Finding the Right Financing Mix: The

Capital Structure Decision

AswathDamodaran

SternSchoolofBusiness

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateand
matchestheassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.

Aswath Damodaran

The Agenda

Whatdeterminestheoptimalmixofdebtandequityforacompany?
Howdoesalteringthemixofdebtandequityaffectinvestment
analysisandvalueatacompany?
Whatistherightkindofdebtforacompany?

Aswath Damodaran

Costs and Benefits of Debt

BenefitsofDebt
TaxBenefits
Addsdisciplinetomanagement

CostsofDebt
BankruptcyCosts
AgencyCosts
LossofFutureFlexibility

Aswath Damodaran

Tax Benefits of Debt

(a)TaxBenefits:Interestondebtistaxdeductiblewhereascashflows
onequity(likedividends)arenot.
Taxbenefiteachyear=trB
Aftertaxinterestrateofdebt=(1t)r

Proposition1:Otherthingsbeingequal,thehigherthemarginaltax
rateofacorporation,themoredebtitwillhaveinitscapitalstructure.

Aswath Damodaran

Issue 1: The Effects of Taxes

1. You are comparing the debt ratios of real estate corporations, which
paythecorporatetaxrate,andrealestateinvestmenttrusts,whichare
nottaxed,butarerequiredtopay95%oftheirearningsasdividends
totheirstockholders.Whichofthesetwogroupswouldyouexpectto
havethehigherdebtratios?
Therealestatecorporations
Therealestateinvestmenttrusts
Cannottell,withoutmoreinformation

Aswath Damodaran

Debt adds discipline to management

Equityisacushion;Debtisasword;
Themanagementoffirmswhichhavehighcashflowsleftovereach
yeararemorelikelytobecomplacentandinefficient.

Aswath Damodaran

Issue 2: Debt and Discipline

2. Assume that you buy into this argument that debt adds discipline to
management. Which of the following types of companies will most
benefitfromdebtaddingthisdiscipline?
Conservativelyfinanced,privatelyownedbusinesses
Conservativelyfinanced,publiclytradedcompanies,withawideand
diversestockholding
Conservatively financed, publicly traded companies, with an activist
andprimarilyinstitutionalholding.

Aswath Damodaran

Bankruptcy Cost

Theexpectedbankruptcycostisafunctionoftwovariables
thecostofgoingbankrupt
directcosts:LegalandotherDeadweightCosts
indirectcosts:LostSales...
durableversusnondurablegoods(cars)
quality/safetyisimportant(airlines)
supplementaryservices(copiers)

theprobabilityofbankruptcy

Aswath Damodaran

The Bankruptcy Cost Proposition

Proposition2:Otherthingsbeingequal,thegreatertheimplicit
bankruptcycostand/orprobabilityofbankruptcyintheoperating
cashflowsofthefirm,thelessdebtthefirmcanaffordtouse.

Aswath Damodaran

10

Issue 3 : Debt & Bankruptcy Cost

3. Rank the following companies on the magnitude of bankruptcy costs
frommosttoleast,takingintoaccountbothexplicitandimplicitcosts:
AGroceryStore
AnAirplaneManufacturer
HighTechnologycompany

Aswath Damodaran

11

Agency Cost

Stockholdersincentivesaredifferentfrombondholderincentives
TakingofRiskyProjects
Payinglargedividends

Proposition3:Otherthingsbeingequal,thegreatertheagency
problemsassociatedwithlendingtoafirm,thelessdebtthefirmcan
affordtouse.

Aswath Damodaran

12

Loss of future financing flexibility

Whenafirmborrowsuptoitscapacity,itlosestheflexibilityof
financingfutureprojectswithdebt.
Proposition4:Otherthingsremainingequal,themoreuncertainafirm
isaboutitsfuturefinancingrequirementsandprojects,thelessdebt
thefirmwilluseforfinancingcurrentprojects.

Aswath Damodaran

13

Relative Importance Of Financing Planning

Principles

Aswath Damodaran

14

Debt: A Balance Sheet Format

AdvantagesofBorrowing

DisadvantagesofBorrowing

1.TaxBenefit:

1.BankruptcyCost:

Highertaxrates>Highertaxbenefit

Higherbusinessrisk>HigherCost

2.AddedDiscipline:

2.AgencyCost:

Greatertheseparationbetweenmanagers

Greatertheseparationbetweenstock

andstockholders>Greaterthebenefit

holders&lenders>HigherCost
3.LossofFutureFinancingFlexibility:
Greatertheuncertaintyaboutfuture

financingneeds>HigherCost

Aswath Damodaran

15

A Hypothetical Scenario

Assumeyouoperateinanenvironment,where

Aswath Damodaran

(a)therearenotaxes
(b)thereisnoseparationbetweenstockholdersandmanagers.
(c)thereisnodefaultrisk
(d)thereisnoseparationbetweenstockholdersandbondholders
(e)firmsknowtheirfuturefinancingneeds

16

The Miller-Modigliani Theorem

Inanenvironment,wheretherearenotaxes,defaultriskoragency
costs,capitalstructureisirrelevant.
Thevalueofafirmisindependentofitsdebtratio.

Aswath Damodaran

17

Implications of MM Theorem
(a)Leverageisirrelevant.Afirm'svaluewillbedeterminedbyitsproject
cashflows.
(b)Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm
increasesitsleverage,thecostofequitywillincreasejustenoughtooffset
anygainstotheleverage

Aswath Damodaran

18

What do firms look at in financing?

A.Isthereafinancinghierarchy?
Argument:
Therearesomewhoarguethatfirmsfollowafinancinghierarchy,with
retainedearningsbeingthemostpreferredchoiceforfinancing,followed
bydebtandthatnewequityistheleastpreferredchoice.

Aswath Damodaran

19

Rationale for Financing Hierarchy

Managersvalueflexibility.Externalfinancingreducesflexibilitymore
thaninternalfinancing.
Managersvaluecontrol.Issuingnewequityweakenscontrolandnew
debtcreatesbondcovenants.

Aswath Damodaran

20

Preference rankings long-term finance: Results

of a survey
Ranking

Source

Score

RetainedEarnings

5.61

StraightDebt

4.88

ConvertibleDebt

3.02

ExternalCommonEquity

2.42

StraightPreferredStock

2.22

ConvertiblePreferred

1.72

Aswath Damodaran

21

Issue 5: Financing Choices

5.YouarereadingtheWallStreetJournalandnoticeatombstoneadfora
company,offeringtosellconvertiblepreferredstock.Whatwouldyou
hypothesizeaboutthehealthofthecompanyissuingthesesecurities?
Nothing
Healthierthantheaveragefirm
Inmuchmorefinancialtroublethantheaveragefirm

Aswath Damodaran

22

What is debt...

GeneralRule:Debtgenerallyhasthefollowingcharacteristics:
Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrol
ofthefirmtothepartytowhompaymentsaredue.

Aswath Damodaran

23

What would you include in debt?

Anyinterestbearingliability,whethershorttermorlongterm.
Anyleaseobligation,whetheroperatingorcapital.

Aswath Damodaran

24

Converting Operating Leases to Debt

Thedebtvalueofoperatingleasesisthepresentvalueofthelease
payments,ataratethatreflectstheirrisk.
Ingeneral,thisratewillbeclosetoorequaltotherateatwhichthe
companycanborrow.

