Intro To Corporate Finance

Applied Corporate Finance
AswathDamodaran
www.damodaran.com
What is corporate finance?
Everydecisionthatabusinessmakeshasfinancialimplications,and
anydecisionwhichaffectsthefinancesofabusinessisacorporate
financedecision.
Definedbroadly,everythingthatabusinessdoesfitsundertherubric
ofcorporatefinance.
The Traditional Accounting Balance Sheet
Otherlongtermobligations
Assetswhicharenotphysical,
LongLivedRealAssets
IntangibleAssets
Shorttermliabilitiesofthefirm
Equity
Debt
FixedAssets
Investmentsinsecurities&
FinancialInvestments
CurrentAssets
Current
Debtobligationsoffirm
Equityinvestmentinfirm
ShortlivedAssets
Other
Liabilities
Assets
TheBalanceSheet
likepatents&trademarks
assetsofotherfirms
Liabilties
Liabilities
The Financial View of the Firm
GrowthAssets
ExpectedValuethatwillbe
FixedClaimoncashflows
Equity
Debt
AssetsinPlace
ResidualClaimoncashflows
ExistingInvestments
Liabilities
Assets
createdbyfutureinvestments
LittleorNoroleinmanagement
SignificantRoleinmanagement
Generatecashflowstoday
FixedMaturity
PerpetualLives
Includeslonglived(fixed)and
TaxDeductible
shortlived(working
capital)assets
Tale of two companies

$6billion
$11billion
$7billion
Investmentsalready
$3billion
$15billion
Investmentsyetto
$77billion
$0.12billion
Equity
Debt
$71.12billion
EBaysFinancialBalanceSheet
Liabilities
Assets
ConEdsFinancialBalanceSheet
made
bemade
First Principles
Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm
The Objective in Decision Making
Intraditionalcorporatefinance,theobjectiveindecisionmakingisto
maximizethevalueofthefirm.
Anarrowerobjectiveistomaximizestockholderwealth.Whenthe
stockistradedandmarketsareviewedtobeefficient,theobjectiveis
tomaximizethestockprice.
Allothergoalsofthefirmareintermediateonesleadingtofirmvalue
maximization,oroperateasconstraintsonfirmvaluemaximization.
The Classical Objective Function

STOCKHOLDERS
Hire&fire
managers
Board
AnnualMeeting
BONDHOLDERS
LendMoney
Maximize
stockholder
wealth
Managers
Protect
bondholder
Interests
Reveal
information
honestlyand
ontime
NoSocialCosts
SOCIETY
Costscanbe
tracedtofirm
Marketsare
efficientand
assesseffecton
value
FINANCIALMARKETS
What can go wrong?

STOCKHOLDERS
Havelittlecontrol
overmanagers
BONDHOLDERS
LendMoney
Managersput
theirinterests
abovestockholders
Managers
SignificantSocialCosts
SOCIETY
Bondholderscan
Somecostscannotbe
getrippedoff
tracedtofirm
Delaybad
Marketsmake
newsor
mistakesand
provide
misleading canoverreact
information
FINANCIALMARKETS
Whos on Board? The Disney Experience 1997
10
Application Test: Who owns/runs your firm?

Lookat:BloombergprintoutHDSforyourfirm
Lookingatthetop15stockholdersinyourfirm,aretopmanagersin
yourfirmalsolargestockholdersinthefirm?
Isthereanyevidencethatthetopstockholdersinthefirmplayan
activeroleinmanagingthefirm?
11
Disneys top stockholders in 2003
12
When traditional corporate financial theory

breaks down, the solution is:
Tochooseadifferentmechanismforcorporategovernance
Tochooseadifferentobjectiveforthefirm.
Tomaximizestockprice,butreducethepotentialforconflictand
breakdown:
Makingmanagers(decisionmakers)andemployeesintostockholders
Byprovidinginformationhonestlyandpromptlytofinancialmarkets
13
An Alternative Corporate Governance System
GermanyandJapandevelopedadifferentmechanismforcorporate
governance,baseduponcorporatecrossholdings.
InGermany,thebanksformthecoreofthissystem.
InJapan,itisthekeiretsus
OtherAsiancountrieshavemodeledtheirsystemafterJapan,withfamily
companiesformingthecoreofthenewcorporatefamilies
Attheirbest,themostefficientfirmsinthegroupworkatbringingthe
lessefficientfirmsuptopar.Theyprovideacorporatewelfaresystem
thatmakesforamorestablecorporatestructure
Attheirworst,theleastefficientandpoorlyrunfirmsinthegrouppull
downthemostefficientandbestrunfirmsdown.Thenatureofthe
crossholdingsmakesitsverydifficultforoutsiders(including
investorsinthesefirms)tofigureouthowwellorbadlythegroupis
doing.
14
Choose a Different Objective Function
Firmscanalwaysfocusonadifferentobjectivefunction.Examples
wouldinclude
maximizingearnings
maximizingrevenues
maximizingfirmsize
maximizingmarketshare
maximizingEVA
Thekeythingtorememberisthattheseareintermediateobjective
functions.
Tothedegreethattheyarecorrelatedwiththelongtermhealthandvalue
ofthecompany,theyworkwell.
Tothedegreethattheydonot,thefirmcanendupwithadisaster
15
Maximize Stock Price, subject to ..
Thestrengthofthestockpricemaximizationobjectivefunctionisits
internalselfcorrectionmechanism.Excessesonanyofthelinkages
lead,ifunregulated,tocounteractionswhichreduceoreliminatethese
excesses
Inthecontextofourdiscussion,
managerstakingadvantageofstockholdershasleadtoamuchmore
activemarketforcorporatecontrol.
stockholderstakingadvantageofbondholdershasleadtobondholders
protectingthemselvesatthetimeoftheissue.
firmsrevealingincorrectordelayedinformationtomarketshasleadto
marketsbecomingmoreskepticalandpunitive
firmscreatingsocialcostshasleadtomoreregulations,aswellasinvestor
andcustomerbacklashes.
16
The Stockholder Backlash
InstitutionalinvestorssuchasCalpersandtheLensFundshave
becomemuchmoreactiveinmonitoringcompaniesthattheyinvestin
anddemandingchangesinthewayinwhichbusinessisdone
IndividualslikeMichaelPricespecializeintakinglargepositionsin
companieswhichtheyfeelneedtochangetheirways(Chase,Dow
Jones,ReadersDigest)andpushforchange
Atannualmeetings,stockholdershavetakentoexpressingtheir
displeasurewithincumbentmanagementbyvotingagainsttheir
compensationcontractsortheirboardofdirectors
17
In response, boards are becoming more

independent
Boardshavebecomesmallerovertime.Themediansizeofaboardof
directorshasdecreasedfrom16to20inthe1970stobetween9and11
in1998.Thesmallerboardsarelessunwieldyandmoreeffectivethan
thelargerboards.
There are fewer insiders on the board. In contrast to the 6 or more
insidersthatmanyboardshadinthe1970s,onlytwodirectorsinmost
boardsin1998wereinsiders.
Directors are increasingly compensated with stock and options in the
company, instead of cash. In 1973, only 4% of directors received
compensationintheformofstockoroptions,whereas78%didsoin
1998.
Moredirectorsareidentifiedandselectedbyanominatingcommittee
rather than being chosen by the CEO of the firm. In 1998, 75% of
boards had nominating committees; the comparable statistic in 1973
was2%.
18
Disneys Board in 2003

BoardMembers
RevetaBowers
JohnBryson
RoyDisney
MichaelEisner
JudithEstrin
StanleyGold
RobertIger
MonicaLozano
GeorgeMitchell
ThomasS.Murphy
LeoODonovan
SidneyPoitier
RobertA.M.Stern
AndreaL.VandeKamp
RaymondL.Watson
GaryL.Wilson
Occupation
HeadofschoolfortheCenterforEarlyEducation,
CEOandChairmanofConEdison
HeadofDisneyAnimation
CEOofDisney
CEOofPacketDesign(aninternetcompany)
CEOofShamrockHoldings
ChiefOperatingOfficer,Disney
ChiefOperationOfficer,LaOpinion(Spanishnewspaper)
Chairmanoflawfirm(Verner,Liipfert,etal.)
ExCEO,CapitalCitiesABC
ProfessorofTheology,GeorgetownUniversity
Actor,WriterandDirector
SeniorPartnerofRobertA.M.SternArchitectsofNewYork
ChairmanofSotheby'sWestCoast
ChairmanofIrvineCompany(arealestatecorporation)
Chairmanoftheboard,NorthwestAirlines.
19
The Counter Reaction

STOCKHOLDERS
1.Moreactivist
investors
2.Hostiletakeovers
Protectthemselves
BONDHOLDERS
1.Covenants
2.NewTypes
Managersofpoorly
runfirmsareput
onnotice.
Managers
Firmsare
punished
formisleading
markets
CorporateGoodCitizenConstraints
SOCIETY
1.Morelaws
2.Investor/CustomerBacklash
Investorsand
analystsbecome
moreskeptical
FINANCIALMARKETS
20
Picking the Right Projects:

Investment Analysis
Letuswatchwellourbeginnings,andresultswillmanage
themselves
AlexanderClark
21
First Principles
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedand
thetimingofthesecashflows;theyshouldalsoconsiderbothpositiveand
negativesideeffectsoftheseprojects.
cashtostockholders.
22
The notion of a benchmark
Sincefinancialresourcesarefinite,thereisahurdlethatprojectshave
tocrossbeforebeingdeemedacceptable.
Thishurdlewillbehigherforriskierprojectsthanforsaferprojects.
Asimplerepresentationofthehurdlerateisasfollows:
Hurdlerate= RisklessRate+RiskPremium
Thetwobasicquestionsthateveryriskandreturnmodelinfinance
triestoanswerare:
Howdoyoumeasurerisk?
Howdoyoutranslatethisriskmeasureintoariskpremium?
23
What is Risk?
Risk,intraditionalterms,isviewedasanegative.Websters
dictionary,forinstance,definesriskasexposingtodangeror
hazard.TheChinesesymbolsforrisk,reproducedbelow,givea
muchbetterdescriptionofrisk
Thefirstsymbolisthesymbolfordanger,whilethesecondisthe
symbolforopportunity,makingriskamixofdangerand
opportunity.
24
Risk and Return Models in Finance

Riskless
Low
High
Risk
E(R)
The
Multi-Factor
Proxy
If
Beta
Since
Betas
In
Equation
Step
there
anAPM
risk
CAPM
Risk
that
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efficient
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Measuring
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is
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and
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that
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will hold
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factorsVariable(s)
Proxy
25
Who are Disneys marginal investors?
26
Limitations of the CAPM

1.Themodelmakesunrealisticassumptions
2.Theparametersofthemodelcannotbeestimatedprecisely
Definitionofamarketindex
Firmmayhavechangedduringthe'estimation'period'
3.Themodeldoesnotworkwell
Ifthemodelisright,thereshouldbe
alinearrelationshipbetweenreturnsandbetas
theonlyvariablethatshouldexplainreturnsisbetas
Therealityisthat
therelationshipbetweenbetasandreturnsisweak
Othervariables(size,price/bookvalue)seemtoexplaindifferencesinreturns
better.
27
Why the CAPM persists
TheCAPM,notwithstandingitsmanycriticsandlimitations,has
survivedasthedefaultmodelforriskinequityvaluationandcorporate
finance.Thealternativemodelsthathavebeenpresentedasbetter
models(APM,Multifactormodel..)havemadeinroadsinperformance
evaluationbutnotinprospectiveanalysisbecause:
Thealternativemodels(whicharericher)doamuchbetterjobthanthe
CAPMinexplainingpastreturn,buttheireffectivenessdropsoffwhenit
comestoestimatingexpectedfuturereturns(becausethemodelstendto
shiftandchange).
Thealternativemodelsaremorecomplicatedandrequiremore
informationthantheCAPM.
Formostcompanies,theexpectedreturnsyougetwiththethealternative
modelsisnotdifferentenoughtobeworththeextratroubleofestimating
fouradditionalbetas.
28
Application Test: Who is the marginal investor

in your firm?
Youcangetinformationoninsiderandinstitutionalholdingsinyourfirm
from:
http://finance.yahoo.com/
Enteryourcompanyssymbolandchooseprofile.
Lookingatthebreakdownofstockholdersinyourfirm,consider
whetherthemarginalinvestoris
Aninstitutionalinvestor
b) Anindividualinvestor
c) Aninsider
a)
29
Inputs required to use the CAPM
Thecapitalassetpricingmodelyieldsthefollowingexpectedreturn:
ExpectedReturn=RiskfreeRate+Beta*(ExpectedReturnontheMarket
PortfolioRiskfreeRate)
Tousethemodelweneedthreeinputs:
(a) Thecurrentriskfreerate
(b)Theexpectedmarketriskpremium(thepremiumexpectedforinvesting
inriskyassets(marketportfolio)overtherisklessasset)
(c)Thebetaoftheassetbeinganalyzed.
30
The Riskfree Rate and Time Horizon
Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.
Therefore,thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,i.e.,tohaveanactualreturnbeequal
totheexpectedreturn,twoconditionshavetobemet
Therehastobenodefaultrisk,whichgenerallyimpliesthatthesecurity
hastobeissuedbythegovernment.Note,however,thatnotall
governmentscanbeviewedasdefaultfree.
Therecanbenouncertaintyaboutreinvestmentrates,whichimpliesthat
itisazerocouponsecuritywiththesamematurityasthecashflowbeing
analyzed.
31
Riskfree Rate in Practice
Theriskfreerateistherateonazerocoupongovernmentbond
matchingthetimehorizonofthecashflowbeinganalyzed.
Theoretically,thistranslatesintousingdifferentriskfreeratesforeach
cashflowthe1yearzerocouponrateforthecashflowinyear1,the
2yearzerocouponrateforthecashflowinyear2...
Practicallyspeaking,ifthereissubstantialuncertaintyaboutexpected
cashflows,thepresentvalueeffectofusingtimevaryingriskfreerates
issmallenoughthatitmaynotbeworthit.
32
The Bottom Line on Riskfree Rates
Usingalongtermgovernmentrate(evenonacouponbond)asthe
riskfreerateonallofthecashflowsinalongtermanalysiswillyielda
closeapproximationofthetruevalue.
Forshorttermanalysis,itisentirelyappropriatetouseashortterm
governmentsecurityrateastheriskfreerate.
Theriskfreeratethatyouuseinananalysisshouldbeinthesame
currencythatyourcashflowsareestimatedin.Inotherwords,ifyour
cashflowsareinU.S.dollars,yourriskfreeratehastobeinU.S.
dollarsaswell.
DataSource:YoucangetriskfreeratesfortheUSinanumberofsites.
Tryhttp://www.bloomberg.com/markets.
33
Measurement of the risk premium
Theriskpremiumisthepremiumthatinvestorsdemandforinvesting
inanaverageriskinvestment,relativetotheriskfreerate.
Asageneralproposition,thispremiumshouldbe
greaterthanzero
increasewiththeriskaversionoftheinvestorsinthatmarket
increasewiththeriskinessoftheaverageriskinvestment
34
What is your risk premium?

Assumethatstocksaretheonlyriskyassetsandthatyouareofferedtwo
investmentoptions:
arisklessinvestment(sayaGovernmentSecurity),onwhichyoucan
make5%
amutualfundofallstocks,onwhichthereturnsareuncertain
Howmuchofanexpectedreturnwouldyoudemandtoshiftyourmoneyfromthe
risklessassettothemutualfund?
a) Lessthan5%
b) Between57%
c) Between79%
d) Between911%
e) Between1113%
f) Morethan13%
Checkyourpremiumagainstthesurveypremiumonmywebsite.
35
Risk Aversion and Risk Premiums
Ifthiswerethecapitalmarketline,theriskpremiumwouldbea
weightedaverageoftheriskpremiumsdemandedbyeachandevery
investor.
Theweightswillbedeterminedbythemagnitudeofwealththateach
investorhas.Thus,WarrenBuffetsriskaversioncountsmoretowards
determiningtheequilibriumpremiumthanyoursandmine.
Asinvestorsbecomemoreriskaverse,youwouldexpectthe
equilibriumpremiumtoincrease.
36
Risk Premiums do change..

