Académique Documents
Professionnel Documents
Culture Documents
CORPORATE
FINANCE
LECTURE
NOTE
PACKET
2
CAPITAL
STRUCTURE,
DIVIDEND
POLICY
AND
VALUATION
B40.2302
Aswath
Damodaran
Aswath Damodaran
First
principles
3
Aswath Damodaran
There
are
only
two
ways
in
which
a
business
can
make
money.
The
rst
is
debt.
The
essence
of
debt
is
that
you
promise
to
make
xed
payments
in
the
future
(interest
payments
and
repaying
principal).
If
you
fail
to
make
those
payments,
you
lose
control
of
your
business.
The
other
is
equity.
With
equity,
you
do
get
whatever
cash
ows
are
leY
over
aYer
you
have
made
debt
payments.
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Revenues
$ Revenues/
Earnings
Earnings
Time
External funding
needs
High, but
constrained by
infrastructure
High, relative
to firm value.
Moderate, relative
to firm value.
Declining, as a
percent of firm
value
Internal financing
Negative or
low
Negative or
low
Low, relative to
funding needs
High, relative to
funding needs
External
Financing
Owners Equity
Bank Debt
Venture Capital
Common Stock
Common stock
Warrants
Convertibles
Debt
Retire debt
Repurchase stock
Growth stage
Stage 1
Start-up
Stage 2
Rapid Expansion
Stage 4
Mature Growth
Stage 5
Decline
Financing
Transitions
Stage 3
High Growth
Bond issues
When
venture
capitalists
enter
the
rm,
they
will
demand
their
fair
share
and
more
of
the
ownership
of
the
rm
to
provide
equity.
When
a
rm
decides
to
go
public,
it
has
to
trade
o
the
greater
access
to
capital
markets
against
the
increased
disclosure
requirements
(that
emanate
from
being
publicly
lists),
loss
of
control
and
the
transac]ons
costs
of
going
public.
When
making
seasoned
oerings,
rms
have
to
consider
issuance
costs
while
managing
their
rela]ons
with
equity
research
analysts
and
rat
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10
op]mal mix?
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11
Benets
of
Debt
Tax
Benets
Adds
discipline
to
management
Costs
of
Debt
Bankruptcy
Costs
Agency
Costs
Loss
of
Future
Flexibility
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12
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13
a.
b.
c.
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14
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15
a.
b.
c.
Assume
that
you
buy
into
this
argument
that
debt
adds
discipline
to
management.
Which
of
the
following
types
of
companies
will
most
benet
from
debt
adding
this
discipline?
Conserva]vely
nanced
(very
li[le
debt),
privately
owned
businesses
Conserva]vely
nanced,
publicly
traded
companies,
with
stocks
held
by
millions
of
investors,
none
of
whom
hold
a
large
percent
of
the
stock.
Conserva]vely
nanced,
publicly
traded
companies,
with
an
ac]vist
and
primarily
ins]tu]onal
holding.
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16
Bankruptcy
Cost
17
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17
a.
b.
c.
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18
Agency
Cost
19
Proposi]on
4:
Other
things
being
equal,
the
greater
the
agency
problems
associated
with
lending
to
a
rm,
the
less
debt
the
rm
can
aord
to
use.
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20
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21
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Ranking
(0-5)
4.55
4.55
4.05
3.99
3.88
3.56
2.47
22
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23
Disney
Significant. The firm
has a marginal tax
rate of 38%. It does
have
large
depreciation
tax
shields.
Aracruz
Significant. The firm
has a marginal tax
rate of 34%, as well.
It does not have very
much in noninterest
tax shields.
Added
discipline
Bankruptcy
costs
Agency costs
Flexibility
needs
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Low.
Assets
are
tangible and liquid.
Tata Chemicals
Significant. The firm
has a 33.99% tax
rates It does have
significant
noninterest tax shields in
the
form
of
depreciation.
Since the Tata family
runs the firm, the
benefits from added
discipline are small.
Firm is mature, with
fairly stable earnings
and cash flows from
its chemicals and
fertilizer
business.
Indirect bankruptcy
costs should be low,
since physical assets
are marketable.
Biggest concern is
that debt may be
utilized
in
other
(riskier)
Tata
companies.
24
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25
A
Hypothe]cal
Scenario
26
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28
Ranking
Source
Score
Retained Earnings
5.61
Straight Debt
4.88
Convertible Debt
3.02
2.42
2.22
Convertible Preferred
1.72
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30
Financing
Choices
31
a.
b.
c.
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31
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32
CAPITAL
STRUCTURE:
FINDING
THE
RIGHT
FINANCING
MIX
You
can
have
too
much
debt
or
too
li[le..
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Assume the firm has $200 million in cash flows, expected to grow 3% a year forever.
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The
beta
for
Disneys
stock
in
May
2009
was
0.9011.
The
T.
bond
rate
at
that
]me
was
3.5%.
Using
an
es]mated
equity
risk
premium
of
6%,
we
es]mated
the
cost
of
equity
for
Disney
to
be
8.91%:
Cost
of
Equity
=
3.5%
+
0.9011(6%)
=
8.91%
Disneys
bond
ra]ng
in
May
2009
was
A,
and
based
on
this
ra]ng,
the
es]mated
pretax
cost
of
debt
for
Disney
is
6%.
Using
a
marginal
tax
rate
of
38%,
the
aYer-tax
cost
of
debt
for
Disney
is
3.72%.
AYer-Tax
Cost
of
Debt
=
6.00%
(1
0.38)
=
3.72%
The
cost
of
capital
was
calculated
using
these
costs
and
the
weights
based
on
market
values
of
equity
(45,193)
and
debt
(16,682):
Cost
of
capital
=
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40
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41
To
get
to
the
unlevered
beta,
we
can
start
with
the
levered
beta
(0.9011)
and
work
back
to
an
unlevered
beta:
Unlevered
beta
=
Levered Beta
0.9011
=
= 0.7333
"
%
"
%
16,682
Debt
'
$1 + (1 - t)
' $#1 + (1 -.38)
&
45,
1
93
Equity &
#
Alterna]vely,
we
can
back
to
the
source
and
es]mate
it
from
the
betas
of
the
businesses.
