Finding the Right Financing Mix: The

Capital Structure Decision

AswathDamodaran

SternSchoolofBusiness

Aswath Damodaran 1
 First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.
Chooseafinancingmixthatminimizesthehurdlerateand
matchestheassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.
Objective:MaximizetheValueoftheFirm

Aswath Damodaran 2
 The Choices in Financing

Thereareonlytwowaysinwhichabusinesscanmakemoney.
Thefirstisdebt.Theessenceofdebtisthatyoupromisetomakefixed
paymentsinthefuture(interestpaymentsandrepayingprincipal).Ifyou
failtomakethosepayments,youlosecontrolofyourbusiness.
Theotherisequity.Withequity,youdogetwhatevercashflowsareleft
overafteryouhavemadedebtpayments.

Aswath Damodaran 3
 Debt versus Equity

DebtversusEquity

FixedClaim ResidualClaim
HighPriorityoncashflows LowestPriorityoncashflows
TaxDeductible NotTaxDeductible
FixedMaturity Infinitelife
NoManagementControl ManagementControl

Debt Hybrids(Combinations Equity

ofdebtandequity)

Aswath Damodaran 4
 The Choices

Equitycantakedifferentforms:
Forverysmallbusinesses:itcanbeownersinvestingtheirsavings
Forslightlylargerbusinesses:itcanbeventurecapital
Forpubliclytradedfirms:itiscommonstock
Debtcanalsotakedifferentforms
Forprivatebusinesses:itisusuallybankloans
Forpubliclytradedfirms:itcantaketheformofbonds

Aswath Damodaran 5
 A Life Cycle View of Financing Choices

Revenues
$Revenues/
Earnings

Earnings

Time

Externalfunding High,but High,relative Moderate,relative Declining,asa

needs Low,asprojectsdry
constrainedby tofirmvalue. tofirmvalue. percentoffirm
up.
infrastructure value

Internalfinancing Negativeor Negativeor Low,relativeto High,relativeto Morethanfundingneeds

low low fundingneeds fundingneeds

External OwnersEquity VentureCapital Commonstock Debt Retiredebt

Financing BankDebt CommonStock Warrants Repurchasestock
Convertibles

Growthstage Stage1 Stage2 Stage3 Stage4 Stage5

Startup RapidExpansion HighGrowth MatureGrowth Decline

Financing
Transitions Accessingprivateequity InitalPublicoffering Seasonedequityissue Bondissues

Aswath Damodaran 6
 The Financing Mix Question

Indecidingtoraisefinancingforabusiness,isthereanoptimalmixof
debtandequity?
Ifyes,whatisthetradeoffthatletsusdeterminethisoptimalmix?
Ifnot,whynot?

Aswath Damodaran 7
 Measuring a firms financing mix

Thesimplestmeasureofhowmuchdebtandequityafirmisusing
currentlyistolookattheproportionofdebtinthetotalfinancing.
Thisratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswellaslong
term.
Equitycanbedefinedeitherinaccountingterms(asbookvalueof
equity)orinmarketvalueterms(baseduponthecurrentprice).The
resultingdebtratioscanbeverydifferent.

Aswath Damodaran 8
 Costs and Benefits of Debt

BenefitsofDebt
TaxBenefits
Addsdisciplinetomanagement
CostsofDebt
BankruptcyCosts
AgencyCosts
LossofFutureFlexibility

Aswath Damodaran 9
 Tax Benefits of Debt

Whenyouborrowmoney,youareallowedtodeductinterestexpenses
fromyourincometoarriveattaxableincome.Thisreducesyour
taxes.Whenyouuseequity,youarenotallowedtodeductpayments
toequity(suchasdividends)toarriveattaxableincome.
Thedollartaxbenefitfromtheinterestpaymentinanyyearisa
functionofyourtaxrateandtheinterestpayment:
Taxbenefiteachyear=TaxRate*InterestPayment

Proposition1:Otherthingsbeingequal,thehigherthemarginaltax
rateofabusiness,themoredebtitwillhaveinitscapitalstructure.

