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Valuation

Aswath Damodaran

Aswath Damodaran

First Principles

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Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

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Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm
Aswath Damodaran

Discounted Cashflow Valuation: Basis for Approach

• where, n = Life of the asset • CFt = Cashflow in period t • r = Discount rate reflecting the riskiness of the estimated cashflows •

Aswath Damodaran

i. s where. the rate of return required by equity investors in the firm. tax obligations and interest and principal payments.e. i.e. Aswath Damodaran .Equity Valuation s The value of equity is obtained by discounting expected cashflows to equity. and the value of a stock is the present value of expected future dividends. at the cost of equity.. CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity The dividend discount model is a specialized case of equity valuation.. the residual cashflows after meeting all expenses.

but prior to debt payments. which is the cost of the different components of financing used by the firm. i..Firm Valuation s The value of the firm is obtained by discounting expected cashflows to the firm. the residual cashflows after meeting all operating expenses and taxes. at the weighted average cost of capital. where.e. CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital Aswath Damodaran . weighted by their market value proportions.

.Generic DCF Valuation Model Length Value Discount Period .. Terminal Growth Firm Forever ofRate CF1 flows Expectedstable of High Growth Cashis in Value growth:CASHFLOW n 5 4 3 2 DISCOUNTED Firm:Cost ofofincash Grows at constant Firm: Pre-debt Firmrate Value GrowthCapital forever Operating Earnings flow Equity: After of Equity Value of Equity Cost debt Growth in Net Income/EPS cash flows VALUATION Aswath Damodaran .......

Aswath Damodaran . The cost of capital is the rate at which we discount free cash flows to the firm. The cost of equity is the rate at which we discount cash flows to equity (dividends or free cash flows to equity). Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. At an intutive level. Discount Rates s s s Critical ingredient in discounted cashflow valuation. the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted.Estimating Inputs: I.

and same own by and defined in firmÕstermsfinancial and a simple stocks nominal) as leverage T. Costto be Premium Riskfree Rate + Beta * Based upon equity 1. athe Has of Premium same beta.Bonds in (real orover valuationthe U.The Cost of Equity: A Recap or Implied Equity = Historical in bottom-up Preferably. Country cash flows risk premium = Country Default Spread* ( σEquity/s Country bond ) (Risk Premium) Aswath Damodaran .S. model 2. in the market is premium earned Average priced today business. Mature Equity firms basedon as cashMarket Premium: currency howother flows.

Estimating the Cost of Capital Weightsborrowing marketof based upon Marginal should beshould be Equity (Equity/(Debt + Equity)) Cost of Capital = reflectingvalue weights equity tax rate. Cost based upon or actual tax benefits bottom-up (1) syntheticof debt bond rating beta (2) default spread Cost of Borrowing = Riskfree rate + Default spread + Cost of Borrowing (1-t) (Debt/(Debt + Equity)) Aswath Damodaran .

48% 6.09% 9.01 10.17% The Home Depot 0.58% 20.58% 79.51% InfoSoft 1.55% 9.Costs of Equity.78% 95. Debt and Capital Boeing 1.62% 12.49 13.38% A 3.91% AA 3.87 9.55% Beta (Bottom-up) Cost of Equity Equity/(Debt + Equity) Rating After-tax Cost of Debt Debt/(Debt + Equity) Cost of Capital Aswath Damodaran 1 .19% 93.77% 4.45% A+ 3.

II.Debt Firm = Free Cashflow to Equity Aswath Damodaran 1 . Estimating Cash Flows EBIT Flows The Strict To Equity Firm Broader View Cash(1-t) View .Net Buybacks StockCap in Working Capital Change Ex (1-Debt Ratio) = Free Cashflow to Ratio) .Chg WC (1 .( Cap Ex Net Income Dividends + Depreciation) .

Estimating Operating Income
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The first adjustment is for financing expenses that accountants treat as operating expenses. The most significant example is operating leases. The second adjustment is the treatment of some capital expenditures as operating expenses. Here, the most dramatic example is the treatment of research and development expenses. The third adjustment is to correct for the incidence of one-time or irregular income and expenses. Any expense (or income) that is truly a one-time expense (or income) should be removed from the operating income and should not be used in forecasting future operating income.

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Operating Income Estimates
Boeing Operating Income $1,720 + Special and One-time Charges $0 + Research and Development Expenses $1,895 - Amortization of Research Asset $1,382 + Imputed Interest Expense on Operating Leases $ 31 = Adjusted Operating Income $2,264 Home Depot $2,661 $0 $0 $0 $ 154 $2,815 InfoSoft $2,000 $0 $4,000 $2,367 $ $3,633

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Estimating a Tax Rate
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The choice is between the effective and the marginal tax rate. In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books. By using the marginal tax rate, we tend to understate the after-tax operating income in the earlier years, but the after-tax tax operating income is more accurate in later years If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time.

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Aswath Damodaran 1 .19% 38.83% Average Effective Tax Rate:94-98 20.44% Marginal tax rate 35% Home Depot 2654 1040 39.78% 35% InfoSoft 1685 707.00% 42% 42% We will use the 35% tax rate to value Boeing and the Home Depot and 42% for InfoSoft.7 42.Tax Rate Estimates Boeing Taxable Income 1397 Taxes 277 Effective Tax Rate 19.

a normalized measure of acquisitions (looking at an average over time) should be used 2. The adjusted cap ex will be Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D expenses . The best place to find acquisitions is in the statement of cash flows. once they have been recategorized as capital expenses. Most firms do not do acquisitions every year.Amortization of Research Asset Acquisitions of other firms. The adjusted cap ex will be Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms . since these are like capital expenditures. usually categorized under other investment activities Aswath Damodaran 1 . Hence.Estimating Capital Expenditures s s Research and development expenses.Amortization of such acquisitions Two caveats: 1.