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42
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43
I.
Cost
of
Equity
44
44
Start
with
the
current
market
value
of
the
rm
=
45,193
+
$16,682
=
$61,875
million
D/(D+E)
0.00%
10.00%
Debt
to
capital
D/E
0.00%
11.11%
D/E
=
10/90
=
.1111
$
Debt
$0
$6,188
10%
of
$61,875
EBITDA
$8,422
$8,422
Same
as
0%
debt
Deprecia]on
$1,593
$1,593
Same
as
0%
debt
EBIT
$6,829
$6,829
Same
as
0%
debt
Interest
$0
$294
Pre-tax
cost
of
debt
*
$
Debt
Pre-tax
Int.
cov
23.24
EBIT/
Interest
Expenses
Likely
Ra]ng
AAA
AAA
From
Ra]ngs
table
Pre-tax
cost
of
debt
4.75%
4.75%
Riskless
Rate
+
Spread
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46
D/(D + E)
10.00%
20.00%
30%
D/E
11.11%
25.00%
$ Debt
$6,188
$12,375
EBITDA
$8,422
$8,422
Depreciation
$1,593
$1,593
EBIT
$6,829
$6,829
Interest expense
$294
$588
23.24
11.62
Likely rating
AAA
AAA
4.75%
4.75%
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48
You
need
taxable
income
for
interest
to
provide
a
tax
savings.
Note
that
the
EBIT
at
Disney
is
$6,829
million.
As
long
as
interest
expenses
are
less
than
$6,829
million,
interest
expenses
remain
fully
tax-deduc]ble
and
earn
the
38%
tax
benet.
At
an
80%
debt
ra]o,
the
interest
expenses
are
$6,683
million
and
the
tax
benet
is
therefore
38%
of
this
amount.
At
a
90%
debt
ra]o,
however,
the
interest
expenses
balloon
to
$7,518
million,
which
is
greater
than
the
EBIT
of
$6,829
million.
We
consider
the
tax
benet
on
the
interest
expenses
up
to
this
amount:
Maximum
Tax
Benet
=
EBIT
*
Marginal
Tax
Rate
=
$6,829
million
*
0.38
=
$2,595
million
Adjusted
Marginal
Tax
Rate
=
Maximum
Tax
Benet/Interest
Expenses
=
$2,595/$7,518
=
34.52%
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Cost of Capital!
14.00%!
13.50%!
13.00%!
12.50%!
12.00%!
11.50%!
90.00%!
80.00%!
70.00%!
60.00%!
50.00%!
40.00%!
30.00%!
20.00%!
10.00%!
10.50%!
0.00%!
11.00%!
Debt Ratio!
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An
Alternate
Approach
Eect
on
Value:
Capital
Structure
Isola]on
55
Increase in rm value =
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56
b.
c.
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57
Sensi]vity
to
Assump]ons
A.
What
if
analysis
The
op]mal
debt
ra]o
is
a
func]on
of
our
inputs
on
opera]ng
income,
tax
rates
and
macro
variables.
We
could
focus
on
one
or
two
key
variables
opera]ng
income
is
an
obvious
choice
and
look
at
history
for
guidance
on
vola]lity
in
that
number
and
ask
what
if
ques]ons.
B.
Economic
Scenario
Approach
We
can
develop
possible
scenarios,
based
upon
macro
variables,
and
examine
the
op]mal
debt
ra]o
under
each
one.
For
instance,
we
could
look
at
the
op]mal
debt
ra]o
for
a
cyclical
rm
under
a
boom
economy,
a
regular
economy
and
an
economy
in
recession.
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58
Key questions:
What does a bad year look like for Disney?
How much volatility is there in operating income?
Recession
Decline in Operating Income
2008-09
Drop of about 10%
2002
Drop of 15.82%
1991
Drop of 22.00%
1981-82
Increased
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59
What
if?
Examining
the
sensi]vity
of
the
op]mal
debt
ra]o..
60
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60
Constraints
on
Ra]ngs
61
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61
Cost
of
AAA
ra]ng
constraint
=
Value
at
40%
Debt
Value
at
20%
Debt
=
$63,651
-
$62,371
=
$1,280
million
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62
63
Actual
Optimal
Tata Chemical looks like it is over levered (34% actual versus 10% optimal), but it is
tough to tell without looking at the rest of the group.
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64
Using Aracruzs actual operating income in 2008, an abysmal year, yields an optimal debt ratio of 0%.
Applying Aracruzs average pretax operating margin between 2004 and 2008 of 27.24% to 2008 revenues of
$R 3,697 million to get a normalized operating income of R$ 1,007 million. That is the number used in
computing the optimal debt ratio in this table.
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65
66
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68
Ra]ng
A-
or
higher
A-
BBB
BB+
B-
CCC
D
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Drop
in
EBITDA
No
eect
2.00%
10.00%
20.00%
25.00%
40.00%
50.00%
69
The optimal debt ratio drops to 30% from the original computation of
40%.
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70
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76
3.
Opera]ng
Risk
77
Unlevered
beta:
Firms
that
face
more
opera]ng
risk
will
tend
to
have
higher
unlevered
betas.
As
they
borrow,
debt
will
magnify
this
already
large
risk
and
push
up
costs
of
equity
much
more
steeply.
Bond
ra]ngs:
For
any
given
level
of
opera]ng
income,
rms
that
face
more
risk
in
opera]ons
will
have
lower
ra]ngs.
The
ra]ngs
are
based
upon
normalized
income.
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78
4.
