different businesses and
estimated the betas for each business based upon comparable firms. The table below provides
the business mix, comparable firms used and the weights attached to each business:

Business Estimated Value Comparable Firms Unlevered Division Weight*Beta

Beta Weight
Creative $ 22,167 Motion Picture and 1.25 35.71% 0.4464
Content TV program
producers
Retailing $ 2,217 High End Specialty 1.5 3.57% 0.0536
Retailers
Broadcasting $ 18,842 TV Broadcasting 0.9 30.36% 0.2732
companies
Theme Parks $ 16,625 Theme Park and 1.1 26.79% 0.2946
Entertainment
Complexes
Real Estate $ 2,217 REITs specializing in 0.7 3.57% 0.0250
hotel and vacation
properties
Firm $ 62,068 100.00% 1.0929

In the first column, we list the businesses that Disney is involved in. In
the second, we list the estimated value of each business to Disney, based upon

11
the operating income (EBIT) of each business and an average multiple of
EBIT (based upon comparable firms) for each business. In the third, we report
the unlevered beta of comparable companies in each business, obtained by
averaging out the betas of firms in each of the businesses and unlevering at
their average debt/equity ratio. In the fourth column, we report the companies
we used as comparable firms and in the last two columns we compute the
weighted average beta. The unlevered beta, based upon the bottom-up
calculation, for Disney is 1.09.
Project Suggestion: When estimating the bottom-up beta, try not to disaggregate
too much or you will have trouble finding comparable firm betas. If your firm
reports operating income by segment, use that to weight the unlevered betas. If
not, use revenues.
To get Disney’s levered beta, we used the current estimated market values
of equity and debt.
Market Value of Equity = Share Price * Number of Shares = 75.38 * 675.13 = 50.88 Billion

To get the market value of debt, we used the book value of debt of $
12.342 billion, the interest expenses of $ 479 million and the face-value weighted
average maturity of 3 years, in conjunction with a current cost of borrowing of
7.50% (see debt section below) to arrive at an estimated market value of debt of
$ 11.18 billion.
Source: The face-value weighted maturity comes from the footnotes to the balance sheet.

Estimated Market Value of Debt =

Using these estimated market values for debt and equity, we estimated a
debt/equity ratio of 21.97% for Disney as a company, and used it in conjunction
with the bottom-up unlevered beta of 1.09 to estimate an levered beta of 1.25
Levered Beta for Disney = 1.09 ( 1 + (1-.36) (11.18/50.88)) = 1.25

Project Suggestion: When you have lots of bonds outstanding, aggregate the
debt and interest expenses as we did for Disney, and compute the market value
once rather than several times. If you have convertible debt which is traded,
this same approach can be used to break the convertible debt into debt and

12
equity components. With preferred stock, use the market value of the
preferred and keep it as a separate component for the cost of capital, with the
preferred yield being the cost of preferred stock. Finally, if you are going to
capitalize operating leases, add the present value of these leases (at the cost of
debt) to the market value of debt.
From Betas to Costs of Equity
To get from the beta to the cost of equity, we needed two other inputs. For
the riskfree rate, we used a long term treasury bond rate (which at the time of the
analysis was 7%). For the risk premium we will use the geometric historical
risk premium for stocks over long term treasury bonds of 5.5%.
Expected Return = 7% + 1.25 (5.5%) = 13.85%

Using the expected return: This is the return that potential investors would
require as a rate of return for investing in Disney stock, and it is also the cost of
equity for Disney.
To estimate the levered beta by division, we used the same debt/equity ratio for all
divisions except real estate, which raises its own debt based upon its properties.

Business Unlevered Beta D/E Ratio Levered Riskfree Risk Cost of

Beta Rate Premium Equity
Creative 1.25 20.92% 1.42 7.00% 5.50% 14.80%
Content
Retailing 1.50 20.92% 1.70 7.00% 5.50% 16.35%
Broadcasting 0.90 20.92% 1.02 7.00% 5.50% 12.61%
Theme Parks 1.11 20.92% 1.26 7.00% 5.50% 13.92%
Real Estate 0.70 50.00% 0.92 7.00% 5.50% 12.08%
Disney 1.09 21.97% 1.25 7.00% 5.50% 13.85%
Using the same riskfree rate of 7% (based upon the long term treasury
bond rate) and a risk premium of 5.5% (based upon historical data) yields us the
costs of equity by division.
Source: Use the latest long-term government bond rate as your riskless rate, and a 5.5%
premium (if it is a US stock, or the country premium (based upon rating) if it is a foreign stock).