517 $1.895 $1.000 $1.686 InfoSoft $2.000 $4.367 $1.000 $2.633 Capital Expenditures R&D Depreciation Amortization of R&D Net Cap Ex w/o R&D Net Cap Ex with R&D Aswath Damodaran 1 .059 $0 $373 $0 $1.584 $1.686 $1.000 $2.382 $67 $580 The Home Depot $2.Net Capital Expenditures: 1998 Boeing $1.

and building these effects into the cash flows. any increases (decreases) in working capital will reduce (increase) cash flows in that period. the working capital is the difference between current assets (inventory. it is important to forecast the effects of such growth on working capital needs. short term debt and debt due within the next year) A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) Any investment in this measure of working capital ties up cash. cash and accounts receivable) and current liabilities (accounts payables.Estimating Net Working Capital Needs s s s s In accounting terms. When forecasting future growth. Therefore. Aswath Damodaran 1 .

42% 6.08% 18.30% InfoSoft 20000 2000 $500 10.Net Working Capital Estimates Boeing Revenues: 1998 Non-cash WC: 1998 ∆ Working capital Non-cash WC as % of Revenues Average from 1994-1998 Industry Average The Home Depot $56.154 30219 $1.00% NA 18.71% 4.12% 7.95% 12.360 2028 $667 $190 2.00% Aswath Damodaran 1 .

If using statement of cash flows EBIT (1-t) EBIT (1-t) + Depreciation + Depreciation . Application Test: Estimating your firm’s FCFF s Estimate the FCFF for your firm in its most recent financial year: In general.FCFF Aswath Damodaran 2 .Capital Expenditures + Capital Expenditures .Change in Non-cash WC + Change in Non-cash WC = FCFF = FCFF Estimate the dollar reinvestment at your firm: Reinvestment = EBIT (1-t) .

we would discount free cash flows to the firm. Here. the free cash flows to equity can be discounted to yield the value of equity.Choosing a Cash Flow to Discount s s s When you cannot estimate the free cash fllows to equity or the firm. we will discount free cash flows to equity. If a firm’s debt ratio is not expected to change over time. we will be discounting dividends. free cash flows to equity become cumbersome to estimate. For Aracruz. For Disney. For financial service firms. For Deutsche Bank. it is difficult to estimate free cash flows. the only cash flow that you can discount is dividends. If a firm’s debt ratio might change over time. Aswath Damodaran 2 . we will discount the free cash flow to the firm.

III. Expected Growth R X einvestment Return on Growth Retention Equity Operating Ratio= Net IncomeCapital ExpectedIncome = EBIT(1-t)/Book Value of Rate = (Net Cap Net Income/Book 1 .Dividends/Net Value of Capital Ex + Chg Equity Income in WC/EBIT(1-t) Aswath Damodaran 2 .

Aswath Damodaran 2 .Expected Growth in EPS • gEPS = Retained Earningst-1/ NIt-1 * ROE = Retention Ratio * ROE = b * ROE Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

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

17% NA 73.53% 131.52% 65.876 $ 1.48% The Home Depot $ 1.Estimating Reinvestment Rate Net Cap Ex Change in Non-Cash WC Total Reinvestment EBIT (1-t) Reinvestment Rate Average : 1994-98 Industry Average Boeing $ 580 $ 667 $ 1.85% 88.686 $ 190 $ 1.793 112.651 75.12% Aswath Damodaran 2 .98% 55.247 $ 1.133 $ 2.830 102.62% InfoSoft $ 2.633 $ 500 $ 3.

830 $ 2.38% 23.59% Industry average ROC 15.651 $ 28.70% The Home Depot InfoSoft $ 1.67% 15.20% Adjusted EBIT (1-t) Adjusted BV of capital ROC Average ROC: 1994-1998 6.10% NA 17.173 $ 11800 16.793 $ 11.07% Aswath Damodaran 2 .Estimating Return on Capital Boeing $ 1.957 5.12% 14.

35% The Home Depot 16.55% Return on Capital Reinvestment Rate Expected Growth Rate Boeing: Used average return on capital and reinvestment rate over last 5 years The Home Depot: Used current return on capital and Industry average reinvestment rate InfoSoft: Used current return on capital and reinvestment rate Aswath Damodaran 2 .62% 14.38% 88.51% InfoSoft 23.98% 4.67% 112.Expected Growth Estimates Boeing 6.59% 65.17% 26.

 Application Test: Estimating Expected Growth
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Estimate the following:
• The reinvestment rate for your firm • The after-tax return on capital • The expected growth in operating income, based upon these inputs

Aswath Damodaran

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IV. Getting Closure in Valuation

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A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.

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

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Stable Growth and Terminal Value

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

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Growth Patterns s A key assumption in all discounted cash flow models is the period of high growth. In general. at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) Aswath Damodaran 3 . in which case the firm is already in stable growth • there will be high growth for a period. and the pattern of growth during that period. at the end of which the growth rate will drop to the stable growth rate (2-stage) • there will be high growth for a period. we can make one of three assumptions: • there is no high growth.

it becomes much more difficult for them to maintain high growth rates s Current growth rate • While past growth is not always a reliable indicator of future growth. s Barriers to entry and differential advantages • Ultimately. As firms become larger. • The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are. comes from barriers to entry and differential advantages. which. Aswath Damodaran 3 . how long they will stay up and how strong they will remain.Determinants of Length of High Growth Period s Size of the firm • Success usually makes a firm larger. in turn. a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now. there is a correlation between current growth and future growth. Thus. high growth comes from high project returns.

of this market and the lack of barriers to competition make us conservative on our estimate. In spite of the firmÕs competitors to overcome the small size. Aswath Damodaran 3 . management team that is focused to be limited. but is entering new businesses and new markets (overseas) Current Excess Returns Firm is earning less than its cost of capital.Analyzing the Growth Period Boeing Firm Size/Market Size Firm has the dominant market share of a slow-growing market The Home Depot Firm has dominant market share of domestic market. 10 years. Significant economies of scale are used to establish cost advantages over rivals. Has a Has both a good product and good software engineers. Firm is earning significant excess returns. entirely because of competitive advantages and barriers to entry. and competitors are extremely aggressive. InfoSoft Firm is a small firm in a market that is experiencing significant growth. can be hired away. Management record over the last few years has been poor. it will be difficult for 5 years. Length of High Growth period 10 years. Competitive advantage is likely Firm is earning substantially more than its cost of capital. since employees on growth and efficiency. and has done so for last 5 years Competitive Advantages Huge capital requirements and technological barriers to new entrants. the competitive nature economies of scale.