Gobacktothepreviousexample.Assumenowthatyouaremakingthe
samechoicebutthatyouaremakingitintheaftermathofastock
marketcrash(ithasdropped25%inthelastmonth).Wouldyou
changeyouranswer?
a) Iwoulddemandalargerpremium
b) Iwoulddemandasmallerpremium
c) Iwoulddemandthesamepremium
37
Estimating Risk Premiums in Practice
Surveyinvestorsontheirdesiredriskpremiumsandusetheaverage
premiumfromthesesurveys.
Assumethattheactualpremiumdeliveredoverlongtimeperiodsis
equaltotheexpectedpremiumi.e.,usehistoricaldata
Estimatetheimpliedpremiumintodaysassetprices.
38
The Survey Approach
Surveyingallinvestorsinamarketplaceisimpractical.
However,youcansurveyafewinvestors(especiallythelarger
investors)andusetheseresults.Inpractice,thistranslatesintosurveys
ofmoneymanagersexpectationsofexpectedreturnsonstocksover
thenextyear.
Thelimitationsofthisapproachare:
therearenoconstraintsonreasonability(thesurveycouldproduce
negativeriskpremiumsorriskpremiumsof50%)
theyareextremelyvolatile
theytendtobeshortterm;eventhelongestsurveysdonotgobeyondone
year
39
The Historical Premium Approach
Thisisthedefaultapproachusedbymosttoarriveatthepremiumto
useinthemodel
Inmostcases,thisapproachdoesthefollowing
itdefinesatimeperiodfortheestimation(1926Present,1962Present....)
itcalculatesaveragereturnsonastockindexduringtheperiod
itcalculatesaveragereturnsonarisklesssecurityovertheperiod
itcalculatesthedifferencebetweenthetwo
andusesitasapremiumlookingforward
Thelimitationsofthisapproachare:
itassumesthattheriskaversionofinvestorshasnotchangedina
systematicwayacrosstime.(Theriskaversionmaychangefromyearto
year,butitrevertsbacktohistoricalaverages)
itassumesthattheriskinessoftheriskyportfolio(stockindex)hasnot
changedinasystematicwayacrosstime.
40
Historical Average Premiums for the United

States
Arithmeticaverage
GeometricAverage
Stocks
Stocks Stocks
Stocks
HistoricalPeriod T.Bills
T.Bonds
T.Bills
T.Bonds
19282004
7.92%
6.53%
6.02%
4.84%
19642004
5.82%
4.34%
4.59%
3.47%
19942004
8.60%
5.82%
6.85%
4.51%
Whatistherightpremium?
Gobackasfarasyoucan.Otherwise,thestandarderrorintheestimatewillbelarge.(
StdErrorinestimate =
AnnualizedStddeviationinStockprices
)
Numberofyearsofhistoricaldata
Beconsistentinyouruseofariskfreerate.
Usearithmeticpremiumsforoneyearestimatesofcostsofequityandgeometric
premiumsforestimatesoflongtermcostsofequity.
DataSource:Checkoutthereturnsbyyearandestimateyourownhistoricalpremiumsby
goingtoupdateddataonmywebsite.
41
What about historical premiums for other

markets?
HistoricaldataformarketsoutsidetheUnitedStatesisavailablefor
muchshortertimeperiods.Theproblemisevengreaterinemerging
markets.
Thehistoricalpremiumsthatemergefromthisdatareflectsthisand
thereismuchgreatererrorassociatedwiththeestimatesofthe
premiums.
42
One solution: Look at a countrys bond rating

and default spreads as a start
RatingsagenciessuchasS&PandMoodysassignratingstocountries
thatreflecttheirassessmentofthedefaultriskofthesecountries.
Theseratingsreflectthepoliticalandeconomicstabilityofthese
countriesandthusprovideausefulmeasureofcountryrisk.In
September2004,forinstance,BrazilhadacountryratingofB2.
Ifacountryissuesbondsdenominatedinadifferentcurrency(say
dollarsoreuros),youcanalsoseehowthebondmarketviewstherisk
inthatcountry.InSeptember2004,BrazilhaddollardenominatedC
Bonds,tradingataninterestrateof10.01%.TheUStreasurybond
ratethatdaywas4%,yieldingadefaultspreadof6.01%forBrazil.
ManyanalystsaddthisdefaultspreadtotheUSriskpremiumtocome
upwithariskpremiumforacountry.Usingthisapproachwouldyield
ariskpremiumof10.85%forBrazil,ifweuse4.84%asthepremium
fortheUS.
43
Beyond the default spread
Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsand
equityriskpremiumsarehighlycorrelated,onewouldexpectequity
spreadstobehigherthandebtspreads.Ifwecancomputehowmuch
moreriskytheequitymarketis,relativetothebondmarket,wecould
usethisinformation.Forexample,
StandardDeviationinBovespa(Equity)=36%
StandardDeviationinBrazilCBond=28.2%
DefaultspreadonCBond=6.01%
CountryRiskPremiumforBrazil=6.01%(36%/28.2%)=7.67%
Notethatthisisontopofthepremiumyouestimateforamature
market.Thus,ifyouassumethattheriskpremiumintheUSis4.84%,
theriskpremiumforBrazilwouldbe12.51%.
44
Implied Equity Premiums
Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.
Analystsexpectearningstogrow8.5%ayearforthenext5years.
January1,2005
52.85
48.71
44.89
41.37
38.13
In2004,dividends&stock
Afteryear5,wewillassumethat
S&P500isat1211.92
buybackswere2.90%of
earningsontheindexwillgrowat
Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof7.87%onstocks(which
isobtainedbysolvingforrinthefollowingequation)
ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=7.87%4.22%=
3.65%
1211.92 =
38.13 41.37
44.89
48.71
52.85
52.85(1.0422)
+
+
+
+
+
(1+ r) (1+ r) 2 (1+ r) 3 (1 + r) 4 (1+ r) 5 (r .0422)(1+ r) 5
45
Implied Premiums in the US

7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
46
Application Test: A Market Risk Premium
Baseduponourdiscussionofhistoricalriskpremiumssofar,therisk
premiumlookingforwardshouldbe:
a) About7.92%,whichiswhatthearithmeticaveragepremiumhasbeen
since1928,forstocksoverT.Bills
b) About4.84%,whichisthegeometricaveragepremiumsince1928,for
stocksoverT.Bonds
c) About3.7%,whichistheimpliedpremiuminthestockmarkettoday
47
Estimating Beta
Thestandardprocedureforestimatingbetasistoregressstockreturns
(Rj)againstmarketreturns(Rm)
Rj=a+bRm
whereaistheinterceptandbistheslopeoftheregression.
Theslopeoftheregressioncorrespondstothebetaofthestock,and
measurestheriskinessofthestock.
48
Estimating Performance
Theinterceptoftheregressionprovidesasimplemeasureof
performanceduringtheperiodoftheregression,relativetothecapital
assetpricingmodel.
Rj =Rf+b(RmRf)
=Rf(1b) +bRm
Rj =a
+bRm
...........
...........
CapitalAssetPricingModel
RegressionEquation
If
a>Rf(1b).... Stockdidbetterthanexpectedduringregressionperiod
a=Rf(1b).... Stockdidaswellasexpectedduringregressionperiod
a<Rf(1b).... Stockdidworsethanexpectedduringregressionperiod
ThedifferencebetweentheinterceptandRf(1b)isJensen'salpha.If
itispositive,yourstockdidperformbetterthanexpectedduringthe
periodoftheregression.
49
Firm Specific and Market Risk
TheRsquared(R2)oftheregressionprovidesanestimateofthe
proportionoftherisk(variance)ofafirmthatcanbeattributedto
marketrisk;
Thebalance(1R2)canbeattributedtofirmspecificrisk.
50
Setting up for the Estimation
Decideonanestimationperiod
Servicesuseperiodsrangingfrom2to5yearsfortheregression
Longerestimationperiodprovidesmoredata,butfirmschange.
Shorterperiodscanbeaffectedmoreeasilybysignificantfirmspecific
eventthatoccurredduringtheperiod(Example:ITTfor19951997)
Decideonareturnintervaldaily,weekly,monthly
Shorterintervalsyieldmoreobservations,butsufferfrommorenoise.
Noiseiscreatedbystocksnottradingandbiasesallbetastowardsone.
Estimatereturns(includingdividends)onstock
Return=(PriceEndPriceBeginning+DividendsPeriod)/PriceBeginning
Includeddividendsonlyinexdividendmonth
Chooseamarketindex,andestimatereturns(inclusiveofdividends)
ontheindexforeachintervalfortheperiod.
51
Choosing the Parameters: Disney
Periodused:5years
ReturnInterval=Monthly
MarketIndex:S&P500Index.
Forinstance,tocalculatereturnsonDisneyinDecember1999,
PriceforDisneyatendofNovember1999=$27.88
PriceforDisneyatendofDecember1999=$29.25
Dividendsduringmonth=$0.21(Itwasanexdividendmonth)
Return=($29.25$27.88+$0.21)/$27.88=5.69%
Toestimatereturnsontheindexinthesamemonth
Indexlevel(includingdividends)atendofNovember1999=1388.91
Indexlevel(includingdividends)atendofDecember1999=1469.25
Return=(1469.251388.91)/1388.91=5.78%
52
Disneys Historical Beta

Figure4.3:DisneyversusS&P500:19992003
30.00%
20.00%
Regressionline
10.00%
Disney
15.00%
0.00%
10.00%
5.00%
0.00%
5.00%
10.00%
15.00%
10.00%
20.00%
30.00%
S&P500
53
The Regression Output
Usingmonthlyreturnsfrom1999to2003,weranaregressionof
returnsonDisneystockagainsttheS*P500.Theoutputisbelow:
ReturnsDisney=0.0467%+1.01ReturnsS&P500(Rsquared=29%)
(0.20)
54
Analyzing Disneys Performance
Intercept=0.0467%
Thisisaninterceptbasedonmonthlyreturns.Thus,ithastobecompared
toamonthlyriskfreerate.
Between1999and2003,
MonthlyRiskfreeRate=0.313%(baseduponaverageT.Billrate:9903)
RiskfreeRate(1Beta)=0.313%(11.01)=..0032%
TheComparisonisthenbetween
Intercept
versus RiskfreeRate(1Beta)
0.0467%
versus 0.313%(11.01)=0.0032%
JensensAlpha=0.0467%(0.0032%)=0.05%
Disneydid0.05%betterthanexpected,permonth,between1999and
2003.
Annualized,Disneysannualexcessreturn=(1.0005)121=0.60%
55
A positive Jensens alpha Who is

responsible?
DisneyhasapositiveJensensalphaof0.60%ayearbetween1999
and2003.Thiscanbeviewedasasignthatmanagementinthefirm
didagoodjob,managingthefirmduringtheperiod.
a) True
b) False
56
Estimating Disneys Beta
SlopeoftheRegressionof1.01isthebeta
Regressionparametersarealwaysestimatedwitherror.Theerroris
capturedinthestandarderrorofthebetaestimate,whichinthecaseof
Disneyis0.20.
AssumethatIaskedyouwhatDisneystruebetais,afterthis
regression.
Whatisyourbestpointestimate?
Whatrangewouldyougiveme,with67%confidence?
Whatrangewouldyougiveme,with95%confidence?
57
The Dirty Secret of Standard Error

Distribution of Standard Errors: Beta Estimates for U.S. stocks
1600
1400
Number of Firms
1200
1000
800
600
400
200
0
<.10
.10 - .20
.20 - .30
.30 - .40
.40 -.50
.50 - .75
> .75
Standard Error in Beta Estimate
58
Breaking down Disneys Risk
RSquared=29%
Thisimpliesthat
29%oftheriskatDisneycomesfrommarketsources
71%,therefore,comesfromfirmspecificsources
Thefirmspecificriskisdiversifiableandwillnotberewarded
59
The Relevance of R Squared

Youareadiversifiedinvestortryingtodecidewhetheryoushouldinvest
inDisneyorAmgen.Theybothhavebetasof1.01,butDisneyhasan
RSquaredof29%whileAmgensRsquaredofonly14.5%.Which
onewouldyouinvestin?
a) Amgen,becauseithasthelowerRsquared
b) Disney,becauseithasthehigherRsquared
c) Youwouldbeindifferent
Wouldyouranswerbedifferentifyouwereanundiversifiedinvestor?
60
Beta Estimation: Using a Service (Bloomberg)
QuickTime and a
TIFF (LZW) decompressor
are needed to see this picture.
61
Estimating Expected Returns for Disney in

September 2004
Inputstotheexpectedreturncalculation
DisneysBeta=1.01
RiskfreeRate=4.00%(U.S.tenyearT.Bondrate)
RiskPremium=4.82%(Approximatehistoricalpremium:19282003)
ExpectedReturn
=RiskfreeRate+Beta(RiskPremium)
=4.00%+1.01(4.82%)=8.87%
62
Use to a Potential Investor in Disney

AsapotentialinvestorinDisney,whatdoesthisexpectedreturnof8.87%
tellyou?
a) ThisisthereturnthatIcanexpecttomakeinthelongtermonDisney,if
thestockiscorrectlypricedandtheCAPMistherightmodelforrisk,
b) ThisisthereturnthatIneedtomakeonDisneyinthelongtermtobreak
evenonmyinvestmentinthestock
c) Both
Assumenowthatyouareanactiveinvestorandthatyourresearch
suggeststhataninvestmentinDisneywillyield12.5%ayearforthe
next5years.Basedupontheexpectedreturnof8.87%,youwould
a) Buythestock
b) Sellthestock
63
How managers use this expected return
ManagersatDisney
needtomakeatleast8.87%asareturnfortheirequityinvestorstobreak
even.
thisisthehurdlerateforprojects,whentheinvestmentisanalyzedfrom
anequitystandpoint
Inotherwords,Disneyscostofequityis8.87%.
Whatisthecostofnotdeliveringthiscostofequity?
64
Application Test: Analyzing the Risk

Regression
UsingyourBloombergriskandreturnprintout,answerthefollowing
questions:
Howwellorbadlydidyourstockdo,relativetothemarket,duringthe
periodoftheregression?(Youcanassumeanannualizedriskfreerateof
4.8%duringtheregressionperiod)
Intercept(4.8%/n)(1Beta)=JensensAlpha
Wherenisthenumberofreturnperiodsinayear(12ifmonthly;52ifweekly)
Whatproportionoftheriskinyourstockisattributabletothemarket?
Whatproportionisfirmspecific?
Whatisthehistoricalestimateofbetaforyourstock?Whatistherange
onthisestimatewith67%probability?With95%probability?
Baseduponthisbeta,whatisyourestimateoftherequiredreturnonthis
stock?
RisklessRate+Beta*RiskPremium
65
A Quick Test
Youareadvisingaveryriskysoftwarefirmontherightcostofequityto
useinprojectanalysis.Youestimateabetaof3.0forthefirmand
comeupwithacostofequityof18.46%.TheCFOofthefirmis
concernedaboutthehighcostofequityandwantstoknowwhether
thereisanythinghecandotolowerhisbeta.
Howdoyoubringyourbetadown?
Shouldyoufocusyourattentiononbringingyourbetadown?
a) Yes
b) No
66
Beta: Exploring Fundamentals

Enron:
Beta
Real
Qwest
General
Microsoft:
Philip
Exxon
Harmony
Networks:
>Morris:
=
<
Mobil:
Communications:
00.95
1
Electric:
Gold
1..25
0.40
0.65
Mining:
3.24
1.10 - 0.10
2.60
67
Determinant 1: Product Type
IndustryEffects:Thebetavalueforafirmdependsuponthe
sensitivityofthedemandforitsproductsandservicesandofitscosts
tomacroeconomicfactorsthataffecttheoverallmarket.
Cyclicalcompanieshavehigherbetasthannoncyclicalfirms
Firmswhichsellmorediscretionaryproductswillhavehigherbetasthan
firmsthatselllessdiscretionaryproducts
68
Determinant 2: Operating Leverage Effects
Operatingleveragereferstotheproportionofthetotalcostsofthe
firmthatarefixed.
Otherthingsremainingequal,higheroperatingleverageresultsin
greaterearningsvariabilitywhichinturnresultsinhigherbetas.
69
Measures of Operating Leverage

FixedCostsMeasure=FixedCosts/VariableCosts
Thismeasurestherelationshipbetweenfixedandvariablecosts.The
highertheproportion,thehighertheoperatingleverage.
EBITVariabilityMeasure=%ChangeinEBIT/%ChangeinRevenues
Thismeasureshowquicklytheearningsbeforeinterestandtaxes
changesasrevenuechanges.Thehigherthisnumber,thegreaterthe
operatingleverage.
70
Disneys Operating Leverage: 1987- 2003