Aswath Damodaran

25

Operating Leases at The Gap

Operatingleaseexpensesin1995=$304.6million
CostofDebtin1995=7.30%
DurationofLeaseObligations=12yrs
PVofLeaseExpenses=$304.6millionfor12yearsat7.30%=
$2,381million

Aswath Damodaran

26

Measuring Financial Leverage

Twovariantsofdebtratio
DebttoCapitalRatio=Debt/(Debt+Equity)
DebttoEquityRatio=Debt/Equity

Ratioscanbebasedonlyonlongtermdebtortotaldebt.
Ratioscanbebaseduponbookvalueormarketvalue.

Aswath Damodaran

27

Measuring Cost of Capital

Itwilldependupon:
(a)thecomponentsoffinancing:Debt,EquityorPreferredstock
(b)thecostofeachcomponent

Insummary,thecostofcapitalisthecostofeachcomponent
weightedbyitsrelativemarketvalue.
WACC=ke(E/(D+E))+kd(D/(D+E))

Aswath Damodaran

28

The Cost of Debt

Thecostofdebtisthemarketinterestratethatthefirmhastopayon
itsborrowing.Itwilldependuponthreecomponents
(a)Thegenerallevelofinterestrates
(b)Thedefaultpremium
(c)Thefirm'staxrate

Aswath Damodaran

29

What the cost of debt is and is not..

Thecostofdebtis

therateatwhichthecompanycanborrowattoday
correctedforthetaxbenefititgetsforinterestpayments.
Costofdebt=kd=LongTermBorrowingRate(1Taxrate)

Thecostofdebtisnot

theinterestrateatwhichthecompanyobtainedthedebtithasonits
books.

Aswath Damodaran

30

What the cost of equity is and is not..

Thecostofequityis
1.therequiredrateofreturngiventherisk
2.inclusiveofbothdividendyieldandpriceappreciation

Thecostofequityisnot
1.thedividendyield
2.theearnings/priceratio

Aswath Damodaran

31

Costs of Debt & Equity

A recent article in an Asian business magazine argued that equity was
cheaper than debt, because dividend yields are much lower than
interestratesondebt.Doyouagreewiththisstatement
Yes
No
Canequityeverbecheaperthandebt?
Yes
No

Aswath Damodaran

32

Calculate the weights of each component

Usetarget/averagedebtweightsratherthanprojectspecificweights.
Usemarketvalueweightsfordebtandequity.

Aswath Damodaran

33

Target versus Project-specific weights

Iffirmusesprojectspecificweights,projectsfinancedwithdebtwill
havelowercostsofcapitalthanprojectsfinancedwithequity.
Isthatfair?
Whatdoyouthinkwillhappentothefirmsdebtratioovertime,withthis
approach?

Aswath Damodaran

34

Market Value Weights

Alwaysusethemarketweightsofequity,preferredstockanddebtfor
constructingtheweights.
Bookvaluesareoftenmisleadingandoutdated.

Aswath Damodaran

35

Fallacies about Book Value

1.Peoplewillnotlendonthebasisofmarketvalue.
2.BookValueismorereliablethanMarketValuebecauseitdoesnot
changeasmuch.
3.Usingbookvalueismoreconservativethanusingmarketvalue.

Aswath Damodaran

36

Issue: Use of Book Value

ManyCFOsarguethatusingbookvalueismoreconservativethanusing
market value, because the market value of equity is usually much
higher than book value. Is this statement true, from a cost of capital
perspective? (Will you get a more conservative estimate of cost of
capitalusingbookvalueratherthanmarketvalue?)
Yes
No

Aswath Damodaran

37

Why does the cost of capital matter?

ValueofaFirm=PresentValueofCashFlowstotheFirm,
discountedbackatthecostofcapital.

Aswath Damodaran

38

Optimum Capital Structure and Cost of Capital

Ifthecashflowstothefirmareheldconstant,andthecostofcapitalis
minimized,thevalueofthefirmwillbemaximized.

Aswath Damodaran

39

Applying Approach: The Textbook Example

Aswath Damodaran

D/(D+E)

ke

kd

AftertaxCostofDebt WACC

10.50%

8%

4.80%

10.50%

10%

11%

8.50%

5.10%

10.41%

20%

11.60%

9.00%

5.40%

10.36%

30%

12.30%

9.00%

5.40%

10.23%

40%

13.10%

9.50%

5.70%

10.14%

50%

14%

10.50%

6.30%

10.15%

60%

15%

12%

7.20%

10.32%

70%

16.10% 13.50%

8.10%

10.50%

80%

17.20%

15%

9.00%

10.64%

90%

18.40%

17%

10.20%

11.02%

100%

19.70%

19%

11.40%

11.40%

40

WACC and Debt Ratios

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

11.40%
11.20%
11.00%
10.80%
10.60%
10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
0

WACC

WeightedAverageCostofCapitalandDebtRatios

DebtRatio

Aswath Damodaran

41

Current Cost of Capital: Disney

Equity
CostofEquity=
MarketValueofEquity=
Equity/(Debt+Equity)=

Debt
AftertaxCostofdebt=
MarketValueofDebt=
Debt/(Debt+Equity)=

13.85%
$50.88Billion
82%
7.50%(1.36)=

4.80%
$11.18Billion
18%

CostofCapital=13.85%(.82)+4.80%(.18)=12.22%

Aswath Damodaran

42

Mechanics of Cost of Capital Estimation

1.EstimatetheCostofEquityatdifferentlevelsofdebt:
Equitywillbecomeriskier>Betawillincrease>CostofEquitywill
increase.
Estimationwilluseleveredbetacalculation

2.EstimatetheCostofDebtatdifferentlevelsofdebt:
Defaultriskwillgoupandbondratingswillgodownasdebtgoesup>
CostofDebtwillincrease.
Toestimatingbondratings,wewillusetheinterestcoverageratio
(EBIT/Interestexpense)

3.EstimatetheCostofCapitalatdifferentlevelsofdebt
4.CalculatetheeffectonFirmValueandStockPrice.

Aswath Damodaran

43

Medians of Key Ratios : 1993-1995

PretaxInterestCoverage
EBITDAInterestCoverage

AAA

AA

BBB

BB

CCC

13.50

9.67

5.76

3.94

2.14

1.51

0.96

17.08

12.80

8.18

6.00

3.49

2.45

1.51

69.1%

45.5%

33.3%

17.7%

11.2%

6.7%

26.8%

20.9%

7.2%

1.4%

1.2%

0.96%

21.4%

19.1%

13.9%

12.0%

7.6%

5.2%

17.8%

15.7%

13.5%

13.5%

12.5%

12.2%

21.1%

31.6%

42.7%

55.6%

62.2%

69.5%

33.6%

39.7%

47.8%

59.4%

67.4%

69.1%

FundsfromOperations/TotalDebt
98.2%
(%)
FreeOperatingCashflow/Total
60.0%
Debt(%)
PretaxReturnonPermanentCapital 29.3%
(%)
OperatingIncome/Sales(%)
22.6%
LongTermDebt/Capital
13.3%
TotalDebt/Capitalization
25.9%

Aswath Damodaran

44

Process of Ratings and Rate Estimation

Weusethemedianinterestcoverageratiosforlargemanufacturing
firmstodevelopinterestcoverageratiorangesforeachratingclass.
Wethenestimateaspreadoverthelongtermbondrateforeach
ratingsclass,baseduponyieldsatwhichthesebondstradeinthe
marketplace.