Firm Characteristics as Growth Changes Variable Risk Dividend Payout Net Cap Ex Return on Capital Leverage High Growth Firms tend to be above-average risk pay little or no dividends have high net cap ex earn high ROC (excess return) have little or no debt Stable Growth Firms tend to be average risk pay high dividends have low net cap ex earn ROC closer to WACC higher leverage Aswath Damodaran 3 .

in which case we assume that the firm will stop earning excess returns on its projects as a result of competition. • Leverage is a tougher call. in which case we assume that this firm in stable growth will look like the average firm in the industry – cost of equity and capital. if they are not. Aswath Damodaran 3 . use industry averages) s Use the relationship between growth and fundamentals to estimate payout and net capital expenditures. can be estimated by looking at – industry averages for these measure. use current leverage. While industry averages can be used here as well. in stable growth.Estimating Stable Growth Inputs s Start with the fundamentals: • Profitability measures such as return on equity and capital. it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are.

62% 6.869 1.58% 10.48% 20.2 10.55% 11.09% 30.60% 3.06% Aswath Damodaran 3 .77% 3.00% 4.17% 8.869 0.489 1.55% 30.62% 9.014 1 0.48% 3.58% 3.78% 9.78% 13.Estimating Stable Period Cost of Capital Beta Cost of Equity After-tax Cost of Debt Debt Ratio Cost of Capital Boeing The Home Depot InfoSoft High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth 1.51% 7.58% 3.00% 6.92% 12.19% 11.42% 9.50% 9.58% 3.

assume that Boeing in stable growth will • grow 5% and that • its return on capital in stable growth will be 8.42% (its cost of capital). • the net capital expenditures and working capital investment each year during the stable growth period will be 59. Reinvestment Rate = gEBIT / Return on Capital s For instance.36% of after-tax operating income.Estimating Stable Period Net Cap Ex gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC s Moving terms around. Reinvestment Rate for Boeing in Stable Growth = 5/8.36% s In other words.42 = 59. Aswath Damodaran 3 .

55% 5.00% Aswath Damodaran 3 .07% Expected Growth Rate 4.10% 23.20% Reinvestment Rate 65.98% 59.51% 5.46% 112.17% 29.59% 8.38% 14.00% 14.35% 88.42% 16.00% 26.62% 35.67% 17.35% 5.Stable Period Return on Capital and Reinvestment Rates Boeing The Home Depot InfoSoft High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth Return on Capital 6.

Aswath Damodaran 3 .Dealing with Cash and Marketable Securities s s The simplest and most direct way of dealing with cash and marketable securities is to keep it out of the valuation . Once the firm has been valued. and the discount rate should not be contaminated by the inclusion of cash. with a history of overpaying on acquisitions. • If you have a particularly incompetent management. (Use betas of the operating assets alone to estimate the cost of equity). markets may discount the value of this cash.the cash flows should be before interest income from cash and securities. add back the value of cash and marketable securities.

183 Marketable Securities $279 Non-Operating Assets $0 Excess of Pension Assets $1. We considered only 50% of the overfunding.323 The Home Depot InfoSoft $62 $100 $0 $400 $0 $0 $0 $0 $62 $500 Boeing has an overfunded pension plan. Aswath Damodaran 4 .Cash and Marketable Securities: Estimates Boeing Cash $2. since the firm will have to pay a tax of 50% if it decides to withdraw the funds.861 Cash and Non-Operating Assets $4.

Can you ever consider a scenario where you would not be willing to pay $ 100 million for this firm? Yes No What is or are the scenario(s)? Aswath Damodaran 4 . we are assuming here that the market will value cash at face value.The Value of Cash s t t s Implicitly. Assume now that you are buying a firm whose only asset is marketable securities worth $ 100 million.

in which case only the dividend from the holdings is shown in the balance sheet • Minority active holdings. in which case the financial statements are consolidated. in which case the share of equity income is shown in the income statements • Majority active holdings. Aswath Damodaran 4 .Dealing with Holdings in Other firms s Holdings in other firms can be categorized into • Minority passive holdings.

Consolidated Firm Aswath Damodaran 4 . Strip operating income of subsidiary and value subsidiary separately. Value subsidiary as a firm and add portion of firm value.How to value holdings in other firms Fin Statement Not consolidated Not consolidated Valuing Equity Firm What to do… Value equity in subsidiary and take share of holding. Add portion of debt in subsidiary to the debt in estimating equity value. Add portion of this value to value of parent firm.

How some deal with subsidiaries. What is wrong with this approach? Aswath Damodaran 4 .. s When financial statements are consolidated. some analysts value the firm with the consolidated operating income and then subtract minority interests from the firm value to arrive at the value of the equity in the firm..

Equity Value and Per Share Value: A Test s Assume that you have done an equity valuation of Microsoft. The total value for equity is estimated to be $ 400 billion and there are 5 billion shares outstanding. What is the value per share? Aswath Damodaran 4 .

Microsoft had 500 million options outstanding.An added fact s In 1999. Estimate the value per share. Aswath Damodaran 4 . These options had an average exercise price of $ 20 (the current stock price is $ 80). granted to employees over time.

Aswath Damodaran 4 . In many firms. s The value of these non-stock equity claims has to be subtracted from the value of equity before dividing by the number of shares outstanding.Equity Value and Per Share Value s s The conventional way of getting from equity value to per share value is to divide the equity value by the number of shares outstanding. that have been granted. but do not trade • conversion options in convertible bonds • contingent value rights. that common stock is the only equity claim on the firm. that are publicly traded • management and employee options. This approach assumes. that are also publicly traded. there are other equity claims as well including: • warrants. however.

s These problems can be partially alleviated by using a binomial option pricing model. allowing for shifts in variance and early exercise.Factors in Using Option Pricing Models to Value Convertibles and Warrants s Option pricing models can be used to value the conversion option with three caveats – • conversion options are long term. and factoring in the dilution effect Aswath Damodaran 4 . and • conversion options are often exercised before expiration. making it dangerous to use European option pricing models. making the assumptions about constant variance and constant dividend yields much shakier. • conversion options result in stock dilution.