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79
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80
Es]ma]ng
the
unlevered
beta,
a
cost
of
equity
based
upon
the
unlevered
beta
and
valuing
the
rm
using
this
cost
of
equity
(which
will
also
be
the
cost
of
capital,
with
an
unlevered
rm)
Alterna]vely,
Unlevered
Firm
Value
=
Current
Market
Value
of
Firm
-
Tax
Benets
of
Debt
(Current)
+
Expected
Bankruptcy
cost
from
Debt
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81
Probability of Bankruptcy
Es]mate
the
synthe]c
ra]ng
that
the
rm
will
have
at
each
level
of
debt
Es]mate
the
probability
that
the
rm
will
go
bankrupt
over
]me,
at
that
level
of
debt
(Use
studies
that
have
es]mated
the
empirical
probabili]es
of
this
occurring
over
]me
-
Altman
does
an
update
every
year)
Cost of Bankruptcy
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82
Ra]ng
AAA
AA
A+
A
A-
BBB
BB
B+
B
B-
CCC
CC
C
D
Likelihood
of
Default
0.07%
0.51%
0.60%
0.66%
Altman estimated these probabilities by
2.50%
looking at bonds in each ratings class ten
7.54%
years prior and then examining the
16.63%
proportion of these bonds that defaulted
25.00%
over the ten years.
36.80%
45.00%
59.01%
70.00%
85.00%
100.00%
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83
= $ 55,638
ra]ng
of
A
Tax
Rate
=
38%
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84
85
discipline)
More
stable
income
->
Higher
debt
ra]os
(Lower
bankruptcy
costs)
More
intangible
assets
->
Lower
debt
ra]os
(More
agency
problems)
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87
88
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89
Using
2008
data
for
rms
listed
on
the
NYSE,
AMEX
and
NASDAQ
data
bases.
The
regression
provides
the
following
results
DFR
=
0.327
-
0.064
Intangible
%
0.138
CLSH
+
0.026
E/V
0.878
GEPS
(25.45a)
(2.16a)
(2.88a)
(1.25)
(12.6a)
where,
DFR
=
Debt
/
(
Debt
+
Market
Value
of
Equity)
Intangible
%
=
Intangible
Assets/
Total
Assets
(in
book
value
terms)
CLSH
=
Closely
held
shares
as
a
percent
of
outstanding
shares
E/V
=
EBITDA/
(Market
Value
of
Equity
+
Debt-
Cash)
GEPS
=
Expected
growth
rate
in
EPS
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90
Disney
had
the
following
values
for
these
inputs
in
2008.
Es]mate
the
op]mal
debt
ra]o
using
the
debt
regression.
Intangible
Assets
=
24%
Closely
held
shares
as
percent
of
shares
outstanding
=
7.7%
EBITDA/Value
=
17.35%
Expected
growth
in
EPS
=
6.5%
Op]mal
Debt
Ra]o
=
0.327
-
0.064
(0.24)
0.138
(0.077)
+
0.0.26
(0.1735)
0.878
(0.065)
=
0.2891
or
28.91%
What
does
this
op]mal
debt
ra]o
tell
you?
Why
might
it
be
dierent
from
the
op]mal
calculated
using
the
weighted
average
cost
of
capital?
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Big
Picture
94
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94
95
No"
Yes"
No"
Take good projects with"
1. Pay off debt with retained"
new equity or with retained" earnings."
earnings."
2. Reduce or eliminate dividends."
3. Issue new equity and pay off "
debt."
No"
Does the firm have good "
projects?"
ROE > Cost of Equity"
ROC > Cost of Capital"
Yes"
Take good projects with"
debt."
No"
Do your stockholders like"
dividends?"
Yes"
Pay Dividends"
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No"
Buy back stock"
96
No"
Yes"
No"
Take good projects with"
1. Pay off debt with retained"
new equity or with retained" earnings."
earnings."
2. Reduce or eliminate dividends."
3. Issue new equity and pay off "
debt."
Yes"
Increase leverage"
quickly"
1. Debt/Equity swaps"
2. Borrow money&"
buy shares."
No"
Do your stockholders like"
dividends?"
Yes"
Pay Dividends"
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No"
Buy back stock"
97
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98
Assets
Cash
Liabilities
Debt
Opearing
Assets in place
Growth Assets
Sell operating assets
and use cash to buy
back stock or pay or
special dividend
Equity
99
To
change
debt
ra]os
over
]me,
you
use
the
same
mix
of
tools
that
you
used
to
change
debt
ra]os
gradually:
Dividends
and
stock
buybacks:
Dividends
and
stock
buybacks
will
reduce
the
value
of
equity.
Debt
repayments:
will
reduce
the
value
of
debt.
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Firm Value
Value of Debt
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Firm Value
Value of Debt
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103
Define Debt
Characteristics
Duration
Duration/
Maturity
Currency
Currency
Mix
Effect of Inflation
Uncertainty about Future
Growth Patterns
Straight versus
Convertible
- Convertible if
cash flows low
now but high
exp. growth
Cyclicality &
Other Effects
Special Features
on Debt
- Options to make
cash flows on debt
match cash flows
on assets
Commodity Bonds
Catastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
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Overlay tax
preferences
Zero Coupons
If tax advantages are large enough, you might override results of previous step
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105
Consider
ratings agency
& analyst concerns
Analyst Concerns
- Effect on EPS
- Value relative to comparables
Ratings Agency
- Effect on Ratios
- Ratios relative to comparables
Regulatory Concerns
- Measures used
Operating Leases
MIPs
Surplus Notes
Can securities be designed that can make these different entities happy?
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106
issue
That
is
tax
deduc]ble
And
failing
to
make
the
payment
can
give
these
shareholders
vo]ng
rights
Aswath Damodaran
107
b.
Aswath Damodaran
108
Factor in agency
conflicts between stock
and bond holders
Aswath Damodaran
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LYONs
109
Aswath Damodaran
110
Cash Flows
on Assets/
Projects
Define Debt
Characteristics
Duration
Currency
Effect of Inflation
Uncertainty about Future
Duration/
Maturity
Currency
Mix
Cyclicality &
Other Effects
Growth Patterns
Straight versus
Convertible
- Convertible if
cash flows low
now but high
exp. growth
Special Features
on Debt
- Options to make
cash flows on debt
match cash flows
on assets
Commodity Bonds
Catastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
Overlay tax
preferences
Consider
ratings agency
& analyst concerns
Zero Coupons
If tax advantages are large enough, you might override results of previous step
Analyst Concerns
- Effect on EPS
- Value relative to comparables
Ratings Agency
- Effect on Ratios
- Ratios relative to comparables
Regulatory Concerns
- Measures used
Operating Leases
MIPs
Surplus Notes
Can securities be designed that can make these different entities happy?