Aswath Damodaran

45

Interest Coverage Ratios and Bond Ratings

IfInterestCoverageRatiois

EstimatedBondRating

>8.50
6.508.50
5.506.50
4.255.50
3.004.25
2.503.00
2.002.50
1.752.00
1.501.75
1.251.50
0.801.25
0.650.80
0.200.65
<0.20

AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

Aswath Damodaran

46

Spreads over long bond rate for ratings classes

Rating
AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

Aswath Damodaran

Coveragegt
Spread
0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%

47

Current Income Statement for Disney: 1996

Revenues
18,739
OperatingExpenses
12,046
EBITDA

6,693
Depreciation

1,134
EBIT

5,559
InterestExpense

479
Incomebeforetaxes
5,080
Taxes

847
Incomeaftertaxes

4,233
Interestcoverageratio=5,559/479=11.61
(AmortizationfromCapitalCitiesacquistionnotconsidered)
Aswath Damodaran

48

Estimating Cost of Equity

CurrentBeta=1.25
Marketpremium=5.5%
DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

D/ERatio
0%
11%
25%
43%
67%
100%
150%
233%
400%
900%

UnleveredBeta=1.09
T.BondRate=7.00%
Beta
1.09
1.17
1.27
1.39
1.56
1.79
2.14
2.72
3.99
8.21

t=36%

CostofEquity
13.00%
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%

49

Disney: Beta, Cost of Equity and D/E Ratio

9.00

60.00%

8.00
50.00%
7.00

40.00%

C o s t o f E q u it y

6.00

B e ta

5.00

30.00%

4.00

3.00

Beta
Cost of Equity

20.00%

2.00
10.00%
1.00

0.00

0.00%
0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Debt Ratio

Aswath Damodaran

50

Estimating Cost of Debt

D/(D+E) 0.00%
D/E0.00% 11.11%
$Debt
$0

10.00% CalculationDetails Step

=[D/(D+E)]/(1[D/(D+E)])
$6,207 =[D/(D+E)]*FirmValue

EBITDA $6,693
Depreciation
EBIT
$5,559
Interest $0
TaxableIncome
Tax $2,001
NetIncome

$6,693
$1,134
$5,559
$447
$5,559
$1,840
$3,558

Keptconstantasdebtchanges.
$1,134 "

PretaxInt.cov
LikelyRating
InterestRate
Eff.TaxRate

AAA
7.20%
36.00%

12.44
AAA
7.20%
36.00%

=(OIDeprec'n)/Int.Exp
Baseduponinterestcoverage
Interestrateforgivenrating
Seenotesoneffectivetaxrate

Aftertaxkd

4.61%

4.61%

=InterestRate*(1TaxRate)

=InterestRate*$Debt
2
$5,112 =OIDepreciationInterest
=TaxRate*TaxableIncome
$3,272 =TaxableIncomeTax
3
4
5

FirmValue=50,888+11,180=$62,068

Aswath Damodaran

51

The Ratings Table

IfInterestCoverageRatiois

EstimatedBondRating

>8.50
6.508.50
5.506.50
4.255.50
3.004.25
2.503.00
2.002.50
1.752.00
1.501.75
1.251.50
0.801.25
0.650.80
0.200.65
<0.20

AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

Aswath Damodaran

52

A Test: Can you do the 20% level?

D/(D+E)
D/E
$Debt
EBITDA
Depreciation
EBIT
InterestExpense
TaxableIncome
PretaxInt.cov
LikelyRating
InterestRate
Eff.TaxRate

0.00%
0.00%
$0
$6,693
$1,134
$5,559
$0
$5,559

AAA
7.20%
36.00%

10.00%
11.11%
$6,207
$6,693
$1,134
$5,559
$447
$5,112
12.44
AAA
7.20%
36.00%

CostofDebt

4.61%

4.61%

Aswath Damodaran

20.00%

SecondIteration

53

Bond Ratings, Cost of Debt and Debt Ratios

D/(D+E)
D/E
$Debt
OperatingInc.
Depreciation
Interest
TaxableIncome
Tax
NetIncome
PretaxInt.cov
LikelyRating
InterestRate
Eff.TaxRate
Costofdebt

0.00%
0.00%
$0
$6,693
$1,134
$0
$5,559
$2,001
$3,558

AAA
7.20%
36.00%
4.61%

Aswath Damodaran

WORKSHEETFORESTIMATINGRATINGS/INTERESTRATES
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
11.11%
25.00%
42.86%
66.67% 100.00% 150.00%
$6,207
$12,414
$18,621
$24,827
$31,034
$37,241
$6,693
$6,693
$6,693
$6,693
$6,693
$6,693
$1,134
$1,134
$1,134
$1,134
$1,134
$1,134
$447
$968
$1,536
$2,234
$3,181
$4,469
$5,112
$4,591
$4,023
$3,325
$2,378
$1,090
$1,840
$1,653
$1,448
$1,197
$856
$392
$3,272
$2,938
$2,575
$2,128
$1,522
$698
12.44
5.74
3.62
2.49
1.75
1.24
AAA
A+
A
BB
B
CCC
7.20%
7.80%
8.25%
9.00%
10.25%
12.00%
36.00%
36.00%
36.00%
36.00%
36.00%
36.00%
4.61%
4.99%
5.28%
5.76%
6.56%
7.68%

70.00%
233.33%
$43,448
$6,693
$1,134
$5,214
$345
$124
$221
1.07
CCC
12.00%
36.00%
7.68%

80.00%
400.00%
$49,655
$6,693
$1,134
$5,959
($400)
($144)
($256)
0.93
CCC
12.00%
33.59%
7.97%

90.00%
900.00%
$55,862
$6,693
$1,134
$7,262
($1,703)
($613)
($1,090)
0.77
CC
13.00%
27.56%
9.42%

54

Stated versus Effective Tax Rates

Youneedtaxableincomeforinteresttoprovideataxsavings
IntheDisneycase,considertheinterestexpenseat70%and80%
70%DebtRatio
EBIT
$5,559m
InterestExpense
$5,214m
TaxSavings
$1,866m
EffectiveTaxRate
36.00%
Pretaxinterestrate
12.00%
AftertaxInterestRate 7.68%

80%DebtRatio
$5,559m
$5,959m
$2,001m
2001/5959=33.59%
12.00%
7.97%

Youcandeductonly$5,559millionofthe$5,959millionofthe
interestexpenseat80%.Therefore,only36%of$5,559isconsidered
asthetaxsavings.