7 $ 9.71 23.34 53.40 $ 19.12 Total Value of Options Outstanding at Boeing = Aswath Damodaran 4 .1 $ 10.25 $ 47.Options Outstanding: Boeing Exercise Price $ $ $ $ $ Number Life (in Ô 000s) Black-Scholes Value/option Total Value (in Ô000 s) $ 76.32 $ 86.23 38.72 $ 350.75 41.223.418.466.32 8480 5 $ 14.5 $ 17.44 1779 7.4 $ 10.37 9481 8.670.543.124.35 4315 4.34 16.65 $ 120.25 4598 7.

Options Outstanding: The Home Depot s s s s s s Average Exercise Price of Options Outstanding = $20.021 million Aswath Damodaran 5 .6 years Number of Options Outstanding = 47.00 Average Maturity of Options Outstanding = 7.728 million Standard Deviation of The Home Depot stock = 30% Value of Options Outstanding = $2.17 Stock Price at time of analysis= $ 37.

skip step 1 and estimate the of equity directly. Step 2:Subtract out the value of the outstanding debt to arrive at the value of equity. Step 3:Subtract out the market value (or estimated market value) of other equity claims: • Value of Warrants = Market Price per Warrant * Number of Warrants : Alternatively estimate the value using OPM • Value of Conversion Option = Market Value of Convertible Bonds Value of Straight Debt Portion of Convertible Bonds s Step 4:Divide the remaining value of equity by the number of shares outstanding to get value per share. Aswath Damodaran 5 .Steps in Getting to Value Per Share s s s Step 1: Value the firm. Alternatively. using discounted cash flow or other valuation models.

00% 1.17% 35% Stable Growth Phase Forever after year 10 59.Return on Capital .Cost of Debt .01 5.Beta .98% 6.50% 30.Expected Growth rate Cost of Capital Inputs .Boeing: Valuation .42% 35% Length Growth Inputs .36% 8.00% 8.59%% 4.92% 9.50% 19.00 5.Reinvestment Rate .42% 5.Tax Rate Aswath Damodaran 5 .Summary of Inputs High Growth Phase 10 years 65.Debt Ratio .35% 1.Cost of Capital General Information .

Nt 3.0435 $666 .14% 1.654 $1.532 $1.528 Growth = 9.630 4.42% FCFF = .01 Government + = 80.58% (0.958 Stable Growth Rate Capital ExpectedUS 17.576 $1.80) + 3.468 $1.88Bond 19.Chg% Rate=59.292 EBIT(1-t)0.0842-. $1.598 $1.348 $1.20) $2.0659 = 8.422 $2.225 Currentyear Cost of to Firm (WACC) ==10.59% 65.496 $2.58% (1-t)D = 1.5% Rate =Debt: D/(D+E)$612 .137 .36% 667 -Options = FCFF 350 417 Value/Share $13.50%)(1-.08% E Cash: Beta 4. gReinv0.668 6.35) in= 5%.05) 31.043 $2.92% $586CpX = 30%.ROC=8.EBIT $1.798 Beta ofonRate RiskfreeCashflow Firm Premium for DiscountRisk : WeightsDebt $1.321 Return Reinvestment Country Value Historical atBeta FirmÕs D/E Unlevered Capital R X isk $1.723 EBIT(1-t) $2.Boeing: A Valuation + =Equity Reinvestment13.17% $1.078 Aswath Damodaran 5 .14 Reinvestment Rate = 74.407 $1.186 = $1.323 (5%+ 25.5% 1.35 WC .00.238 $1.5001078/(.58% (0.876 Cost Value: TerminalEquity 10 = $1.194 $638 $695 $725 $757 $790 $824 $860 0% 5.77% Terminal $1.651 10.132 $2.6598* 5% .98% Premium Ratio: Sectors: : 5.58% 568 $2.

62% 16.Cost of Debt .80% 4.55% 9.37% 14.50% 30.Beta .Debt Ratio .Reinvestment Rate .51% 0.52% 35% Stable Growth Phase Forever after year 10 35.00% 7.87 5.The Home Depot: Valuation Inputs High Growth Phase 10 years 88.87 5.00% 0.46% 14.Tax Rate Aswath Damodaran 5 .Cost of Capital General Information .10% 5.92% 35% Length Growth Inputs .Expected Growth rate Cost of Capital Inputs .Return on Capital .

1637= .77% (0.081 =Equity Reinvestment64.1% 807 705 616 538 469 410 358 313 Debt: Nt 3.79% CurrentD/E CostDepot: A Valuation (0.5% Rate =273 D/(D+E) = .87 Government + = 95.05)==9.ROC=14.80%)(1-.829 9.51 % .799 4.9555) + 3.0792-.486 The + 6285 5489 4793 4186 3655 3192 2788 2434 2126 1857 .35) g Reinv Beta = 4.7092 6194 5409 4723 4125 3602 3146 2747 2399 2095 EBIT(1-t) Return Reinvestment Country Growth Historical Value FirmÕs atBeta Unlevered Capital R X isk Growth Beta ofonRate RiskfreeCashflow Firm Premium DiscountRisk WeightsDebt for Cost Value: Rate TerminalEquity : of Capital Stable Home10 =to Firm (WACC) ExpectedUS 68.46% 190 -Options = FCFF 2.45% in= 5%.EBIT 16.021 <160> Value/Share $42.37% 88.76% 1.930 14.86Bond 62 FCFF 0% CpX 5.55 Reinvestment Rate =108.0445) = 9. EBIT(1-t)0.87.8862*.62% Premium Ratio: Sectors: 5.52% 164.79%0. (1-t)D = 0.238 = 5% 30%.75% Aswath Damodaran 5 .Chg WC Rate=35.1451 .77% 1.55% E Cash: : (5%+ 4.9494806/(.5% 0.

Debt Ratio .17% 23.62% 12.54% 42% Stable Growth Phase Forever after year 5 29.Expected Growth rate Cost of Capital Inputs .Cost of Capital General Information .Return on Capital .67% 26.Tax Rate Aswath Damodaran 5 .00% 1.InfoSoft: Valuation Estimates High Growth Phase 5 years 112.2% 5.Cost of Debt .Reinvestment Rate .20 6.Beta .49 6.62% 11.05% 42% Length Growth Inputs .00% 6.55% 1.00% 6.07% 17.