Year
Net Sales
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
1987-2003
1996-2003
2877
3438
4594
5844
6182
7504
8529
10055
12112
18739
22473
22976
23435
25418
25172
25329
27061
% Change
in Sales
19.50%
33.62%
27.21%
5.78%
21.38%
13.66%
17.89%
20.46%
54.71%
19.93%
2.24%
2.00%
8.46%
-0.97%
0.62%
6.84%
15.83%
11.73%
EBIT
756
848
1177
1368
1124
1287
1560
1804
2262
3024
3945
3843
3580
2525
2832
2384
2713
% Change
in EBIT
12.17%
38.80%
16.23%
-17.84%
14.50%
21.21%
15.64%
25.39%
33.69%
30.46%
-2.59%
-6.84%
-29.47%
12.16%
-15.82%
13.80%
10.09%
4.42%
71
Reading Disneys Operating Leverage
OperatingLeverage
=%ChangeinEBIT/%ChangeinSales
=10.09%/15.83%=0.64
Thisislowerthantheoperatingleverageforotherentertainmentfirms,
whichwecomputedtobe1.12.ThiswouldsuggestthatDisneyhas
lowerfixedcoststhanitscompetitors.
TheacquisitionofCapitalCitiesbyDisneyin1996maybeskewing
theoperatingleverage.Lookingatthechangessincethen:
OperatingLeverage199603=4.42%/11.73%=0.38
LookslikeDisneysoperatingleveragehasdecreasedsince1996.
72
Determinant 3: Financial Leverage
Asfirmsborrow,theycreatefixedcosts(interestpayments)thatmake
theirearningstoequityinvestorsmorevolatile.
Thisincreasedearningsvolatilitywhichincreasestheequitybeta
73
Equity Betas and Leverage
Thebetaofequityalonecanbewrittenasafunctionoftheunlevered
betaandthedebtequityratio
L=u(1+((1t)D/E))
where
L=LeveredorEquityBeta
u=UnleveredBeta
t=Corporatemarginaltaxrate
D=MarketValueofDebt
E=MarketValueofEquity
74
Effects of leverage on betas: Disney
TheregressionbetaforDisneyis1.01.Thisbetaisaleveredbeta
(becauseitisbasedonstockprices,whichreflectleverage)andthe
leverageimplicitinthebetaestimateistheaveragemarketdebtequity
ratioduringtheperiodoftheregression(1999to2003)
Theaveragedebtequityratioduringthisperiodwas27.5%.
TheunleveredbetaforDisneycanthenbeestimated(usingamarginal
taxrateof37.3%)
=CurrentBeta/(1+(1taxrate)(AverageDebt/Equity))
=1.01/(1+(10.373))(0.275))=0.8615
75
Disney : Beta and Leverage

DebttoCapital
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
Debt/EquityRatio
0.00%
11.11%
25.00%
42.86%
66.67%
100.00%
150.00%
233.33%
400.00%
900.00%
Beta
0.86
0.92
1.00
1.09
1.22
1.40
1.67
2.12
3.02
5.72
EffectofLeverage
0.00
0.06
0.14
0.23
0.36
0.54
0.81
1.26
2.16
4.86
76
Betas are weighted Averages
Thebetaofaportfolioisalwaysthemarketvalueweightedaverageof
thebetasoftheindividualinvestmentsinthatportfolio.
Thus,
thebetaofamutualfundistheweightedaverageofthebetasofthe
stocksandotherinvestmentinthatportfolio
thebetaofafirmafteramergeristhemarketvalueweightedaverageof
thebetasofthecompaniesinvolvedinthemerger.
77
Bottom-up versus Top-down Beta
Thetopdownbetaforafirmcomesfromaregression
Thebottomupbetacanbeestimatedbydoingthefollowing:
Findoutthebusinessesthatafirmoperatesin
Findtheunleveredbetasofotherfirmsinthesebusinesses
Takeaweighted(bysalesoroperatingincome)averageofthese
unleveredbetas
Leverupusingthefirmsdebt/equityratio
Thebottomupbetawillgiveyouabetterestimateofthetruebeta
when
thestandarderrorofthebetafromtheregressionishigh(and)thebetafor
afirmisverydifferentfromtheaverageforthebusiness
thefirmhasreorganizedorrestructureditselfsubstantiallyduringthe
periodoftheregression
whenafirmisnottraded
78
Disneys business breakdown
UnleveredBeta
(1 Cash/FirmValue)
Unle vered
Ave rage
beta
Numbe r levered Media n Unle vered Cash/Firm correct ed
for cash
of firms beta
D/E
beta
Value
Business
Comparab le
firms
Medi a
Networks
Rad ia and TV
br oadcasting
companies
24
1.22
Parks an d
Resorts
Theme p ark &

Entertainment
firms
1.58
11
1.16
27.96%
77
1.06
9.18%
Studio
Movie
Entertainment companies
Consumer
Products
Toy and
apparel
retail ers;
Entertainment
software
20.45%
1.0768
0.75%
1.0850
120.76% 0.8853
2.77%
0.9105
0.9824
14.08%
1.1435
0.9981
12.08%
1.1353
79
Disneys bottom up beta

EV/Sales =
(MarketValueofEquity + Debt Cash)

Sales
Business
MediaNetworks
ParksandResorts
Studio
Entertainment
ConsumerProducts
Disney
Disneys
Revenues
$10,941
$6,412
$7,364
$2,344
$27,061
Estimated
EV/Sales
Value
3.41
$37,278.62
2.37
$15,208.37
2.63
1.63
$19,390.14
$3,814.38
$75,691.51
FirmValue
Proportion
49.25%
20.09%
Unlevered
beta
1.0850
0.9105
25.62%
5.04%
100.00%
1.1435
1.1353
1.0674
80
Disneys Cost of Equity
Business
Medi a Networks
Parksan d
Resorts
Studio
Entertainment
Consumer
Products
Disn e y
D/E
UnleveredBeta Ratio
1.08 5 0
26.6 2 %
Lever e d
Beta
1.26 6 1
Costof
Equit y
10.1 0 %
0.91 0 5
26.6 2 %
1.06 2 5
9.12%
1.14 3 5
26.6 2 %
1.33 4 4
10.4 3 %
1.13 5 3
1.06 7 4
26.6 2 %
26.6 2 %
1.32 4 8
1.24 5 6
10.3 9 %
10.0 0 %
81
Discussion Issue
IfyouwerethechieffinancialofficerofDisney,whatcostofequity
wouldyouuseincapitalbudgetinginthedifferentdivisions?
a) ThecostofequityforDisneyasacompany
b) ThecostofequityforeachofDisneysdivisions?
82
Estimating Betas for Non-Traded Assets
Theconventionalapproachesofestimatingbetasfromregressionsdo
notworkforassetsthatarenottraded.
Therearetwowaysinwhichbetascanbeestimatedfornontraded
assets
usingcomparablefirms
usingaccountingearnings
83
Using comparable firms to estimate beta for

Bookscape
Assumethatyouaretryingtoestimatethebetaforaindependent
bookstoreinNewYorkCity.
Firm
Beta
Debt
Equity
Cash
BooksAMillion 0.532
$45
$45
$5
BordersGroup 0.844
$182
$1,430
$269
Barnes&Noble 0.885
$300
$1,606
$268
CourierCorp
0.815
$1
$285
$6
InfoHoldings
0.883
$2
$371
$54
JohnWiley&Son 0.636
$235
$1,662
$33
ScholasticCorp 0.744
$549
$1,063
$11
Sector
0.7627 $1,314
$6,462
$645
UnleveredBeta=0.7627/(1+(1.35)(1314/6462))=0.6737
CorrectedforCash=0.6737/(1645/(1314+6462))=0.7346
84
Estimating Bookscape Levered Beta and Cost

of Equity
Sincethedebt/equityratiosusedaremarketdebtequityratios,andthe
onlydebtequityratiowecancomputeforBookscapeisabookvalue
debt equity ratio, we have assumed that Bookscape is close to the
industryaveragedebttoequityratioof20.33%.
Using a marginal tax rate of 40% (based upon personal income tax
rates)forBookscape,wegetaleveredbetaof0.82.
LeveredbetaforBookscape=0.7346(1+(1.40)(.2033))=0.82
Usingariskfreerateof4%(UStreasurybondrate)andahistorical
riskpremiumof4.82%:
CostofEquity=4%+0.82(4.82%)=7.95%
85
Is Beta an Adequate Measure of Risk for a

Private Firm?
Theownersofmostprivatefirmsarenotdiversified.Betameasures
theriskaddedontoadiversifiedportfolio.Therefore,usingbetato
arriveatacostofequityforaprivatefirmwill
a) Underestimatethecostofequityfortheprivatefirm
b) Overestimatethecostofequityfortheprivatefirm
c) Couldunderoroverestimatethecostofequityfortheprivatefirm
86
Total Risk versus Market Risk
Adjustthebetatoreflecttotalriskratherthanmarketrisk.This
adjustmentisarelativelysimpleone,sincetheRsquaredofthe
regressionmeasurestheproportionoftheriskthatismarketrisk.
TotalBeta=MarketBeta/Correlationofthesectorwiththemarket
IntheBookscapeexample,wherethemarketbetais0.82andthe
averageRsquaredofthecomparablepubliclytradedfirmsis16%,
MarketBeta
Rsquared
0.82
.16
= 2.06
TotalCostofEquity=4%+2.06(4.82%)=13.93%
87
Application Test: Estimating a Bottom-up

Beta
Baseduponthebusinessorbusinessesthatyourfirmisinrightnow,
anditscurrentfinancialleverage,estimatethebottomupunlevered
betaforyourfirm.
DataSource:Youcangetalistingofunleveredbetasbyindustryon
mywebsitebygoingtoupdateddata.
88
From Cost of Equity to Cost of Capital
Thecostofcapitalisacompositecosttothefirmofraisingfinancing
tofunditsprojects.
Inadditiontoequity,firmscanraisecapitalfromdebt
89
What is debt?
GeneralRule:Debtgenerallyhasthefollowingcharacteristics:
Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrol
ofthefirmtothepartytowhompaymentsaredue.
Asaconsequence,debtshouldinclude
Anyinterestbearingliability,whethershorttermorlongterm.
Anyleaseobligation,whetheroperatingorcapital.
90
Estimating the Cost of Debt
Ifthefirmhasbondsoutstanding,andthebondsaretraded,theyield
tomaturityonalongterm,straight(nospecialfeatures)bondcanbe
usedastheinterestrate.
Ifthefirmisrated,usetheratingandatypicaldefaultspreadonbonds
withthatratingtoestimatethecostofdebt.
Ifthefirmisnotrated,
andithasrecentlyborrowedlongtermfromabank,usetheinterestrate
ontheborrowingor
estimateasyntheticratingforthecompany,andusethesyntheticratingto
arriveatadefaultspreadandacostofdebt
Thecostofdebthastobeestimatedinthesamecurrencyasthecostof
equityandthecashflowsinthevaluation.
91
Estimating Synthetic Ratings
Theratingforafirmcanbeestimatedusingthefinancial
characteristicsofthefirm.Initssimplestform,theratingcanbe
estimatedfromtheinterestcoverageratio
InterestCoverageRatio=EBIT/InterestExpenses
Forafirm,whichhasearningsbeforeinterestandtaxesof$3,500
millionandinterestexpensesof$700million
InterestCoverageRatio=3,500/700=5.00
In2003,Bookscapehadoperatingincomeof$2millionafterinterest
expensesof500,000.Theresultinginterestcoverageratiois4.00.
Interestcoverageratio=2,000,000/500,000=4.00
92
Interest Coverage Ratios, Ratings and Default

Spreads: Small Companies
InterestCoverageRatio
>12.5
9.5012.50
7.509.50
6.007.50
4.506.00
4.004.50
3.504.00
3.003.50
2.503.00
2.002.50
1.502.00
1.251.50
0.801.25
0.500.80
<0.65
Rating
AAA
AA
A+
A
A
BBB
BB+
BB
B+
B
B
CCC
CC
C
D
Typicaldefaultspread
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
93
Synthetic Rating and Cost of Debt for

Bookscape
Ratingbasedoninterestcoverageratio=BBB
DefaultSpreadbaseduponrating=1.50%
Pretaxcostofdebt=RiskfreeRate+DefaultSpread=4%+1.50%=
5.50%
Aftertaxcostofdebt=Pretaxcostofdebt(1taxrate)=5.50%
(1.40)=3.30%
94
Estimating Cost of Debt with rated companies
Forthethreepubliclytradedfirmsinoursample,wewillusethe
actualbondratingstoestimatethecostsofdebt:
S&PRating
Disney
BBB+
DeutscheBank AA
Aracruz
B+
RiskfreeRate
4%($)
4.05%(Eu)
4%($)
Default
Spread
1.25%
1.00%
3.25%
Costof
Debt
5.25%
5.05%
7.25%
Tax Aftertax
Rate CostofDebt
37.3% 3.29%
38% 3.13%
34% 4.79%
WecomputedthesyntheticratingsforDisneyandAracruzusingthe
interestcoverageratios:
Disney:Coverageratio=2,805/758=3.70
Syntheticrating=A
Aracruz:Coverageratio=888/339=2.62
Syntheticrating=BBB
Disneyssyntheticratingisclosetoitsactualrating.Aracruzhastwo
ratingsoneforitslocalcurrencyborrowingsofBBBandoneforits
dollarborrowingsofB+.
95
Application Test: Estimating a Cost of Debt
Baseduponyourfirmscurrentearningsbeforeinterestandtaxes,its
interestexpenses,estimate
Aninterestcoverageratioforyourfirm
Asyntheticratingforyourfirm(usetheinterestcoveragetable)
Apretaxcostofdebtforyourfirm
Anaftertaxcostofdebtforyourfirm
96
Weights for Cost of Capital Calculation
Theweightsusedinthecostofcapitalcomputationshouldbemarket
values.
Therearethreespeciousargumentsusedagainstmarketvalue
Book value is more reliable than market value because it is not as
volatile: While it is true that book value does not change as much as
marketvalue,thisismoreareflectionofweaknessthanstrength
Using book value rather than market value is a more conservative
approach to estimating debt ratios: For most companies, using book
valueswillyieldalowercostofcapitalthanusingmarketvalueweights.
Since accounting returns are computed based upon book value,
consistency requires the use of book value in computing cost of capital:
While it may seem consistent to use book values for both accounting
returnandcostofcapitalcalculations,itdoesnotmakeeconomicsense.
97
Estimating Market Value Weights
MarketValueofEquityshouldincludethefollowing
MarketValueofSharesoutstanding
MarketValueofWarrantsoutstanding
MarketValueofConversionOptioninConvertibleBonds
MarketValueofDebtismoredifficulttoestimatebecausefewfirms
haveonlypubliclytradeddebt.Therearetwosolutions:
Assumebookvalueofdebtisequaltomarketvalue
Estimatethemarketvalueofdebtfromthebookvalue
ForDisney,withbookvalueof13,100million,interestexpensesof$666
million,acurrentcostofborrowingof5.25%andanweightedaverage
maturityof11.53years.
(1
13,100
(1.0525)11.53
666
+
= $12, 915million
EstimatedMVofDisneyDebt=
.0525
(1.0525)11.53
98
Converting Operating Leases to Debt
Thedebtvalueofoperatingleasesisthepresentvalueofthelease
payments,ataratethatreflectstheirrisk.
Ingeneral,thisratewillbeclosetoorequaltotherateatwhichthe
companycanborrow.
99
Operating Leases at Disney

ThepretaxcostofdebtatDisneyis5.25%
Year
Commitment
PresentValue
1
$271.00
$257.48
2
$242.00
$218.46
3
$221.00
$189.55
4
$208.00
$169.50
5
$275.00
$212.92
69
$258.25
$704.93
DebtValueofleases=
$1,752.85
DebtoutstandingatDisney=$12,915+$1,753=$14,668million
100
Application Test: Estimating Market Value
Estimatethe
MarketvalueofequityatyourfirmandBookValueofequity
Marketvalueofdebtandbookvalueofdebt(Ifyoucannotfindthe
averagematurityofyourdebt,use3years):Remembertocapitalizethe
valueofoperatingleasesandaddthemontoboththebookvalueandthe
marketvalueofdebt.
Estimatethe
Weightsforequityanddebtbaseduponmarketvalue
Weightsforequityanddebtbaseduponbookvalue
101
Current Cost of Capital: Disney
Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=4%+1.25(4.82%)=10.00%
MarketValueofEquity=
$55.101Billion
Equity/(Debt+Equity)=
79%
Debt
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
102
Disneys Divisional Costs of Capital