Aswath Damodaran

55

Cost of Debt
14.00%

12.00%

10.00%
Interest Rate
AT Cost of Debt

8.00%
6.00%

4.00%

2.00%

0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

Aswath Damodaran

56

Disneys Cost of Capital Schedule

DebtRatio
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
Aswath Damodaran

CostofEquity
13.00%
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%

ATCostofDebt
4.61%
4.61%
4.99%
5.28%
5.76%
6.56%
7.68%
7.68%
7.97%
9.42%

CostofCapital
13.00%
12.55%
12.17%
11.84%
11.64%
11.70%
12.11%
11.97%
12.17%
13.69%
57

Disney: Cost of Capital Chart

14.00%
13.50%

Cost of Capital

13.00%
12.50%

Cost of Capital

12.00%
11.50%

Aswath Damodaran

Debt Ratio

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

0.00%

10.50%

10.00%

11.00%

58

Effect on Firm Value

FirmValuebeforethechange=50,888+11,180=$62,068
WACCb=12.22%
WACCa=11.64%
WACC=0.58%

AnnualCost=$62,068*12.22%=$7,583million
AnnualCost=$62,068*11.64%=$7,226million
ChangeinAnnualCost
=$357million

Ifthereisnogrowthinthefirmvalue,(ConservativeEstimate)
Increaseinfirmvalue=$357/.1164=$3,065million
ChangeinStockPrice=$3,065/675.13=$4.54pershare

Ifthereisgrowth(of7.13%)infirmvalueovertime,
Increaseinfirmvalue=$357*1.0713/(.1164.0713)=$8,474
ChangeinStockPrice=$8,474/675.13=$12.55pershare

ImpliedGrowthRateobtainedby
FirmvalueToday=FCFF(1+g)/(WACCg):Perpetualgrowthformula
$62,068=$3,222(1+g)/(.1222g):Solveforg
Aswath Damodaran

59

A Test: The Repurchase Price

11.LetussupposethattheCFOofDisneyapproachedyouabout
buyingbackstock.Hewantstoknowthemaximumpricethathe
shouldbewillingtopayonthestockbuyback.(Thecurrentpriceis$
75.38)Assumingthatfirmvaluewillgrowby7.13%ayear,estimate
themaximumprice.

Whatwouldhappentothestockpriceafterthebuybackifyouwere
abletobuystockbackat$75.38?

Aswath Damodaran

60

The Downside Risk

DoingWhatifanalysisonOperatingIncome
A.StandardDeviationApproach

StandardDeviationInPastOperatingIncome
StandardDeviationInEarnings(IfOperatingIncomeIsUnavailable)
ReduceBaseCaseByOneStandardDeviation(OrMore)

B.PastRecessionApproach
LookAtWhatHappenedToOperatingIncomeDuringTheLastRecession.
(HowMuchDidItDropIn%Terms?)
ReduceCurrentOperatingIncomeBySameMagnitude

ConstraintonBondRatings

Aswath Damodaran

61

Disneys Operating Income: History

Aswath Damodaran

Year

OperatingIncome

ChangeinOperatingIncome

1981

$119.35

1982

$141.39

18.46%

1983

$133.87

5.32%

1984

$142.60

6.5%

1985

$205.60

44.2%

1986

$280.58

36.5%

1987

$707.00

152.0%

1988

$789.00

11.6%

1989

$1,109.00

40.6%

1990

$1,287.00

16.1%

1991

$1,004.00

22.0%

1992

$1,287.00

28.2%

1993

$1,560.00

21.2%

1994

$1,804.00

15.6%

1995

$2,262.00

25.4%

1996

$3,024.00

33.7%

62

Disney: Effects of Past Downturns

Recession
1991
198182
WorstYear

DeclineinOperatingIncome
Dropof22.00%
Increased
Dropof26%

Thestandarddeviationinpastoperatingincomeisabout39%.

Aswath Damodaran

63

Disney: The Downside Scenario

Disney: Cost of Capital with 40% lower EBIT
18.00%
17.00%
16.00%

Cost

15.00%
Cost of Capital
14.00%
13.00%
12.00%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

0.00%

10.00%

10.00%

11.00%

Debt Ratio

Aswath Damodaran

64

Constraints on Ratings

Managementoftenspecifiesa'desiredRating'belowwhichtheydo
notwanttofall.
Theratingconstraintisdrivenbythreefactors
itisonewayofprotectingagainstdownsideriskinoperatingincome(so
donotdoboth)
adropinratingsmightaffectoperatingincome
thereisanegofactorassociatedwithhighratings

Caveat:EveryRatingConstraintHasACost.
ProvideManagementWithAClearEstimateOfHowMuchTheRating
ConstraintCostsByCalculatingTheValueOfTheFirmWithoutThe
RatingConstraintAndComparingToTheValueOfTheFirmWithThe
RatingConstraint.

Aswath Damodaran

65

Ratings Constraints for Disney

AssumethatDisneyimposesaratingconstraintofBBBorgreater.
TheoptimaldebtratioforDisneyisthen30%(seenextpage)
Thecostofimposingthisratingconstraintcanthenbecalculatedas
follows:
Valueat40%Debt
=$70,542million
Valueat30%Debt
=$67,419million
CostofRatingConstraint
=$3,123million

Aswath Damodaran

66

Effect of A Ratings Constraint: Disney

DebtRatio Rating Firm Value
0%
AAA
$53,172
10%
AAA
$58,014
20%
A+
$62,705
30%
A$67,419
40%
BB
$70,542
50%
B
$69,560
60%
CCC
$63,445
70%
CCC
$65,524
80%
CCC
$62,751
90%
CC
$47,140

Aswath Damodaran

67

Why Is The Rating At The Current Debt Ratio In

The Spreadsheet Different From The Firm's
Current Rating?
1.Differencesbetweencurrentmarketinterestratesandratesatwhich
companywasabletoborrowhistorically
Ifcurrentmarketrates>Historicalinterestrates>Ratingwillbelower
Ifcurrentmarketrates<Historicalinterestrates>Ratingwillbehigher

2.Subjectivefactors
3.Lagsintheratingprocess

Aswath Damodaran

68

Ways of dealing with this inconsistency

1.Donothing:Thiswillgiveyouanestimateoftheoptimalcapital
structureassumingrefinancingatcurrentmarketinterestrates.
2.Buildinexistinginterestcostsintotheanalysis,i.e.Allowexistingdebt
tobecarriedatexistingratesfortherestoftheirmaturity.
3.Buildinthesubjectivefactorsintoratings.Forinstance,ifthecompany
iscurrentlyratedtwonotchesabovetheratingyougetfromthe
interestcoverageratio,addtwonotchestoeachofthecalculated
ratingsintheanalysis.

Aswath Damodaran

69

What if you do not buy back stock..

Theoptimaldebtratioisultimatelyafunctionoftheunderlying
riskinessofthebusinessinwhichyouoperateandyourtaxrate
Willtheoptimalbedifferentifyoutookprojectsinsteadofbuying
backstock?
NO.Aslongastheprojectsfinancedareinthesamebusinessmixthat
thecompanyhasalwaysbeeninandyourtaxratedoesnotchange
significantly.
YES,iftheprojectsareinentirelydifferenttypesofbusinessesorifthe
taxrateissignificantlydifferent.