38% Government 2.67% 112.135 26.2% -1104 -872 -689 -545 Debt: 3.36% (0.9520 7165 5661 4474 3535 EBIT(1-t) Return Reinvestment Country Historical Growth FirmÕs Value Unlevered Capital Risk X9067 atBeta Beta ofonRate RiskfreeCashflow Firm Premium DiscountRisk WeightsDebt for Cost Value: 59.Chg WC Rate=29.2% (0.55 % .583 .ROC=17.36% 4. EBIT(1-t)1.17% Premium Ratio: Sectors: 5.1106-.07% 500 = FCFF <340> Reinvestment Rate = 112.20% g Reinv Beta = 6. (5%+ 1.2367 =2.2186753/(.= 23.20.384 TerminalEquity : of Capital Stable Growth Ratein ExpectedUS A10 =to Firm (WACC) ==13.05) 111.09% 1.00%)(1-.5% 7.633 --430 = 5% 6.62% EBIT (1-t): D = 1.9338) + 3.17% Aswath Damodaran 5 .42) 13.4993.43Bond 500 6753 FCFF 0% 5.62%.793 + Cash: E = 5%.5% Rate =Nt CpX D/(D+E) = 1.2655 =Equity Reinvestment55.55% CurrentD/E CostValuation InfoSoft: + 2773 10071 7937 6350 5029 3965 .1217*.0662) = 12.

Examples include -• Price/Earnings (P/E) ratios – and variants (EBIT multiples. book value or revenues. EBITDA multiples. cashflows. Cash Flow multiples) • Price/Book (P/BV) ratios – and variants (Tobin's Q) • Price/Sales ratios Aswath Damodaran 5 . standardized using a common variable such as earnings.Relative Valuation s In relative valuation. the value of an asset is derived from the pricing of 'comparable' assets.

Equity Multiples: Determinants s s Gordon Growth Model: Dividing both sides by the earnings. If the return on equity is written in terms of the retention ratio and the expected growth rate Dividing by the Sales per share. s Dividing both sides by the book value of equity. s s Aswath Damodaran 5 .

can be written as follows: s s Aswath Damodaran 6 .Firm Value Multiples s The value of a firm in stable growth can be written as: Value of Firm = Dividing both sides by the expected free cash flow to the firm yields the Value/FCFF multiple for a stable growth firm: The value/EBITDA multiple. for instance.

Net Capital Expenditure needs. Risk. Payout. Net Margin Growth. Leverage. Payout. Leverage. Payout. Operating Margin Value/Book Capital Growth. Net Capital Expenditure needs. Aswath Damodaran 6 . Risk Growth. Risk. ROE Growth. Leverage.Determinants of Multiples Multiple Price/Earnings Ratio Price/Book Value Ratio Price/Sales Ratio Value/EBITDA Determining Variables Growth. Risk Value/Sales Growth. Risk and ROC Companion variable is in italics. Risk.

the multiple is regressed against one or more variables. For instance. Aswath Damodaran 6 . the average multiple is adjusted using one variable. and the regression is used to estimate the value any firm.Using Multiples based upon Comparables s s s Simple Averages: The average multiple of comparable firms is used to value any firm. Regression Estimates: Here. the PE ratio may be divided by growth to arrive at a PEG ratio. Adjusted Averages: Here. This works only if the firm is similar to the average firm in the sector.

10 1.00 11.49 1.47 0.04 0.83 8.67 1.18 10.61 9.75 0.62 1.43 0.86 39.53 13.54 0.04 12.02 0.43 0.PE Ratios and Growth Rates: Software Firms Company Name Spanlink Communications Expert Software Applied Microsystems Tripos MathSoft Comshare Eagle Point Software TSR Computer Outsourcing Services Data Research Associates Mecon Forsoft HIE CFI ProServices Adept Technology TechForce InVision Technologies American Software A Viasoft Micrografx Orcad MySoftware Integrated Measurement Systems Jetform Aladdin Knowledge Systems Average PE 51.96 23.14 153.26 1.28 0.57 12.41 Expected Growth 50% 15% 20% 25% 30% 10% 5% 20% 40% 15% 30% 25% 38% 22% 19% 15% 23% 30% 17% 35% 16% 30% 11% 20% 18% 23% PEG 1.05 122.63 0.14 46.40 Aswath Damodaran 6 .17 18.55 16.53 3.54 23.14 6.74 9.00 15.40 0.33 9.54 0.73 14.56 16.53 28.54 0.55 0.06 46.53 1.87 9.31 0.39 0.13 5.81 1.15 9.71 10.

03% • Value of Equity = $977.056 million Aswath Damodaran 6 .41 = $27.Valuing InfoSoft s s Using Simple Average Value of Equity = InfoSoft Net Earnings in 1998* Average PE ratio for sector = $977.40 • Expected Growth Rate for InfoSoft= 27.300 * 28.40 * 27.300 million * 1.03 = $ 37.765 million Using Average Adjusted for Growth • PEG Ratio = 1.

50 3.15% 35.46% 27.09% 16.46% 36.15% 37.83 2.62% 27.33 2.51% 16.95% 15.32 3.12% 19.07% 47.46 2.10% 13.02% 27.32% 33.38% 33.41% 25.63% 26.66 3.93 1. Litton Inds.19% 32.02% 10.17 1.57% 14.22 4.Boeing: Price to Book Ratios for Aerospace/Defense Firms Company AAR Corp.84% Standarad Deviation in Stock Prices 61.38% 6 . Sundstrand Corp. 'B' Lockheed Martin Boeing Average Aswath Damodaran PBV 1.23% 19.03% 11.48% 22.16% 39. Orbital Sci Corp CAE Inc.59 0.28% 25.49 7.62% 18.65 4.85% 3.77 6. 'A' Gen'l Dynamics Bombardier Inc.07% 34.59% 36.00 3.32 ROE 11. Northrop Grumman Raytheon Co.40% 16. Alliant Techsystems Precision Castparts Howmet Intl Cordant Techn.83 3.29% 9.