Factor in agency
conflicts between stock
and bond holders
Consider
Information
Aswath
Damodaran
Asymmetries
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LYONs
111
I. Intui]ve Approach
Are
the
projects
typically
long
term
or
short
term?
What
is
the
cash
ow
pa[ern
on
projects?
How
much
growth
poten]al
does
the
rm
have
rela]ve
to
current
projects?
How
cyclical
are
the
cash
ows?
What
specic
factors
determine
the
cash
ows
on
projects?
Aswath Damodaran
112
Aswath Damodaran
113
Aswath Damodaran
114
Aswath Damodaran
115
116
Aswath Damodaran
117
The
ques]on
of
how
sensi]ve
a
rms
asset
cash
ows
are
to
a
variety
of
factors,
such
as
interest
rates,
ina]on,
currency
rates
and
the
economy,
can
be
directly
tested
by
regressing
changes
in
the
opera]ng
income
against
changes
in
these
variables.
n This
analysis
is
useful
in
determining
the
coupon/interest
payment
structure
of
the
debt.
n
Firm Value
Aswath Damodaran
118
Aswath Damodaran
119
Aswath Damodaran
120
Aswath Damodaran
121
Aswath Damodaran
122
Aswath Damodaran
123
Traditional Duration
Measures
Uses:
1. Projected Cash Flows
Assumes:
1. Cash Flows are unaffected by
changes in interest rates
2. Changes in interest rates are
small.
Aswath Damodaran
P/r=
Percentage Change
in Value for a
percentage change in
Interest Rates
Regression:
P = a + b (r)
Uses:
1. Historical data on changes in
firm value (market) and interest
rates
Assumes:
1. Past project cash flows are
similar to future project cash
flows.
2. Relationship between cash
flows and interest rates is
stable.
3. Changes in market value
reflect changes in the value of
the firm.
124
125
Aswath Damodaran
126
Regression
Results
127
127
Aswath Damodaran
128
Regression
Results
129
129
Aswath Damodaran
130
Regression
Results
131
131
Summarizing
132
years
Disney
is
increasingly
aected
by
economic
cycles
Disney
is
hurt
by
a
stronger
dollar
Disneys
opera]ng
income
tends
to
move
with
ina]on
Aswath Damodaran
132
Bo[om-up
Es]mates
133
These weights
reflect the
estimated values
of the businesses
Aswath Damodaran
133
The
debt
issued
should
be
long
term
and
should
have
dura]on
of
about
5
years.
A
signicant
por]on
of
the
debt
should
be
oa]ng
rate
debt,
reec]ng
Disneys
capacity
to
pass
ina]on
through
to
its
customers
and
the
fact
that
opera]ng
income
tends
to
increase
as
interest
rates
go
up.
Given
Disneys
sensi]vity
to
a
stronger
dollar,
a
por]on
of
the
debt
should
be
in
foreign
currencies.
The
specic
currency
used
and
the
magnitude
of
the
foreign
currency
debt
should
reect
where
Disney
makes
its
revenues.
Based
upon
2008
numbers
at
least,
this
would
indicate
that
about
20%
of
the
debt
should
be
in
Euros
and
about
10%
of
the
debt
in
Japanese
Yen
reec]ng
Disneys
larger
exposures
in
Europe
and
Asia.
As
its
broadcas]ng
businesses
expand
into
La]n
America,
it
may
want
to
consider
using
either
Mexican
Peso
or
Brazilian
Real
debt
as
well.
Aswath Damodaran
134
Aswath Damodaran
135
It
can
swap
some
of
its
exis]ng
xed
rate,
dollar
debt
for
oa]ng
rate,
foreign
currency
debt.
Given
Disneys
standing
in
nancial
markets
and
its
large
market
capitaliza]on,
this
should
not
be
dicult
to
do.
If
Disney
is
planning
new
debt
issues,
either
to
get
to
a
higher
debt
ra]o
or
to
fund
new
investments,
it
can
use
primarily
oa]ng
rate,
foreign
currency
debt
to
fund
these
new
investments.
Although
it
may
be
mismatching
the
funding
on
these
investments,
its
debt
matching
will
become
be[er
at
the
company
level.
Aswath Damodaran
136
Aswath Damodaran
137
Aswath Damodaran
138
First
Principles
139
Aswath Damodaran
139
Cashflows from
Operations to
Equity Investors
Cash available
for return to
stockholders
What do your
stockholders prefer?
Stock Buybacks
Cash Paid out
Dividends
Aswath Damodaran
140
Aswath Damodaran
141
Quarter
Dividend Increase
Dividend initiated
Dividend decrease
Dividend suspensions
Q1 2007
102
1
1
1
Q2 2007
63
1
1
5
Q3 2007
59
2
2
0
Q4 2007
63
7
4
2
Q1 2008
93
3
7
4
Q2 2008
65
0
9
0
Q3 2008
45
2
6
8
Q4 2008
32
0
17
10
Aswath Damodaran
142
Aswath Damodaran
143
Aswath Damodaran
145
Aswath Damodaran
146
pays
in
dividends
If
the
net
income
is
nega]ve,
the
payout
ra]o
cannot
be
computed.
dividends
alone
Becomes
part
of
the
expected
return
on
the
investment.
Aswath Damodaran
147
Aswath Damodaran
148
Aswath Damodaran
149
150
Aswath Damodaran
Aswath Damodaran
151
Aswath Damodaran
152
1.
If
(a)
there
are
no
tax
disadvantages
associated
with
dividends
(b)
companies
can
issue
stock,
at
no
cost,
to
raise
equity,
whenever
needed
Dividends do not ma[er, and dividend policy does not aect value.
Aswath Damodaran
153
Aswath Damodaran
154
If
a
rm's
investment
policies
(and
hence
cash
ows)
don't
change,
the
value
of
the
rm
cannot
change
as
it
changes
dividends.
If
a
rm
pays
more
in
dividends,
it
will
have
to
issue
new
equity
to
fund
the
same
projects.
By
doing
so,
it
will
reduce
expected
price
apprecia]on
on
the
stock
but
it
will
be
oset
by
a
higher
dividend
yield.