Disney’s Cost of Debt

To estimate Disney’s cost of debt, we obtained the current bond rating of
the company. Standard and Poor’s assigns a rating of AA to Disney’s traded
debt. Based upon the long term treasury bond rate of 7% and an estimated default

13
spread of 0.50%, we estimate a pre-tax cost of borrowing of 7.50%. The after-tax
cost of debt for Disney reflects the tax savings accruing to interest:
After-tax Cost of Debt = 7.50% (1 - .36) = 4.80%

We will also assume that all of Disney’s divisions face the same cost of
borrowing.
Source: Bloomberg corporate bond page for Disney. If it does not exist, use a synthetic rating.

Project Suggestion: If your company has multiple bonds outstanding, it might

also have multiple ratings. Use the rating on a recently issued straight bond. If
you cannot find a rating, use the synthetic rating spreadsheet to estimate a rating.
If you are capitalizing operating leases, be consistent, and treat these expenses
like interest expenses.
Disney’s Weights for Debt and Equity
Using the market values of debt and equity, estimated earlier in the section
on levered betas to be $ 50.88 billion for equity and $ 11.18 billion for debt, we
estimate the following weights for debt and equity in the capital structure
calculation:
Equity Ratio = 50.88/62.06 = 82%
Debt Ratio = 11.18 /62.06 = 18%

Disney’s Cost of Capital

Having estimated a cost of equity of 13.85% and an after-tax cost of debt
of 4.80%, the cost of capital for Disney can be computed as follows:
Cost of Capital = 13.85% (0.82) + 4.80% (0.18) = 12.22%

The divisional costs of capital can also be estimated similarly, using the
divisional costs of equity and the same debt ratio for all divisions except for real
estate.
Business E/(D+E) Cost of D/(D+E) After-tax Cost of Cost of
Equity Debt Capital
Creative Content 82.70% 14.80% 17.30% 4.80% 13.07%
Retailing 82.70% 16.35% 17.30% 4.80% 14.36%
Broadcasting 82.70% 12.61% 17.30% 4.80% 11.26%
Theme Parks 82.70% 13.92% 17.30% 4.80% 12.32%
Real Estate 66.67% 12.08% 33.33% 4.80% 9.65%
Disney 81.99% 13.85% 18.01% 4.80% 12.22%

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 The costs of capital for the divisions range from a high of 14.36% for
retailing to 9.65% for real estate.

Relevance of Costs of Equity and Capital

The costs of equity and capital become hurdle rates for Disney as a company,
with different rates applying for different divisions. In using these rates,
 The cost of equity is the appropriate hurdle rate, when returns are
measured to equity investors in the company. Thus, a new store has to earn a
return on equity of more than 16.35% to be considered a good investment.
 The cost of capital is the appropriate hurdle rate, when returns are
measured to all investors in the firm (debt as well as equity). Thus, a new theme
park will have to earn a return on all capital invested of greater than 12.22% to
be considered a good investment
IV. Investment Return Analysis
A. Typical Project
Given the diversity of Disney’s business mix, it is difficult to identify one
typical project. Instead, we will identify the likely characteristics of projects in
each of Disney’s divisions:
Business Project Cash Flow Characteristics
Creative Content Projects are likely to
 be short term
 have cash outflows are primarily in dollars (since Disney makes most of its
movies and T.V programs in the U.S.) but cash inflows could have a
substantial foreign currency component (because of overseas sales)
 have net cash flows which are heavily driven by whether the movie or T.V
series is a "hit", which is often difficult to predict.
Retailing Projects are likely to be
1. medium term (tied to store life)
2. primarily in dollars (most of the stores are still in the United States)
3. cyclical
Broadcasting Projects are likely to be
1. short term
2. primarily in dollars, though foreign component is growing
3. driven by advertising revenues and show success
Theme Parks Projects are likely to be
 very long term
 primarily in dollars, but a significant proportion of revenues come from
foreign tourists, who may be impacted by exchange rate movements.
 affected by success of movie and broadcasting divisions.