15% (2. which is trading at 3.PBV Regression s Regressing price to book ratios against returns on equity and risk (standard deviation).09% and a standard deviation of 34.97 Standard Deviation R2 = 76.50 times book value.97) (3.41) s Using this regression.69 ROE –6.3432) = 2.54 + 12. Aswath Damodaran 6 .54 + 12.35) (2.69 (. we get a predicted price to book value ratio for Boeing. based upon its return on equity of 9.97 (.32%: Predicted PBVBoeing = 3.0909) –6.27 s Boeing. we get PBV = 3. looks over valued.

Is Boeing fairly valued? s t t t s t t Based upon the PBV ratio. over or correctly valued? Under Valued Over Valued Correctly Valued Will this valuation give you a higher or lower valuation than the discounted cashflow valuation? Higher Lower Aswath Damodaran 6 . is Boeing under.

on average.Relative Valuation Assumptions s t t t t t t Assume that you are reading an equity research report where a buy recommendation for a company is being based upon the fact that its PE ratio is lower than the average for the industry. what is the underlying assumption or assumptions being made by this analyst? The sector itself is. Implicitly. fairly priced The earnings of the firms in the group are being measured consistently The firms in the group are all of equivalent risk The firms in the group are all at the same stage in the growth cycle The firms in the group are of equivalent risk and have similar cash flow patterns All of the above Aswath Damodaran 6 .

stern.edu/~adamodar Aswath Damodaran 6 .Value Enhancement: Back to Basics Aswath Damodaran http://www.nyu.

Price Enhancement versus Value Enhancement Aswath Damodaran 7 .

by either – increasing after-tax earnings from assets in place or – reducing reinvestment needs (net capital expenditures or working capital) • The expected growth rate in these cash flows can be increased by either – Increasing the rate of reinvestment in the firm – Improving the return on capital on those reinvestments • The length of the high growth period can be extended to allow for more years of high growth. there are four basic ways in which the value of a firm can be enhanced: • The cash flows from existing assets to the firm can be increased.The Paths to Value Creation s Using the DCF framework. • The cost of capital can be reduced by – Reducing the operating risk in investments/assets – Changing the financial mix – Changing the financing composition Aswath Damodaran 7 .

the length of the high growth period or the discount rate cannot affect value.A Basic Proposition s For an action to affect the value of the firm. Aswath Damodaran 7 . future growth. it has to • • • • Affect current cash flows (or) Affect future growth (or) Affect the length of the high growth period (or) Affect the discount rate (cost of capital) s Proposition 1: Actions that do not affect current cash flows.

Accounting decisions that affect reported earnings but not cash flows should have no effect on value.Value-Neutral Actions s s Stock splits and stock dividends change the number of units of equity in a firm. Decisions that create new securities on the existing assets of the firm (without altering the financial mix) such as tracking stock cannot Aswath Damodaran create value. though they might affect perceptions and hence the price. s 7 . • Changing inventory valuation methods from FIFO to LIFO or vice versa in financial reports but not for tax purposes • Changing the depreciation method used in financial reports (but not the tax books) from accelerated to straight line depreciation • Major non-cash restructuring charges that reduce reported earnings but are not tax deductible • Using pooling instead of purchase in acquisitions cannot change the value of a target firm. growth or risk. but cannot affect firm value since they do not affect cash flows.

Change in Non-cash Working Capital = Free Cash Flow to Firm Proposition 2: A firm that can increase its current cash flows.(Capital Expenditures . The cash flows discounted in valuation are after taxes and reinvestment needs have been met: EBIT ( 1-t) . will increase its value. To the extent that these investments were poorly made and/or poorly managed. without significantly impacting future growth or risk.Depreciation) .Value Creation 1: Increase Cash Flows from Assets in Place s s s The assets in place for a firm reflect investments that have been made historically by the firm. it is possible that value can be increased by increasing the after-tax cash flows generated by these assets. Aswath Damodaran 7 .

Chg in Working Capital = FCFF Aswath Damodaran 7 .Tax Rate * EBIT = EBIT (1-t) + Depreciation .Ways of Increasing Cash Flows from Assets in Place Better tax Live efficient Reduce past overMoreoffassets that Divest inventory Revenues rate management investment .moving income operations andEBIT have negativeandto lower tax locales tighter credit .risk management Higher Margins = EBIT .Capital Expenditures .Operating Margin cost cuttting: policies * transfer pricing .

Operating Margin and Value Per Share: Boeing Figure 25.00 $0.2: Boeing: Operating Margin Effect on Value $140.00 $20.00 $80.00 $120.00 Value/Share $40.00 3% 5% 7% 9% 11% 13% 15% After-tax Operating Margin Aswath Damodaran 7 .00 $60.00 $100.

000 0% 10% 20% 30% 40% 50% Aswath Damodaran 7 .000 $58.000 $57.3: Tax Rate and InfoSoft Value $60.000 $53.000 $59.000 $56.Tax Rate and Value: InfoSoft Figure 25.000 $54.000 $52.000 $55.

00 $35.00 0% 5% 10% 15% 20% Non-Cash Working Capital as % of Revenues Aswath Damodaran 7 .00 $15.00 $30.00 $25.00 $40.00 $45.5: The Home Depot: Working Capital and Value/Share $50.00 Value/Share $20.Working Capital and Value: The Home Depot Figure 25.00 $5.00 $0.00 $10.

The expected growth in earnings of any firm is a function of two variables: • The amount that the firm reinvests in assets and projects • The quality of these investments Aswath Damodaran 7 . increasing the expected growth in earnings will increase the value of a firm.Value Creation 2: Increase Expected Growth s s Keeping all else constant.

Value Enhancement through Growth Increase capital turnover ratio Do acquisitionsin Reinvest operating Reinvestment Rate more margins projects * Return on Capital = Expected Growth Rate Aswath Damodaran 8 .

62% 14.38% 88.14 The Home Depot 9.Reviewing the Valuation Inputs Boeing 9.55 InfoSoft 12.72% $13.17% 27.51% $42.15 Cost of Capital Return on Capital Reinvestment Rate Expected Growth Rate Value Per Share Aswath Damodaran 8 .51% 16.17% 6.59% 65.98% 5.55% 23.67% 112.03% $55.