Business
Costof
Equity
MediaNetworks
10.10%
ParksandResorts
9.12%
StudioEntertainment 10.43%
ConsumerProducts 10.39%
Disney
10.00%
Aftertax
costofdebt
3.29%
3.29%
3.29%
3.29%
3.29%
E/(D+E)
D/(D+E)
Costofcapital
78.98%
78.98%
78.98%
78.98%
78.98%
21.02%
21.02%
21.02%
21.02%
21.02%
8.67%
7.90%
8.93%
8.89%
8.59%
103
Application Test: Estimating Cost of Capital
Usingthebottomupunleveredbetathatyoucomputedforyourfirm,
andthevaluesofdebtandequityyouhaveestimatedforyourfirm,
estimateabottomupleveredbetaandcostofequityforyourfirm.
Baseduponthecostsofequityanddebtthatyouhaveestimated,and
theweightsforeach,estimatethecostofcapitalforyourfirm.
Howdifferentwouldyourcostofcapitalhavebeen,ifyouusedbook
valueweights?
104
Choosing a Hurdle Rate
Eitherthecostofequityorthecostofcapitalcanbeusedasahurdle
rate,dependinguponwhetherthereturnsmeasuredaretoequity
investorsortoallclaimholdersonthefirm(capital)
Ifreturnsaremeasuredtoequityinvestors,theappropriatehurdlerate
isthecostofequity.
Ifreturnsaremeasuredtocapital(orthefirm),theappropriatehurdle
rateisthecostofcapital.
105
Back to First Principles
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedand
thetimingofthesecashflows;theyshouldalsoconsiderbothpositiveand
negativesideeffectsoftheseprojects.
cashtostockholders.
106
Measuring Investment Returns
Showmethemoney
JerryMaguire
107
First Principles
Returnsonprojectsshouldbemeasuredbasedoncashflows
generatedandthetimingofthesecashflows;theyshouldalso
considerbothpositiveandnegativesideeffectsoftheseprojects.
cashtostockholders.
108
Measures of return: earnings versus cash flows
PrinciplesGoverningAccountingEarningsMeasurement
AccrualAccounting:Showrevenueswhenproductsandservicesaresold
orprovided,notwhentheyarepaidfor.Showexpensesassociatedwith
theserevenuesratherthancashexpenses.
OperatingversusCapitalExpenditures:Onlyexpensesassociatedwith
creatingrevenuesinthecurrentperiodshouldbetreatedasoperating
expenses.Expensesthatcreatebenefitsoverseveralperiodsarewritten
offovermultipleperiods(asdepreciationoramortization)
Togetfromaccountingearningstocashflows:
youhavetoaddbacknoncashexpenses(likedepreciation)
youhavetosubtractoutcashoutflowswhicharenotexpensed(suchas
capitalexpenditures)
youhavetomakeaccrualrevenuesandexpensesintocashrevenuesand
expenses(byconsideringchangesinworkingcapital).
109
Measuring Returns Right: The Basic Principles
Usecashflowsratherthanearnings.Youcannotspendearnings.
Useincrementalcashflowsrelatingtotheinvestmentdecision,i.e.,
cashflowsthatoccurasaconsequenceofthedecision,ratherthantotal
cashflows.
Usetimeweightedreturns,i.e.,valuecashflowsthatoccurearlier
morethancashflowsthatoccurlater.
TheReturnMantra:Timeweighted,IncrementalCashFlow
Return
110
Earnings versus Cash Flows: A Disney Theme

Park
ThethemeparkstobebuiltnearBangkok,modeledonEuroDisneyin
Paris,willincludeaMagicKingdomtobeconstructed,beginning
immediately,andbecomingoperationalatthebeginningofthesecond
year,andasecondthemeparkmodeledonEpcotCenteratOrlandoto
beconstructedinthesecondandthirdyearandbecomingoperational
atthebeginningofthefifthyear.
TheearningsandcashflowsareestimatedinnominalU.S.Dollars.
111
Earnings on Project
MagicKing d om
Seco n d The m e Pa rk
Resort&Prop e rties
TotalRevenues
Magic Kingdom:Operating
Expenses
EpcotII:Operating
Expenses
Resort&Prop e rty:
OperatingExpenses
Depreciation&Amortization
AllocatedG&ACosts
OperatingIncome
Taxes
OperatingIncom
e aft e r
Taxes
Now(0)1
$0
$0
$0
$0
2
3
4
5
6
7
8
9
10
$1,0 0 0 $1,4 0 0 $1,7 0 0 $2,0 0 0 $2,2 0 0 $2,4 2 0 $2,6 6 2 $2,9 2 8 $2,9 8 7
$0
$0
$300 $500 $550 $605 $666 $732 $747
$250 $350 $500 $625 $688 $756 $832 $915 $933
$1,2 5 0 $1,7 5 0 $2,5 0 0 $3,1 2 5 $3,4 3 8 $3,7 8 1 $4,1 5 9 $4,5 7 5 $4,6 6 7
$600 $840 $1,0 2 0 $1,2 0 0 $1,3 2 0 $1,4 5 2 $1,5 9 7 $1,7 5 7 $1,7 9 2
$0
$0
$0
$180 $300 $330 $363 $399 $439 $448
$0
$0
$0
$0
$0
$188
$537
$188
$262
$98
$263
$508
$263
$123
$46
$375
$430
$375
$120
$45
$164 $77
$75
$469
$359
$469
$329
$1 23
$516
$357
$516
$399
$149
$567
$358
$567
$473
$177
$624
$361
$624
$554
$206
$6 86
$366
$686
$641
$239
$700
$369
$700
$657
$245
$206 $250 $297 $347 $402 $412
112
And the Accounting View of Return
Year
1
2
3
4
5
6
7
8
9
10
After -tax
Operating
Income
$0
-$165
-$77
$75
$206
$251
$297
$347
$402
$412
$175
BV of
Capital:
Beginning
$2,500
$3,500
$4,294
$4,616
$4,524
$4,484
$4,464
$4,481
$4,518
$4,575
BV of
Capital:
Ending
$3,500
$4,294
$4,616
$4,524
$4,484
$4,464
$4,481
$4,518
$4,575
$4,617
Ave rage BV
of Capital
$3,000
$3,897
$4,455
$4,570
$4,504
$4,474
$4,472
$4,499
$4,547
$4,596
$4,301
ROC
NA
-4.22%
-1.73%
1.65%
4.58%
5.60%
6.64%
7.72%
8.83%
8.97%
4.23%
113
Should there be a risk premium for foreign

projects?
Theexchangerateriskshouldbediversifiablerisk(andhenceshould
notcommandapremium)if
thecompanyhasprojectsisalargenumberofcountries(or)
theinvestorsinthecompanyaregloballydiversified.
ForDisney,thisriskshouldnotaffectthecostofcapitalused.Consequently,
wewouldnotadjustthecostofcapitalforDisneysinvestmentsinother
maturemarkets(Germany,UK,France)
Thesamediversificationargumentcanalsobeappliedagainstpolitical
risk,whichwouldmeanthatittooshouldnotaffectthediscountrate.
Itmay,however,affectthecashflows,byreducingtheexpectedlife
orcashflowsontheproject.
ForDisney,thisistheriskthatweareincorporatingintothecostof
capitalwhenitinvestsinThailand(oranyotheremergingmarket)
114
Estimating a hurdle rate for the theme park
Wedidestimateacostofequityof9.12%fortheDisneythemepark
businessinthelastchapter,usingabottomupleveredbetaof1.0625
forthebusiness.
This cost of equity may not adequately reflect the additional risk
associatedwiththethemeparkbeinginanemergingmarket.
Tocounterthisrisk,wecomputethecostofequityforthethemepark
using a risk premium that includes a country risk premium for
Thailand:
The rating for Thailand is Baa1 and the default spread for the country bond
is 1.50%. Multiplying this by the relative volatility of 2.2 of the equity
market in Thailand (strandard deviation of equity/standard devaiation of
country bond) yields a country risk premium of 3.3%.
CostofEquityinUS$=4%+1.0625(4.82%+3.30%)=12.63%
CostofCapitalinUS$=12.63%(.7898)+3.29%(.2102)=10.66%
115
Would lead us to conclude that...
Donotinvestinthispark.Thereturnoncapitalof4.23%islower
thanthecostofcapitalforthemeparksof10.66%;Thiswould
suggestthattheprojectshouldnotbetaken.
Giventhatwehavecomputedtheaverageoveranarbitraryperiodof
10years,whilethethemeparkitselfwouldhavealifegreaterthan10
years,wouldyoufeelcomfortablewiththisconclusion?
a) Yes
b) No
116
From Project to Firm Return on Capital: Disney

in 2003
Justasacomparisonofprojectreturnoncapitaltothecostofcapital
yieldsameasureofwhethertheprojectisacceptable,acomparison
canbemadeatthefirmlevel,tojudgewhethertheexistingprojectsof
thefirmareaddingordestroyingvalue.
Disney,in2003,hadearningsbeforeinterestandtaxesof$2,713
million,hadabookvalueofequityof$23,879millionandabook
valueofdebtof14,130million.Withataxrateof37.3%,weget
ReturnonCapital=2713(1.373)/(23879+14130)=4.48%
CostofCapitalforDisney=8.59%
ExcessReturn=4.48%8.59%=4.11%
Thiscanbeconvertedintoadollarfigurebymultiplyingbythecapital
invested,inwhichcaseitiscalledeconomicvalueadded
EVA=(..0448.0859)(23879+14130)=$1,562million
117
Application Test: Assessing Investment

Quality
Forthemostrecentperiodforwhichyouhavedata,computetheafter
taxreturnoncapitalearnedbyyourfirm,whereaftertaxreturnon
capitaliscomputedtobe
AftertaxROC=EBIT(1taxrate)/(BVofdebt+BVofEquity) previousyear
Forthemostrecentperiodforwhichyouhavedata,computethe
returnspreadearnedbyyourfirm:
ReturnSpread=AftertaxROCCostofCapital
Forthemostrecentperiod,computetheEVAearnedbyyourfirm
EVA=ReturnSpread*((BVofdebt+BVofEquity) previousyear
118
The cash flow view of this project..
Operating Income after Taxes

+ Depreciation & Amortization
- Capital Expenditures
$2,500 $1,000
- Change in Working Capital
$0
$0
Cashflow to Firm
-$2,500 -$1,000
2
-$165
$537
$1,269
$63
-$960
3
-$77
$508
$805
$25
-$399
4
$75
$430
$301
$38
$166
5
$206
$359
$287
$31
$247
6
$251
$357
$321
$16
$271
Togetfromincometocashflow,we
addedbackallnoncashchargessuchasdepreciation
subtractedoutthecapitalexpenditures
subtractedoutthechangeinnoncashworkingcapital
119
The incremental cash flows on the project

$500millionhasalreadybeenspent
OperatingIncomeafterTaxes
Now(0)
$537 $508 $430 $359 $357 $358 $361 $366 $369
+ Depreciation & ortization

Am
- CapitalExpenditures
- ChangeniWorkingCapital
$2,500 $1,000 $1,269 $805 $301 $287 $321 $358 $379 $403 $406
$0
+ Non
-incrementa
l Allocated
Expense
(1-t)
+ Sun
k Costs
Cashflow to Firm
2
3
4
5
6
7
8
9
10
-$165 -$77 $75 $206 $251 $297 $347 $402 $412
$0
$63
$25
$38 $31 $16 $17 $19 $21
$5
$0
$78
$110 $157 $196 $216 $237 $261 $287 $293
500
-$2,000 -$1,000 -$880 -$289 $324 $443 $486 $517 $571 $631 $663
2/3rdofallocatedG&Aisfixed.
Addbackthisamount(1t)
Togetfromcashflowtoincrementalcashflows,we
Takenoutofthesunkcostsfromtheinitialinvestment
Addedbackthenonincrementalallocatedcosts(inaftertaxterms)
120
To Time-Weighted Cash Flows
Incrementalcashflowsintheearlieryearsareworthmorethan
incrementalcashflowsinlateryears.
Infact,cashflowsacrosstimecannotbeaddedup.Theyhavetobe
broughttothesamepointintimebeforeaggregation.
Thisprocessofmovingcashflowsthroughtimeis
discounting,whenfuturecashflowsarebroughttothepresent
compounding,whenpresentcashflowsaretakentothefuture
Thediscountingandcompoundingisdoneatadiscountratethatwill
reflect
Expectedinflation:HigherInflation>HigherDiscountRates
Expectedrealrate:Higherrealrate>HigherDiscountrate
Expecteduncertainty:Higheruncertainty>HigherDiscountRate
121
Present Value Mechanics

CashFlowType
1.SimpleCF
2.Annuity
3.GrowingAnnuity
DiscountingFormula
CFn/(1+r)n
CompoundingFormula
CF (1+r)n
0
1
n
(1+ r)
A
(1 + g)n
1
(1 + r)n
A(1 + g)
r g
(1
+ r) 1
A
4.Perpetuity
A/r
5.GrowingPerpetuity ExpectedCashflownextyear/(rg)
122
Discounted cash flow measures of return
NetPresentValue(NPV):Thenetpresentvalueisthesumofthe
presentvaluesofallcashflowsfromtheproject(includinginitial
investment).
NPV=Sumofthepresentvaluesofallcashflowsontheproject,including
theinitialinvestment,withthecashflowsbeingdiscountedatthe
appropriatehurdlerate(costofcapital,ifcashflowiscashflowtothe
firm,andcostofequity,ifcashflowistoequityinvestors)
DecisionRule:AcceptifNPV>0
InternalRateofReturn(IRR):Theinternalrateofreturnisthe
discountratethatsetsthenetpresentvalueequaltozero.Itisthe
percentagerateofreturn,baseduponincrementaltimeweightedcash
flows.
DecisionRule:AcceptifIRR>hurdlerate
123
Closure on Cash Flows
Inaprojectwithafiniteandshortlife,youwouldneedtocomputea
salvagevalue,whichistheexpectedproceedsfromsellingallofthe
investmentintheprojectattheendoftheprojectlife.Itisusuallyset
equaltobookvalueoffixedassetsandworkingcapital
Inaprojectwithaninfiniteorverylonglife,wecomputecashflows
forareasonableperiod,andthencomputeaterminalvalueforthis
project,whichisthepresentvalueofallcashflowsthatoccurafterthe
estimationperiodends..
Assumingtheprojectlastsforever,andthatcashflowsafteryear9
grow2%(theinflationrate)forever,thepresentvalueattheendof
year10ofcashflowsafterthatcanbewrittenas:
TerminalValueinyear10=CFinyear11/(CostofCapitalGrowthRate)
=663(1.02)/(.1066.02)=$7,810million
124
Which yields a NPV of..