If
we
ignore
personal
taxes,
investors
have
to
be
indierent
to
receiving
either
dividends
or
capital
gains.
Underlying
Assump]ons:
(a)
There
are
no
tax
dierences
to
investors
between
dividends
and
capital
gains.
(b)
If
companies
pay
too
much
in
cash,
they
can
issue
new
stock,
with
no
ota]on
costs
or
signaling
consequences,
to
replace
this
cash.
(c)
If
companies
pay
too
li[le
in
dividends,
they
do
not
use
the
excess
cash
for
bad
projects
or
acquisi]ons.
Aswath Damodaran
155
Aswath Damodaran
156
Assume
that
you
are
the
owner
of
a
stock
that
is
approaching
an
ex-
dividend
day
and
you
know
that
dollar
dividend
with
certainty.
In
addi]on,
assume
that
you
have
owned
the
stock
for
several
years.
Initial buy
At $P
Pb
Pa
Ex-dividend day
Dividend = $ D
157
Aswath Damodaran
158
Intui]ve
Implica]ons
159
Aswath Damodaran
159
Aswath Damodaran
Ordinary
tax
rate
=
50%
Capital
gains
rate
=
20%
Price
chg/
Dividend
=
0.85
1986-1990
Ordinary
tax
rate
=
70%
Capital
gains
rate
=
28%
Price
chg/
Dividend
=
0.78
1981-1985
1966-1969
160
Ordinary
tax
rate
=
28%
Capital
gains
rate
=
28%
Price
chg/
Dividend
=
0.90
160
Dividend
Arbitrage
161
c.
d.
Aswath Damodaran
161
Aswath Damodaran
162
Aswath Damodaran
163
Aswath Damodaran
164
20.00%
15.00%
10.00%
5.00%
0.00%
Under $1 mil
$1.0-1.9 mil
$2.0-4.9 mil
$5.0-$9.9 mil
$10-19.9 mil
$20-49.9 mil
Size of Issue
Cost of Issuing bonds
Aswath Damodaran
165
Aswath Damodaran
166
Aswath Damodaran
Class A
shares pay
cash
dividend
Class B
shares offer
the same
amount as a
stock
dividend &
can be
converted to
class A
shares
167
Company
Consolidated Bathurst
+ 19.30%
Donfasco
+ 13.30%
Dome Petroleum
+ 0.30%
Imperial Oil
+12.10%
+ 1.80%
Royal Trustco
+ 17.30%
Stelco
+ 2.70%
TransAlta
+1.10%
+ 7.54%
Aswath Damodaran
168
stocks
and
(b)
Poorer
investors
tended
to
hold
high
dividend
stocks
Aswath Damodaran
169
C
oe
f
f
i
c
i
e
n
t
I
mp
l
i
e
s
C o n s t a n t
4 . 2 2 %
B
e
t
a
C
o
e
f
f
i
c
i
e
n
t
- 2 . 1 4 5
H
i
g
h
e
r
b
e
t
a
s
t
o
c
k
s
p
a
y
l
o
w
e
r
d
i
v
i
d
e
n
d
s
.
A g e / 1 0 0
3 . 1 3 1
F
i
r
m
s
w
i
t
h
o
l
d
e
r
i
n
v
e
s
t
o
r
s
p
a
y
h
i
g
h
e
r
d
i
v
i
d
e
n
d
s
.
I n c o m e / 1 0 0 0
- 3 . 7 2 6
F
i
r
m
s
w
i
t
h
w
e
a
l
t
h
i
e
r
i
n
v
e
s
t
o
r
s
p
a
y
l
o
w
e
r
d
i
v
i
d
e
n
d
s
.
D
i
f
f
e
r
e
n
t
i
a
l
T
a
x
R
a
t
e
- 2 . 8 4 9
I
f
o
r
d
i
n
a
r
y
i
n
c
o
m
e
i
s
t
a
x
e
d
a
t
a
h
i
g
h
e
r
r
a
t
e
t
h
a
n
c
a
p
i
t
a
l
g
a
i
n
s
,
t
h
e
f
i
r
m
p
a
y
s
l
e
s
s
d
i
v
i
d
e
n
d
s
.
a.
b.
c.
d.
Assume
that
you
run
a
phone
company,
and
that
you
have
historically
paid
large
dividends.
You
are
now
planning
to
enter
the
telecommunica]ons
and
media
markets.
Which
of
the
following
paths
are
you
most
likely
to
follow?
Courageously
announce
to
your
stockholders
that
you
plan
to
cut
dividends
and
invest
in
the
new
markets.
Con]nue
to
pay
the
dividends
that
you
used
to,
and
defer
investment
in
the
new
markets.
Con]nue
to
pay
the
dividends
that
you
used
to,
make
the
investments
in
the
new
markets,
and
issue
new
stock
to
cover
the
shor}all
Other
Aswath Damodaran
171
Aswath Damodaran
172
0!
3!
6!
9! 12! 15!
CAR!
-1!
-1.5!
-2!
Day (0: Announcement date)!
Aswath Damodaran
176
Aswath Damodaran
177
Aswath Damodaran
178
Aswath Damodaran
179
ques]on?
How
well
has
my
stock
performed
during
the
period
in
ques]on?
Aswath Damodaran
180
Aswath Damodaran
181
Aswath Damodaran
182
Disneys
FCFE
183
Aswath Damodaran
183
Aswath Damodaran
184
Net
Income
-
(1-
)
(Capital
Expenditures
-
Deprecia]on)
-
(1-
)
Working
Capital
Needs
=
Free
Cash
ow
to
Equity
=
Debt/Capital
Ra]o
Proceeds
from
new
debt
issues
=
Principal
Repayments
+
(Capital
Expenditures
-
Deprecia]on
+
Working
Capital
Needs)
Aswath Damodaran
185
- $ 35 (1-0)
186
MicrosoY:
Dividends?