00% 0.00% 20.00% -30.00% 10.6: Effect of Changes in the Reinvestment Rate on the Value of Equity 30.00% Change in Reinvestment Rate Boeing The Home Depot InfoSoft Aswath Damodaran 8 .00% Change in Value of Equity -20.00% -20% -10% 10% 20% -10.Changing the Reinvestment Rate Figure 25.

but reduces it at Boeing. Why? Aswath Damodaran 8 .Reinvestment Rate and Value s Increasing the reinvestment rate increases value per share at The Home Depot and InfoSoft.

other things remaining equal. The high growth period refers to the period over which a firm is able to sustain a growth rate greater than this “stable” growth rate. at some point in the future. it will increase value. If a firm is able to increase the length of its high growth period. will become a stable growth firm. The length of the high growth period is a direct function of the competitive advantages that a firm brings into the process. Aswath Damodaran 8 . Creating new competitive advantage or augmenting existing ones can create value. growing at a rate equal to or less than the economy in which it operates.Value Creation 3: Increase Length of High Growth Period s s s s Every firm.

3. Aswath Damodaran 8 . Firms that are able to improve their brand name value over time can increase both their growth rate and the period over which they can expect to grow at rates above the stable growth rate. thus increasing value.1: The Brand Name Advantage s s Some firms are able to sustain above-normal returns and growth because they have well-recognized brand names that allow them to charge higher prices than their competitors and/or sell more than their competitors.

02% 65.65% 4.56% 1.67 12.90%) 8.67 31.33% 97.00% (19.Illustration: Valuing a brand name: Coca Cola Aswath Damodaran AT Operating Margin Sales/BV of Capital ROC Reinvestment Rate Expected Growth Length Cost of Equity E/(D+E) AT Cost of Debt D/(D+E) Cost of Capital Value Coca Cola 18.16% 2.53% 65.16% 10 years 12.50% 1.35% 12.35% 12.00% (47.33% 97.16% 2.35%) 20.13% $115 Generic Cola Company 7.13% $13 8 .15% 10 yea 12.65% 4.

however. come with restrictions on excess returns. Licenses and government-sanctioned monopolies also provide protection against competition.2: Patents and Legal Protection s s s The most complete protection that a firm can have from competitive pressure is to own a patent. for instance.3. since they cannot protect a firm against a competitive product that meets the same need but is not covered by the patent protection. They may. Note that patents only provide partial protection. are monopolies but are regulated when it comes to price increases and returns. utilities in the United States. Aswath Damodaran 8 . copyright or some other kind of legal protection allowing it to be the sole producer for an extended period.

while reducing the costs of switching from competitor products to their own will be able to increase their expected length of growth. The greater the switching costs. Firms that devise ways to increase the cost of switching from their products to competitors’ products. the more difficult it is for competitors to come in and compete away excess returns.3: Switching Costs s s s Another potential barrier to entry is the cost associated with switching from one firm’s products to another. Aswath Damodaran 8 .3.

where scale can be used to reduce costs. economies of scale can give bigger firms advantages over smaller firms • Owning or having exclusive rights to a distribution system can provide firms with a cost advantage over its competitors.4: Cost Advantages s There are a number of ways in which firms can establish a cost advantage over their competitors. but have a much higher operating margin. • The firm may charge lower prices than its competitors and have a much higher capital turnover ratio. • Owning or having the rights to extract a natural resource which is in restricted supply (The undeveloped reserves of an oil or mining company. for instance) s These cost advantages will show up in valuation in one of two ways: • The firm may charge the same price as its competitors. Aswath Damodaran 8 . and use this cost advantage as a barrier to entry: • In businesses.3.

7: Value of InfoSoft and Expected Growth Period 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 Aswath Damodaran 9 .Growth Period and Value: InfoSoft Figure 25.

Gauging Barriers to Entry s Ë Ë Ë Ë Which of the following barriers to entry are most likely to work for the firm that you are analyzing? Brand Name Patents and Legal Protection Switching Costs Cost Advantages Aswath Damodaran 9 .

Value Creation 4: Reduce Cost of Capital s The cost of capital for a firm can be written as: Cost of Capital = ke (E/(D+E)) + kd (D/(D+E)) Where. ke = Cost of Equity for the firm kd = Borrowing rate (1 . given current interest rates and its own default risk.tax rate) s s The cost of equity reflects the rate of return that equity investors in the firm would demand to compensate for risk. Holding the cash flows constant. reducing the cost of capital will increase the value of the firm. The cash flows generated over time are discounted back to the present at the cost of capital. Aswath Damodaran 9 . while the borrowing rate reflects the current long-term rate at which the firm can borrow.

reducing leverage less discretionary to advertising characteristics default risk customers Aswath Damodaran 9 .Reducing Cost of Capital Hybrids Derivatives Swaps Flexible financing Outsourcing More Changing Match operating mix Reduce wage Make product (E/(D+E) ChangeEquity contracts & Cost ofdebt to or service+ Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital cost structure effective product assets.

09% 9.55% 9.23% 6.55% 20% 12.28% Boeing The Home Depot InfoSoft Aswath Damodaran 9 .16% 4.Actual versus Optimal Debt Ratios Current Optimal Cost of Capital Debt Ratio Cost of Capital Debt Ratio 20.55% 12.51% 20% 9.17% 30% 9.

By matching cash flows on debt to cash flows on the asset. a firm reduces its risk of default and increases its capacity to carry debt. reduces its cost of capital. Aswath Damodaran 9 . Firms which mismatch cash flows on debt and cash flows on assets by using • Short term debt to finance long term assets • Dollar debt to finance non-dollar assets • Floating rate debt to finance assets whose cash flows are negatively or not affected by inflation will end up with higher default risk. in turn. which. and increases value. higher costs of capital and lower firm value.Changing Financing Type s s s The fundamental principle in designing the financing of a firm is to ensure that the cash flows on the debt should match as closely as possible the cash flows on the asset.