Aswath Damodaran 10
 The Effects of Taxes

Youarecomparingthedebtratiosofrealestatecorporations,whichpay
thecorporatetaxrate,andrealestateinvestmenttrusts,whicharenot
taxed, but are required to pay 95% of their earnings as dividends to
their stockholders. Which of these two groups would you expect to
havethehigherdebtratios?
Therealestatecorporations
Therealestateinvestmenttrusts
Cannottell,withoutmoreinformation

Aswath Damodaran 11
 Implications of The Tax Benefit of Debt

Thedebtratiosoffirmswithhighertaxratesshouldbehigherthanthe
debt ratios of comparable firms with lower tax rates. In supporting
evidence,
Firmsthathavesubstantialnondebttaxshields,suchasdepreciation,
shouldbelesslikelytousedebtthanfirmsthatdonothavethesetax
shields.
Iftaxratesincreaseovertime,wewouldexpectdebtratiostogoup
overtimeaswell,reflectingthehighertaxbenefitsofdebt.
Althoughitisalwaysdifficulttocomparedebtratiosacrosscountries,
wewouldexpectdebtratiosincountrieswheredebthasamuchlarger
taxbenefittobehigherthandebtratiosincountrieswhosedebthasa
lowertaxbenefit.

Aswath Damodaran 12
 Debt adds discipline to management

Ifyouaremanagersofafirmwithnodebt,andyougeneratehigh
incomeandcashflowseachyear,youtendtobecomecomplacent.
Thecomplacencycanleadtoinefficiencyandinvestinginpoor
projects.Thereislittleornocostbornebythemanagers
Forcingsuchafirmtoborrowmoneycanbeanantidotetothe
complacency.Themanagersnowhavetoensurethattheinvestments
theymakewillearnatleastenoughreturntocovertheinterest
expenses.Thecostofnotdoingsoisbankruptcyandthelossofsucha
job.

Aswath Damodaran 13
 Debt and Discipline

Assume that you buy into this argument that debt adds discipline to
management. Which of the following types of companies will most
benefitfromdebtaddingthisdiscipline?
Conservativelyfinanced(verylittledebt),privatelyownedbusinesses
Conservativelyfinanced,publiclytradedcompanies,withstocksheld
by millions of investors, none of whom hold a large percent of the
stock.
Conservatively financed, publicly traded companies, with an activist
andprimarilyinstitutionalholding.

Aswath Damodaran 14
 Empirical Evidence on the Discipline of Debt

Firmsthatareacquiredinhostiletakeoversaregenerallycharacterized
by poor performance in both accounting profitability and stock
returns.
There is evidence that increases in leverage are followed by
improvements in operating efficiency, as measured by operating
marginsandreturnsoncapital.
Palepu (1990) presents evidence of modest improvements in operating
efficiencyatfirmsinvolvedinleveragedbuyouts.
Kaplan(1989)andSmith(1990)alsofindthatfirmsearnhigherreturnson
capitalfollowingleveragedbuyouts.
Denis and Denis (1993) study leveraged recapitalizations and report a
medianincreaseinthereturnonassetsof21.5%.

Aswath Damodaran 15
 Bankruptcy Cost

Theexpectedbankruptcycostisafunctionoftwovariables
thecostofgoingbankrupt
directcosts:LegalandotherDeadweightCosts
indirectcosts:Costsarisingbecausepeopleperceiveyoutobeinfinancial
trouble
theprobabilityofbankruptcy,whichwilldependuponhowuncertainyou
areaboutfuturecashflows
Asyouborrowmore,youincreasetheprobabilityofbankruptcyand
hencetheexpectedbankruptcycost.

Aswath Damodaran 16
 Indirect Bankruptcy Costs should be highest
for.