187
Aswath Damodaran
187
Aswath Damodaran
188
Aswath Damodaran
189
Aswath Damodaran
190
$9,000
$8,000
$2,500
$7,000
$2,000
$1,500
$5,000
$4,000
$1,000
Cash Balance
Cash Flow
$6,000
$3,000
$500
$2,000
$0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
($500)
$1,000
$0
Year
= Free CF to Equity
Aswath Damodaran
= Cash to Stockholders
Cumulated Cash
191
In General,
Net
Income
+
Deprecia]on
&
Amor]za]on
-
Capital
Expenditures
-
Change
in
Non-Cash
Working
Capital
-
Preferred
Dividend
-
Principal
Repaid
+
New
Debt
Issued
=
FCFE
Compare
to
Dividends
(Common)
+
Stock
Buybacks
Aswath Damodaran
Common
Dividend
Stock
Buybacks
192
How much did the firm pay out? How much could it have afforded to pay out?"
What it could have paid out!
What it actually paid out!
Net Income"
Dividends"
- (Cap Ex - Deprn) (1-DR)"
+ Equity Repurchase"
- Chg Working Capital (1-DR)"
= FCFE"
Aswath Damodaran
193
A
Dividend
Matrix
194
Aswath Damodaran
194
More
on
MicrosoY
195
MicrosoY
was
being
penalized
for
holding
such
a
large
cash
balance
Stockholders
were
becoming
res]ve
about
the
cash
balance.
There
was
no
hue
and
cry
demanding
more
dividends
or
stock
buybacks.
Why?
In
2004,
MicrosoY
announced
a
huge
special
dividend
of
$
33
billion
and
made
clear
that
it
would
try
to
return
more
cash
to
stockholders
in
the
future.
What
do
you
think
changed?
Aswath Damodaran
195
Cash Balance
Between
1994
&
2003,
Disney
generated
$969
million
in
FCFE
each
year.
Between
1994
&
2003,
Disney
paid
out
$639
million
in
dividends
and
stock
buybacks
each
year.
Disney
had
a
cash
balance
in
excess
of
$
4
billion
at
the
end
of
2003.
Performance measures
Aswath Damodaran
196
a.
b.
a.
b.
Aswath Damodaran
197
Aswath Damodaran
198
a.
b.
It
replaced
its
CEO,
Michael
Eisner,
with
a
new
CEO,
Bob
Iger,
who
at
least
on
the
surface
seemed
to
be
more
recep]ve
to
stockholder
concerns.
Its
stock
price
performance
improved
(posi]ve
Jensens
alpha)
Its
project
choice
improved
(ROC
moved
from
being
well
below
cost
of
capital
to
above)
Aswath Damodaran
199
Performance
measures
Between
1999
and
2003,
Aracruz
has
generated
a
return
on
equity,
on
its
projects,
about
1.5%
more
than
the
cost
of
equity,
on
average
each
year.
Between
1999
and
2003,
Aracruzs
stock
has
delivered
about
2%
more
than
the
cost
of
equity,
on
average
each
year.
Aswath Damodaran
200
Yes
No
Yes
No
Aswath Damodaran
201
a.
b.
c.
d.
Aswath Damodaran
202
a.
b.
Aswath Damodaran
203
Summary of calculations
Average
Standard Deviation
Maximum
Minimum
$571.10
$1,382.29
$3,764.00
($612.50)
$1,496.30
$448.77
$2,112.00
$831.00
Dividends+Repurchases
$1,496.30
$448.77
$2,112.00
$831.00
11.49%
20.90%
-21.59%
Free CF to Equity
Dividends
84.77%
Aswath Damodaran
-1.67%
204
Aswath Damodaran
205
Aswath Damodaran
206
Summary of calculations
Average
Standard Deviation
Maximum
Minimum
Free CF to Equity
($34.20)
$109.74
$96.89
($242.17)
Dividends
$40.87
$32.79
$101.36
$5.97
Dividends+Repurchases
$40.87
$32.79
$101.36
$5.97
18.59%
19.07%
29.26%
-19.84%
Aswath Damodaran
1.69%
207
Aswath Damodaran
208
Aswath Damodaran
209
Summing
up
210
Aswath Damodaran
210
Aswath Damodaran
211
Aswath Damodaran
212
Aswath Damodaran
213
Aswath Damodaran
214
Regressing
dividend
yield
and
payout
against
expected
growth
across
all
US
companies
in
January
2009
yields:
Aswath Damodaran
215
Subs]tu]ng
into
the
regression
equa]ons
for
the
dividend
payout
ra]o
and
dividend
yield,
we
es]mate
a
predicted
payout
ra]o:
Predicted
Payout
=
0.683
0.185
(.1305)
-1.07
(.1930)
0.313
(.145)
=0.4069
Predicted
Yield
=
0.039
0.039
(.1930)
0.010
(.077)
0.093
(.145)
=
.0172
Based
on
this
analysis,
Disney
with
its
dividend
yield
of
1.67%
and
a
payout
ra]o
of
approximately
20%
is
paying
too
li[le
in
dividends.
This
analysis,
however,
fails
to
factor
in
the
huge
stock
buybacks
made
by
Disney
over
the
last
few
years.
Aswath Damodaran
216
Aswath Damodaran
217
VALUATION
Cynic:
A
person
who
knows
the
price
of
everything
but
the
value
of
nothing..
Oscar
Wilde
First
Principles
218
Aswath Damodaran
218
Aswath Damodaran
219
where,
n
=
Life
of
the
asset
r
=
Discount
rate
reec]ng
the
riskiness
of
the
es]mated
cashows
Aswath Damodaran
220
Equity
Valua]on
221
CF to Equity t
(1+k e )t
t=1
Value of Equity=
where,
CF
to
Equity
t
=
Expected
Cashow
to
Equity
in
period
t
ke
=
Cost
of
Equity
Aswath Damodaran
221
Firm
Valua]on
222
CF to Firm t
t
t=1 (1+WACC)
Value of Firm=
where,
CF
to
Firm
t
=
Expected
Cashow
to
Firm
in
period
t
WACC
=
Weighted
Average
Cost
of
Capital
Aswath Damodaran
222
Aswath Damodaran
223
Aswath Damodaran
224
Aswath Damodaran
225
In
2007,
Deutsche
Bank
paid
out
dividends
of
2,146
million
Euros
on
net
income
of
6,510
million
Euros.
In
early
2008,
we
valued
Deutsche
Bank
using
the
dividends
it
paid
in
2007.