Divest asse ts/projects with Divestiture Value > Continuing Value 2. Reducethe ope rating risk of the fi rm. ry Cost of Financ ing 1. by making p roduc les ts s discretiona to customers. Changepricing strategy to requ irements. Use the optimal fi nanc ing mix to finan new ce investments. Use economies of sc or cost ale advan tages to crea highe te r return on capital. t Aswath Damodaran 1. Could work if. Terminate projects with Liquidation Value > Continuing Value 3. Recap ze to move the itali fi rm towards its optimal deb ratio. 1. or by increa sing ratio. Expec Growth ted Leng of High G th rowth Peri od Increas reinves e tment rate o r marginal return on cap or ital both in firmÕ existing s bus iness es. Eliminate ope rating expen that generate no ses current revenue and no s growth.The Value Enhancement Chain Assets in Place GimmeÕ 1. do so Odds on. Buil d up b rand n ame 2. Reducenet working c apital 1. Increas reinves e tment rate o r marginal return on cap or ital both in new bus inesse s. Changefi nanc type and ing use innova se tive curiti es to reflect the typesof asse ts being finan ced 2. Make cost structure more fl exible to redu operating ce leve . Eliminate new cap ital expend itures that are expe cted to earn les than the cos of s t cap ital If any o the fi rmÕ produc or f s ts services canbe pa tented and protected. 3. accounts payable. Reducecapital maintenan ce expend itureson assets in place . Increas the cos of e t switching from produc and t reducecos of switching to t it. by redu cing maximize the p roduc of t inven tory andaccoun ts profit margins andturnover rece ivable. 2. rage 9 . 1.. Use swaps and de rivatives to match deb more closely t to fir mÕs ts asse 2.

08 .01 25.92% in= 5%.00.298(.2542.38% Aswath Damodaran 9 .50%)(1-.73 Reinvestment Rate = 80.Chg% Rate=40% 667 -Options = FCFF 350 417 Value/Share $28.56% (0. EBIT(1-t)0.35) 13.5% 978 904 Debt: Nt 3.25 WC .194 =Equity Reinvestment40.0842-.50% 65.776 8.323 + = 80.16% CurrentD/E Cost of to Firm (WACC)Valuation 67.EBIT 12.58% (0.ROC=12.58% 1.20) = 9.039 8.3830 3648 3370 3113 2876 2657 2454 2267 2095 1935 1788 EBIT(1-t) Return Reinvestment Country Growth Historical Value FirmÕs atBeta Unlevered Capital R X isk Beta ofonRate RiskfreeCashflow Firm Premium DiscountRisk for WeightsDebt : Cost Value: A 10 = TerminalEquity Restructured Stable Growth Rate Capital ExpectedUS 33.6598*.125 = .88Bond 2298 1241 1146 1059 713 658 608 FCFF 0% CpX 5.123 E Cash: (5%+ 0.771 = 5% 30%.80) + 3.08% 2.5% 1.14% Government 4.148 Boeing: + 1532 2407 2223 2054 1898 1753 1619 1496 1382 1277 1179 .85% : g Reinv Beta = 19. (1-t)D = 1.98% Premium Ratio: Sectors: 5.05)==10.5% Rate =835 D/(D+E) = .

9837 8320 7036 5950 5032 4256 3599 3044 2574 2177 EBIT(1-t) Return Reinvestment Country Growth Historical Value FirmÕs atBeta Unlevered Capital R X isk Growth Beta ofonRate RiskfreeCashflow Firm Premium DiscountRisk WeightsDebt for Cost Value: Rate TerminalEquity : of Capital Stable Home10 =to Firm (WACC) ExpectedUS 89.1677= 1.813 --336 = 5% 30%.146 The + 11356 9604 8122 6869 5809 4913 4155 3514 2972 2513 .80) + 4.8506666/(.76% Premium Ratio: Sectors: 5.46% 190 -Options = FCFF 2.23% CurrentD/E CostDepot: A Restructured Valuation 228.ROC=14.35) 10.00%)(1-.86Bond 62 -1284 -1086 FCFF 0% 5.77% 108.39% (0.98 25% Government + = 80% E Cash: : (5%+ 2.841 g Reinv Beta = 0.0792-.1824 =Equity Reinvestment86. (1-t) 20% EBIT(1-t)0.55% 3.76% Aswath Damodaran 9 .5% Rate =Nt CpX D/(D+E) = 1.027 18.24 % .87.1% -1519 -919 -777 -657 -556 -470 -397 Debt: 4.55% (0.20) = 9.021 <161> Value/Share $56.39% D = 1.EBIT 16. in= 5%.0876*.885 .81 Reinvestment Rate =108.05)==10.Chg WC Rate=35.5% 0.

= 23.793 + Cash: E = 5%.6480% Government 2.29% InfoSoft: + 33011 26086 20613 16288 12871 10170 8047 6350 5018 3965 .20.20) = 12.ROC=17.5% 7.17% Premium Ratio: Sectors: 5.37% (0. EBIT (1-t): = 20% EBIT(1-t)1.17% Aswath Damodaran 9 .43Bond 500 -3582 -2831 -2237 -1767 -1397 FCFF 0% 5.2% 1.37% 2.02% D g Reinv Beta = 1.29429 23255 18376 14521 11474 7165 5661 4474 3535 EBIT(1-t) Return Reinvestment Country Historical Growth FirmÕs Value Unlevered Capital Risk X9067 atBeta Beta ofonRate RiskfreeCashflow Firm Premium DiscountRisk WeightsDebt for Cost Value: Cost of 21918/(.07% 26.02% (0.80) + 5.05) = 409453 TerminalEquity :Restructured Valuation Stable Growth Ratein ExpectedUS A10 = Capital CurrentD/E 121522to Firm (WACC) = 14.00%)(1-.2367= 4. (5%+ 4.1217*.Chg WC 117439 500 = FCFF <340> Reinvestment Rate = 112.1035-.5% Rate =Nt CpX D/(D+E) =20%.09% 1.42) 14.633 .583 --430 = 5% -1103 -872 -689 -544 Debt: 5.55 % .67% 112.2655 =Equity Reinvestment Rate=29.

First Principles s Invest in projects that yield a return greater than the minimum acceptable hurdle rate. • The hurdle rate should be higher for riskier projects and reflect the financing mix used . Objective: Maximize the Value of the Firm Aswath Damodaran 10 .will depend upon the stockholders’ characteristics. • The form of returns . s s Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows. If there are not enough investments that earn the hurdle rate.dividends and stock buybacks . they should also consider both positive and negative side effects of these projects. return the cash to stockholders.