Debt and Value: Beyond MillerModigliani

Aswath Damodaran

Stern School of Business

Aswath Damodaran

1

The fundamental question: Does the mix of
debt and equity affect the value of a business?

Assets
Existing Investments
Assets in Place
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments

Different Value?

Aswath Damodaran

Growth Assets

Liabilities
Debt

Equity

Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible

Residual Claim on cash flows
Significant Role in management
Perpetual Lives

Different Financing Mix?

2

Debt and Value in Equity Valuation
Will the value of equity per share increase as debt increases?
Figure 5.5: Equity Valuation
Assets
Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth

Assets in Place

Growth Assets

Liabilities
Debt

Equity

Discount rate reflects only the
cost of raising equity financing

Present value is value of just the equity claims on the firm

Changing debt will change cash
flows to equity
Aswath Damodaran

As debt increases, equity
will become riskier and
cost of equity will go up.

3

in proportion to their use Present value is value of the entire firm. value should increase. Cash flows are before debt payments.6: Firm Valuation Assets Cash flows considered are cashflows from assets.Debt and Value in Firm Valuation Will the value of operating assets increase as debt goes up? Figure 5. and reflects the value of all claims on the firm. prior to any debt payments but after firm has reinvested to create growth assets Assets in Place Growth Assets Liabilities Debt Equity Discount rate reflects the cost of raising both debt and equity financing. If it goes down. Should not be affected by debt (or should it?) Aswath Damodaran Effects of debt show up in cost of capital. 4 .

A basic proposition about debt and value  For debt to affect value. • If the benefits exceed the costs. • If the benefits exactly offset the costs. there have to be tangible benefits and costs associated with using debt instead of equity. debt will not affect value • If the benefits are less than the costs. there will be a gain in value to equity investors from the use of debt. increasing debt will lower value Aswath Damodaran 5 .

Added Discipline: 2. Bankruptcy Cost: Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost 2.Debt: The Basic Trade Off Advantages of Borrowing Disadvantages of Borrowing 1. Agency Cost: Greater the separation between managers Greater the separation between stock- and stockholders --> Greater the benefit holders & lenders --> Higher Cost 3. Tax Benefit: 1. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost Aswath Damodaran 6 .

A Hypothetical Scenario (a) There are no taxes (b) Managers have stockholder interests at hear and do what’s best for stockholders. (c) No firm ever goes bankrupt (d) Equity investors are honest with lenders. there is no subterfuge or attempt to find loopholes in loan agreements (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 7 .

capital structure is irrelevant. The value of a firm is independent of its debt ratio and the cost of capital will remain unchanged as the leverage changes. where there are no taxes.The Miller-Modigliani Theorem   In an environment. Aswath Damodaran 8 . default risk or agency costs.

For the same firm. increasing debt can increase the value of some firms and reduce the value of others. default risk and agency costs. it is no longer true that debt and value are unrelated. debt can increase value up to a point and decrease value beyond that point. Aswath Damodaran 9 .But here is the real world…    In a world with taxes. In fact.

Tools for assessing the effects of debt     The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm. Aswath Damodaran 10 . The Life Cycle Approach: The optimal debt ratio is the one that best suits where the firm is in its life cycle. The Adjusted Present Value Approach: The optimal debt ratio is the one that maximizes the overall value of the firm. The Sector Approach: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of financing mix.

I. discounted back at the cost of capital. The Cost of Capital Approach   Value of a Firm = Present Value of Cash Flows to the Firm. Aswath Damodaran 11 . If the cash flows to the firm are held constant. and the cost of capital is minimized. the value of the firm will be maximized.

Equity or Preferred stock • (b) the cost of each component  In summary. WACC = Cost of Equity (Equity / (Debt + Equity)) + After-tax Cost of debt (Debt/(Debt + Equity)) Aswath Damodaran 12 . the cost of capital is the cost of each component weighted by its relative market value.Measuring Cost of Capital  It will depend upon: • (a) the components of financing: Debt.