Year
0
1
2
3
4
5
6
7
8
9
10
Annual
Cashflo w
-$2,000
-$1,000
-$880
-$289
$324
$443
$486
$517
$571
$631
$663
Terminal
Value
$7,810
Present
Value
-$2,000
-$904
-$719
-$213
$216
$267
$265
$254
$254
$254
$3,076
$749
125
Which makes the argument that..
Theprojectshouldbeaccepted.Thepositivenetpresentvalue
suggeststhattheprojectwilladdvaluetothefirm,andearnareturnin
excessofthecostofcapital.
Bytakingtheproject,Disneywillincreaseitsvalueasafirmby$749
million.
126
The IRR of this project

Figure5.5:NPVProfileforDisneyThemePark
$4,000.00
$3,000.00
$2,000.00
InternalRateofReturn
$1,000.00
NPV
$0.00
8%
9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
$1,000.00
$2,000.00
$3,000.00
DiscountRate
127
The IRR suggests..
Theprojectisagoodone.Usingtimeweighted,incrementalcash
flows,thisprojectprovidesareturnof11.97%.Thisisgreaterthanthe
costofcapitalof10.66%.
TheIRRandtheNPVwillyieldsimilarresultsmostofthetime,
thoughtherearedifferencesbetweenthetwoapproachesthatmay
causeprojectrankingstovarydependingupontheapproachused.
128
Currency Choices and NPV
Theanalysiswasdoneindollars.Wouldtheconclusionshavebeen
anydifferentifwehaddonetheanalysisinThaiBaht?
a) Yes
b) No
129
Disney Theme Park: Thai Baht NPV

InflationrateinThailand=10%
InflationrateinUS=2%
Bt/$inyear1=42.09(1.10/1.02)=45.39
Year
0
1
2
3
4
5
6
7
8
9
10
Cashflow ($)
-2000
-1000
-880
-289
324
443
486
517
571
631
8474
Bt/$
42.09
45.39
48.95
52.79
56.93
61.40
66.21
71.40
77.01
83.04
89.56
Cashflow (Bt) Present Value

-84180
-84180
-45391
-38034
-43075
-30243
-15262
-8979
18420
9080
27172
11223
32187
11140
36920
10707
43979
10687
52412
10671
758886
129470
31542
NPV=31,542Bt/42.09Bt=$749Million
NPVisequaltoNPVindollarterms
130
The Role of Sensitivity Analysis
Ourconclusionsonaprojectareclearlyconditionedonalargenumber
ofassumptionsaboutrevenues,costsandothervariablesoververy
longtimeperiods.
Tothedegreethattheseassumptionsarewrong,ourconclusionscan
alsobewrong.
Onewaytogainconfidenceintheconclusionsistochecktoseehow
sensitivethedecisionmeasure(NPV,IRR..)istochangesinkey
assumptions.
131
Side Costs and Benefits
Mostprojectsconsideredbyanybusinesscreatesidecostsand
benefitsforthatbusiness.
Thesidecostsincludethecostscreatedbytheuseofresourcesthatthe
businessalreadyowns(opportunitycosts)andlostrevenuesforother
projectsthatthefirmmayhave.
Thebenefitsthatmaynotbecapturedinthetraditionalcapital
budgetinganalysisincludeprojectsynergies(wherecashflowbenefits
mayaccruetootherprojects)andoptionsembeddedinprojects
(includingtheoptionstodelay,expandorabandonaproject).
Thereturnsonaprojectshouldincorporatethesecostsandbenefits.
132
First Principles
Returnsonprojectsshouldbemeasuredbasedoncashflows
generatedandthetimingofthesecashflows;theyshouldalso
considerbothpositiveandnegativesideeffectsoftheseprojects.
cashtostockholders.
133
Finding the Right Financing Mix: The

Capital Structure Decision
134
First Principles
cashtostockholders.
135
Growthstage
Stage2
Time
Stage1
Stage4
Stage5
External
OwnersEquity
Earnings
Revenues
VentureCapital
Retiredebt
Debt
Externalfunding
High,but
High,relative
Moderate,relative
Declining,asa
Low,asprojectsdry
Internalfinancing
Commonstock
Stage3
Low,relativeto
High,relativeto
Financing
Bondissues
Seasonedequityissue
InitalPublicoffering
Accessingprivateequity
Morethanfundingneeds
$Revenues/
Negativeor
FinancingChoicesacrossthelifecycle
RapidExpansion
Startup
MatureGrowth
Decline
Financing
BankDebt
CommonStock
Repurchasestock
needs
constrainedby
tofirmvalue.
percentoffirm
up.
Warrants
HighGrowth
low
fundingneeds
Transitions
Earnings
136
Measuring a firms financing mix
Thesimplestmeasureofhowmuchdebtandequityafirmisusing
currentlyistolookattheproportionofdebtinthetotalfinancing.This
ratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswellaslong
term.
Equitycanbedefinedeitherinaccountingterms(asbookvalueof
equity)orinmarketvalueterms(baseduponthecurrentprice).The
resultingdebtratioscanbeverydifferent.
137
Debt: Summarizing the Trade Off

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
138
A Hypothetical Scenario
Assumeyouoperateinanenvironment,where
(a)therearenotaxes
(b)thereisnoseparationbetweenstockholdersandmanagers.
(c)thereisnodefaultrisk
(d)thereisnoseparationbetweenstockholdersandbondholders
(e)firmsknowtheirfuturefinancingneeds
139
The Miller-Modigliani Theorem
Inanenvironment,wheretherearenotaxes,defaultriskoragency
costs,capitalstructureisirrelevant.
Thevalueofafirmisindependentofitsdebtratio.
140
Implications of MM Theorem
Leverageisirrelevant.Afirm'svaluewillbedeterminedbyitsproject
cashflows.
Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm
increasesitsleverage,thecostofequitywillincreasejustenoughto
offsetanygainstotheleverage
141
Pathways to the Optimal
TheCostofCapitalApproach:Theoptimaldebtratioistheonethat
minimizesthecostofcapitalforafirm.
TheSectorApproach:Theoptimaldebtratioistheonethatbringsthe
firmclosestoitspeergroupintermsoffinancingmix.
142
I. The Cost of Capital Approach
ValueofaFirm=PresentValueofCashFlowstotheFirm,
discountedbackatthecostofcapital.
Ifthecashflowstothefirmareheldconstant,andthecostofcapitalis
minimized,thevalueofthefirmwillbemaximized.
143
Applying Cost of Capital Approach: The

Textbook Example
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%
144
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
145
Equity
=4%+1.25(4.82%)=10.00%
$55.101Billion
79%
Debt
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
146
Mechanics of Cost of Capital Estimation

1.EstimatetheCostofEquityatdifferentlevelsofdebt:
Equitywillbecomeriskier>Betawillincrease>CostofEquitywill
increase.
Estimationwilluseleveredbetacalculation
2.EstimatetheCostofDebtatdifferentlevelsofdebt:
Defaultriskwillgoupandbondratingswillgodownasdebtgoesup>Cost
ofDebtwillincrease.
Toestimatingbondratings,wewillusetheinterestcoverageratio
(EBIT/Interestexpense)
3.EstimatetheCostofCapitalatdifferentlevelsofdebt
4.CalculatetheeffectonFirmValueandStockPrice.
147
Estimating Cost of Equity

UnleveredBeta=1.0674(BottomupbetabaseduponDisneysbusinesses)
Marketpremium=4.82%
T.BondRate=4.00%
Taxrate=37.3%
DebtRatio
D/ERatio
LeveredBeta
CostofEquity
0.00%
0.00%
1.0674
9.15%
10.00%
11.11%
1.1418
9.50%
20.00%
25.00%
1.2348
9.95%
30.00%
42.86%
1.3543
10.53%
40.00%
66.67%
1.5136
11.30%
50.00%
100.00%
1.7367
12.37%
60.00%
150.00%
2.0714
13.98%
70.00%
233.33%
2.6291
16.67%
80.00%
400.00%
3.7446
22.05%
90.00%
900.00%
7.0911
38.18%
148
Estimating Cost of Debt

Startwiththecurrentmarketvalueofthefirm=55,101+14668=$69,769mil
D/(D+E)
0.00%
10.00%
Debttocapital
D/E
0.00%
11.11%
D/E=10/90=.1111
$Debt
$0
$6,977
10%of$69,769

EBITDA
$3,882
$3,882
Sameas0%debt
Depreciation
$1,077
$1,077
Sameas0%debt
EBIT
$2,805
$2,805
Sameas0%debt
Interest
$0
$303
Pretaxcostofdebt*$Debt

PretaxInt.cov
9.24
EBIT/InterestExpenses
LikelyRating
AAA
AAA
FromRatingstable
Pretaxcostofdebt
4.35%
4.35%
RisklessRate+Spread
149
The Ratings Table

Interest Co verage Ratin
Ratio
g
> 8.5
AAA
6.50 - 6.50
AA
5.50 6.50
A+
4.25 5.50
A
3.00 4.25
A2.50 3.00
BBB
2.05 - 2.50
BB+
1.90 2.00
BB
1.75 1.90
B+
1.50 - 1.75
B
1.25 1.50
B0.80 1.25
CCC
0.65 0.80
CC
0.20 0.65
C
< 0.20
D
Typical de fault
spread
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
Market inte rest rate

on d ebt
4.35%
4.50%
4.70%
4.85%
5.00%
5.50%
6.00%
6.50%
7.25%
8.00%
10.00%
12.00%
14.00%
16.00%
24.00%
150
A Test: Can you do the 20% level?

D/(D+E)
0.00%
10.00%
20.00% 2ndIteration 3rd?
D/E
$Debt

EBITDA
Depreciation
EBIT
Interest

PretaxInt.cov
LikelyRating
Costofdebt
0.00%
$0
$3,882
$1,077
$2,805
$0
AAA
4.35%
11.11%
$6,977
25.00%
$13,954
$3,882
$1,077
$2,805
$303
$3,882
$1,077
$2,805
$606 .0485*13954=676
9.24
AAA
4.35%
4.62
2805/676=4.15
A
A
4.85% 5.00%
151
Bond Ratings, Cost of Debt and Debt Ratios

Debt
Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Interest
Interest Coverage
Debt expense Ratio
$0
$0
$6,977 $303
9.24
$13,954 $698
4.02
$20,931 $1,256
2.23
$27,908 $3,349
0.84
$34,885 $5,582
0.50
$41,861 $6,698
0.42
$48,838 $7,814
0.36
$55,815 $8,930
0.31
$62,792 $10,047
0.28
Interest
Bond rate on
debt
Rating
AAA
4.35%
AAA
4.35%
A5.00%
BB+
6.00%
CCC
12.00%
C
16.00%
C
16.00%
C
16.00%
C
16.00%
C
16.00%
Cost of
Tax
Debt
Rate (after -tax)
37.30% 2.73%
37.30% 2.73%
37.30% 3.14%
37.30% 3.76%
31.24% 8.25%
18.75% 13.00%
15.62% 13.50%
13.39% 13.86%
11.72% 14.13%
10.41% 14.33%
152
Stated versus Effective Tax Rates
Youneedtaxableincomeforinteresttoprovideataxsavings
IntheDisneycase,considertheinterestexpenseat30%and40%
30%DebtRatio
40%DebtRatio
EBIT
$2,805m
$2,805m
InterestExpense
$1,256m
$3,349m
TaxSavings
$1,256*.373=468 2,805*.373=$1,046
TaxRate
37.30%
1,046/3,349=31.2%
Pretaxinterestrate
6.00%
12.00%
AftertaxInterestRate 3.76%
8.25%
Youcandeductonly$2,805millionofthe$3,349millionofthe
interestexpenseat40%.Therefore,only37.3%of$2,805millionis
consideredasthetaxsavings.
153
Disneys Cost of Capital Schedule

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
CostofEquity
9.15%
9.50%
9.95%
10.53%
11.50%
13.33%
15.66%
19.54%
27.31%
50.63%
CostofDebt(aftertax)
2.73%
2.73%
3.14%
3.76%
8.25%
13.00%
13.50%
13.86%
14.13%
14.33%
CostofCapital
9.15%
8.83%
8.59%
8.50%
10.20%
13.16%
14.36%
15.56%
16.76%
17.96%
154
Disney: Cost of Capital Chart

Figure8.3:DisneyCostofCapitalatdifferentDebtRatios
60.00%
20.00%
18.00%
50.00%
16.00%
14.00%
40.00%
Costofequity
climbsas
leveredbeta
increases
OptimalDebtratioisatthispoint
12.00%
30.00%
10.00%
8.00%
Costsofdebtandequity
20.00%
CostofCapital
6.00%
4.00%
10.00%
Aftertaxcostofdebtincreasesas
interestcoverageratiodeteriorates
andwithitthesyntheticrating.
0.00%
2.00%
0.00%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
DebtRatio
CostofEquity
AftertaxCostofDebt
CostofCapital
155
Effect on Firm Value
FirmValuebeforethechange=55,101+14,668=$69,769
WACCb=8.59%
WACCa=8.50%
WACC=0.09%
AnnualCost=$69,769*8.59%=$5,993million
AnnualCost=$69,769*8.50%=$5,930million
ChangeinAnnualCost
=$63million
Ifthereisnogrowthinthefirmvalue,(ConservativeEstimate)
Increaseinfirmvalue=$63/.0850=$741million
ChangeinStockPrice=$741/2047.6=$0.36pershare
Ifweassumeaperpetualgrowthof4%infirmvalueovertime,
Increaseinfirmvalue=$63/(.0850.04)=$1,400million
ChangeinStockPrice=$1,400/2,047.6=$0.68pershare
ImpliedGrowthRateobtainedby
FirmvalueToday=FCFF(1+g)/(WACCg):Perpetualgrowthformula
$69,769=$1,722(1+g)/(.0859g):Solveforg>Impliedgrowth=5.98%
156
A Test: The Repurchase Price
LetussupposethattheCFOofDisneyapproachedyouaboutbuying
backstock.Hewantstoknowthemaximumpricethatheshouldbe
willingtopayonthestockbuyback.(Thecurrentpriceis$26.91)
Assumingthatfirmvaluewillgrowby4%ayear,estimatethe
maximumprice.
Whatwouldhappentothestockpriceafterthebuybackifyouwere
abletobuystockbackat$26.91?
157
The Downside Risk
DoingWhatifanalysisonOperatingIncome
A.StandardDeviationApproach
StandardDeviationInPastOperatingIncome
StandardDeviationInEarnings(IfOperatingIncomeIsUnavailable)
ReduceBaseCaseByOneStandardDeviation(OrMore)
B.PastRecessionApproach
LookAtWhatHappenedToOperatingIncomeDuringTheLastRecession.
(HowMuchDidItDropIn%Terms?)
ReduceCurrentOperatingIncomeBySameMagnitude
ConstraintonBondRatings
158
Disneys Operating Income: History

Year
EBIT
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
756
848
1177
1368
1124
1287
1560
1804
2262
3024
3945
3843
3580
2525
2832
2384
2713
% Change
in EBIT
12.17%
38.80%
16.23%
-17.84%
14.50%
21.21%
15.64%
25.39%
33.69%
30.46%
-2.59%
-6.84%
-29.47%
12.16%
-15.82%
13.80%
159
Disney: Effects of Past Downturns

Recession
2002
1991
198182
WorstYear
DeclineinOperatingIncome
Dropof15.82%
Dropof22.00%
Increased
Dropof29.47%
Thestandarddeviationinpastoperatingincomeisabout20%.
160
Disney: The Downside Scenario

%DropinEBITDA
EBIT
OptimalDebtRatio
0%
$2,805
30%
5%
$2,665
20%
10%
$2,524
20%
15%
$2385
20%
20%
$2,245
20%
161
Constraints on Ratings
Managementoftenspecifiesa'desiredRating'belowwhichtheydo
notwanttofall.
Theratingconstraintisdrivenbythreefactors
itisonewayofprotectingagainstdownsideriskinoperatingincome(so
donotdoboth)
adropinratingsmightaffectoperatingincome
thereisanegofactorassociatedwithhighratings
Caveat:EveryRatingConstraintHasACost.
ProvideManagementWithAClearEstimateOfHowMuchTheRating
ConstraintCostsByCalculatingTheValueOfTheFirmWithoutThe
RatingConstraintAndComparingToTheValueOfTheFirmWithThe
RatingConstraint.
162
Ratings Constraints for Disney

Atitsoptimaldebtratioof30%,Disneyhasanestimatedratingof
BB+.
AssumethatDisneyimposesaratingconstraintofAorgreater.
TheoptimaldebtratioforDisneyisthen20%(seenextpage)
Thecostofimposingthisratingconstraintcanthenbecalculatedas
follows:
Valueat30%Debt
=$71,239million
Valueat20%Debt
=$69,837million
CostofRatingConstraint
=$1,376million
163
Effect of Ratings Constraints: Disney