Firms that sell durable products with long lives that require
replacementpartsandservice
Firmsthatprovidegoodsorservicesforwhichqualityisanimportant
attributebutwherequalitydifficulttodetermineinadvance
Firms producing products whose value to customers depends on the
services and complementary products supplied by independent
companies:
Firmsthatsellproductsrequiringcontinuousserviceandsupportfrom
themanufacturer

Aswath Damodaran 17
 The Bankruptcy Cost Proposition

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

Aswath Damodaran 18
 Debt & Bankruptcy Cost

Rank the following companies on the magnitude of bankruptcy costs

frommosttoleast,takingintoaccountbothexplicitandimplicitcosts:
AGroceryStore
AnAirplaneManufacturer
HighTechnologycompany

Aswath Damodaran 19
 Implications of Bankruptcy Cost Proposition

Firmsoperatinginbusinesseswithvolatileearningsandcashflows
shouldusedebtlessthanotherwisesimilarfirmswithstablecash
flows.
Iffirmscanstructuretheirdebtinsuchawaythatthecashflowson
thedebtincreaseanddecreasewiththeiroperatingcashflows,they
canaffordtoborrowmore.
Ifanexternalentity,suchasthegovernmentoranagencyofthe
government,providesprotectionagainstbankruptcythrougheither
insuranceorbailoutsfortroubledfirms,firmswilltendtoborrow
more.
Firmswithassetsthatcanbeeasilydividedandsoldshouldborrow
morethanfirmswithassetsthatarelessliquid.

Aswath Damodaran 20
 Agency Cost

Anagencycostariseswheneveryouhiresomeoneelsetodosomethingfor
you.Itarisesbecauseyourinterests(astheprincipal)maydeviatefromthose
ofthepersonyouhired(astheagent).
Whenyoulendmoneytoabusiness,youareallowingthestockholderstouse
thatmoneyinthecourseofrunningthatbusiness.Stockholdersinterestsare
differentfromyourinterests,because
You(aslender)areinterestedingettingyourmoneyback
Stockholdersareinterestedinmaximizingyourwealth
Insomecases,theclashofinterestscanleadtostockholders
Investinginriskierprojectsthanyouwouldwantthemto
Payingthemselveslargedividendswhenyouwouldratherhavethemkeepthe
cashinthebusiness.
Proposition3:Otherthingsbeingequal,thegreatertheagencyproblems
associatedwithlendingtoafirm,thelessdebtthefirmcanaffordtouse.

Aswath Damodaran 21
 Debt and Agency Costs

Assume that you are a bank. Which of the following businesses would you

perceivethegreatestagencycosts?
ALargePharmaceuticalcompany
ALargeRegulatedElectricUtility

Why?

Aswath Damodaran 22
 How agency costs show up...

If bondholders believe there is a significant chance that stockholder

actions might make them worse off, they can build this expectation
intobondpricesbydemandingmuchhigherratesondebt.
Ifbondholderscanprotectthemselvesagainstsuchactionsbywriting
inrestrictivecovenants,twocostsfollow
the direct cost of monitoring the covenants, which increases as the
covenantsbecomemoredetailedandrestrictive.
the indirect cost of lost investments, since the firm is not able to take
certainprojects,usecertaintypesoffinancing,orchangeitspayout;this
costwillalsoincreaseasthecovenantsbecomesmorerestrictive.

Aswath Damodaran 23
 Implications of Agency Costs..

Theagencycostarisingfromriskshiftingislikelytobegreatestin
firmswhoseinvestmentscannotbeeasilyobservedandmonitored.
Thesefirmsshouldborrowlessthanfirmswhoseassetscanbeeasily
observedandmonitored.
Theagencycostassociatedwithmonitoringactionsandsecond
guessinginvestmentdecisionsislikelytobelargestforfirmswhose
projectsarelongterm,followunpredictablepaths,andmaytakeyears
tocometofruition.Thesefirmsshouldalsoborrowless.

Aswath Damodaran 24
 Loss of future financing flexibility

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

Aswath Damodaran 25
 What managers consider important in deciding
on how much debt to carry...

AsurveyofChiefFinancialOfficersoflargeU.S.companiesprovided
thefollowingranking(frommostimportanttoleastimportant)forthe
factorsthattheyconsideredimportantinthefinancingdecisions
Factor Ranking(05)
1.Maintainfinancialflexibility 4.55
2.Ensurelongtermsurvival 4.55
3.MaintainPredictableSourceofFunds 4.05
4.MaximizeStockPrice 3.99
5.Maintainfinancialindependence 3.88
6.Maintainhighdebtrating 3.56
7.Maintaincomparabilitywithpeergroup 2.47

