Aswath Damodaran 1

The Tools of Corporate Finance

Present Value
Financial Statement Analysis
Fundamentals of Valuation
Aswath Damodaran 2
Present Value
Aswath Damodaran
Aswath Damodaran 3
Intuition Behind Present Value
There are three reasons why a dollar tomorrow is worth less than a
dollar today
Individuals prefer present consumption to future consumption. To
induce people to give up present consumption you have to offer them
more in the future.
When there is monetary inflation, the value of currency decreases over
time. The greater the inflation, the greater the difference in value between
a dollar today and a dollar tomorrow.
If there is any uncertainty (risk) associated with the cash flow in the
future, the less that cash flow will be valued.
Other things remaining equal, the value of cash flows in future time
periods will decrease as
the preference for current consumption increases.
expected inflation increases.
the uncertainty in the cash flow increases.

Aswath Damodaran 4
Discounting and Compounding
The mechanism for factoring in these elements is the discount rate.
Discount Rate: The discount rate is a rate at which present and future
cash flows are traded off. It incorporates -
(1) Preference for current consumption (Greater ....Higher Discount Rate)
(2) expected inflation (Higher inflation .... Higher Discount Rate)
(3) the uncertainty in the future cash flows (Higher Risk....Higher Discount Rate)
A higher discount rate will lead to a lower value for cash flows in the
future.
The discount rate is also an opportunity cost, since it captures the returns
that an individual would have made on the next best opportunity.
- Discounting future cash flows converts them into cash flows in present
value dollars. Just a discounting converts future cash flows into present
cash flows,
- Compounding converts present cash flows into future cash flows.

Aswath Damodaran 5
Present Value Principle 1
Cash flows at different points in time cannot be compared and
aggregated. All cash flows have to be brought to the same point in
time, before comparisons and aggregations are made.

Aswath Damodaran 6
Time Lines
Aswath Damodaran 7
Cash Flow Types and Discounting Mechanics
There are five types of cash flows -
- simple cash flows,
- annuities,
- growing annuities
- perpetuities and
- growing perpetuities
Aswath Damodaran 8
I.Simple Cash Flows
A simple cash flow is a single cash flow in a specified future time
period.
Cash Flow: CF
t

_______________________________________________|
Time Period: t
The present value of this cash flow is-
PV of Simple Cash Flow = CF
t
/ (1+r)
t
The future value of a cash flow is -
FV of Simple Cash Flow = CF
0
(1+ r)
t


Aswath Damodaran 9
Application: The power of compounding -
Stocks, Bonds and Bills
Between 1926 and 1998, Ibbotson Associates found that stocks on the
average made about 11% a year, while government bonds on average
made about 5% a year.
If your holding period is one year,the difference in end-of-period
values is small:
Value of $ 100 invested in stocks in one year = $ 111
Value of $ 100 invested in bonds in one year = $ 105

Aswath Damodaran 10
Holding Period and Value
Aswath Damodaran 11
Concept Check
Most pension plans allow individuals to decide where their pensions
funds will be invested - stocks, bonds or money market accounts.
Where would you choose to invest your pension funds?
Predominantly or all equity
Predominantly or all bonds and money market accounts
A Mix of Bonds and Stocks
Will your allocation change as you get older?
Yes
No

Aswath Damodaran 12
The Frequency of Compounding
The frequency of compounding affects the future and present values of
cash flows. The stated interest rate can deviate significantly from the
true interest rate
For instance, a 10% annual interest rate, if there is semiannual
compounding, works out to-
Effective Interest Rate = 1.05
2
- 1 = .10125 or 10.25%
Frequency Rate t Formula Effective Annual Rate
Annual 10% 1 r 10.00%
Semi-Annual 10% 2 (1+r/2)
2
-1

10.25%
Monthly 10% 12 (1+r/12)
12
-1

10.47%
Daily 10% 365 (1+r/365)
365
-1

10.5156%
Continuous 10% exp
r
-1 10.5171%

Aswath Damodaran 13
II. Annuities
An annuity is a constant cash flow that occurs at regular intervals for a
fixed period of time. Defining A to be the annuity,
A A A A
| | | |
0 1 2 3 4