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Rating
AAA
AAA
A
BB+
CCC
C
C
C
C
C
FirmValue
$62,279
$66,397
$69,837
$71,239
$51,661
$34,969
$30,920
$27,711
$25,105
$22,948
164
What if you do not buy back stock..
Theoptimaldebtratioisultimatelyafunctionoftheunderlying
riskinessofthebusinessinwhichyouoperateandyourtaxrate.
Willtheoptimalbedifferentifyouinvestedinprojectsinsteadof
buyingbackstock?
No.Aslongastheprojectsfinancedareinthesamebusinessmixthatthe
companyhasalwaysbeeninandyourtaxratedoesnotchange
significantly.
Yes,iftheprojectsareinentirelydifferenttypesofbusinessesorifthetax
rateissignificantlydifferent.
165
Analyzing Financial Service Firms
Theinterestcoverageratios/ratingsrelationshipislikelytobedifferent
forfinancialservicefirms.
Thedefinitionofdebtismessyforfinancialservicefirms.Ingeneral,
usingalldebtforafinancialservicefirmwillleadtohighdebtratios.
Useonlyinterestbearinglongtermdebtincalculatingdebtratios.
Theeffectofratingsdropswillbemuchmorenegativeforfinancial
servicefirms.
Therearelikelytoregulatoryconstraintsoncapital
166
Interest Coverage ratios, ratings and Operating

income
LongTermInterestCoverageRatio Ratingis Spreadis OperatingIncomeDecline
<0.05
D
16.00%
50.00%
0.050.10
C
14.00%
40.00%
0.100.20
CC
12.50%
40.00%
0.200.30
CCC
10.50%
40.00%
0.300.40
B
6.25%
25.00%
0.400.50
B
6.00%
20.00%
0.500.60
B+
5.75%
20.00%
0.600.75
BB
4.75%
20.00%
0.750.90
BB+
4.25%
20.00%
0.901.20
BBB
2.00%
20.00%
1.201.50
A
1.50%
17.50%
1.502.00
A
1.40%
15.00%
2.002.50
A+
1.25%
10.00%
2.503.00
AA
0.90%
5.00%
>3.00
AAA
0.70%
0.00%
167
Deutsche Bank: Optimal Capital Structure
Debt
Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Beta
0.44
0.47
0.50
0.55
0.62
0.71
0.84
1.07
1.61
3.29
Costof
Equity
6.15%
6.29%
6.48%
6.71%
7.02%
7.45%
8.10%
9.19%
11.83%
19.91%
Bond
Interest
Tax CostofDebt
Firm
Rating rateondebt Rate (aftertax) WACC Value(G)
AAA
4.75% 38.00% 2.95%
6.15% $111,034
AAA
4.75% 38.00% 2.95%
5.96% $115,498
AAA
4.75% 38.00% 2.95%
5.77% $120,336
AAA
4.75% 38.00% 2.95%
5.58% $125,597
AAA
4.75% 38.00% 2.95%
5.39% $131,339
A+
5.30% 38.00% 3.29%
5.37% $118,770
A
5.45% 38.00% 3.38%
5.27% $114,958
A
5.45% 38.00% 3.38%
5.12% $119,293
BB+
8.30% 32.43% 5.61%
6.85% $77,750
BB
8.80% 27.19% 6.41%
7.76% $66,966
168
Determinants of Optimal Debt Ratios
FirmSpecificFactors
1.TaxRate
Highertaxrates
>HigherOptimalDebtRatio
Lowertaxrates
>LowerOptimalDebtRatio
2.PreTaxCFonFirm=EBITDA/MVofFirm
HigherPretaxCF >HigherOptimalDebtRatio
LowerPretaxCF >LowerOptimalDebtRatio
3.VarianceinEarnings[Showsupwhenyoudo'whatif'analysis]
HigherVariance >LowerOptimalDebtRatio
LowerVariance
MacroEconomicFactors
1.DefaultSpreads
Higher
Lower
>LowerOptimalDebtRatio
169
Application Test: Your firms optimal

financing mix
Usingtheoptimalcapitalstructurespreadsheetprovided:
Estimatetheoptimaldebtratioforyourfirm
Estimatethenewcostofcapitalattheoptimal
Estimatetheeffectofthechangeinthecostofcapitalonfirmvalue
Estimatetheeffectonthestockprice
Intermsofthemechanics,whatwouldyouneedtodotogettothe
optimalimmediately?
170
II. Relative Analysis

I.IndustryAveragewithSubjectiveAdjustments
Thesafestplaceforanyfirmtobeisclosetotheindustryaverage
Subjectiveadjustmentscanbemadetotheseaveragestoarriveatthe
rightdebtratio.
Highertaxrates>Higherdebtratios(Taxbenefits)
Lowerinsiderownership>Higherdebtratios(Greaterdiscipline)
Morestableincome>Higherdebtratios(Lowerbankruptcycosts)
Moreintangibleassets>Lowerdebtratios(Moreagencyproblems)
171
Comparing to industry averages
Disney Entertainment Aracruz

MarketDebtRatio 21.02%
19.56%
30.82%
BookDebtRatio 35.10%
28.86%
43.12%
PaperandPulp(Emerging
Market)
27.71%
49.00%
172
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
projects?
Yes
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
173
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

projects?
Yes
No
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
projects?
Yes
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
174
Application Test: Getting to the Optimal
Baseduponyouranalysisofboththefirmscapitalstructureand
investmentrecord,whatpathwouldyoumapoutforthefirm?
Immediatechangeinleverage
Gradualchangeinleverage
Nochangeinleverage
Wouldyourecommendthatthefirmchangeitsfinancingmixby
Payingoffdebt/Buyingbackequity
Takeprojectswithequity/debt
175
Designing Debt: The Fundamental Principle
Theobjectiveindesigningdebtistomakethecashflowsondebt
matchupascloselyaspossiblewiththecashflowsthatthefirm
makesonitsassets.
Bydoingso,wereduceourriskofdefault,increasedebtcapacityand
increasefirmvalue.
176
Design the perfect financing instrument
Theperfectfinancinginstrumentwill
Haveallofthetaxadvantagesofdebt
Whilepreservingtheflexibilityofferedbyequity
CommodityBonds
EffectofInflation
Duration
Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced
Cyclicality&
GrowthPatterns
DefineDebt
Duration/
Currency
Fixedvs.FloatingRate
Straightversus
SpecialFeatures
Startwiththe
UncertaintyaboutFuture
OtherEffects
Characteristics
Maturity
Mix
*Morefloatingrate
Convertible
onDebt
CashFlows
CatastropheNotes
ifCFmovewith
Convertibleif
Optionstomake
onAssets/
inflation
cashflowslow
cashflowsondebt
Projects
withgreateruncertainty
nowbuthigh
matchcashflows
onfuture
exp.growth
onassets
177
Ensuring that you have not crossed the line

drawn by the tax code
Allofthisdesignworkislost,however,ifthesecuritythatyouhave
designeddoesnotdeliverthetaxbenefits.
Inaddition,theremaybeatradeoffbetweenmismatchingdebtand
gettinggreatertaxbenefits.
Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
Overlaytax
ZeroCoupons
Deductibilityofcashflows
Differencesintaxrates
preferences
fortaxpurposes
acrossdifferentlocales
178
While keeping equity research analysts, ratings

agencies and regulators applauding
Ratingsagencieswantcompaniestoissueequity,sinceitmakesthem
safer.Equityresearchanalystswantthemnottoissueequitybecauseit
dilutesearningspershare.Regulatoryauthoritieswanttoensurethat
youmeettheirrequirementsintermsofcapitalratios(usuallybook
value).Financingthatleavesallthreegroupshappyisnirvana.
Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?
OperatingLeases
Consider
AnalystConcerns
RatingsAgency
RegulatoryConcerns
MIPs
ratingsagency
EffectonEPS
EffectonRatios
Measuresused
SurplusNotes
&analystconcerns
Valuerelativetocomparables
Ratiosrelativetocomparables
179
Debt or Equity: The Strange Case of Trust

Preferred
Trustpreferredstockhas
Afixeddividendpayment,specifiedatthetimeoftheissue
Thatistaxdeductible
Andfailingtomakethepaymentcancause?(Canitcausedefault?)
Whentrustpreferredwasfirstcreated,ratingsagenciestreateditas
equity.Astheyhavebecomemoresavvy,ratingsagencieshave
startedgivingfirmsonlypartialequitycreditfortrustpreferred.
180
Debt, Equity and Quasi Equity
Assumingthattrustpreferredstockgetstreatedasequitybyratings
agencies,whichofthefollowingfirmsisthemostappropriatefirmto
beissuingit?
Afirmthatisunderlevered,buthasaratingconstraintthatwouldbe
violatedifitmovedtoitsoptimal
Afirmthatisoverleveredthatisunabletoissuedebtbecauseofthe
ratingagencyconcerns.
181
Soothe bondholder fears
Therearesomefirmsthatfaceskepticismfrombondholderswhen
theygoouttoraisedebt,because
Oftheirpasthistoryofdefaultsorotheractions
Theyaresmallfirmswithoutanyborrowinghistory
Bondholderstendtodemandmuchhigherinterestratesfromthese
firmstoreflecttheseconcerns.
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds
Convertibiles
Factorinagency
ObservabilityofCashFlows
TypeofAssetsfinanced
ExistingDebtcovenants
PuttableBonds
conflictsbetweenstock
byLenders
Tangibleandliquidassets
RestrictionsonFinancing
RatingSensitive
andbondholders
Lessobservablecashflows
createlessagencyproblems
leadtomoreconflicts
Notes
LYONs
182
And do not lock in market mistakes that work

against you
Ratingsagenciescansometimesunderrateafirm,andmarketscan
underpriceafirmsstockorbonds.Ifthisoccurs,firmsshouldnot
lockinthesemistakesbyissuingsecuritiesforthelongterm.In
particular,
Issuingequityorequitybasedproducts(includingconvertibles),when
equityisunderpricedtransferswealthfromexistingstockholderstothe
newstockholders
Issuinglongtermdebtwhenafirmisunderratedlocksinratesatlevels
thatarefartoohigh,giventhefirmsdefaultrisk.
Whatisthesolution
Ifyouneedtouseequity?
Ifyouneedtousedebt?
183
Designing Debt: Bringing it all together

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
UncertaintyaboutFutureCashflows
Whenthereismoreuncertainty,it
maybebettertouseshorttermdebt
Credibility&QualityoftheFirm
Firmswithcredibilityproblems
willissuemoreshorttermdebt
Convertibiles
PuttableBonds
RatingSensitive
Notes
LYONs
184
The Right Debt for Disney

Business
Movies
Broadcasting
ProjectCashFlowCharacteristics
Projectsarelikelyto
1. Be short term
2. Have cash outflows primaril
y in dollars (sinceDisneymakesmostof
its movies in theU.S.) but cashinflows could havea substantial
foreign currency component (becausef overseas
o
sales)
3. Have net cash flows thatear
heavily driven by whether the movie is a
hit, which is often difficul t to predict.
Projects are likel
y to be
1. Short term
2. Primarily in dollars, though foreign componentis growing
3. Driven by advertising revenuesandshowsuccess
TypeofFinancing
Debt should be
1. Short term
2. Primarily dollar debt.
3. If possible,tied to the success
of movies.(Lion King or
Nemo Bonds)
Debt should be
1. Short term
2. Primarily dollar debt
3. If possible,linked to network
ratings.
Theme Parks
Projects are likel
y to be
Debt should be
1. Very long term
1. Long term
2. Primarily in dollars, but a significant proportion of revenues come 2. Mix of currencies,basedupon
from foreign tourists, who are likely to stay away if the dollar
tourist make up.
strengthens
3. Affected by success of movie and
broadcast
ing divisions.
Consumer Products Projectsare likely to be shor
t to mediumterm and linked to the success ofDebt should be
the movie division. Most of Disneys product offerings are derived from a. Medium term
their movieproductions.
b. Dollar debt.
185
Analyzing Disneys Current Debt
Disney has $13.1 billion in debt with an average maturity of 11.53

years. Even allowing for the fact that the maturity of debt is higher
thantheduration,thiswouldindicatethatDisneysdebtisfartoolong
termforitsexistingbusinessmix.
Ofthedebt,about12%isEurodebtandnoyendenominateddebt.
Baseduponouranalysis,alargerportionofDisneysdebtshouldbe
inforeigncurrencies.
Disney has about $1.3 billion in convertible debt and some floating
rate debt, though no information is provided on its magnitude. If
floating rate debt is a relatively small portion of existing debt, our
analysiswouldindicatethatDisneyshouldbeusingmoreofit.
186
Adjusting Debt at Disney
Itcanswapsomeofitsexistinglongterm,fixedrate,dollardebtwith
shorter term, floating rate, foreign currency debt. Given Disneys
standing in financial markets and its large market capitalization, this
shouldnotbedifficulttodo.
If Disney is planning new debt issues, either to get to a higher debt
ratio or to fund new investments, it can use primarily short term,
floating rate, foreign currency debt to fund these new investments.
While it may be mismatching the funding on these investments, its
debtmatchingwillbecomebetteratthecompanylevel.
187
Returning Cash to the Owners:

Dividend Policy
188
First Principles
cashtostockholders.
189
Steps to the Dividend Decision

Cashflow
Cashflows
Reinvestment
Cash
Stock
Dividends
How
What
much
good
is
do
available
held
Paid
Buybacks
ayour
reasonable
are
back
out
to
from
didDebt
back
your
you borrow?
investment
cash balance?
choices?
stockholders
from
(Principal
Operations
into
for
by
the
return
thecompany
business
to
repaid,
toprefer?
Operations
Interest
Equity
stockholders
Investors
190
I. Dividends are sticky
191
II. Dividends tend to follow earnings

60.00
50.00
40.00
30.00
Earnings
Dividends
20.00
10.00
0.00
192
III. More and more firms are buying back stock,

rather than pay dividends...
$300,000.00
$250,000.00
$200,000.00
$150,000.00
$100,000.00
$50,000.00
$
1988
1989
1990
1991
1992
1993
1994
1995
StockBuybacks
1996
1997
1998
1999
2000
2001
2002
Dividends
193
IV. But the change in dividend tax law in 2003

may cause a shift back to dividends
194
Measures of Dividend Policy
DividendPayout:
measuresthepercentageofearningsthatthecompanypaysindividends
=Dividends/Earnings
DividendYield
measuresthereturnthataninvestorcanmakefromdividendsalone
=Dividends/StockPrice
195
Dividend Payout Ratios: January 2005

PayoutRatio:UScompaniesinJanuary2005
300
250
200
150
100
50
0
010%
1020%
2030%
3040%
4050%
5060%
6070%
7080%
8090%
90100%
>100%
196
Dividend Yields in the United States: January

2005
140
5362companiespaidnodividendsin2004
1729companiespaiddividends
120
100
80
60
40
20
0
0
02 0.4 0.6
0.2% 0.4% 0.6% 0.8%
0.8
1%
1
1.2 1.4 1.6
1.2% 1.4% 1.6% 1.8%
1.8
2%
2
2.2 2.4 2.6
2.2% 2.4% 2.6% 2.8%
2.8
3%
3
3.5%
3.5
4%
4
4.5%
4.5
5%
>5%
197
Three Schools Of Thought On Dividends
1.If
(a)therearenotaxdisadvantagesassociatedwithdividends
(b)companiescanissuestock,atnocost,toraiseequity,whenever
needed
Dividendsdonotmatter,anddividendpolicydoesnotaffectvalue.
2.Ifdividendshaveataxdisadvantage,
Dividendsarebad,andincreasingdividendswillreducevalue
3.Ifstockholderslikedividends,ordividendsoperateasasignaloffutureprospects,
Dividendsaregood,andincreasingdividendswillincreasevalue
198
The balanced viewpoint
Ifacompanyhasexcesscash,andfewgoodinvestmentopportunities
(NPV>0),returningmoneytostockholders(dividendsorstock
repurchases)isgood.
Ifacompanydoesnothaveexcesscash,and/orhasseveralgood
investmentopportunities(NPV>0),returningmoneytostockholders
(dividendsorstockrepurchases)isbad.
199
Assessing Dividend Policy
Approach1:TheCash/TrustNexus
Assesshowmuchcashafirmhasavailabletopayindividends,relative
whatitreturnstostockholders.Evaluatewhetheryoucantrustthe
managersofthecompanyascustodiansofyourcash.
Approach2:PeerGroupAnalysis
Pickadividendpolicyforyourcompanythatmakesitcomparableto
otherfirmsinitspeergroup.
200
I. The Cash/Trust Assessment
Step1:Howmuchcouldthecompanyhavepaidoutduringtheperiod
underquestion?
Step2:Howmuchdidthethecompanyactuallypayoutduringthe
periodinquestion?
Step3:HowmuchdoItrustthemanagementofthiscompanywith
excesscash?
Howwelldidtheymakeinvestmentsduringtheperiodinquestion?
Howwellhasmystockperformedduringtheperiodinquestion?
201
A Measure of How Much a Company Could

have Afforded to Pay out: FCFE
TheFreeCashflowtoEquity(FCFE)isameasureofhowmuchcash
isleftinthebusinessafternonequityclaimholders(debtandpreferred
stock)havebeenpaid,andafteranyreinvestmentneededtosustain
thefirmsassetsandfuturegrowth.
NetIncome
+Depreciation&Amortization
=CashflowsfromOperationstoEquityInvestors
PreferredDividends
CapitalExpenditures
WorkingCapitalNeeds
PrincipalRepayments
+ProceedsfromNewDebtIssues
=FreeCashflowtoEquity
202
Estimating FCFE when Leverage is Stable

NetIncome
(1)(CapitalExpendituresDepreciation)
(1)WorkingCapitalNeeds
=FreeCashflowtoEquity
=Debt/CapitalRatio
Forthisfirm,
Proceedsfromnewdebtissues=PrincipalRepayments+(Capital
ExpendituresDepreciation+WorkingCapitalNeeds)
203
An Example: FCFE Calculation
ConsiderthefollowinginputsforMicrosoftin1996.In1996,
MicrosoftsFCFEwas:
NetIncome=$2,176Million
CapitalExpenditures=$494Million
Depreciation=$480Million
ChangeinNonCashWorkingCapital=$35Million
DebtRatio=0%
FCFE= NetIncome(CapexDepr)(1DR)ChgWC(!DR)
= $2,176
(494480)(10)
= $2,127Million
$35(10)
204
Microsoft: Dividends?
Bythisestimation,Microsoftcouldhavepaid$2,127Millionin
dividends/stockbuybacksin1996.Theypaidnodividendsandbought
backnostock.Wherewillthe$2,127millionshowupinMicrosofts
balancesheet?
205
Dividends versus FCFE: U.S.