Aswath Damodaran

70

ANALYZING FINANCIAL SERVICE FIRMS

Theinterestcoverageratios/ratingsrelationshipislikelytobe
differentforfinancialservicefirms.
Thedefinitionofdebtismessyforfinancialservicefirms.Ingeneral,
usingalldebtforafinancialservicefirmwillleadtohighdebtratios.
Useonlyinterestbearinglongtermdebtincalculatingdebtratios.
Theeffectofratingsdropswillbemuchmorenegativeforfinancial
servicefirms.
Therearelikelytoregulatoryconstraintsoncapital

Aswath Damodaran

71

Interest Coverage ratios, ratings and Operating

income

Aswath Damodaran

InterestCoverageRatio

Ratingis

Spreadis OperatingIncomeDecline

<0.05

10.00%

50.00%

0.050.10

7.50%

40.00%

0.100.20

CC

6.00%

40.00%

0.200.30

CCC

5.00%

40.00%

0.300.40

4.25%

25.00%

0.400.50

3.25%

20.00%

0.500.60

B+

2.50%

20.00%

0.600.80

BB

2.00%

20.00%

0.801.00

BBB

1.50%

20.00%

1.001.50

1.25%

17.50%

1.502.00

1.00%

15.00%

2.002.50

A+

0.80%

10.00%

2.503.00

AA

0.50%

5.00%

>3.00

AAA

0.20%

0.00%

72

Deutsche Bank: Optimal Capital Structure

Aswath Damodaran

Debt

Costof

CostofDebt

WACC

FirmValue

Ratio

Equity

0%

10.13%

4.24%

10.13%

DM124,288.85

10%

10.29%

4.24%

9.69%

DM132,558.74

20%

10.49%

4.24%

9.24%

DM142,007.59

30%

10.75%

4.24%

8.80%

DM152,906.88

40%

11.10%

4.24%

8.35%

DM165,618.31

50%

11.58%

4.24%

7.91%

DM165,750.19

60%

12.30%

4.40%

7.56%

DM162,307.44

70%

13.51%

4.57%

7.25%

DM157,070.00

80%

15.92%

4.68%

6.92%

DM151,422.87

90%

25.69%

6.24%

8.19%

DM30,083.27

73

Analyzing Companies after Abnormal Years

Theoperatingincomethatshouldbeusedtoarriveatanoptimaldebt
ratioisanormalizedoperatingincome
Anormalizedoperatingincomeistheincomethatthisfirmwould
makeinanormalyear.
Foracyclicalfirm,thismaymeanusingtheaverageoperatingincome
overaneconomiccycleratherthanthelatestyearsincome
Forafirmwhichhashadanexceptionallybadorgoodyear(duetosome
firmspecificevent),thismaymeanusingindustryaveragereturnson
capitaltoarriveatanoptimalorlookingatpastyears
Foranyfirm,thiswillmeannotcountingonetimechargesorprofits

Aswath Damodaran

74

Analyzing Aracruz Celluloses Optimal Debt

Ratio

In1996,Aracruzhadearningsbeforeinterestandtaxesofonly15
millionBR,andclaimeddepreciationof190millionBr.Capital
expendituresamountedto250millionBR.
Aracruzhaddebtoutstandingof1520millionBR.Whilethenominal
rateonthisdebt,especiallytheportionthatisinBrazilianReal,is
high,wewillcontinuetodotheanalysisinrealterms,andusea
currentrealcostofdebtof5.5%,whichisbaseduponarealriskfree
rateof5%andadefaultspreadof0.5%.
ThecorporatetaxrateinBrazilisestimatedtobe32%.
Aracruzhad976.10millionsharesoutstanding,trading2.05BRper
share.Thebetaofthestockisestimated,usingcomparablefirms,to
be0.71.

Aswath Damodaran

75

Setting up for the Analysis

CurrentCostofEquity=5%+0.71(7.5%)=10.33%
MarketValueofEquity=2.05BR*976.1=2,001millionBR
CurrentCostofCapital
=10.33%(2001/(2001+1520))+5.5%(1.32)(1520/(2001+1520)=7.48%

1996wasapooryearforAracruz,bothintermsofrevenuesand
operatingincome.In1995,Aracruzhadearningsbeforeinterestand
taxesof271millionBR.WewillusethisasournormalizedEBIT.

Aswath Damodaran

76

Aracruzs Optimal Debt Ratio

Debt
Ratio
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
Aswath Damodaran

Beta
Equity
0.47
0.50
0.55
0.60
0.68
0.79
0.95
1.21
1.76
3.53

Costof
Debt
8.51%
8.78%
9.11%
9.53%
10.10%
10.90%
12.09%
14.08%
18.23%
31.46%

Rating
ofDebt
AAA
AAA
AA
A
A
BB
B
CCC
CCC
CCC

Costof
Capital
5.20%
5.20%
5.50%
6.00%
6.25%
7.00%
9.25%
10.00%
10.00%
10.00%

ATCost Costof FirmValue

3.54%
3.54%
3.74%
4.08%
4.25%
4.76%
6.29%
6.80%
6.92%
7.26%

8.51%
8.25%
8.03%
7.90%
7.76%
7.83%
8.61%
8.98%
9.18%
9.68%

2,720BR
2,886BR
3,042BR
3,148BR
3,262BR
3,205BR
2,660BR
2,458BR
2,362BR
2,149BR
77

Analyzing a Private Firm

Theapproachremainsthesamewithimportantcaveats
Itisfarmoredifficultestimatingfirmvalue,sincetheequityandthedebt
ofprivatefirmsdonottrade
Mostprivatefirmsarenotrated.
Ifthecostofequityisbaseduponthemarketbeta,itispossiblethatwe
mightbeoverstatingtheoptimaldebtratio,sinceprivatefirmowners
oftenconsiderallrisk.

Aswath Damodaran

78

Estimating the Optimal Debt Ratio for a Private

Bookstore
=EBIT+OperatingLeaseExpenses
=$2,000,000+$500,000=$2,500,000
WhileBookscapehasnodebtoutstanding,thepresentvalueofthe
operatingleaseexpensesof$3.36millionisconsideredasdebt.
Toestimatethemarketvalueofequity,weuseamultipleof22.41
timesofnetincome.Thismultipleistheaveragemultipleatwhich
comparablefirmswhicharepubliclytradedarevalued.
EstimatedMarketValueofEquity=NetIncome*AveragePE

=1,160,000*22.41=26,000,000
Theinterestratesatdifferentlevelsofdebtwillbeestimatedbased
uponasyntheticbondrating.Thisratingwillbeassessedusing
interestcoverageratiosforsmallfirmswhichareratedbyS&P.

AdjustedEBIT

Aswath Damodaran

79

Interest Coverage Ratios, Spreads and Ratings:

Small Firms
InterestCoverageRatio
>12.5
9.5012.50
7.59.5
6.07.5
4.56.0
3.54.5
3.03.5
2.53.0
2.02.5
1.52.0
1.251.5
0.81.25
0.50.8
<0.5

Aswath Damodaran

Rating
AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

SpreadoverTBondRate
0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%

80

Optimal Debt Ratio for Bookscape

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Beta CostofEquity
1.03
12.65%
1.09
13.01%
1.18
13.47%
1.28
14.05%
1.42
14.83%
1.62
15.93%
1.97
17.84%
2.71
21.91%
4.07
29.36%
8.13
51.72%

Aswath Damodaran

BondRating
AA
AA
BBB
B+
B
CC
CC
C
C
C

InterestRate
7.50%
7.50%
8.50%
9.50%
11.25%
13.00%
13.00%
14.50%
14.50%
14.50%

ATCostofDebt
4.35%
4.35%
4.93%
5.51%
6.53%
7.54%
7.96%
10.18%
10.72%
11.14%

CostofCapital
12.65%
12.15%
11.76%
11.49%
11.51%
11.73%
11.91%
13.70%
14.45%
15.20%

FirmValue
$26,781
$29,112
$31,182
$32,803
$32,679
$31,341
$30,333
$22,891
$20,703
$18,872