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Real Estate Projects are likely to be
 long term
 primarily in dollars.
 affected by real estate values in the area

Project Suggestion: This might be difficult to do for companies which do not

have typical projects. Give it your best shot. If a firm has multiple divisions, try
to look at each division separately.
A. Measuring Past Returns
To measure returns on Disney’s existing projects, we begin with a couple
of assumptions. We assume that the current earnings of the firm are earnings
attributable to existing projects. Consequently, we adjust earnings by adding
back one-time charges and amortization of goodwill (on the Capital Cities
acquisition). We also assume that the current book value of assets and equity
reflect the current capital and equity invested in existing projects. Using the net
income and book value of equity, we compute a return on equity of:
Return on Equity = Net Income1996 / Average BV of Equity for 1995 and 1996
= $2,836 million / $ 11,368 million = 24.95%

The average book value of equity was obtained by adding up the book
values of equity for 1995 and 1996 and dividing by two.
Using the after-tax operating income and book value of capital, we estimate a
return on capital of
Return on Capital = EBIT1996 (1-t)/ Average BV of Capital from 1995 to 1996
= $5,559 (1-.36)/ (19,031) = 18.69%

[Book value of capital = Book Value of Equity + Book Value of Debt; the
average is obtained by summing up the book values for the two years and
dividing by two.]
Both the net income and earnings before interest and taxes were cleansed
of one-time charges and any extraordinary items.
Project Suggestion: For book value of equity, use only common equity. If your
company’s book value of equity, do not compute the return on equity, since it is
meaningless. You can also use the book value of equity and capital from the end
of the last year to compute returns on equity and capital. The more your company
has grown in the last year, the more I would be inclined towards using the
average.

16
B. Evaluation Of Past Returns
To evaluate whether these returns measure up to requirements, we
compare the return on equity to the cost of equity from the previous section.
Return on Equity = 24.95%
Cost of Equity = 13.85%
Equity Return Spread = 24.95% - 13.85% = 11.10%

This spread, when multiplied by the book value of equity, yields a measure
of the surplus value created by existing projects (called the Equity EVA).
Equity EVA = (Return on Equity — Cost of Equity) (BV of Equity)
= (.2495 — 1385) ($11,368 million) = $1,262 million

A similar analysis, comparing return on capital to cost of capital, yields the

following numbers.
Return on Capital = 18.69%
Cost of Capital = 12.22%
EVA = (.1869 — .1222) ( 19,031 million) = $1,232 million

On both measures, it looks like Disney is creating about $1.2 billion in

surplus value each year because of the excess returns it makes on its existing
projects. While we have a measure of operating income at the division level, we
do not have a breakdown of book value at the division level. If we did, we could
compute the returns on capital, on a division level, and compare them to costs of
capital, on a division level, to estimate divisional EVA.
Finally, we compare Disney’s equity and firm EVA to those created by
entertainment firms as a whole in the most recent year in the table below:
  Disney Entertainment Firms
Equity EVA $1,262 million - $ 52 million
Firm EVA $1,232 million - $ 40 million

Source: My web site/datasets/EVA

In contrast to other entertainment firms, Disney is creating significant

surplus value from existing projects.

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C. Assessments for the Future
We believe that the theme parks, creative content, retailing and real estate
divisions are likely to continue generating surplus value into the future, because
of several barriers to entry, including:
 Disney’s strong brand name value is likely to allow them to charge higher
prices, earn higher margins and maintain healthy returns on capital into the
future.
 The bulk of the investment, especially in the theme parks, has been made
already. Disney will continue to enjoy the benefits of this investment in the
form of earnings at these parks.
 The potential for excess returns in the creative content (movie) division
will continue to be greater for Disney Studios (where the brand name
counts) than for Touchstone Studios, where the brand name value counts
for less.
 The broadcasting division is likely to be the most questionable of the
divisions in terms of being able to earn surplus value into the future. The
bulk of the broadcasting division is Capital Cities/ABC, which competes
in a very competitive market place with other networks and cable
channels. The technical constraints on broadcasting which have allowed
existing networks to earn excess returns are being challenged by satellite
dishes and the internet, and it is entirely possible that the excess returns
from being in broadcasting will disappear as this competition heats up.
Project Suggestion: This is an extremely subjective analysis, but note that no one
really knows the answers to these questions. Again, bring to bear what you know
about the company, its products, its management and the competitors to give it
your best shot.