We
are
assuming
the
dividends
are
not
only
reasonable
but
sustainable.
In
early
2009,
in
the
aYermath
of
the
crisis,
Deutsche
Banks
dividend
policy
was
in
ux.
The
net
income
had
plummeted
and
capital
ra]os
were
being
reassessed.
To
forecast
future
dividends,
we
rst
forecast
net
income
(ROE*
Asset
Base)
and
then
es]mated
the
investments
in
regulatory
capital:
Aswath Damodaran
226
Aswath Damodaran
227
Aswath Damodaran
228
Aswath Damodaran
229
In
early
2009,
the
Euro
riskfree
rate
had
dropped
to
3.6%
and
the
equity
risk
premium
had
risen
to
6%
for
mature
markets:
Cost
of
equity
Jan
2009
=
Riskfree
Rate
Jan
2009
+
Beta
(Equity
Risk
Premium)
=
3.6%
+
1.162
(6%)
=
10.572%
Aswath Damodaran
230
Aswath Damodaran
231
The
beta
for
Disneys
stock
in
May
2009
was
0.9011.
The
T.
bond
rate
at
that
]me
was
3.5%.
Using
an
es]mated
equity
risk
premium
of
6%,
we
es]mated
the
cost
of
equity
for
Disney
to
be
8.91%:
Cost
of
Equity
=
3.5%
+
0.9011(6%)
=
8.91%
Disneys
bond
ra]ng
in
May
2009
was
A,
and
based
on
this
ra]ng,
the
es]mated
pretax
cost
of
debt
for
Disney
is
6%.
Using
a
marginal
tax
rate
of
38%,
the
aYer-tax
cost
of
debt
for
Disney
is
3.72%.
AYer-Tax
Cost
of
Debt
=
6.00%
(1
0.38)
=
3.72%
The
cost
of
capital
was
calculated
using
these
costs
and
the
weights
based
on
market
values
of
equity
(45,193)
and
debt
(16,682):
45,193
16,682
Cost
of
capital
=
8.91%
+ 3.72%
= 7.51%
(16,682 + 45,193)
Aswath Damodaran
(16,682 + 45,193)
232
Aswath Damodaran
233
Expected Growth
Net Income
Retention Ratio=
1 - Dividends/Net
Income
Aswath Damodaran
Return on Equity
Net Income/Book Value of
Equity
Operating Income
Reinvestment
Rate = (Net Cap
Ex + Chg in
WC/EBIT(1-t)
Return on Capital =
EBIT(1-t)/Book Value of
Capital
234
In
2007,
Deutsche
Bank
reported
net
income
of
6.51
billion
Euros
on
a
book
value
of
equity
of
33.475
billion
Euros
at
the
start
of
the
year
(end
of
2006),
and
paid
out
2.146
billion
Euros
as
dividends.
6,510
Return
on
Equity
=
Net Income
=
= 19.45%
Book Value of Equity
33,475
Reten]on
Ra]o
=
1 Dividends = 1 2,146 = 67.03%
2007
2006
Net Income
6,510
If
Deutsche
Bank
maintains
the
return
on
equity
(ROE)
and
reten]on
ra]o
that
it
delivered
in
2007
for
the
long
run:
Expected
Growth
Rate
Exis]ng
Fundamentals
=
0.6703
*
0.1945
=
13.04%
If
we
replace
the
net
income
in
2007
with
average
net
income
of
$3,954
million,
from
2003
to
2007:
Average Net Income
3,954
Normalized
Return
on
Equity
=
Book Value of Equity = 33,475 = 11.81%
Normalized
Reten]on
Ra]o
=
1 Dividends = 1 2,146 = 45.72%
Net Income
3,954
Expected
Growth
Rate
Normalized
Fundamentals
=
0.4572
*
0.1181
=
5.40%
2003-07
2006
Aswath Damodaran
235
Net Income
31,033
=
= 17.34%
Normalized
Return
on
Equity
=
Book Value of Equity
178,992
Expected
Growth
in
Net
Income
=
63.62%
*
17.34%
=
11.03%
Total 2004-08
Total 2004-08
Aswath Damodaran
236
Aswath Damodaran
237
Decomposing
ROE
238
Aswath Damodaran
238
Aswath Damodaran
239
If
Disney
maintains
its
2008
normalized
reinvestment
rate
of
53.72%
and
return
on
capital
of
9.91%
for
the
next
few
years,
its
growth
rate
will
be
5.32
percent.
240
Since
we
cannot
es]mate
cash
ows
forever,
we
es]mate
cash
ows
for
a
growth
period
and
then
es]mate
a
terminal
value,
to
capture
the
value
at
the
end
of
the
period:
t=N CF
t + Terminal Value
Value =
N
t
(1+r)
(1+r)
t=1
When
a
rms
cash
ows
grow
at
a
constant
rate
forever,
the
present
value
of
those
cash
ows
can
be
wri[en
as:
Value
=
Expected
Cash
Flow
Next
Period
/
(r
-
g)
where,
r
=
Discount
rate
(Cost
of
Equity
or
Cost
of
Capital)
g
=
Expected
growth
rate
forever.
This
constant
growth
rate
is
called
a
stable
growth
rate
and
cannot
be
higher
than
the
growth
rate
of
the
economy
in
which
the
rm
operates.
Aswath Damodaran
241
The
assump]on
of
how
long
high
growth
will
con]nue
will
depend
upon
several
factors
including:
Aswath Damodaran
242
Aswath Damodaran
243
Respect
the
cap:
The
growth
rate
forever
is
assumed
to
be
3%.
This
is
set
lower
than
the
riskfree
rate
(3.5%).
Think
about
stable
period
excess
returns:
The
return
on
capital
for
Disney
will
drop
from
its
high
growth
period
level
of
9.91%
to
a
stable
growth
return
of
9%.
This
is
s]ll
higher
than
the
cost
of
capital
of
7.95%
but
the
compe]]ve
advantages
that
Disney
has
are
unlikely
to
dissipate
completely
by
the
end
of
the
10th
year.
Reinvest
to
grow:
The
expected
growth
rate
in
stable
growth
will
be
3%.