Aswath Damodaran 26
 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

Aswath Damodaran 27
 A Qualitative Analysis

Item Boeing TheHomeDepot InfoSoft

TaxBenefits Significant.Thefirmhasa Significant.Thefirmhasa Significant.Theownersof
marginaltaxrateof35%. marginaltaxrateof35%, InfoSoftfacea42%tax
Itdoeshavelarge aswell.Itdoesnothave rate.Byborrowing
depreciationtaxshields. verymuchinnoninterest money,theincomethat
taxshields. flowsthroughtothe
investorcanbereduced.
AddedDiscipline Benefitswillbehigh, Benefitsaresmaller,since Benefitsarenonexistent.
sincemanagersarenot theCEOisafounderand Thisisaprivatefirm.
largestockholders. largestockholder.
BankruptcyCost Directcostsarelikelyto Directcostsarelikelyto Costsmaybesmallbut
besmall,butindirectcosts besmall.Assetsare theownerhasallofhis
canbesubstantial.. mostlyrealestate.Indirect wealthinvestedinthe
costswillalsobesmall. firm.
AgencyCosts Low.Assetsaregenerally Low.Assetsarestoresand High.Assetsare
tangibleandmonitoring realestate,tangibleand intangibleanddifficultto
shouldbefeasible. marketable. bothmonitorandto
liquidate.
FlexibilityNeeds Low.Firmhasalong Lowinexistingbusiness, High.Firmmighthaveto
gestationperiodfor buthigh,givenitsplansto changeitsproductand
projects,andknowshow growoverseasandonline. businessmix,onshort
muchitneedstoinvestin Expansionandacquisition notice,astechnology
advance. needscreateneed. changes

Aswath Damodaran 28
 Application Test: Would you expect your firm to
gain or lose from using a lot of debt?

Considering,foryourfirm,
Thepotentialtaxbenefitsofborrowing
Thebenefitsofusingdebtasadisciplinarymechanism
Thepotentialforexpectedbankruptcycosts
Thepotentialforagencycosts
Theneedforfinancialflexibility
Wouldyouexpectyourfirmtohaveahighdebtratiooralowdebt
ratio?
Doesthefirmscurrentdebtratiomeetyourexpectations?

Aswath Damodaran 29
 A Hypothetical Scenario

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

Aswath Damodaran 30
 The Miller-Modigliani Theorem

Inanenvironment,wheretherearenotaxes,defaultriskoragency
costs,capitalstructureisirrelevant.
Thevalueofafirmisindependentofitsdebtratio.

Aswath Damodaran 31
 Implications of MM Theorem

(a)Leverageisirrelevant.Afirm'svaluewillbedeterminedbyitsproject
cashflows.
(b)Thecostofcapitalofthefirmwillnotchangewithleverage.Asa
firmincreasesitsleverage,thecostofequitywillincreasejustenough
tooffsetanygainstotheleverage.

Aswath Damodaran 32
 Can debt be irrelevant in a world with taxes?

Inthepresenceofpersonaltaxesonbothinterestincomeandincome
fromequity,itcanbearguedthatdebtcouldstillbeirrelevantifthe
cumulativetaxespaid(bythefirmandinvestors)ondebtandequity
arethesame.
Thus,iftdisthepersonaltaxrateoninterestincomereceivedby
investors,teisthepersonaltaxrateonincomeonequityandtcisthe
corporatetaxrate,debtwillbeirrelevantif:
(1td)=(1tc)(1te)

Aswath Damodaran 33
 Is there an optimal capital structure? The
Empirical Evidence

Theempiricalevidenceonwhetherleverageaffectsvalueismixed.
Bradley,Jarrell,andKim(1984)notethatthedebtratioislowerforfirms
withmorevolatileoperatingincomeandforfirmswithsubstantialR&D
andadvertisingexpenses.
Barclay,SmithandWatts (1995)lookedat6780companiesbetween1963
and1993andconcludethatthemostimportantdeterminantofafirm'sdebt
ratio is its' investment opportunities. Firms with better investment
opportunities(asmeasuredbyahighpricetobookratio)tendtohavemuch
lowerdebtratiosthanfirmswithlowpricetobookratios.
Smith(1986) notes that leverageincreasing actions seem to be
accompaniedbypositiveexcessreturnswhileleveragereducingactions
seemtobefollowedbynegativereturns.Thisisnotconsistentwiththe
theory that there is an optimal capital structure, unless we assume that
firmstendtobeunderlevered.