18
V. Capital Structure Choices
Current Financing Mix
Disney currently has the following debt on its books:
Type of Financing Dollar Amount Interest Rate on Books Maturity
Commercial Paper $4,185 million 5.5% 1
Debentures $4,399 million 6.6% 2-6 years
Dual Currency and Foreign Notes $1,987 million 5.4% 1-4 years
Senior Participating Notes $ 1,099 million 6.3% 3-4 years
Other $ 672 million 5.6% 1-15 years
Total $ 12,342 million Approximately 3 years

Source: Footnotes to Balance Sheet on Borrowings

Disney’s commercial paper reflects the money borrowed by Disney in its

acquisition of Capital Cities, and Disney has replaced almost $ 4 bilion of its
original commercial paper borrowing with longer term notes. The Company
foreign currency notes are mostly in three currencies — British Pounds ( $ 520
million), Japanese Yen ( $1.4 billion) and Italian Lira ( $ 190 million).
The company’s senior debt is rated AA, and the market interest rate on AA
bonds at the time of this analysis is 7.50%. Disney’s medium term notes were
trading at a yield to maturity of roughly 6.9%. Given that these notes are shorter
term, we will continue to use the 7.50% as our cost of debt.
Project Suggestion: Some companies provide more information than other
companies on their borrowing. If you are working with a foreign company, you
might be able to get far less information on this component.

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Trade Off on Debt versus Equity
Looking at the advantages and disadvantages of debt, and Disney’s specific
characteristics yields the following:

Factor Disney
Tax Benefit Disney has a marginal tax rate of about 40%. It has an effective tax rate of
43.58%.
Added Discipline of Disney is a widely held firm. While institutional stockholders own a significant
Debt percentage of the firm, no individual stockholder or institution is large enough to
have much say in management. The firm has significant cash flows and should
gain from the use of debt.
Bankruptcy Risk Some of Disney’s earnings are volatile, but a significant portion of the cash flows
are stable (especially cash flows from theme parks). The bankruptcy risk should
be low, given this factor and the size of the company
Agency Costs The agency costs are likely to be large for borrowings by the creative content and
broadcasting divisions, where it is difficult to track the funds. It is likely to be
smaller in the real estate, retailing and theme park divisions.
Future Flexibility The need for financing flexibility is increasing as the media business changes
technologically and becomes more global.

Project Suggestion: This is a subjective analysis and is meant to be so. If you are
comparing across companies, use this table to compare the companies on each of
these factors. You can then make statements about which of the companies
should have the highest debt ratio and which should have the lowest debt ratio.
A Qualitative Judgment
Based upon this trade off, we would expect Disney to have significant debt
capacity. It has potentially large benefits from debt — tax benefits and added
discipline — and has the cash flows to sustain the debt without significant
bankruptcy and agency costs. Disney’s current debt ratio is probably too low.
VI. Optimal Capital Structure
Current Cost of Capital / Financing Mix
To estimate the current cost of capital, we used the market value of equity
and estimated market value of debt from the earlier section on hurdle rates. Using
the market value of equity of $ 50.88 billion, the market value of debt of $ 11.18
billion, the cost of equity of 13.85% (based upon the bottom-up beta) and the
after-tax cost of borrowing of 4.80%, we estimate a cost of capital as follows:

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 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