Figure11.2:Dividendspaidas%ofFCFE
300
250
200
150
100
50
206
The Consequences of Failing to pay FCFE

$3,000
$9,000
$8,000
$2,500
$7,000
$2,000
$6,000
$1,500
$5,000
$1,000
$4,000
$3,000
$500
$2,000
$0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
($500)
$1,000
$0
= Free CF to Equity
= Cash to Stockholders
Cumulated Cash
207
Application Test: Estimating your firms FCFE

InGeneral,
NetIncome
CapitalExpenditures
ChangeinNonCashWorkingCapital
PreferredDividend
PrincipalRepaid
+NewDebtIssued
=FCFE
Compareto
Dividends(Common)
+StockBuybacks
Ifcashflowstatementused
NetIncome
+CapitalExpenditures
+ChangesinNoncashWC
+PreferredDividend
+IncreaseinLTBorrowing
+DecreaseinLTBorrowing
+ChangeinSTBorrowing
=FCFE
CommonDividend
DecreaseinCapitalStock
+IncreaseinCapitalStock
208
A Practical Framework for Analyzing Dividend

Policy
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
Firm pays out too little
FCFE > Dividends
Firm pays out too much

FCFE < Dividends
Do you trust managers in the company with

your cash?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
What investment opportunities does the

firm have?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
Firm has history of

good project choice
and good projects in
the future
Firm has history

of poor project
choice
Firm has good

projects
Give managers the

flexibility to keep
cash and set
dividends
Force managers to
justify holding cash
or return cash to
stockholders
Firm should
cut dividends
and reinvest
more
Firm has poor

projects
Firm should deal

with its investment
problem first and
then cut dividends
209
A Dividend Matrix
real out
setting
pay
any,
problem
to stockholders
dividend
more istoinpolicy
investment policy.
stockholders
as
dividends or stock
210
Disney: An analysis of FCFE from 1994-2003

Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Net
Capital
Income Depreciation Expend
itures
$1,110.40 $1,608.30 $1,026.11
$1,380.10 $1,853.00
$896.50
$1,214.00 $3,944.00 $13,464.00
$1,966.00 $4,958.00 $1,922.00
$1,850.00 $3,323.00 $2,314.00
$1,300.00 $3,779.00 $2,134.00
$920.00 $2,195.00 $2,013.00
($158.00) $1,754.00 $1,795.00
$1,236.00 $1,042.00 $1,086.00
$1,267.00 $1,077.00 $1,049.00
Average $1,208.55 $2,553.33
$2,769.96
Changein
FCFE
FCFE
non-cash
(befor
e
Net CF
(after
WC
debtCF)
fromDebt DebtCF)
$654.10 $1,038.49 $551.10 $1,589.59
($270.70
)
$2,607.30 $14.20 $2,621.50
$617.00 ($8,923.00) $8,688.00 ($235.00)
($174.00) $5,176.00 ($1,641.00)$3,535.00
$939.00 $1,920.00 $618.00 $2,538.00
($363.00) $3,308.00 ($176.00) $3,132.00
($1,184.00) $2,286.00 ($2,118.00) $168.00
$244.00 ($443.00)
$77.00 ($366.00)
$27.00
$1,165.00 $1,892.00 $3,057.00
($264.00) $1,559.00 ($1,145.00) $414.00
$22.54
$969.38
$676.03 $1,645.41
211
Disneys Dividends and Buybacks from 1994 to

2003
Disney
Year
Dividends(in$)
EquityRepurchases(in
$)
CashtoEquity
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
$153
$180
$271
$342
$412
$0
$434
$438
$428
$429
$571
$349
$462
$633
$30
$19
$166
$1,073
$0
$0
$724
$529
$733
$975
$442
$19
$600
$1,511
$428
$429
Average
$308.70
$330.30
$639
212
Disney: Dividends versus FCFE
Disneypaidout$330millionlessindividends(andstockbuybacks)
thanitcouldaffordtopayout(Dividendsandstockbuybackswere
$639million;FCFEbeforenetdebtissueswas$969million).How
muchcashdoyouthinkDisneyaccumulatedduringtheperiod?
213
Disneys track record on projects and

stockholder wealth
DisneyacquiredCap
Citiesin1996
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
20.00%
30.00%
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
214
Can you trust Disneys management?
GivenDisneystrackrecordoverthelast10years,ifyouwerea
Disneystockholder,wouldyoubecomfortablewithDisneysdividend
policy?
Yes
No
215
The Bottom Line on Disney Dividends
Disneycouldhaveaffordedtopaymoreindividendsduringthe
periodoftheanalysis.
Itchosenotto,andusedthecashforacquisitions(CapitalCities/ABC)
andillfatedexpansionplans(Go.com).
Whilethecompanymayhaveflexibilitytosetitsdividendpolicya
decadeago,itsactionsoverthatdecadehavefritteredawaythis
flexibility.
Bottomline:Largecashbalanceswillnotbetoleratedinthis
company.Expecttofacerelentlesspressuretopayoutmore
dividends.
216
Aracruz: Dividends and FCFE: 1998-2003
Year
1998
1999
2000
2001
2002
2003
Net
Income
$3.45
$90.77
$201.71
$18.11
$111.91
$148.09
Average $95.67
Change in FCFE
Capital
non-cash (before net Net Debt
DepreciationExpenditures WC
Debt CF) Cashflow
$152.80
$88.31
$76.06
($8.11)
$174.27
$158.83
$56.47
$2.18
$190.95 ($604.48)
$167.96
$219.37
$12.30
$138.00 ($292.07)
$162.57
$421.49
($56.76) ($184.06) $318.24
$171.50
$260.70
($5.63)
$28.34
$36.35
$162.57
$421.49
($7.47)
($103.37) $531.20
$162.70
$244.64
$3.45
$10.29
$27.25
FCFE
(after net
Debt CF)
$166.16
($413.53)
($154.07)
$134.19
$64.69
$427.83
$37.54
217
Aracruz: Cash Returned to Stockholders
Year
1998
1999
2000
2001
2002
2003
1998
2003
Net IncomeDividendsPayout Ra
tio
$3.45
$90.77
$201.71
$18.11
$111.91
$148.09
$574.04
$24.39
$18.20
$57.96
$63.17
$73.80
$109.31
$346.83
FCFE
Cash retur
nedto Cash Returned/FCFE
Stockholders
707.51% $166.16
$50.79
30.57%
20.05% ($413.53)
$18.20
NA
28.74% ($154.07)
$80.68
NA
348.87% $134.19
$63.17
47.08%
65.94%
$64.69
$75.98
117.45%
73.81%
$427.83
$112.31
26.25%
60.42%
$225.27
$401.12
178.07%
218
Aracruz: Stock and Project Returns

40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
20.00%
1998
1999
2000
ROE
2001
Returnonstock
2002
2003
19982003
CostofEquity
219
Aracruz: Its your call..
AssumethatyouarealargestockholderinAracruz.Theyhavebeen
payingmoreindividendsthantheyhaveavailableinFCFE.Their
projectchoicehasbeenacceptableandyourstockhasperformedwell
overtheperiod.Wouldyouacceptacutindividends?
Yes
No
220
Mandated Dividend Payouts
Therearemanycountrieswherecompaniesaremandatedtopayouta
certainportionoftheirearningsasdividends.Givenourdiscussionof
FCFE,whattypesofcompanieswillbehurtthemostbytheselaws?
Largecompaniesmakinghugeprofits
Smallcompanieslosingmoney
Highgrowthcompaniesthatarelosingmoney
Highgrowthcompaniesthataremakingmoney
221
BP: Dividends- 1983-92

1
NetIncome
10
$712.00
$947.00
$1,256.00
$1,626.00 $2,309.00 $1,098.00
$2,076.00
(Cap.ExpDepr)*(1DR) $1,499.00
$1,281.00 $1,737.50 $1,600.00
$580.00
WorkingCapital*(1DR)
$369.50
($286.50)
$678.50
=FreeCFtoEquity
($612.50)
$631.50
($107.00) ($584.00) $3,764.00
$1,940.50 $1,022.00
Dividends
$831.00
$949.00
$1,079.00 $1,314.00
$1,391.00
$1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00
$831.00
$949.00
$1,079.00 $1,314.00
$1,391.00
$1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00
66.16%
58.36%
$82.00
$2,140.00 $2,542.00 $2,946.00
$1,184.00 $1,090.50 $1,975.50 $1,545.50 $1,100.00
($2,268.00) ($984.50)
$429.50
$1,047.50
($77.00)
($305.00) ($415.00)
($528.50)
$262.00
+EquityRepurchases
=CashtoStockholders
DividendRatios
PayoutRatio
CashPaidas%ofFCFE
135.67%
46.73%
119.67%
67.00%
91.64%
68.69%
64.32%
296.63%
177.93%
150.28% 1008.41% 225.00%
36.96%
101.06%
170.84% 2461.04% 399.62%
643.13%
PerformanceRatios
1.AccountingMeasure
ROE
9.58%
12.14%
19.82%
9.25%
12.43%
15.60%
21.47%
19.93%
4.27%
7.66%
Requiredrateofreturn
19.77%
6.99%
27.27%
16.01%
5.28%
14.72%
26.87%
0.97%
25.86%
7.12%
Difference
10.18%
5.16%
7.45%
6.76%
7.15%
0.88%
5.39%
20.90%
21.59%
0.54%
222
BP: Summary of Dividend Policy
Summaryofcalculations
Average
StandardDeviation
$571.10
$1,382.29
$3,764.00
($612.50)
Dividends
$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%
FreeCFtoEquity
DividendPayoutRatio
84.77%
CashPaidas%ofFCFE
262.00%
ROERequiredreturn
1.67%
Maximum Minimum
223
BP: Just Desserts!
224
The Limited: Summary of Dividend Policy:

1983-1992
Summaryofcalculations
Average
StandardDeviation
Maximum Minimum
FreeCFtoEquity
($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
DividendPayoutRatio
18.59%
19.07%
29.26%
19.84%
CashPaidas%ofFCFE 119.52%
ROERequiredreturn
1.69%
225
Growth Firms and Dividends

Highgrowthfirmsaresometimesadvisedtoinitiatedividendsbecause
itsincreasesthepotentialstockholderbaseforthecompany(since
therearesomeinvestorslikepensionfundsthatcannotbuystocks
thatdonotpaydividends)and,byextension,thestockprice.Doyou
agreewiththisargument?
Yes
No
Why?
226
Summing up
Figure11.5:AnalyzingDividendPolicy
PoorProjects
GoodProjects
Increasepayout
Flexibilityto
ReduceInvestment
accumulate
cash
Disney
CashReturned<FCFE
Microsoft
Aracruz
CashReturned>FCFE
Cutpayout
Cutpayout
ReduceInvestment
InvestinProjects
ROECostofEquity
227
Valuation
AswathDamodaran
228
First Principles
cashtostockholders.
229
Discounted Cashflow Valuation: Basis for

Approach
t = n CF
t
Value =
t
t = 1 (1 + r)
where,
n=Lifeoftheasset
CFt=Cashflowinperiodt
r=Discountratereflectingtheriskinessoftheestimatedcashflows
230
Equity Valuation
Thevalueofequityisobtainedbydiscountingexpectedcashflowsto
equity,i.e.,theresidualcashflowsaftermeetingallexpenses,tax
obligationsandinterestandprincipalpayments,atthecostofequity,
i.e.,therateofreturnrequiredbyequityinvestorsinthefirm.
t=n
CFtoEquity t
(1+ k e )t
t=1
ValueofEquity =
where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity
Thedividenddiscountmodelisaspecializedcaseofequityvaluation,
andthevalueofastockisthepresentvalueofexpectedfuture
dividends.
231
Firm Valuation
Thevalueofthefirmisobtainedbydiscountingexpectedcashflowsto
thefirm,i.e.,theresidualcashflowsaftermeetingalloperating
expensesandtaxes,butpriortodebtpayments,attheweighted
averagecostofcapital,whichisthecostofthedifferentcomponents
offinancingusedbythefirm,weightedbytheirmarketvalue
proportions.
t=n
CFtoFirm t
t
t=1 (1+ WACC)
ValueofFirm =
where,
CFtoFirmt=ExpectedCashflowtoFirminperiodt
WACC=WeightedAverageCostofCapital
232
Generic DCF Valuation Model

Value
Length
Cash
Expected
Firm
Forever
Terminal
CF
Discount
.........
inofValue
stable
Rate
Growth
Period
growth:
of High
Growth
1 isflows
2
3
4
5
n
DISCOUNTED
CASHFLOW
GrowsValue
Firm:Cost
Firm:
Pre-debt
Growth
at constant
ofofCapital
inFirm
cashrate
flow
Operating
forever
Earnings
Equity: Value
After of
Growth
Cost
debt
ofEquity
inEquity
cashIncome/EPS
Net
flows
VALUATION
233
Estimating Inputs:
I. Discount Rates
Criticalingredientindiscountedcashflowvaluation.Errorsin
estimatingthediscountrateormismatchingcashflowsanddiscount
ratescanleadtoseriouserrorsinvaluation.
Atanintuitivelevel,thediscountrateusedshouldbeconsistentwith
boththeriskinessandthetypeofcashflowbeingdiscounted.
Thecostofequityistherateatwhichwediscountcashflowstoequity
(dividendsorfreecashflowstoequity).Thecostofcapitalistherate
atwhichwediscountfreecashflowstothefirm.
234
Reviewing Disneys Costs of Equity & Debt
Business
Medi a Networks
Parksan d
Resorts
Studio
Entertainment
Consumer
Products
Disn e y
D/E
UnleveredBeta Ratio
1.08 5 0
26.6 2 %
Lever e d
Beta
1.26 6 1
Costof
Equit y
10.1 0 %
0.91 0 5
26.6 2 %
1.06 2 5
9.12%
1.14 3 5
26.6 2 %
1.33 4 4
10.4 3 %
1.13 5 3
1.06 7 4
26.6 2 %
26.6 2 %
1.32 4 8
1.24 5 6
10.3 9 %
10.0 0 %
DisneysCostofDebt(baseduponrating)=5.25%
Disneystaxrate=37.3%
235
Equity
=4%+1.25(4.82%)=10.00%
$55.101Billion
79%
Debt
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%
CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101/
(55.101+14.668)
236
II. Estimating Cash Flows

EBIT
To
The
Equity
Firm
Strict
Broader
(1-t)
View
View
Cash
Flows
Dividends
-Net
( Cap
Income
Ex +- Depreciation)
-Stock
Net Cap
Change
Buybacks
in
ExWorking
(1-Debt Capital
Ratio)
- Chg
=
FreeWC
Cashflow
(1 - Debt
to Firm
Ratio)
= Free Cashflow to Equity
237
Estimating FCFF in 2003: Disney
EBIT=$2,805Million
Taxrate=37.30%
Capitalspending=$1,735Million
Depreciation=$1,254Million
IncreaseinNoncashWorkingcapital=$454Million
EstimatingFCFF
EBIT*(1taxrate)
NetCapitalExpenditures
ChangeinWorkingCapital
FreeCashflowtoFirm
$1,759
$481
$454
$824
:2805(1.373)
:(17351254)
TotalReinvestment=NetCapEx+ChangeinWC=481+454=935
ReinvestmentRate=935/1759=53.18%
238
III. Expected Growth

Net
Operating
Retention
Return
R
X
Income
on Ratio=
Equity
Income
Capital
=
Eeinvestment
xpected
Growth
1 - Dividends/Net
Net
Rate
EBIT(1-t)/Book
Income/Book
= (Net CapValue
Value
of of
Income
Equity
Ex
Capital
+ Chg in
WC/EBIT(1-t)
239
Estimating Growth in EBIT: Disney
Webeginbyestimatingthereinvestmentrateandreturnoncapitalfor
Disney in 2003, using the numbers from the latest financial
statements.Wedidconvertoperatingleasesintodebtandadjustedthe
operatingincomeandcapitalexpenditureaccordingly.
ReinvestmentRate2003=(CapExDepreciation+ChginnoncashWC)/
EBIT(1t)=(17351253+454)/(2805(1.373))=53.18%
Returnoncapital2003 =EBIT(1t)2003/(BVofDebt2002+BVofEquity2002)
=2805(1.373)/(15,883+23,879)=4.42%
ExpectedGrowthRatefromexistingfundamentals= 53.18%*4.42%=
2.35%
WewillassumethatDisneywillbeabletoearnareturnoncapitalof
12% on its new investments and that the reinvestment rate will be
53.18%fortheimmediatefuture.
Expected Growth Rate in operating income = Return on capital *
ReinvestmentRate=12%*.5318=6.38%
240
IV. Getting Closure in Valuation
Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueis
thereforethepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)
Sincewecannotestimatecashflowsforever,weestimatecashflows
foragrowthperiodandthenestimateaterminalvalue,tocapture
thevalueattheendoftheperiod:
CF
t
Value =
t