. you should include the following in debt • All interest bearing debt. short as well as long term • The present value of operating lease commitments Aswath Damodaran 13 .  General Rule: Debt generally has the following characteristics: • Commitment to make fixed payments in the future • The fixed payments are tax deductible • Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due..What is debt.  Using this principle.

0525  (1.   1 (1   Estimated MV of Disney Debt = 666 (1.0525)11.93 Debt Value of leases = $ 1.00 $ 212.0525)11.53  13.668 million Aswath Damodaran 14 .00 $ 218. Disney had book value of debt of 13.Estimating the Market Value of Debt  The market value of interest bearing debt can be estimated: • In 2004.753= $14. a current cost of borrowing of 5.53 years.50 5 $ 275.53   Year Commitment Present Value 1 $ 271. interest expenses of $666 million.46 3 $ 221.55 4 $ 208.752.25 $ 704. 915 million    .00 $ 189.00 $ 169.92 6 –9 $ 258.100  $12.100 million.915 + $ 1.48  2 $ 242.85  Debt outstanding at Disney = $12.25% and an weighted average maturity of 11.00 $ 257.

No reinvestment risk .No default risk .Premium for average risk investment Financial Leverage Base Equity Premium Country Risk Premium 15 .Estimating the Cost of Equity Cost of Equity Risk fre e Rate : .In sa me currency and in sa me te rms (real or nominal as cash flows + Be ta .Measures market risk X Type of Business Aswath Damodaran Operating Leverage Risk Pre mium .

• The cost of debt is • The rate at which the company can borrow long term today • Composed of the riskfree rate and a default spread • Corrected for the tax benefit it gets for interest payments.What the cost of debt is and is not..Tax rate) • Which tax rate should you use? • The cost of debt is not • Aswath Damodaran the interest rate at which the company obtained the debt that it has on its books. Cost of debt = kd = Long Term Borrowing Rate(1 . 16 .

25%) (1-.21) = 8.00%(.79)+3.101+14.00% • Market Value of Equity = $55.Current Cost of Capital: Disney  Equity • Cost of Equity = Riskfree rate + Beta * Risk Premium = 4% + 1.373) = 3.59% 55.29%(.668 Billion • Debt/(Debt +Equity) = 21%  Cost of Capital = 10.101 Billion • Equity/(Debt+Equity ) = 79%  Debt • After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t) = (4%+1.82%) = 10.29% • Market Value of Debt = $ 14.25 (4.101/ (55.668) Aswath Damodaran 17 .

Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. Calculate the effect on Firm Value and Stock Price. To estimating bond ratings. Aswath Damodaran 18 . Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Beta will increase -> Cost of Equity will increase. Estimation will use levered beta calculation 2. we will use the interest coverage ratio (EBIT/Interest expense) 3.Mechanics of Cost of Capital Estimation 1. Estimate the Cost of Capital at different levels of debt 4.

30% 50.00% 11.00% 66.05% 90.00% 7.00% 900.00% 25.00% 3.00% 2.00% 400.00% 100.00% 1.00% Tax rate=37.86% 1.67% 80.0674 9.11% 1.Bond Rate = 4.00% 0.98% 70.00% 233.00% 150.67% 1.50% 20.53% 40.15% 10.0674 (Bottom up beta based upon Disney’s businesses) Market premium = 4.1418 9.3543 10.33% 2.0714 13.Estimating Cost of Equity Unlevered Beta = 1.18% Aswath Damodaran 19 .0911 38.00% 1.37% 60.3% Debt Ratio D/E Ratio Levered Beta Cost of Equity 0.95% 30.7446 22.82% T.7367 12.00% 42.2348 9.00% 1.6291 16.5136 11.