Aswath Damodaran 34
 How do firms set their financing mixes?

LifeCycle:Somefirmschooseafinancingmixthatreflectswhere
theyareinthelifecycle;startupfirmsusemoreequity,andmature
firmsusemoredebt.
Comparablefirms:Manyfirmsseemtochooseadebtratiothatis
similartothatusedbycomparablefirmsinthesamebusiness.
FinancingHeirarchy:Firmsalsoseemtohavestrongpreferenceson
thetypeoffinancingused,withretainedearningsbeingthemost
preferredchoice.Theyseemtoworkdownthepreferencelist,rather
thanpickingafinancingmixdirectly.

Aswath Damodaran 35
 The Debt Equity Trade Off Across the Life
Cycle
Stage1 Stage2 Stage3 Stage4 Stage5
Startup RapidExpansion HighGrowth MatureGrowth Decline

Revenues
$Revenues/
Earnings

Earnings

Time

Zero,if Low,asearnings Increase,with High High,but

TaxBenefits losingmoney arelimited earnings declining

AddedDisceipline Low,asowners Low.Evenif Increasing,as High.Managersare Declining,asfirm

ofDebt runthefirm public,firmis managersownless separatedfrom doesnottakemany
closelyheld. offirm owners newinvestments

BamkruptcyCost Veryhigh.Firmhas Veryhigh. High.Earningsare Declining,asearnings Low,butincreasesas

noornegative Earningsarelow increasingbutstill fromexistingassets existingprojectsend.
earnings. andvolatile volatile increase.

Veryhigh,asfirm High.New High.Lotsofnew Declining,asassets

AgencyCosts hasalmostno investmentsare investmentsand inplacebecomea Low.Firmtakesfew
assets difficulttomonitor unstablerisk. largerportionoffirm. newinvestments

Veryhigh,asfirm High.Expansion High.Expansion Low.Firmhaslow Nonexistent.Firmhasno

NeedforFlexibility looksforwaysto needsarelargeand needsremain andmorepredictable newinvestmentneeds.
establishitself unpredicatble unpredictable investmentneeds.

Costsexceedbenefits Costsstilllikely Debtstartsyielding Debtbecomesamore Debtwillprovide

NetTradeOff Minimaldebt toexceedbenefits. netbenefitstothe attractiveoption. benefits.
Mostlyequity firm

Aswath Damodaran 36
 Comparable Firms

Whenwelookatthedeterminantsofthedebtratiosofindividual
firms,thestrongestdeterminantistheaveragedebtratioofthe
industriestowhichthesefirmsbelong.
Thisisnotinconsistentwiththeexistenceofanoptimalcapital
structure.Iffirmswithinabusinesssharecommoncharacteristics
(hightaxrates,volatileearningsetc.),youwouldexpectthemtohave
similarfinancingmixes.
Thisapproachcanleadtosuboptimalleverage,iffirmswithina
businessdonotsharecommoncharacteristics.

Aswath Damodaran 37
 Rationale for Financing Hierarchy

Managersvalueflexibility.Externalfinancingreducesflexibilitymore
thaninternalfinancing.
Managersvaluecontrol.Issuingnewequityweakenscontrolandnew
debtcreatesbondcovenants.

Aswath Damodaran 38
 Preference rankings : Results of a survey

Ranking Source Score

1 RetainedEarnings 5.61
2 StraightDebt 4.88
3 ConvertibleDebt 3.02
4 ExternalCommonEquity 2.42
5 StraightPreferredStock 2.22
6 ConvertiblePreferred 1.72

Aswath Damodaran 39
 Financing Choices

YouarereadingtheWallStreetJournalandnoticeatombstoneadfora
company,offeringtosellconvertiblepreferredstock.Whatwouldyou
hypothesizeaboutthehealthofthecompanyissuingthesesecurities?
Nothing
Healthierthantheaveragefirm
Inmuchmorefinancialtroublethantheaveragefirm