Aswath Damodaran 14
Present Value of an Annuity
The present value of an annuity can be calculated by taking each cash
flow and discounting it back to the present, and adding up the present
values. Alternatively, there is a short cut that can be used in the
calculation [A = Annuity; r = Discount Rate; n = Number of years]

PV of an Annuity = PV(A, r, n) = A
1 -
1
(1 + r)
n
r




(

(
(
Aswath Damodaran 15
Example: PV of an Annuity
The present value of an annuity of $1,000 at the end of each year for
the next five years, assuming a discount rate of 10% is -




The notation that will be used in the rest of these lecture notes for the
present value of an annuity will be PV(A,r,n).
PV of $1000 each year for next 5 years = $1000
1 -
1
(1.10)
5
. 10




(

(
(
= $3,791
Aswath Damodaran 16
Annuity, given Present Value
The reverse of this problem, is when the present value is known and
the annuity is to be estimated - A(PV,r,n).

Annuity given Present Value = A(PV, r, n) = PV
r
1 -
1
(1 + r)
n




(

(
(
Aswath Damodaran 17
Computing Monthly Payment on a Mortgage
Suppose you borrow $200,000 to buy a house on a 30-year mortgage
with monthly payments. The annual percentage rate on the loan is 8%.
The monthly payments on this loan, with the payments occurring at the
end of each month, can be calculated using this equation:
Monthly interest rate on loan = APR/ 12 = 0.08/12 = 0.0067
Monthly Payment on Mortgage = $200,000
0. 0067
1 -
1
(1.0067)
360




(

(
(
= $1473.11
Aswath Damodaran 18
Future Value of an Annuity
The future value of an end-of-the-period annuity can also be calculated
as follows-


FV of an Annuity = FV(A,r,n) = A
(1+r)
n
- 1
r



(

(
Aswath Damodaran 19
An Example
Thus, the future value of $1,000 at the end of each year for the next
five years, at the end of the fifth year is (assuming a 10% discount
rate) -




The notation that will be used for the future value of an annuity will be
FV(A,r,n).
FV of $1, 000 each year for next 5 years = $1000
(1.10)
5
- 1
.10



(

(
= $6, 105
Aswath Damodaran 20
Annuity, given Future Value
if you are given the future value and you are looking for an annuity -
A(FV,r,n) in terms of notation -


Annuity given Future Value = A(FV, r, n) = FV
r
(1+ r)
n
- 1



(

(
Aswath Damodaran 21
Application : Saving for College Tuition
Assume that you want to send your newborn child to a private college
(when he gets to be 18 years old). The tuition costs are $ 16000/year
now and that these costs are expected to rise 5% a year for the next 18
years. Assume that you can invest, after taxes, at 8%.
Expected tuition cost/year 18 years from now = 16000*(1.05)
18
= $38,506
PV of four years of tuition costs at $38,506/year = $38,506 * PV(A ,8%,4
years)= $127,537
If you need to set aside a lump sum now, the amount you would need
to set aside would be -
Amount one needs to set apart now = $127,357/(1.08)
18
= $31,916
If set aside as an annuity each year, starting one year from now -
If set apart as an annuity = $127,537 * A(FV,8%,18 years) = $3,405
Aswath Damodaran 22
Application : How much is an MBA worth?
Assume that you were earning $40,000/year before entering program
and that tuition costs are $16000/year. Expected salary is $
54,000/year after graduation. You can invest money at 8%.
For simplicity, assume that the first payment of $16,000 has to be made at
the start of the program and the second payment one year later.
PV Of Cost Of MBA = $16,000+16,000/1.08 + 40000 * PV(A,8%,2
years) = $102,145
Assume that you will work 30 years after graduation, and that the
salary differential ($14000 = $54000-$40000) will continue through
this period.
PV of Benefits Before Taxes = $14,000 * PV(A,8%,30 years) = $157,609
This has to be discounted back two years - $157,609/1.08
2
= $135,124
The present value of getting an MBA is = $135,124 - $102,145 = $32,979
Aswath Damodaran 23
Some Follow-up Questions
1. How much would your salary increment have to be for you to break
even on your MBA?
2. Keeping the increment constant, how many years would you have to
work to break even?
Aswath Damodaran 24
Application: Savings from Refinancing Your
Mortgage
Assume that you have a thirty-year mortgage for $200,000 that carries
an interest rate of 9.00%. The mortgage was taken three years ago.
Since then, assume that interest rates have come down to 7.50%, and
that you are thinking of refinancing. The cost of refinancing is
expected to be 2.50% of the loan. (This cost includes the points on the
loan.) Assume also that you can invest your funds at 6%.
Monthly payment based upon 9% mortgage rate (0.75% monthly rate)
= $200,000 * A(PV,0.75%,360 months)
= $1,609
Monthly payment based upon 7.50% mortgage rate (0.625% monthly rate)
= $200,000 * A(PV,0.625%,360 months)
= $1,398
Monthly Savings from refinancing = $1,609 - $1,398 = $211