00 1.00 2.0 0 % 16.6.50% 4.50 4.25 – 1.0 0 % 20.50% 6.0 0 % 24. 5 0 1.50% 0.90 – 2.0 0% 6.50 3.65 < 0.75 – 1.80 – 1.1.20 Aswath Damodaran Rati n g AAA AA A+ A ABBB BB+ BB B+ B BCCC CC C D Typical de f ault spread 0.50% 3.The Ratings Table Interest Co v era ge Ratio > 8.00% 2.25% 8.0 0 % 12.00% 10.00 – 4.50 – 6.85% 1.0 0 % 12.20 – 0.2.00% 8.5 6.80 0.05 .25 0.70% 0.35% 0.75 1.00% 10.50% 2.50 5.50 – 3.25 – 5.0 0 % 20 .00% 5.25% 4.0 0 % 14.0 0 % Market inte rest rat e on d e bt 4.50 .35% 4.50 0.25 2.85% 5.50% 7.70% 4.00% 1.00% 6.50 .65 – 0.90 1.

0 0 % 16 .8 6 % 11.6 2 % 13.14% 37. Cost of Debt and Debt Ratios De bt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Aswath Damodaran De bt $0 $6.5 0 % 13.5 8 2 $6.25% 18.0 0 % 16.42 C 0.2 4 % 8.Bond Ratings. 0 47 Interest Cove rag e Bond Ratio Rating • AAA 9.0 0 % 16.00% 12.3 0 % 3.28 C Interest rate o n debt 4.0 0 % 16.2 5 6 $3.6 9 8 $7. 8 15 $62.3 0 % 2.9 3 0 $10.8 1 4 $8.36 C 0. 8 38 $55.00% 6. 8 85 $41.7 2 % 14.35% 4. 9 31 $27.76% 31.7 5 % 13.0 2 A2. 9 54 $20.3 0 % 3.1 3 % 10.73% 37.50 C 0.84 CCC 0.3 9 % 13.24 AAA 4.3 0 % 2.4 1 % 14.0 0 % Cost of Tax De bt Rate (af ter -tax) 37.0 0 % 16.3 4 9 $5. 8 61 $48. 7 92 Interest expense $0 $303 $698 $1. 9 08 $34.9 7 7 $13.3 3 % 21 .23 BB+ 0.73% 37.35% 5.31 C 0.0 0 % 15.

56% 16.15% 9.20% 13.14% 3.96% 22 .25% 13.31% 50.50% 13.50% 10.Disney’s Cost of Capital Schedule Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Aswath Damodaran Cost of Equity 9.50% 9.33% 15.13% 14.16% 14.33% Cost of Capital 9.76% 17.66% 19.54% 27.95% 10.76% 8.63% Cost of Debt (after-tax) 2.59% 8.86% 14.73% 2.83% 8.00% 13.73% 3.36% 15.15% 8.50% 13.53% 11.

00% 2.00% 8.00% 14.3: Disney Cost of Capital at different Debt Ratios 60.00% 16.00% 6.00% Cost of equity climbs as levered beta increases Optimal Debt ratio is at this point 12.00% 18.Disney: Cost of Capital Chart Figure 8.00% 20.00% 30.00% 10.00% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt Ratio Cost of Equity Aswath Damodaran After-tax Cost of Debt Cost of Capital 23 .00% 4.00% 0.00% After-tax cost of debt increases as interest coverage ratio deteriorates and with it the synthetic rating.00% 20. 0.00% Cost of Capital Costs of debt and equity 50.00% 40.00% 10.

047.Effect on Firm Value  Firm Value before the change = 55.68 per share Implied Growth Rate obtained by Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula $69.0859-g): Solve for g -> Implied growth = 5. • • Increase in firm value = $63 /(.769 WACCb = 8.400/2.36 per share If we assume a perpetual growth of 4% in firm value over time.930 million Change in Annual Cost = $ 63 million Increase in firm value = $63 / .6= $0.59%= $5.668= $ 69.6 = $ 0. (Conservative Estimate) • •  Annual Cost = $69.722(1+g)/(.04) = $ 1.0850-.993 million Annual Cost = $69.09%  If there is no growth in the firm value.59% WACCa = 8.769 *8.400 million Change in Stock Price = $1.0850= $ 741 million Change in Stock Price = $741/2047.769 *8.50% = $5.98% Aswath Damodaran 24 .101+14.769 = $1.50% WACC = 0.