In
conjunc]on
with
the
return
on
capital
of
9%,
this
yields
a
stable
period
reinvestment
rate
of
33.33%:
Adjust
risk
and
cost
of
capital:
The
beta
for
the
stock
will
drop
to
one,
reec]ng
Disneys
status
as
a
mature
company.
Aswath Damodaran
244
Approach used
Aswath Damodaran
245
To
value
Deutsche
Bank,
we
started
with
the
normalized
income
over
the
previous
ve
years
(3,954
million
Euros)
and
the
dividends
in
2008
(2,146
million
Euros).
We
assumed
that
the
payout
ra]o
and
ROE,
based
on
these
numbers
will
con]nue
for
the
next
5
years:
Payout
ra]o
=
2,146/3954
=
54.28%
Expected
growth
rate
=
(1-.5428)
*
.1181
=
0.054
or
5.4%
Cost
of
equity
=
9.23%
Aswath Damodaran
246
At
the
end
of
year
5,
the
rm
is
in
stable
growth.
We
assume
that
the
cost
of
equity
drops
to
8.5%
(as
the
beta
moves
to
1)
and
that
the
return
on
equity
also
drops
to
8.5
(to
equal
the
cost
of
equity).
Stable
Period
Payout
Ra]o
=
1
g/ROE
=
1
0.03/0.085
=
0.6471
or
64.71%
Expected
Dividends
in
Year
6
=
Expected
Net
Income5
*(1+gStable)*
Stable
Payout
Ra]o
=
5,143
(1.03)
*
0.6471
=
3,427
million
Terminal
Value
=
Expected Dividends6
3,247
(Cost of Equity-g)
PV of Terminal Value =
(.085-.03)
Terminal Value n
62,318
=
= 40, 079 mil Euros
(1+Cost of Equity High growth )n (1.0923)5
474.2
Stock was trading at 89 Euros per share at the ]me of the analysis.
Aswath Damodaran
247
Aswath Damodaran
248
Aswath Damodaran
249
AYer
year
ve,
we
will
assume
that
the
beta
will
increase
to
1
and
that
the
equity
risk
premium
will
decline
to
7.5
percent
(we
assumed
India
country
risk
would
drop).
The
resul]ng
cost
of
equity
is
11.5
percent.
Cost
of
Equity
in
Stable
Growth
=
4%
+
1(7.5%)
=
11.5%
We
will
assume
that
the
growth
in
net
income
will
drop
to
4%
and
that
the
return
on
equity
will
rise
to
11.5%
(which
is
also
the
cost
of
equity).
Equity
Reinvestment
Rate
Stable
Growth
=
4%/11.5%
=
34.78%
FCFE
in
Year
6
=
10,449(1.04)(1
0.3478)
=
Rs
7,087
million
Terminal
Value
of
Equity
=
7,087/(0.115
0.04)
=
Rs
94,497
million
Aswath Damodaran
250
Aswath Damodaran
251
Reinvestment Rate
53.72%
Year
1
EBIT (1-t)
$4,591
- Reinvestment $2,466
FCFF
$2,125
2
$4,835
$2,598
$2,238
Expected Growth
in EBIT (1-t)
.5372*.0991=.0532
5.32%
3
$5,093
$2,736
$2,357
4
$5,364
$2,882
$2,482
5
$5,650
$3,035
$2,615
6
$5,924
$2,941
$2,983
Stable Growth
g = 3%; Beta = 1.00;
Cost of capital =7.95%
ROC= 9%;
Reinvestment Rate=3/9=33.33%
Terminal Value10 = 4704/(.0795-.03) = 94,928
Growth decreases
gradually to 3%
First 5 years
Return on Capital
9.91%
7
$6,185
$2,818
$3,366
8
$6,428
$2,667
$3,761
9
$6,650
$2,488
$4,162
10
$6,850
$2,283
$4,567
Term Yr
7055
2351
4704
Cost of Equity
8.91%
Riskfree Rate:
Riskfree rate = 3.5%
252
Aswath Damodaran
Cost of Debt
(3.5%+2.5%)(1-.38)
= 3.72%
Based on actual A rating
Beta
0.90
Weights
E = 73% D = 27%
Risk Premium
6%
D/E=36.91%
253
Aswath Damodaran
Aswath Damodaran
Efficiency Growth
Growth generated by
using existing assets
better
254
Disney - Restructured
Current Cashflow to Firm
EBIT(1-t)= 7030(1-.38)= 4,359
- Nt CpX=
2,101
- Chg WC
241
= FCFF
2,017
Reinvestment Rate = 2342/4359
=53.72%
Return on capital = 9.91%
Reinvestment Rate
53.72%
Year
1
EBIT (1-t)
$4,640
- Reinvestment $2,492
FCFF
$2,147
Expected Growth
in EBIT (1-t)
.5372*.12=.0645
6.45%
Stable Growth
g = 3%; Beta = 1.00;
Cost of capital =7.19%
ROC= 9%;
Reinvestment Rate=3/9=33.33%
Terminal Value10 = 5067/(.0719-.03) = 120,982
Growth decreases
gradually to 3%
First 5 years
Op. Assets 81,089
+ Cash:
3,795
+ Non op inv 1,763
- Debt
16,682
- Minority int 1,344
=Equity
68621
-Options
528
Value/Share $ 36.67
Return on Capital
12%
2
$4,939
$2,653
$2,286
3
$5,257
$2,824
$2,433
4
$5,596
$3,006
$2,590
5
$5,957
$3,200
$2,757
6
$6,300
$3,127
$3,172
7
$6,619
$3,016
$3,603
8
$6,909
$2,866
$4,043
9
$7,164
$2,680
$4,484
10
$7,379
$2,460
$4,919
Term Yr
7600
2533
5067
Cost of Equity
9.74%
Riskfree Rate:
Riskfree rate = 3.5%
Cost of Debt
(3.5%+2.5%)(1-.38)
= 3.72%
Based on synthetic A rating
Beta
1.04
255
Aswath Damodaran
Weights
E = 60% D = 40%
Risk Premium
6%
D/E=66.67%
First
Principles
256
Aswath Damodaran
256