Aswath Damodaran 25
Refinancing: The Trade Off
If you plan to remain in this house indefinitely,
Present Value of Savings (at 6% annually; 0.5% a month)
= $211 * PV(A,0.5%,324 months)
= $33,815
The savings will last for 27 years - the remaining life of the existing mortgage.
You will need to make payments for three additional years as a consequence of the
refinancing -
Present Value of Additional Mortgage payments - years 28,29 and 30
= $1,398 * PV(A,0.5%,36 months)/1.06
27
= $9,532
Refinancing Cost = 2.5% of $200,000 = $5,000
Total Refinancing Cost = $9,532 + $5,000 = $14,532
Net Effect = $ 33,815 - $ 14,532 = $ 19,283: Refinance
Aswath Damodaran 26
Follow-up Questions
1. How many years would you have to live in this house for you break
even on this refinancing?
2. We've ignored taxes in this analysis. How would it impact your
decision?

Aswath Damodaran 27
Valuing a Straight Bond
You are trying to value a straight bond with a fifteen year maturity and
a 10.75% coupon rate. The current interest rate on bonds of this risk
level is 8.5%.
PV of cash flows on bond = 107.50* PV(A,8.5%,15 years) + 1000/1.085
15
=
$ 1186.85
If interest rates rise to 10%,
PV of cash flows on bond = 107.50* PV(A,10%,15 years)+ 1000/1.10
15
=
$1,057.05
Percentage change in price = -10.94%
If interest rate fall to 7%,
PV of cash flows on bond = 107.50* PV(A,7%,15 years)+ 1000/1.07
15
=
$1,341.55
Percentage change in price = +13.03%
This asymmetric response to interest rate changes is called convexity.

Aswath Damodaran 28
Contrasting Short Term and Long Term Bonds
Price Changes as a function of Bond Maturities
Bond Maturity
%

C
h
a
n
g
e

i
n

P
r
i
c
e
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
1 5 15 30
% Change if rate drops
to 7%
% Change if rate
increases to 10%
Aswath Damodaran 29
Bond Pricing Proposition 1
The longer the maturity of a bond, the more sensitive it is to changes in
interest rates.

Aswath Damodaran 30
Contrasting Low-coupon and High-coupon
Bonds
Bond Price Changes as a function of Coupon Rates
Coupon Rate
%

P
r
i
c
e

C
h
a
n
g
e
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
0% 5% 10.75% 12%
% Change if rate
drops to 7%
% Change if rate
increases to 10%
Aswath Damodaran 31
Bond Pricing Proposition 2
The lower the coupon rate on the bond, the more sensitive it is to
changes in interest rates.

Aswath Damodaran 32
III. Growing Annuity
A growing annuity is a cash flow growing at a constant rate for a
specified period of time. If A is the current cash flow, and g is the
expected growth rate, the time line for a growing annuity looks as
follows
Aswath Damodaran 33
Present Value of a Growing Annuity
- The present value of a growing annuity can be estimated in all cases,
but one - where the growth rate is equal to the discount rate, using the
following model:





- In that specific case, the present value is equal to the nominal sums of
the annuities over the period, without the growth effect.