> Higher Optimal Debt Ratio Lower tax rates ...> Higher Optimal Debt Ratio 25 ... Pre-Tax Returns on Firm = (Operating Income) / MV of Firm Higher Pre-tax Returns ...> Lower Optimal Debt Ratio 2.> Lower Optimal Debt Ratio 3. Default Spreads Higher Lower Aswath Damodaran . Variance in Earnings [ Shows up when you do 'what if' analysis] Higher Variance .Determinants of Optimal Debt Ratios  Firm Specific Factors • • • • • • • • •  1.> Lower Optimal Debt Ratio .> Higher Optimal Debt Ratio Macro-Economic Factors • 1. Tax Rate Higher tax rates ...> Higher Optimal Debt Ratio Lower Pre-tax Returns .> Lower Optimal Debt Ratio Lower Variance .

II. the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value Firm Value = Unlevered Firm Value + (Tax Benefits of Debt Expected Bankruptcy Cost from the Debt) The optimal dollar debt level is the one that maximizes firm value Aswath Damodaran 26 . The APV Approach to Optimal Capital Structure    In the adjusted present value approach.

and multiply by the cost of bankruptcy (including both direct and indirect costs) to estimate the expected bankruptcy cost.Tax Benefits of Debt (Current) + Expected Bankruptcy cost from Debt  Step 2: Estimate the tax benefits at different levels of debt. with an unlevered firm) 2. This can be done in one of two ways: 1.Implementing the APV Approach  Step 1: Estimate the unlevered firm value. The simplest assumption to make is that the savings are perpetual. Aswath Damodaran 27 . Estimating the unlevered beta. in which case •  Tax benefits = Dollar Debt * Tax Rate Step 3: Estimate a probability of bankruptcy at each debt level. 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. Unlevered Firm Value = Current Market Value of Firm . Alternatively.

158 $13.556 $6.218 $56.810 10.00% $14.Disney: APV at Debt Ratios Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% $ Debt Tax Rate Unlevered Firm Value Tax Benefits Bond Rating Probability of Default Expected Bankruptcy Cost Value of Levered Firm $0 37.979 37.870 $41.852 13.556 $7.218 $56.809 BB+ 7.01% $2 $67.555 $6.107 $34.37% $64.556 $5.218 $56.556 $6.556 $6.870 $55.00% $14.958 37.60% $64.531 C 80.158 $64.00% $14.41% $246 $69.20% $64.873 15.531 C 80.01% $2 $64.30% $64.556 $6.937 37.531 C 80.603 AAA 0.72% $64.218 $56.30% $64.556 $6.894 18.206 A1.517 $20.531 C 80.00% $14.40% $64.831 11.556 $2.00% $1.099 $27.708 CCC 50.556 $8.916 31.556 $0 AAA 0.00% $14.00% $9.30% $64.870 $48.870 Aswath Damodaran 28 .531 C 80.218 $56.266 $71.30% $64.870 $62.70% $64.

III. • • • • Aswath Damodaran Higher tax rates -> Higher debt ratios (Tax benefits) Lower insider ownership -> Higher debt ratios (Greater discipline) More stable income -> Higher debt ratios (Lower bankruptcy costs) More intangible assets -> Lower debt ratios (More agency problems) 29 . Relative Analysis I. Industry Average with Subjective Adjustments  The “safest” place for any firm to be is close to the industry average  Subjective adjustments can be made to these averages to arrive at the right debt ratio.

Comparing to industry averages Disney Entertainment Aracruz Market Debt Ratio 21.56% 30.10% 28.02% 19.71% 49.12% Aswath Damodaran Paper and Pulp (Emerging Market) 27.00% 30 .86% 43.82% Book Debt Ratio 35.