Project Suggestion: Since the optimal capital structure analysis forces you to
pick between only debt and equity, those of you who have preferred stock in
your capital structures will have to do some fancy footwork at this stage. The
simplest way of dealing with this is to calculate the cost of capital without
preferred stock at this stage. To be consistent then, when you calculate the EBIT
to use in the optimal capital structure analysis below, use (EBIT — Preferred
Dividends).
Costs of Capital at Different Financing Mixes
We estimated the costs of equity and debt at different debt ratios — using
betas for costs of equity and estimated ratings for costs of debt.
Debt Ratio Cost of Equity AT Cost of Debt Cost of Capital
0.00% 13.00% 4.61% 13.00%
10.00% 13.43% 4.61% 12.55%
20.00% 13.96% 4.99% 12.17%
30.00% 14.65% 5.28% 11.84%
40.00% 15.56% 5.76% 11.64%
50.00% 16.85% 6.56% 11.70%
60.00% 18.77% 7.68% 12.11%
70.00% 21.97% 7.68% 11.97%
80.00% 28.95% 7.97% 12.17%
90.00% 52.14% 9.42% 13.69%

Based upon the objective of minimizing the cost of capital, the optimal
debt ratio for Disney was 40%.
Project Suggestion: If you are analyzing multiple companies, just show the cost
of capital (and not the costs of debt and equity) for each company at each debt
ratio in this table (instead of having a table for each company). Then highlight
the optimal cost of capital box for each company separately. You need not
include the capital structure spreadsheet output in your project.
Firm Value at Optimal
To estimate firm value at the optimal debt, we estimated the dollar savings
we would have from moving from the current cost of capital of 12.22% to the
cost of capital at the optimal (11.64%), and converted it into present value terms:

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 Firm Value before the change = 50,888+11,180= $ 62,068
WACCb = 12.22% Annual Cost = $62,068 *12.22%= $7,583 million
WACCa = 11.64% Annual Cost = $62,068 *11.64% = $7,226 million
WACC = 0.58% Change in Annual Cost = $ 357 million

Assuming an implied growth rate (of 7.13%) in firm value over time,
 Increase in firm value = $357 * 1.0713 /(.1164-.0713) = $ 8,474
 Change in Stock Price = $8,474/675.13 = $12.55 per share

Implied Growth Rate

The implied growth rate is based upon the assumption that the market
value of Disney as a company reflects a market expectation of future growth. To
estimate it, we used the following perpetual growth formula
Firm value Today =FCFF(1+g)/(WACC-g)

Substituting today’s market value for Disney as a firm (debt + equity) of $

62,068 million, the free cash flow to the firm of $3,255 million and the current
cost of capital of 12.22%, we solved for the expected growth rate of 7.13%.
In summary, we are arguing that increasing debt ratio to the optimal will
increase the stock price approximately $12.55 per share, which translates into a
16.65 % change in the current stock price of $ 75.38. This is also based upon the
assumption that the stock repurchase will occur at the higher price (thus, allowing
investors who sell their stock back to the firm to also share in the spoils).
Project Suggestion: If you are comparing the optimal debt ratios of two or more
firms in a sector, estimate EBITDA as a percentage of firm value for each firm.
The magnitude of this ratio will be highly correlated with the optimal debt ratio.
Constraints
I. Operating Income Variability: What If Analysis
We examined the sensitivity of the optimal debt ratio to changes in the
operating income. Looking at the last two decades of operating income changes,
we estimated a standard deviation in operating income of 39%. In conjunction
with Disney’s worst year of operating income (-26%) and the behavior of its
operating income during the last two recessions (-22% in 1990-91 recession and
no change during the 1980-82 recession), this lead us to use a worst case scenario

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drop in the operating income of 40%. The optimal debt ratio with this lower
operating income was between 20 and 30%.

II. Rating Constraints

To provide a cushion against downside risk, we also considered a rating
constraint of BBB or higher. Using the same table as the one used for the optimal
debt ratio, we obtained the following ratings at different debt ratios:

While the

unconstrained optimal debt ratio for Disney is 40%, the optimal debt ratio is
30%, when we introduce a BBB constraint.
In Summary

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 Both the operating income worst-case scenario and the rating constraints
suggest to us that Disney’s excess debt capacity is not an artifact of just a good
operating year. The analyses present a powerful argument that Disney is under
levered and should use more debt in its financing mix.

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Exhibit 1: Directors at Disney and Relationship to Mr. Eisner

Exhbit 2: CEO Pay Package

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