PV of an Annuity = PV(A, r, g,n) = A(1 +g)
1 -
(1+g)
n
(1+r)
n
(r - g)







(

(
(
(
(
(
Aswath Damodaran 34
The Value of a Gold Mine
Consider the example of a gold mine, where you have the rights to the
mine for the next 20 years, over which period you plan to extract 5,000
ounces of gold every year. The price per ounce is $300 currently, but it
is expected to increase 3% a year. The appropriate discount rate is
10%. The present value of the gold that will be extracted from this
mine can be estimated as follows
PV of extracted gold = $300 * 5000 * (1.03)
1 -
(1.03)
20
(1.10)
20
.10 - .03





(

(
(
(
= $16, 145, 980
Aswath Damodaran 35
PV of Extracted Gold as a Function of
Expected Growth Rate
Present Value of Extracted Gold as a function of Growth Rate
$-
$5,000,000
$10,000,000
$15,000,000
$20,000,000
$25,000,000
$30,000,000
$35,000,000
$40,000,000
$45,000,000
$50,000,000
0
%
1
%
2
%
3
%
4
%
5
%
6
%
7
%
8
%
9
%
1
0
%
1
1
%
1
2
%
1
3
%
1
4
%
1
5
%
Growth Rate in Gold Prices
P
r
e
s
e
n
t

V
a
l
u
e

o
f

E
x
t
r
a
c
t
e
d

G
o
l
d
Aswath Damodaran 36
Concept Check
If both the growth rate and the discount rate go up by 1%, will the
present value of the gold to be extracted from this mine increase or
decrease?
Aswath Damodaran 37
IV. Perpetuity
A perpetuity is a constant cash flow at regular intervals forever. The
present value of a perpetuity is-

PV of Perpetuity =
A
r
Aswath Damodaran 38
Valuing a Console Bond
A console bond is a bond that has no maturity and pays a fixed
coupon. Assume that you have a 6% coupon console bond. The value
of this bond, if the interest rate is 9%, is as follows -
Value of Console Bond = $60 / .09 = $667

Aswath Damodaran 39
V. Growing Perpetuities
A growing perpetuity is a cash flow that is expected to grow at a
constant rate forever. The present value of a growing perpetuity is -



where
CF
1
is the expected cash flow next year,
g is the constant growth rate and
r is the discount rate.

PV of Growing Perpetuity =
CF
1
(r - g)
Aswath Damodaran 40
Valuing a Stock with Growing Dividends
Southwestern Bell paid dividends per share of $2.73 in 1992. Its
earnings and dividends have grown at 6% a year between 1988 and
1992, and are expected to grow at the same rate in the long term. The
rate of return required by investors on stocks of equivalent risk is
12.23%.
Current Dividends per share = $2.73
Expected Growth Rate in Earnings and Dividends = 6%
Discount Rate = 12.23%
Value of Stock = $2.73 *1.06 / (.1223 -.06) = $46.45