81

Determinants of Optimal Debt Ratios

FirmSpecificFactors

1.TaxRate
Highertaxrates
>HigherOptimalDebtRatio
Lowertaxrates
>LowerOptimalDebtRatio
2.PreTaxReturnsonFirm=(OperatingIncome)/MVofFirm
HigherPretaxReturns
>HigherOptimalDebtRatio
LowerPretaxReturns
>LowerOptimalDebtRatio
3.VarianceinEarnings[Showsupwhenyoudo'whatif'analysis]
HigherVariance >LowerOptimalDebtRatio
LowerVariance >HigherOptimalDebtRatio

MacroEconomicFactors

1.DefaultSpreads
Higher
Lower

Aswath Damodaran

>LowerOptimalDebtRatio
>HigherOptimalDebtRatio

82

Optimal Debt Ratios and EBITDA/Value

Youareestimatingtheoptimaldebtratiosfortwofirms.Reebokhas
anEBITDAof$450million,andamarketvalueforthefirmof$2.2
billion.NikehasanEBITDAof$745millionandamarketvaluefor
thefirmof$8.8billion.Whichofthesefirmsshouldhavethehigher
optimaldebtratio
Nike
Reebok

Aswath Damodaran

83

Relative Analysis
I.IndustryAveragewithSubjectiveAdjustments
Thesafestplaceforanyfirmtobeisclosetotheindustryaverage
Subjectiveadjustmentscanbemadetotheseaveragestoarriveatthe
rightdebtratio.

Aswath Damodaran

Highertaxrates>Higherdebtratios(Taxbenefits)
Lowerinsiderownership>Higherdebtratios(Greaterdiscipline)
Morestableincome>Higherdebtratios(Lowerbankruptcycosts)
Moreintangibleassets>Lowerdebtratios(Moreagencyproblems)

84

Disneys Comparables

Company Name
Disney (Walt)
Time Warner
Westinghouse Electric
Viacom Inc. 'A'
Gaylord Entertainm. 'A'
Belo (A.H.) 'A' Corp.
Evergreen Media 'A'
Tele-Communications Intl Inc
King World Productions
Jacor Communications
LIN Television
Regal Cinemas
Westwood One
United Television
Average of Large Firms

Aswath Damodaran

Market Debt Ratio

Book Debt Ratio
18.19%
43.41%
29.39%
68.34%
26.98%
51.97%
48.14%
46.54%
13.92%
41.47%
23.34%
63.04%
16.77%
39.45%
23.28%
34.60%
0.00%
0.00%
30.91%
57.91%
19.48%
71.66%
4.53%
15.24%
11.40%
60.03%
4.51%
15.11%
19.34%
43.48%

85

II. Regression Methodology

Step1:Runaregressionofdebtratiosonproxiesforbenefitsand
costs.Forexample,
DEBTRATIO=a+b(TAXRATE)+c(EARNINGS
VARIABILITY)+d(EBITDA/FirmValue)
Step2:Estimatetheproxiesforthefirmunderconsideration.
Pluggingintothecrosssectionalregression,wecanobtainanestimate
ofpredicteddebtratio.
Step3:Comparetheactualdebtratiotothepredicteddebtratio.

Aswath Damodaran

86

Applying the Regression Methodology:

Entertainment Firms
Usingasampleof50entertainmentfirms,wearrivedatthefollowing
regression:
DebtRatio=0.1067+0.69TaxRate+0.61EBITDA/Value0.07OI

(0.90)
(2.58)
(2.21)
(0.60)
TheRsquaredoftheregressionis27.16%.Thisregressioncanbe
usedtoarriveatapredictedvalueforDisneyof:
PredictedDebtRatio=0.1067+0.69(.4358)+0.61(.0837)0.07
(.2257)=.2314
Baseduponthecapitalstructureofotherfirmsintheentertainment
industry,Disneyshouldhaveamarketvaluedebtratioof23.14%.

Aswath Damodaran

87

Cross Sectional Regression: 1996 Data

Using1996datafor2929firmslistedontheNYSE,AMEXand
NASDAQdatabases.Theregressionprovidesthefollowingresults

DFR

=0.19060.0552PRVAR.1340CLSH0.3105CPXFR+0.1447FCP
(37.97a)(2.20a) (6.58a)
(8.52a)
(12.53a)

where,
DFR
=Debt/(Debt+MarketValueofEquity)
PRVAR =VarianceinFirmValue
CLSH
=Closelyheldsharesasapercentofoutstandingshares
CPXFR =CapitalExpenditures/BookValueofCapital
FCP=FreeCashFlowtoFirm/MarketValueofEquity

Whilethecoefficientsallhavetherightsignandarestatistically
significant,theregressionitselfhasanRsquaredofonly13.57%.

Aswath Damodaran

88

An Aggregated Regression
Onewaytoimprovethepredictivepoweroftheregressionisto
aggregatethedatafirstandthendotheregression.Toillustratewith
the1994data,thefirmsareaggregatedintotwodigitSICcodes,and
thesameregressionisrerun.
DFR=0.23700.1854PRVAR+.1407CLSH+1.3959CPXF.6483
FCP

(6.06a)(1.96b)

(1.05a)

(5.73a)

(3.89a)

TheRsquaredofthisregressionis42.47%.

Aswath Damodaran

89

Applying the Regression

Letscheckwhetherwecanusethisregression.Disneyhadthefollowingvaluesfor
theseinputsin1996.Estimatetheoptimaldebtratiousingthedebtregression.
VarianceinFirmValue=.04
Closelyheldsharesaspercentofsharesoutstanding=4%(.04)
CapitalExpendituresasfractionoffirmvalue=6.00%(.06)
FreeCashFlowaspercentofEquityValue=3%(.03)

OptimalDebtRatio
=0.23700.1854()+.1407()+1.3959().6483()
Whatdoesthisoptimaldebtratiotellyou?

Whymightitbedifferentfromtheoptimalcalculatedusingtheweightedaverage
costofcapital?

Aswath Damodaran

90

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. Equity for Debt swap
2. Sell Assets; 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. 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.

Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.

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

Aswath Damodaran

No
Buy back stock

91

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. Equity for Debt swap
2. Sell Assets; 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. 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.

Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.

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

Aswath Damodaran

No
Buy back stock

92

Designing Debt
Startwiththe

CashFlows
onAssets/
Projects

DefineDebt
Characteristics

Duration

Currency

EffectofInflation
UncertaintyaboutFuture

Duration/
Maturity

Currency
Mix

Fixedvs.FloatingRate
*Morefloatingrate
ifCFmovewith
inflation
withgreateruncertainty
onfuture

Cyclicality&
OtherEffects

GrowthPatterns

Straightversus
Convertible
Convertibleif
cashflowslow
nowbuthigh
exp.growth

SpecialFeatures
onDebt
Optionstomake
cashflowsondebt
matchcashflows
onassets

CommodityBonds
CatastropheNotes

Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced

Overlaytax
preferences
Consider
ratingsagency
&analystconcerns

Deductibilityofcashflows
fortaxpurposes

Differencesintaxrates
acrossdifferentlocales

ZeroCoupons

Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
AnalystConcerns
EffectonEPS
Valuerelativetocomparables

RatingsAgency
EffectonRatios
Ratiosrelativetocomparables

RegulatoryConcerns
Measuresused

OperatingLeases
MIPs
SurplusNotes

Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?