but increases as existing project s end. Even if public. as earnings from exist ing assets increase. The Debt-Equity Trade off and Life Cycle St age 1 St art-up St age 2 Rapid Expansion St age 3 High Growt h St age 4 Mat ure Growt h St age 5 Declin e Revenues $ Revenues/ Earnings Earnings Time Tax Benefits Zero. as firm High. Earnings are increasing but st ill vo latile Declining. Firm t akes few in place become a larger portion of firm. Non-exist ent . as managers own less of firm High. as assets Low. with earn in gs High Added Disceipline of Debt Lo w. Firm has Very high.IV. as owners run th e firm Low. Agency Costs Very high. Debt will provide benefits. New has almost no invest men ts are assets difficult to mon it or High. Firm has no new investment needs. as earnings are limit ed Increase. Declining. but declining Declining. no or negat ive Earnings are low earnings. Exp ansion looks for ways t o needs are large an d est ablish itself un predicat ble High. if losing money Low. Net Trade Off Aswath Damodaran High. and volatile High. Managers are separated from owners Bamkruptcy Cost Very high. firm is closely held. new investment s Need for Flexibility Very high. Exp ansion needs remain un predictable Low. Firm has low and more predictable invest ment needs. net benefits t o t he Mostly equity firm Debt becomes a more at t ractive opt ion. as firm does not t ake many new investment s Low. as firm High. Increasing. Lot s of new invest men ts and un st able risk. Cost s exceed benefits Co st s st ill likely Debt start s yielding Minimal debt t o exceed ben efit s. 31 .

Aswath Damodaran 32 .Concern 1: Changing Debt Ratios and Firm Value  In some cases. with appropriate costs of capital. The same can be said for distressed firms with too much debt: a combination of operating improvements and debt restructuring is assumed to bring the debt ratio down. • Use year-specific debt ratios. it is routine to overshoot in the initial years (have a debt ratio well above the optimal) and to use asset sales and operating cash flows to bring the debt down to manageable levels. to value the firm. you may expect the debt ratio to change in predictable ways over the next few years.  In many leveraged buyout deals. You have two choices: • Use a target debt ratio for the entire valuation and assume that the transition to the target will be relatively painless and easy.

738 $1 .690 $2 7 $3 0 $2 7 $2 1 $1 9 $3 92 $8 32 $9 49 $1 .Cap Ex .80% 12.00 16.390 $1 .102 $1 .80% 2.00 16.058 $11.80% Cost of Equity 16.86 Risk Pre mium 4% Current D/E: 4 41% Term.80% 12.675 )($1.260 7.88% 1.526 )($1.Value o f De bt $ = Value of Equity $ .272 )$3 20 ($1.738 )($1.20% 11.0736-.88% 60.00 8.91% 13.738 )($1.675 )($1.324 $0 $4 6 $4 8 $4 2 $2 5 ($3.580 $1 .72% Base Equity Premium Fore ver 1.95% 11.00 16.80% 74.694 $1 . Year $13.530 2.40 10.80 12.371 ($1.353 $ 20 $ 677 Country Risk Premium 33 .80% 74.80% Operating Leverage X 1.8%+8 .461 6 7 8 9 10 Beta Cost of Equity Cost of Debt Debt Ratio Cost of Capit al 3.98% 9.0%=12.80% 74.565 )($1.8% + 3.697 $2 .94 2 $12 .80% 6.0 5) =$ 28.533 $1 .201 $1 .92% 3.33% NOL: 2.186 $2 .93% 12.00> 1.276 $7 36 $7 73 $8 11 $8 52 $8 94 $1 .716 $1 .187 $ 3.76% 40.761 )($903) ($472) $2 2 1 2 3 4 5 $1 0.659 $1 3.609 $1 .80% 3.6 83 5.80% 12.94% Cost of De bt 4.10 Internet/ Reta il Aswath Damodaran 2.923 $8 .00% 9.074 $1 .565 )($1.248 $ 2.111 $ 939 $ 2.40% 8.186 $2 .80% 3.Current Revenue $ 3.407 $1 .790 4.911 $2 .36% Reinvest 67.051 $3 .91% -> 40 % Global Crossing November 2001 Stock price = $1.Equity Options $ Value p er share $ Stable Stable Revenue EBITDA/ Growth: 5% Sales 30% EBITDA/Sales -> 30% Stable ROC=7.038 $3 .92% 53.272 )$3 20 $1 .80% 12.00 16.308 $9 . Bond rate = 4.589 $1 .508 $3 .00% 7.697 $2 .550 $1 .82% Stable Growth Cap ex growth slows and net cap ex decreases EBIT -1 895m Revenue Growth: 13.22 Revenues EBITDA EBIT EBIT (1-t ) + Depreciat ion .261 $1 .20 13.60 15.804 $5 .00 16.139 ($95) $ 0 $3 46 $8 31 $1 .91% 13.91% 13.80% Be ta 3.80% 74.91% 13.074 $1 .804 Current Margin: -4 9.460 $1 .809 $2 .93% Terminal Value= 677(.053 $11.98% Weights Debt= 74.923 2867 14 3.80% 74.326 $6 .84% 67.292 $1 .8% Tax rate = 0% -> 35% Risk fre e Rate: T.96% 10.96% 46.91% 13.Chg WC FCFF $3 .322 $2 .60% 10.076m Value o f Op Assets $ + Ca sh & Non-op $ = Value of Firm $ .431 $1 .902 $ 4.80% 12.550 $1 .