Aswath Damodaran 41
Financial Statement Analysis
Aswath Damodaran 42
Questions we would like answered
Assets Liabilities
Asset s in Place Debt
Equit y
What is t he value of t he debt?
How risky is t he debt ?
What is t he value of t he equity?
How risky is t he equit y?
Growth Asset s
What are the asset s in place?
How valuable are t hese asset s?
How risky are t hese asset s?
What are the growt h assets?
How valuable are t hese asset s?
Aswath Damodaran 43
Basic Financial Statements
The balance sheet, which summarizes what a firm owns and owes at a
point in time.
The income statement, which reports on how much a firm earned in
the period of analysis
The statement of cash flows, which reports on cash inflows and
outflows to the firm during the period of analysis
Aswath Damodaran 44
The Balance Sheet
Assets Li abi li ti es
Fixed Assets
Debt
Equit y
Short -t erm liabilit ies of t he firm
Int angible Asset s
Long Lived Real Asset s
Asset s which are not physical,
like pat ents & trademarks
Current Assets
Financial Invest ments Invest ments in securit ies &
asset s of ot her firms
Short -lived Assets
Equit y invest ment in firm
Debt obligat ions of firm
Current
Liabilt ies
Other
Liabilit ies
Other long-t erm obligat ions
Figure 4.1: The Balance Sheet
Aswath Damodaran 45
A Financial Balance Sheet
Assets Liabilities
Asset s in Place Debt
Equit y
Fixed Claim on cash flows
Lit tle or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Asset s
Exist ing Invest ment s
Generat e cashflows today
Includes long lived (fixed) and
short -lived(working
capit al) assets
Expect ed Value t hat will be
creat ed by future investment s
Aswath Damodaran 46
The Income Statement
Figure 4.2: Income Statement
Revenues
Gross revenues from sale
of products or services
- Operating Expenses
Expenses associates with
generating revenues
= Operating Income Operating income for the
period
- Financial Expenses Expenses associated with
borrowing and other financing
- Taxes Taxes due on taxable income
= Net Income before extraordinary items
Earnings to Common &
Preferred Equity for
Current Period
- (+) Extraordinary Losses (Profits) Profits and Losses not
associated with operations
- Income Changes Associated with Accounting Changes Profits or losses associated
with changes in accounting
rules
- Preferred Dividends Dividends paid to preferred
stockholders
= Net Income to Common Stockholders
Aswath Damodaran 47
Modifications to Income Statement
There are a few expenses that consistently are miscategorized in
financial statements.In particular,
Operating leases are considered as operating expenses by accountants but
they are really financial expenses
R &D expenses are considered as operating expenses by accountants but
they are really capital expenses.
The degree of discretion granted to firms on revenue recognition and
extraordinary items is used to manage earnings and provide misleading
pictures of profitability.
Aswath Damodaran 48
Dealing with Operating Lease Expenses
Debt Value of Operating Leases = PV of Operating Lease Expenses at
the pre-tax cost of debt
This now creates an asset - the value of which is equal to the debt
value of operating leases. This asset now has to be depreciated over
time.
Finally, the operating earnings has to be adjusted to reflect these
changes:
Adjusted Operating Earnings = Operating Earnings + Operating Lease
Expense - Depreciation on the leased asset
If we assume that depreciation = principal payment on the debt value of
operating leases, we can use a short cut:
Adjusted Operating Earnings = Operating Earnings + Debt value of
Operating leases * Cost of debt
Aswath Damodaran 49
Operating Leases at Boeing and The Home
Depot in 1998
Boeing Home Depot
Year Operating Lease Expense Present Value at
5.5%
Operating
Lease Expense
Present Value
at 5.8%
1 $ 205 $ 194.31 $ 294 $ 277.88
2 $ 167 $ 150.04 $ 291 $ 259.97
3 $ 120 $ 102.19 $ 264 $ 222.92
4 $ 86 $ 69.42 $ 245 $ 195.53
5 $ 61 $ 46.67 $ 236 $ 178.03
Yr 6 -15 $ - $ - $ 270 $ 1,513.37
PV of Operating Lease Expenses $ 562.64 $ 2,647.70
Aswath Damodaran 50
Imputed Interest Expenses on Operating
Leases
Boeing The Home Depot
PV of Operating Leases $ 562.64 $ 2647.70
Interest rate on Debt 5.50% 5.80%
Imputed interest expense on PV of operating leases $ 30.95 $ 153.57
Aswath Damodaran 51
The Effects of Capitalizing Operating Leases
Debt : will increase, leading to an increase in debt ratios used in the
cost of capital and levered beta calculation
Operating income: will increase, since operating leases will now be
before the imputed interest on the operating lease expense
Net income: will be unaffected since it is after both operating and
financial expenses anyway
Return on Capital will generally decrease since the increase in
operating income will be proportionately lower than the increase in
book capital invested