(1 + r)
241
Stable Growth and Terminal Value
Whenafirmscashflowsgrowataconstantrateforever,the
presentvalueofthosecashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate
Thisconstantgrowthrateiscalledastablegrowthrateandcannot
behigherthanthegrowthrateoftheeconomyinwhichthefirm
operates.
Whilecompaniescanmaintainhighgrowthratesforextendedperiods,
theywillallapproachstablegrowthatsomepointintime.
Whentheydoapproachstablegrowth,thevaluationformulaabove
canbeusedtoestimatetheterminalvalueofallcashflowsbeyond.
242
Growth Patterns
Akeyassumptioninalldiscountedcashflowmodelsistheperiodof
highgrowth,andthepatternofgrowthduringthatperiod.Ingeneral,
wecanmakeoneofthreeassumptions:
thereisnohighgrowth,inwhichcasethefirmisalreadyinstablegrowth
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdroptothestablegrowthrate(2stage)
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdeclinegraduallytoastablegrowthrate(3stage)
Theassumptionofhowlonghighgrowthwillcontinuewilldepend
uponseveralfactorsincluding:
thesizeofthefirm(largerfirm>shorterhighgrowthperiods)
currentgrowthrate(ifhigh>longerhighgrowthperiod)
barrierstoentryanddifferentialadvantages(ifhigh>longergrowth
period)
243
Firm Characteristics as Growth Changes

Variable
Risk
DividendPayout
NetCapEx
ReturnonCapital
Leverage
HighGrowthFirmstendto
beaboveaveragerisk
paylittleornodividends
havehighnetcapex
earnhighROC(excessreturn)
havelittleornodebt
StableGrowthFirmstendto
beaveragerisk
payhighdividends
havelownetcapex
earnROCclosertoWACC
higherleverage
244
Estimating Stable Growth Inputs
Startwiththefundamentals:
Profitabilitymeasuressuchasreturnonequityandcapital,instable
growth,canbeestimatedbylookingat
industryaveragesforthesemeasure,inwhichcaseweassumethatthisfirmin
stablegrowthwilllookliketheaveragefirmintheindustry
costofequityandcapital,inwhichcaseweassumethatthefirmwillstop
earningexcessreturnsonitsprojectsasaresultofcompetition.
Leverageisatoughercall.Whileindustryaveragescanbeusedhereas
well,itdependsuponhowentrenchedcurrentmanagementisandwhether
theyarestubbornabouttheirpolicyonleverage(Iftheyare,usecurrent
leverage;iftheyarenot;useindustryaverages)
Usetherelationshipbetweengrowthandfundamentalstoestimate
payoutandnetcapitalexpenditures.
245
Estimating Stable Period Inputs: Disney
Thebetaforthestockwilldroptoone,reflectingDisneysstatusasamature
company.Thiswilllowerthecostofequityforthefirmto8.82%.
CostofEquity=RiskfreeRate+Beta*RiskPremium=4%+4.82%=8.82%
ThedebtratioforDisneywillriseto30%.Thisistheoptimalwecomputed
for Disney earlier and we are assuming that investor pressure will be the
impetus for this change. Since we assume that the cost of debt remains
unchangedat5.25%,thiswillresultinacostofcapitalof7.16%
Costofcapital=8.82%(.70)+5.25%(1.373)(.30)=7.16%
ThereturnoncapitalforDisneywilldropfromitshighgrowthperiodlevelof
12% to a stable growth return of 10%. This is still higher than the cost of
capitalof7.16%butthecompetitiveadvantagesthatDisneyhasareunlikely
todissipatecompletelybytheendofthe10thyear.Theexpectedgrowthratein
stable growth will be 4%. In conjunction with the return on capital of 10%,
thisyieldsastableperiodreinvestmentrateof40%:
ReinvestmentRate=GrowthRate/ReturnonCapital=4%/10%=40%
246
Disney: Inputs to Valuation
HighGrowthPhase
TransitionPhase
5years
5years
LengthofPeriod
TaxRate
37.3%
ReturnonCapital
12% (lastyearsreturno
StableGrowthPhase
Foreverafter10years
37.3%
37.3%
n Declineslinearlyto10%
StableROCof10%
capitalwas4.42%)
ReinvestmentRate
53.18%
(Last
years Declines to40%asROCan d 40% ofafte rtax operating
(NetCapEx+WorkingCapita l reinvestmentrate)
growthratesdrop:
income, estimatedfromstabl e
Investments/EBIT)
ReinvestmentRate=g/ROC
growth rateof4%and return

oncapitalof10%.
Reinvestmentrate=4/10=40%
ExpectedGrowthRateinEBIT ROC *ReinvestmentRate
= Linear
declinet
Stable 4%:Settoriskfreerate
12%*0.5318=6.38%
GrowthRateof4%
Debt/CapitalRatio
21%(Existingdebtratio)
Increaseslinearlyto30%
RiskParameters
Beta=1.25,ke=10%
Betadecreaseslinearlyto1.00; Beta=1.00;k e=8.82%
CostofDebt=5.25%
Costofdebtstaysat5.25%
Costofdebtstaysat5.25%
Costofcapital=8.59%
Costofcapitaldropsto7.16%
Costofcapital=7.16%
Stabledebtratioof30%
247
Disney: FCFF Estimates
Year
Current
1
2
3
4
5
6
7
8
9
10
Expected
Growth
6.38 %
6.38 %
6.38 %
6.38 %
6.38 %
5.90 %
5.43 %
4.95 %
4.48 %
4.00 %
EBIT
$2,805
$2,984
$3,174
$3,377
$3,592
$3,822
$4,047
$4,267
$4,478
$4,679
$4,866
EBIT (1t)
$1,871
$1,990
$2,117
$2,252
$2,396
$2,538
$2,675
$2,808
$2,934
$3,051
Reinvestment
Rate
Reinvestment
53.18 %
53.18 %
53.18 %
53.18 %
53.18 %
50.54 %
47.91 %
45.27 %
42.64 %
40.00 %
$994.92
$1,058.41
$1,125.94
$1,197.79
$1,274.23
$1,282.59
$1,281.71
$1,271.19
$1,250.78
$1,220.41
FCFF
$876.06
$931.96
$991.43
$1,054.70
$1,122.00
$1,255.13
$1,393.77
$1,536.80
$1,682.90
$1,830.62
248
Disney: Costs of Capital and Present Value
Year
Cost of c apital
FCFF
1
8.59 %
$876.06
2
8.59 %
$931.96
3
8.59 %
$991.43
4
8.59 %
$1,054.70
5
8.59 %
$1,122.00
6
8.31 %
$1,255.13
7
8.02 %
$1,393.77
8
7.73 %
$1,536.80
9
7.45 %
$1,682.90
10
7.16 %
$1,830.62
PV of cashflows during high growth =
PV of FCFF
$806.74
$790.31
$774.21
$758.45
$743.00
$767.42
$788.91
$807.42
$822.90
$835.31
$7,894.66
249
Disney: Terminal Value and Firm Value
TerminalValue
FCFF11=EBIT11(1t)(1ReinvestmentRateStableGrowth)/
=4866(1.04)(1.40)=$1,903.84million
TerminalValue=FCFF11/(CostofcapitalStableGrowthg)
=1903.84/(.0716.04)=$60,219.11million
Valueoffirm
PVofcashflowsduringthehighgrowthphase
=$7,894.66
PVofterminalvalue
=$27,477.81
+CashandMarketableSecurities
=$1,583.00
+NonoperatingAssets(Holdingsinothercompanies)=$1,849.00
Valueofthefirm
=$38,804.48
250
From Firm to Equity Value: What do you

subtract out?
Thefirstthingyouhavetosubtractoutisthedebtthatyoucomputed(and
usedinestimatingthecostofcapital).Ifyouhavecapitalizedoperatingleases,
youshouldcontinuetotreatoperatingleasesasdebtinthisstageinthe
process.
Thisisalsoyourlastchancetoconsiderotherpotentialliabilitiesthatmaybe
facedbythefirmincluding
Expected liabilities on lawsuits: You could be analyzing a firm that is the defendant
in a lawsuit, where it potentially could have to pay tens of millions of dollars in
damages. You should estimate the probability that this will occur and use this
probability to estimate the expected liability.
Unfunded Pension and Health Care Obligations: If a firm has significantly under
funded a pension or a health plan, it will need to set aside cash in future years to
meet these obligations. While it would not be considered debt for cost of capital
purposes, it should be subtracted from firm value to arrive at equity value.
Deferred Tax Liability: The deferred tax liability that shows up on the financial
statements of many firms reflects the fact that firms often use strategies that reduce
their taxes in the current year while increasing their taxes in the future years.
251
From Equity Value to Equity Value per share:

The Effect of Options
Whentherearewarrantsandemployeeoptionsoutstanding,the
estimatedvalueoftheseoptionshastobesubtractedfromthevalueof
theequity,beforewedividebythenumberofsharesoutstanding.
Therearetwoalternativeapproachesthatareusedinpractice:
Oneistodividethevalueofequitybythefullydilutednumberofshares
outstanding rather than by the actual number. This approach will
underestimatethevalueoftheequity,becauseitfailstoconsiderthecash
proceedsfromoptionexercise.
Theothershortcut,whichiscalledthetreasurystockapproach,addsthe
expected proceeds from the exercise of the options (exercise price
multipliedbythenumberofoptionsoutstanding)tothenumeratorbefore
dividing by the number of shares outstanding. While this approach will
yieldamorereasonableestimatethanthefirstone,itdoesnotincludethe
timevalueoftheoptionsoutstanding.
252
Valuing Disneys options
Attheendof2003,Disneyhad219millionoptionsoutstanding,with
aweightedaverageexercisepriceof$26.44andweightedaveragelife
of6years.
Using the current stock price of $26.91, an estimated standard
deviationof40,adividendyieldof1.21%.ariskfreerateof4%and
the BlackScholes option pricing model we arrived at a value of
$2,129million.
Since options expenses are taxdeductible, we used the tax rate of
37.30%toestimatethevalueoftheemployeeoptions:
Valueofemployeeoptions=2129(1.373)=$1334.67million
253
Disney: Value of Equity per Share
Subtracting out the market value of debt (including operating leases)

of$14,668.22millionandthevalueoftheequityoptions(estimatedto
be worth $1,334.67 million in illustration 12.10) yields the value of
thecommonstock:
Value of equity in common stock = Value of firm Debt Equity
Options=$38,804.48 $14,668.22$1334.67=$22,801.59
Dividing by the number of shares outstanding (2047.60 million), we
arriveatavaluepershareo$11.14,wellbelowthemarketpriceof$
26.91atthetimeofthisvaluation.
254
Intransitionphase,
Current
Growthdropsto4%
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
RiskfreeRate
Beta
M
X
UnleveredBetafor
FirmsD/E
ReinvestmentRate
ReturnonCapital
TermYr
Disneywastradingatabout
EBIT(1t)
Cashflows
aturemarket
Assets
ofGrowth
Equity
Debt
Cashflow
Value
atGrowth
35,373
Cost
$1,871
: =
of1,904/(.0716-.04)
to
Capital
$1,990
Firm $2,117
(WACC)
$2,252
==10.00%
60,219
$2,396(.79)
$2,538
+ 3.29%
$2,675 (0.21)
$2,808 =$2,934
8.59 $3,051
10
+
Disney:Valuation
EBIT(1-t)
in
g
(4.00%+1.25%)(1-.373)
E
+Cash:
RiskfreeRate=4%
1.2456
premium
Sectors:1.0674
Ratio:24.77%
53.18%%
12%
3089
$26atthetimeofthis
debtratioincreasesto30%andcost
Reinvestment
10%
==EBIT
4%;
79%(1-t)
Beta
D: = $995
3,432
21%
= 1.00;$1,058
1,759$1,126 $1,198 $1,274 $1,283 $1,282 $1,271 $1,251 $1,220
255
CostFinancing
Current
The
Investment
Return
Reinvestment
Expected
Existing
New
Financing
Investment
Dividend
Investments
of on
capital
EBIT
Growth
Mix
Choices
Capital
decision
(1-t)
Rate
Decision
=Decision
10%
Decision
Rate
affects
(.79)
= Financing
12%
+risk
3.29%
* 53.18%
of assets
(.21)
being
= 8.59%
finance
andFirm
financing
decision affects hurdle rate
Disney:
Corporate
Decisiions
and
Value
$ you
Invest
If
Choose
12%
53.18%
=
Investments
D=21%;
Fxed
1,759
6.38%
rate
cannot
in aE=
projects
US
financing
79%
find
$ that
investments
mix
earn
thata that earn
256
Year
Expected
EBIT
E
BIT
Reinvestment
Growth
(1-t)
Reinvestment
FCFF
Cost
PV
of
Rate
of
cap
FC
Current$5,327
1
7.98%
$5,752
$3,606
53.18%
$1,918
$1,688
8.40%
$1,558
2
7.98%
$6,211
$3,894
53.18%
$2,071
$1,823
8.40%
$1,551
3
7.98%
$6,706
$4,205
53.18%
$2,236
$1,969
8.40%
$1,545
4
7.98%
$7,241
$4,540
53.18%
$2,414
$2,126
8.40%
$1,539
5
7.98%
$7,819
$4,902
53.18%
$2,607
$2,295
8.40%
$1,533
6
7.18%
$8,380
$5,254
50.54%
$2,656
$2,599
8.16%
$1,605
7
6.39%
$8,915
$5,590
47.91%
$2,678
$2,912
7.91%
$1,667
8
5.59%
$9,414
$5,902
45.27%
$2,672
$3,230
7.66%
$1,717
9
4.80%
$9,865
$6,185
42.64%
$2,637
$3,548
7.41%
$1,756
104.00%
$10,260
$6,433
40.00%
$2,573
$3,860
7.16%
$1,783
Terminal Value
$126,967
$58,64
Value
of
$74,90
Oper
+
Cash
$3,432
&
No
Value
of
$78,33
firm
Debt
$14,64
Options
$1,335
Value
of
$62,34
equit
Value per
sha
$30.45
257
First Principles
cashtostockholders.
258

Intro To Corporate Finance

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Intro To Corporate Finance

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Applied Corporate Finance

What is corporate finance?

The Traditional Accounting Balance Sheet

The Financial View of the Firm

Tale of two companies

The Objective in Decision Making

The Classical Objective Function

What can go wrong?

Whos on Board? The Disney Experience 1997

Application Test: Who owns/runs your firm?

Disneys top stockholders in 2003

When traditional corporate financial theory

An Alternative Corporate Governance System

Choose a Different Objective Function

Maximize Stock Price, subject to ..

The Stockholder Backlash

In response, boards are becoming more

Disneys Board in 2003

The Counter Reaction

Picking the Right Projects:

The notion of a benchmark

Risk and Return Models in Finance

Who are Disneys marginal investors?

Limitations of the CAPM

Why the CAPM persists

Application Test: Who is the marginal investor

Inputs required to use the CAPM

The Riskfree Rate and Time Horizon

Riskfree Rate in Practice

The Bottom Line on Riskfree Rates

Measurement of the risk premium

What is your risk premium?

Risk Aversion and Risk Premiums

Risk Premiums do change..

Estimating Risk Premiums in Practice

The Survey Approach

The Historical Premium Approach

Historical Average Premiums for the United

What about historical premiums for other

One solution: Look at a countrys bond rating

Beyond the default spread

Implied Equity Premiums

Implied Premiums in the US

Application Test: A Market Risk Premium

Firm Specific and Market Risk

Setting up for the Estimation

Choosing the Parameters: Disney

Disneys Historical Beta

The Regression Output

Analyzing Disneys Performance

A positive Jensens alpha Who is

Estimating Disneys Beta

The Dirty Secret of Standard Error

Standard Error in Beta Estimate

Breaking down Disneys Risk

The Relevance of R Squared

Beta Estimation: Using a Service (Bloomberg)

Estimating Expected Returns for Disney in

Use to a Potential Investor in Disney

How managers use this expected return

Application Test: Analyzing the Risk

Beta: Exploring Fundamentals

Determinant 1: Product Type