Factorinagency
conflictsbetweenstock
andbondholders

ObservabilityofCashFlows
byLenders
Lessobservablecashflows
leadtomoreconflicts

TypeofAssetsfinanced
Tangibleandliquidassets
createlessagencyproblems

ExistingDebtcovenants
RestrictionsonFinancing

Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds

ConsiderInformation
Asymmetries
Aswath Damodaran

UncertaintyaboutFutureCashflows
Whenthereismoreuncertainty,it
maybebettertouseshorttermdebt

Credibility&QualityoftheFirm
Firmswithcredibilityproblems
willissuemoreshorttermdebt

Convertibiles
PuttableBonds
RatingSensitive
Notes
LYONs

93

Approaches for evaluating Asset Cash Flows

I.IntuitiveApproach
Aretheprojectstypicallylongtermorshortterm?Whatisthecashflow
patternonprojects?
Howmuchgrowthpotentialdoesthefirmhaverelativetocurrentprojects?
Howcyclicalarethecashflows?Whatspecificfactorsdeterminethecash
flowsonprojects?

II.ProjectCashFlowApproach
Projectcashflowsonatypicalprojectforthefirm
Doscenarioanalysesonthesecashflows,basedupondifferentmacro
economicscenarios

III.HistoricalData
OperatingCashFlows
FirmValue

Aswath Damodaran

94

Coming up with the financing details: Intuitive

Approach
Business

ProjectCashFlowCharacteristics

TypeofFinancing

Creative

Projectsarelikelyto

Debtshouldbe

Content

1. beshortterm

1. shortterm

2. havecashoutflowsareprimar ilyindollars(butcashinflows 2. primarilydollar

couldhaveasubstantialforeigncurrencycomponent
3. havenetcashflowswhichareheavilydrivenbywhetherthe

3. ifpossible,tiedtothe
successofmovies.

movieorT.Vseriesisahit
Retailing

Projectsarelikelytobe

Debtshouldbeintheform

1.mediumterm(tiedtostorelife)

ofoperatingleases.

2.primarilyindollars(mostinUSstill)
3.cyclical
Broadcasting

Projectsarelikelytobe

Debtshouldbe

1.shortterm

1. shortterm

2.primarilyindollars,thoughforeigncomponentisgrowing

2. primarilydollardebt

3.drivenbyadvertisingrevenuesandshowsuccess

3. ifpossible,linkedto
networkratings.

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95

Financing Details: Other Divisions

ThemeParks

Projectsarelikelytobe

Debtshouldbe

1. verylongterm

1. longterm

2. primarilyindollars,butasignificantproportionofrevenues 2. mixofcurrencies,based
comefromforeigntourists.

upontouristmakeup.

3. affectedbysuccessofmovieandbr oadcastingdivisions.
RealEstate

Projectsarelikelytobe

Debtshouldbe

1. longterm

1. longterm

2. primarilyindollars.

2. dollars

3. affectedbyrealestatevaluesinthearea

3. realestatelinked
(MortgageBonds)

Aswath Damodaran

96

II. QUANTITATIVE APPROACH

1.OperatingCashFlows
Thequestionofhowsensitiveafirmsassetcashflowsaretoavarietyof
factors,suchasinterestrates,inflation,currencyratesandtheeconomy,can
bedirectlytestedbyregressingchangesintheoperatingincomeagainst
changesinthesevariables.
ChangeinOperatingIncome(t)=a+bChangeinMacroEconomic
Variable(t)
Thisanalysisisusefulindeterminingthecoupon/interestpaymentstructure
ofthedebt.

2.FirmValue
Thefirmvalueisclearlyafunctionofthelevelofoperatingincome,butit
alsoincorporatesotherfactorssuchasexpectedgrowth&costofcapital.
Thefirmvalueanalysisisusefulindeterminingtheoverallstructureofthe
debt,particularlymaturity.
Aswath Damodaran

97

The Historical Data

Year
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996

Aswath Damodaran

FirmValue %Change OperatingIncome

$ 1,707
$ 119.35
$ 2,108 23.46% $ 141.39

$ 1,817 13.82% $ 133.87

$ 2,024
11.4%
$ 142.60
$ 3,655
80.6%
$ 205.60
$ 5,631
54.1%
$ 280.58
$ 8,371
48.7%
$ 707.00
$ 9,195
9.8%
$ 789.00
$16,015
74.2%
$ 1,109.00
$14,963
6.6%
$ 1,287.00
$17,122
14.4%
$ 1,004.00
$24,771
44.7%
$ 1,287.00
$25,212
1.8%
$ 1,560.00
$26,506
5.1%
$ 1,804.00
$33,858
27.7%
$ 2,262.00
$39,561
16.8%
$ 3,024.00

%Change
18.46%
5.32%
6.5%
44.2%
36.5%
152.0%
11.6%
40.6%
16.1%
22.0%
28.2%
21.2%
15.6%
25.4%
33.7%

98

The Macroeconomic Data

LongBondRate
ChangeinInterestRateRealGNP
13.98%
3854
10.47%
3.51%
3792
11.80%
1.33%
4047
11.51%
0.29%
4216
8.99%
2.52%
4350
7.22%
1.77%
4431
8.86%
1.64%
4633
9.14%
0.28%
4789
7.93%
1.21%
4875
8.07%
0.14%
4895
6.70%
1.37%
4894
6.69%
0.01%
5061
5.79%
0.90%
5219
7.82%
2.03%
5416
5.57%
2.25%
5503
6.42%
0.85%
5679

Aswath Damodaran

GNPGrowth WeightedDollarChange in Dollar

InflationRate Change in Inflation Rate
115.65
8.90%
1.6%
123.14
6.48%
3.80%
5.10%
6.7%
128.65
4.47%
3.80%
0.00%
4.2%
138.89
8.0%
4.00%
0.20%
3.2%
125.95
9.3%
3.80%
0.20%
1.9%
112.89
10.4%
1.20%
2.60%
4.6%
95.88
15.1%
4.40%
3.20%
3.4%
95.32
0.6%
4.40%
0.00%
1.8%
102.26
7.3%
4.60%
0.20%
0.4%
96.25
5.9%
6.10%
1.50%
0.0%
98.82
2.7%
3.10%
3.00%
3.4%
104.58
5.8%
2.90%
0.20%
3.1%
105.22
0.6%
2.70%
0.20%
3.8%
98.6
6.3%
2.70%
0.00%
1.6%
95.1
3.5%
2.50%
0.20%
3.2%
101.5
6.7%
3.30%
0.80%

99

Sensitivity to Interest Rate Changes

Theanswertothisquestionisimportantbecauseit
itprovidesameasureofthedurationofthefirmsprojects
itprovidesinsightintowhetherthefirmshouldbeusingfixedorfloating
ratedebt.

Aswath Damodaran

100

Firm Value versus Interest Rate Changes

Regressingchangesinfirmvalueagainstchangesininterestratesover
thisperiodyieldsthefollowingregression
ChangeinFirmValue=0.22
7.43(ChangeinInterestRates)
(3.09)
(1.69)
Tstatisticsareinbrackets.
Conclusion:Theduration(interestratesensitivity)ofDisneysasset
valuesisabout7.43years.Consequently,itsdebtshouldhaveatleast
aslongaduration.