Aswath Damodaran 34 .are priced by the market today. • In discounted cashflow valuation.e. traditional valuation models may yield an over-optimistic estimate of value.  When there is a significant likelihood that a firm will not survive the immediate future (next few years). • In relative valuation..Concern 2: The Going Concern Assumption  Traditional valuation techniques are built on the assumption of a going concern. I. which usually is based upon an infinite life and ever-growing cashflows. a firm that has continuing operations and there is no significant threat to these operations.most of which are healthy . this going concern assumption finds its place most prominently in the terminal value calculation. this going concern assumption often shows up implicitly because a firm is valued based upon how other firms .

we get • With a 10-year bond.05) t1 t 8  Solving for the probability of bankruptcy. To estimate the probability of default (with a treasury bond rate of 5% used as the riskfree rate): 120(1   Distress )t 1000(1   Distress )8 653    t N (1.1353)10 = 23.53%   To estimate the cumulative probability of distress over 10 years:  Cumulative probability of surviving 10 years = (1 .63% Aswath Damodaran 35 .. it is a process of trial and error to estimate this value.05) (1. Distress = Annual probability of default = 13. The solver function in excel accomplishes the same in far less time..37%  Cumulative probability of distress over 10 years = 1 .2337 = .Estimating the probability of distress…  Global Crossing has a 12% coupon bond with 8 years to maturity trading at $ 653.7663 or 76.

647 million Distress sale value of equity = $ 0 Distress adjusted value of equity • Value of Global Crossing = $3.75 Aswath Damodaran 36 .633 million Book value of debt = $7.25*14531 = $3.Valuing Global Crossing with Distress  Probability of distress • Cumulative probability of distress = 76.531 million Distress sale value = 25% of book value = .63%  Distress sale value of equity • • • •  Book value of capital = $14.00 (.7663) + $0.7663) = $ 0.22 (1-.

Sell Assets. No Do your stockholders like dividends? Yes Pay Dividends Aswath Damodaran No Buy back stock 37 . Is the firm a takeover target? Yes Increase leverage quickly 1. 3. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. Reduce or eliminate dividends.A Framework for Getting to the Optimal 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. Pay off debt with retained new equity or with retained earnings. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes No Take good projects with 1. 2. Borrow money& buy shares. Debt/Equity swaps 2. use cash to pay off debt 3. Issue new equity and pay off debt. earnings. Equity for Debt swap 2.

Debt/Equity swaps 2. Equity for Debt swap 2. 2. Sell Assets. Issue new equity and pay off debt. Is the firm a takeover target? Yes Increase leverage quickly 1. No Do your stockholders like dividends? Yes Pay Dividends Aswath Damodaran No Buy back stock 38 . use cash to pay off debt 3. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes No Take good projects with 1. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. Pay off debt with retained new equity or with retained earnings. Reduce or eliminate dividends. 3.Disney: Applying the Framework 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. earnings.

In conclusion: Debt matters in valuation. It can both create and destroy value. Assets Existing Investments Assets in Place Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Different Value? Aswath Damodaran Growth Assets Liabilities Debt Equity Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Residual Claim on cash flows Significant Role in management Perpetual Lives Different Financing Mix? 39 ..