Aswath Damodaran 40
 The Search for an Optimal Financing Mix:
Approaches

TheOperatingIncomeApproach:Inthisapproach,theoptimaldebt
forafirmischosentoensurethattheprobabilitythatthefirmwill
defaultdoesnotexceedamanagementspecifiedlimit.
TheCostofCapitalApproach:Inthisapproach,theoptimaldebtratio
ischosentominimizecostofcapital,ifoperatingcashflowsare
unaffectedbyfinancingmix,ortomaximizefirmvalue.
TheAdjustedPresentValueApproach:Inthisapproach,theeffectof
addingdebttofirmvalueisevaluatedbymeasuringboththetaxbenefits
andthebankruptcycosts.
TheReturnDifferentialApproach:Inthisapproach,thedebtratiois
chosentomaximizethedifferencebetweenROEandcostofequity.
ComparablesApproach:Thedebtratioischosenbylookingathow
comparablefirmsarefunded.

Aswath Damodaran 41
 I. The Operating Income Approach

Assess the firms capacity to generate operating income based upon past
history. The result is a distribution for expected operating income, with
probabilitiesattachedtodifferentlevelsofincome.
For any given level of debt, we estimate the interest and principal payments
thathavetobemadeovertime.
Given the probability distribution of operating cash flows, we estimate the
probabilitythatthefirmwillbeunabletomakedebtpayments.
Wesetalimitontheprobability ofitsbeingunable tomeetdebtpayments.
Clearly, the more conservative the management of the firm, the lower this
probabilityconstraintwillbe.
Wecomparetheestimatedprobabilityofdefaultatagivenlevelofdebttothe
probability constraint. If the probability of default is higher than the
constraint, the firm chooses a lower level of debt; if it is lower than the
constraint,thefirmchoosesahigherlevelofdebt.

Aswath Damodaran 42
 Boeing: Assessing the Probability Distribution

Figure 16.1: Boeing: Operating Income Changes - 1980-98

4.5

3.5

2.5

1.5

0.5

0
<-30% -10% to -30% + 10% to - 10% 10 to 30% 30-50% >50%
% Change in Year

Aswath Damodaran 43
 Estimating Debt Payments

We estimate the interest and principal payments on a proposed bond

issueof$5billionbyassumingthatthedebtwillberatedA,lowerthan
Boeings current bond rating of AA. Based upon this rating, we
estimatedaninterestrateof6%onthedebt.Inaddition,weassumethat
thesinkingfundpaymentsetasidetorepaythebondsis5%ofthebond
issue.Thisresultsinanannualdebtpaymentof$550million.
AdditionalDebtPayment=InterestExpense +SinkingFundPayment
=0.06*5,000 +.05*5,000 =$550million
The total debt payment then can be computed by adding the interest
paymentonexistingdebtin1998$453milliontotheadditional
debtpaymentcreatedbytakingon$5billioninadditionaldebt.
TotalDebtPayment=InterestonExistingDebt+AdditionalDebtPayment
=$453million+$550million=$1,003million

Aswath Damodaran 44
 Estimating Probability of Default

We can now estimatethe probability of default from the distribution

of operating income by assuming that the percentage changes in
operating income are normally distributed and by considering the
earnings before interest, taxes, depreciation and amortization
(EBITDA)of$3,237millionthatBoeingearnedin1998asthebase
yearincome.
Tstatistic=(CurrentEBITDADebtPayment)/OI(CurrentOperating
Income)
=($3,237$1,003million)/(.3583*$3237)=1.93
Baseduponthiststatistic,theprobabilityofdefault<3%.

Aswath Damodaran 45
 Management Constraints and Maximum Debt
Capacity

AssumethatthemanagementatBoeingsetaconstraintthattheprobability
ofdefaultbenogreaterthan5%.
If the distribution of operating income changes is normal, we can estimate
the level of debt payments Boeing can afford to make for a probability of
defaultof5%.
Tstatisticfor5%probabilitylevel=1.645
($3,237X)/(.3583*$3,237)=1.645
BreakEvenDebtPayment=$1,329million
Ifweassumethattheinterestrateremainsunchangedat6%andthesinking
fundwillremainat5%oftheoutstandingdebt,thisyieldsanoptimaldebt
levelof$12,082million.
OptimalDebt=BreakEvenDebtPayment/(InterestRate+SinkingFundRate)
=$1,329/(.06+.05)=$12,082million