Aswath Damodaran 52
R&D Expenses: Operating or Capital Expenses
Accounting standards require us to consider R&D as an operating
expense even though it is designed to generate future growth. It is
more logical to treat it as capital expenditures.
To capitalize R&D,
Specify an amortizable life for R&D (2 - 10 years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the amortizable
life is 5 years, the research asset can be obtained by adding up 1/5th of the
R&D expense from five years ago, 2/5th of the R&D expense from four
years ago...:
Aswath Damodaran 53
Capitalizing R&D Expenses: Boeing
Year R&D Unamort ized
Port ion
Val ue
1989 $754 0.10 $75
1990 $827 0.20 $165
1991 $1,417 0.30 $425
1992 $1,846 0.40 $738
1993 $1,661 0.50 $831
1994 $1,704 0.60 $1,022
1995 $1,300 0.70 $910
1996 $1,633 0.80 $1,306
1997 $1,924 0.90 $1,732
1998 $1,895 1.00 $1,895
Capital ized Val ue of R& D Expenses = $9,100
Aswath Damodaran 54
Boeings Corrected Operating Income
Boeing
Operating Income $1,720
+ Research and Development Expenses $1,895
- Amortization of Research Asset $1,382
+ Imputed Interest Expense on Operating
Leases
$ 31
= Adjusted Operating Income $2,264
Aswath Damodaran 55
The Effect of Capitalizing R&D
Operating Income will generally increase, though it depends upon
whether R&D is growing or not. If it is flat, there will be no effect
since the amortization will offset the R&D added back. The faster
R&D is growing the more operating income will be affected.
Net income will increase proportionately, depending again upon how
fast R&D is growing
Book value of equity (and capital) will increase by the capitalized
Research asset
Capital expenditures will increase by the amount of R&D;
Depreciation will increase by the amortization of the research asset;
For all firms, the net cap ex will increase by the same amount as the
after-tax operating income.
Aswath Damodaran 56
The Statement of Cash Flows
Cash Flows From Operations
+ Cash Flows From Investing
+ Cash Flows from Financing
Net cash flow from operations,
after taxes and interest expenses
Includes divestiture and acquisition
of real assets (capital expenditures)
and disposal and purchase of
financial assets. Also includes
acquisitions of other firms.
Net cash flow from the issue and
repurchase of equity, from the
issue and repayment of debt and after
dividend payments
= Net Change in Cash Balance
Figure 4.3: Statement of Cash Flows
Aswath Damodaran 57
The Financial perspective on cash flows
In financial analysis, we are much more concerned about
Cash flows to the firm or operating cash flows, which are before cash
flows to debt and equity)
Cash flows to equity, which are after cash flows to debt but prior to cash
flows to equity
Aswath Damodaran 58
Fundamentals of Valuation
Aswath Damodaran 59
Discounted Cashflow Valuation: Basis for
Approach



where,
n = Life of the asset
CF
t
= Cashflow in period t
r = Discount rate reflecting the riskiness of the estimated cashflows
Value =
CF
t
(1+ r)
t
t =1
t = n

Aswath Damodaran 60
Two Measures of Cash Flows
Cash flows to Equity: Thesea are the cash flows generated by the
asset after all expenses and taxes, and also after payments due on the
debt. This cash flow, which is after debt payments, operating expenses
and taxes, is called the cash flow to equity investors.
Cash flow to Firm: There is also a broader definition of cash flow that
we can use, where we look at not just the equity investor in the asset,
but at the total cash flows generated by the asset for both the equity
investor and the lender. This cash flow, which is before debt payments
but after operating expenses and taxes, is called the cash flow to the
firm
Aswath Damodaran 61
Two Measures of Discount Rates
Cost of Equity: This is the rate of return required by equity investors
on an investment. It will incorporate a premium for equity risk -the
greater the risk, the greater the premium.
Cost of capital: This is a composite cost of all of the capital invested
in an asset or business. It will be a weighted average of the cost of
equity and the after-tax cost of borrowing.
Aswath Damodaran 62
Equity Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects only the
cost of raising equity financing
Growth Assets
Figure 5.5: Equity Valuation
Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth
Present value is value of just the equity claims on the firm
Aswath Damodaran 63
Valuing Equity in a Finite Life Asset
Assume that you are trying to value the Home Depots equity
investment in a new store.
Assume that the cash flows from the store after debt payments and
reinvestment needs are expected will be $ 850,000 a year, growing at
5% a year for the next 12 years.
In addition, assume that the salvage value of the store, after repaying
remaining debt will be $ 1 million.
Finally, assume that the cost of equity is 9.78%.