Aswath Damodaran

101

Regression Constraints
Whichofthefollowingaspectsofthisregressionwouldbotheryouthe
most?
ThelowRsquaredofonly10%
ThefactthatDisneytodayisaverydifferentfirmfromthefirm
capturedinthedatafrom1981to1996
Both
Neither

Aswath Damodaran

102

Why the coefficient on the regression is

duration..

Thedurationofastraightbondorloanissuedbyacompanycanbe
writtenintermsofthecoupons(interestpayments)onthebond(loan)
andthefacevalueofthebondtobe

DurationofBond = dP/dr =

t= N t * Coupon t N * FaceValue
(1+ r) t

(1+ r) N
t =1

t =N Coupon t FaceValue

t
N

t=1 (1+ r)
(1+ r)

Holdingotherfactorsconstant,thedurationofabondwillincrease
withthematurityofthebond,anddecreasewiththecouponrateon
thebond.

Aswath Damodaran

103

Duration of a Firms Assets

Thismeasureofdurationcanbeextendedtoanyassetwithexpected
cashflowsonit.Thus,thedurationofaprojectorassetcanbe
estimatedintermsofthepredebtoperatingcashflowsonthatproject.
t = N t *CFt N * TerminalValue

N
(1+ r)t

(1 + r)
t=1
DurationofProject/Asset = dPV/dr =
t= N CFt
TerminalValue

t


(1 + r)N
t =1 (1 + r)

where,
CFt=Aftertaxoperatingcashflowontheprojectinyeart
TerminalValue=SalvageValueattheendoftheprojectlifetime
N=Lifeoftheproject

Thedurationofanyassetprovidesameasureoftheinterestraterisk
embeddedinthatasset.

Aswath Damodaran

104

Duration of Disney Theme Park

Year

FCFF

TerminalValue TotalFCFF

PVofFCFF

PV*t

($39,078Bt)

($39,078Bt)

(31,180Bt)

31180.4

($36,199Bt)

($36,199Bt)

(23,046Bt)

46092.4

($11,759Bt)

($11,759Bt)

(5,973Bt)

17920

16,155Bt

16,155Bt

6,548Bt

26193.29

21,548Bt

21,548Bt

6,969Bt

34844.55

33,109Bt

33,109Bt

8,544Bt

51264.53

46,692Bt

46,692Bt

9,614Bt

67299.02

58,169Bt

58,169Bt

9,557Bt

76454.39

70,423Bt

909,143Bt

119,182Bt

1072635

100,214Bt

1,233,498

Sum

838,720Bt

DurationoftheProject=1,233,498/100,214=12.30years

Aswath Damodaran

105

Duration: Comparing Approaches

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.

106

Operating Income versus Interest Rates

Regressingchangesinoperatingcashflowagainstchangesininterest
ratesoverthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.314.99(ChangeinInterestRates)
(2.90) (0.78)
Conclusion:Disneysoperatingincome,likeitsfirmvalue,hasbeenvery
sensitivetointerestrates,whichconfirmsourconclusiontouselongterm
debt.

Generallyspeaking,theoperatingcashflowsaresmoothedoutmore
thanthevalueandhencewillexhibitlowerdurationthatthefirm
value.

Aswath Damodaran

107

Sensitivity to Changes in GNP

Theanswertothisquestionisimportantbecause
itprovidesinsightintowhetherthefirmscashflowsarecyclicaland
whetherthecashflowsonthefirmsdebtshouldbedesignedtoprotect
againstcyclicalfactors.

Ifthecashflowsandfirmvaluearesensitivetomovementsinthe
economy,thefirmwilleitherhavetoissuelessdebtoverall,oradd
specialfeaturestothedebttotiecashflowsonthedebttothefirms
cashflows.

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108

Regression Results
RegressingchangesinfirmvalueagainstchangesintheGNPoverthis
periodyieldsthefollowingregression
ChangeinFirmValue=0.31
+1.71(GNPGrowth)
(2.43)
(0.45)

Conclusion:Disneyisonlymildlysensitivetocyclicalmovementsinthe
economy.

RegressingchangesinoperatingcashflowagainstchangesinGNPover
thisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.17+4.06(GNPGrowth)
(1.04)
(0.80)

Conclusion:Disneysoperatingincomeisslightlymoresensitivetothe
economiccycle.ThismaybebecauseofthelaggedeffectofGNPgrowthon
operatingincome.
Aswath Damodaran

109

Sensitivity to Currency Changes

Theanswertothisquestionisimportant,because
itprovidesameasureofhowsensitivecashflowsandfirmvalueareto
changesinthecurrency
itprovidesguidanceonwhetherthefirmshouldissuedebtinanother
currencythatitmaybeexposedto.

Ifcashflowsandfirmvaluearesensitivetochangesinthedollar,the
firmshould
figureoutwhichcurrencyitscashflowsarein;
andissuedsomedebtinthatcurrency

Aswath Damodaran

110

Regression Results
Regressingchangesinfirmvalueagainstchangesinthedollaroverthis
periodyieldsthefollowingregression
ChangeinFirmValue=0.26 1.01(ChangeinDollar)
(3.46)
(0.98)

Conclusion:Disneysvaluehasnotbeenverysensitivetochangesinthe
dollaroverthelast15years.

Regressingchangesinoperatingcashflowagainstchangesinthedollar
overthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.26 3.03(ChangeinDollar)
(3.14)
(2.59)

Conclusion:Disneysoperatingincomehasbeenmuchmoresignificantly
impactedbythedollar.Astrongerdollarseemstohurtoperatingincome.

Aswath Damodaran

111

Sensitivity to Inflation

Theanswertothisquestionisimportant,because
itprovidesameasureofwhethercashflowsarepositivelyornegatively
impactedbyinflation.
itthenhelpsinthedesignofdebt;whetherthedebtshouldbefixedor
floatingratedebt.

Ifcashflowsmovewithinflation,increasing(decreasing)asinflation
increases(decreases),thedebtshouldhavealargerfloatingrate
component.

Aswath Damodaran

112

Regression Results
Regressingchangesinfirmvalueagainstchangesininflationoverthis
periodyieldsthefollowingregression
ChangeinFirmValue
=0.26 0.22(ChangeinInflationRate)
(3.36)
(0.05)

Conclusion:Disneysfirmvaluedoesnotseemtobeaffectedtoomuchby
changesintheinflationrate.

Regressingchangesinoperatingcashflowagainstchangesininflationover
thisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.32+10.51(ChangeinInflationRate)
(3.61)(2.27)

Conclusion:Disneysoperatingincomeseemstoincreaseinperiodswhen
inflationincreases.However,thisincreaseinoperatingincomeseemstobeoffset
bytheincreaseindiscountratesleadingtoamuchmoremutedeffectonvalue.

Aswath Damodaran

113

Overall Recommendations

Thedebtissuedshouldbelongterm,andshouldhaveanaverage
durationofapproximately7.5years.
Sincethecashflowstendtoweakenwhenthedollarstrengthens,some
ofthedebtshouldbeinforeigncurrency,withthemagnitudeofthe
exposureandthecurrencyusedbeingdeterminedbythemixof
touriststhatarriveatthethemeparksandtheexpansionplansforthe
creativecontentandtelevisionbusinesses.
Sincethecashflowstendtomovewithinflation,aportionofthedebt
shouldbefloatingratedebt.

Aswath Damodaran

114

First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateand
matchestheassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.

Aswath Damodaran

115