Value of Equity in Store =
850,000 (1.05) 1 -
(1.05)
12
(1.0978)
12
|
\


|
.
|
|
(.0978-.05)
+
1,000,000
(1.0978)
12
= $8,053,999
Aswath Damodaran 64
Firm Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects the cost
of raising both debt and equity
financing, in proportion to their
use
Growth Assets
Figure 5.6: Firm Valuation
Cash flows considered are
cashflows from assets,
prior to any debt payments
but after firm has
reinvested to create growth
assets
Present value is value of the entire firm, and reflects the value of
all claims on the firm.
Aswath Damodaran 65
Valuing a Finite-Life Asset
Consider the Home Depot's investment in a proposed store. The store
is assumed to have a finite life of 12 years and is expected to have cash
flows before debt payments and after reinvestment needs of $ 1
million, growing at 5% a year for the next 12 years.
The store is also expected to have a value of $ 2.5 million at the end of
the 12
th
year (called the salvage value).
The Home Depot's cost of capital is 9.51%.
Aswath Damodaran 66
Expected Cash Flows and present value
Year Expected Cash Fl ows Val ue at End PV at 9.51%
1 $ 1,050 ,000 $ 958 ,817
2 $ 1,102 ,500 $ 919 ,329
3 $ 1,157 ,625 $ 881 ,468
4 $ 1,215 ,506 $ 845 ,166
5 $ 1,276 ,282 $ 810 ,359
6 $ 1,340 ,096 $ 776 ,986
7 $ 1,407 ,100 $ 744 ,987
8 $ 1,477 ,455 $ 714 ,306
9 $ 1,551 ,328 $ 684 ,888
10 $ 1,628 ,895 $ 656 ,682
11 $ 1,710 ,339 $ 629 ,638
12 $ 1,795 ,856 $ 2,500 ,000 $ 1,444,124
Val ue of St ore = $ 10 ,066,749
Aswath Damodaran 67
Valuation with Infinite Life
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
CF
1
CF
2
CF
3
CF
4
CF
5
Forever
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value
CF
n
.........
Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity
Value
Firm: Value of Firm
Equity: Value of Equity
DISCOUNTED CASHFLOW VALUATION
Length of Period of High Growth
Aswath Damodaran 68
Valuing the Home Depots Equity
Assume that we expect the free cash flows to equity at th Home Depot
to grow for the next 10 years at rates much higher than the growth rate
for the economy. To estimate the free cash flows to equity for the next
10 years, we make the following assumptions:
The net income of $1,614 million will grow 15% a year each year for the
next 10 years.
The firm will reinvest 75% of the net income back into new investments
each year, and its net debt issued each year will be 10% of the
reinvestment.
To estimate the terminal price, we assume that net income will grow 6% a
year forever after year 10. Since lower growth will require less
reinvestment, we will assume that the reinvestment rate after year 10 will
be 40% of net income; net debt issued will remain 10% of reinvestment.

Aswath Damodaran 69
Estimating cash flows to equity: The Home
Depot
Year Net Income Rei nvestment Needs Net Debt
Issued
FCFE PV of FCFE
1 $ 1,856 $ 1,392 $ (139) $ 603 $ 549
2 $ 2,135 $ 1,601 $ (160) $ 694 $ 576
3 $ 2,455 $ 1,841 $ (184) $ 798 $ 603
4 $ 2,823 $ 2,117 $ (212) $ 917 $ 632
5 $ 3,246 $ 2,435 $ (243) $ 1,055 $ 662
6 $ 3,733 $ 2,800 $ (280) $ 1,213 $ 693
7 $ 4,293 $ 3,220 $ (322) $ 1,395 $ 726
8 $ 4,937 $ 3,703 $ (370) $ 1,605 $ 761
9 $ 5,678 $ 4,258 $ (426) $ 1,845 $ 797
10 $ 6,530 $ 4,897 $ (490) $ 2,122 $ 835
Sum of PV of FCFE = $6,833
Aswath Damodaran 70
Terminal Value and Value of Equity today
FCFE
11
= Net Income
11
Reinvestment
11
Net Debt Paid (Issued)
11
= $6,530 (1.06) $6,530 (1.06) (0.40) (-277) = $ 4,430 million
Terminal Price
10
= FCFE
11
/(k
e
g)
= $ 4,430 / (.0978 - .06) = $117,186 million
The value per share today can be computed as the sum of the present
values of the free cash flows to equity during the next 10 years and the
present value of the terminal value at the end of the 10
th
year.
Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978)
10

= $52,927 million
Aswath Damodaran 71
Valuing Boeing as a firm
Assume that you are valuing Boeing as a firm, and that Boeing has
cash flows before debt payments but after reinvestment needs and
taxes of $ 850 million in the current year.
Assume that these cash flows will grow at 15% a year for the next 5
years and at 5% thereafter.
Boeing has a cost of capital of 9.17%.
Aswath Damodaran 72
Expected Cash Flows and Firm Value
Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049 million
Year Cash Flow Terminal Value Present Value
1 $978 $895
2 $1,124 $943
3 $1,293 $994
4 $1,487 $1,047
5 $1,710 $43,049 $28,864
Value of Boeing as a firm = $32,743