Aswath Damodaran 46
 II. The Cost of Capital Approach

Itwilldependupon:
(a)thecomponentsoffinancing:Debt,EquityorPreferredstock
(b)thecostofeachcomponent
Insummary,thecostofcapitalisthecostofeachcomponent
weightedbyitsrelativemarketvalue.
WACC=ke(E/(D+E))+kd(D/(D+E))

Aswath Damodaran 47
 Recapping the Measurement of cost of capital

Thecostofdebtisthemarketinterestratethatthefirmhastopayon
itsborrowing.Itwilldependuponthreecomponents
(a)Thegenerallevelofinterestrates
(b)Thedefaultpremium
(c)Thefirm'staxrate
Thecostofequityis
1.therequiredrateofreturngiventherisk
2.inclusiveofbothdividendyieldandpriceappreciation
Theweightsattachedtodebtandequityhavetobemarketvalue
weights,notbookvalueweights.

Aswath Damodaran 48
 Costs of Debt & Equity

A recent article in an Asian business magazine argued that equity was

cheaper than debt, because dividend yields are much lower than
interestratesondebt.Doyouagreewiththisstatement
Yes
No
Canequityeverbecheaperthandebt?
Yes
No

Aswath Damodaran 49
 Issue: Use of Book Value

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

Aswath Damodaran 50
 Why does the cost of capital matter?

ValueofaFirm=PresentValueofCashFlowstotheFirm,
discountedbackatthecostofcapital.
Ifthecashflowstothefirmareheldconstant,andthecostofcapitalis
minimized,thevalueofthefirmwillbemaximized.

Aswath Damodaran 51
 Firm Value, Cost of Capital and Debt Ratios: A
Simple Example

StrunksInc.,aleadingmanufacturerofchocolatesandothercandies,
hascashflowstothefirmof$200million.
Strunksisinarelativelystablemarket,andthesecashflowsare
expectedtogrowat6%forever,andtobeunaffectedbythedebtratio
ofthefirm.
Thevalueofthefirmatanycostofcapitalcanbewrittenas:
FirmValue=Cashflowtothefirm(1+g)/(Costofcapitalg)
=200(1.06)/(Costofcapital.06)

Aswath Damodaran 52
 Cost of Capital and Firm Value

D/(D+E) CostofEquity CostofDebt WACC FirmValue

0 10.50% 4.80% 10.50% $4,711
10% 11.00% 5.10% 10.41% $4,807
20% 11.60% 5.40% 10.36% $4,862
30% 12.30% 5.52% 10.27% $4,970
40% 13.10% 5.70% 10.14% $5,121
50% 14.00% 6.30% 10.15% $5,108
60% 15.00% 7.20% 10.32% $4,907
70% 16.10% 8.10% 10.50% $4,711
80% 17.20% 9.00% 10.64% $4,569
90% 18.40% 10.20% 11.02% $4,223
100% 19.70% 11.40% 11.40% $3,926

Aswath Damodaran 53
 A Pictorial View

Figure19.2:CostofCapitalandFirmValue

11.60% $6,000

11.40%

11.20% $5,000

11.00%

$4,000
10.80%

10.60%
WACC
$3,000
FirmValue
10.40%

10.20%
$2,000

10.00%

9.80%
$1,000

9.60%

9.40% $0
0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
DebtRatio

Aswath Damodaran 54
 Current Cost of Capital: Boeing

ThebetaforBoeing'sstockinMarch1999was1.01.Thetreasurybond
rateatthattimewas5%.Usinganestimatedmarketriskpremiumof
5.5%,weestimatedthecostofequityforBoeingtobe10.58%:
CostofEquity=Riskfreerate+Beta*(MarketPremium)
=5.00%+1.01(5.5%)=10.58%
Boeing'sseniordebtwasratedAA;,theestimatedpretaxcostofdebt
forBoeingis5.50%.Thetaxrateusedfortheanalysisis35%.
AftertaxCostofdebt =Pretaxinterestrate(1taxrate)
=5.50%(10.35)=3.58%
CostofCapital=CostofEquity(Equity/(Equity+Debt))+Aftertax
CostofDebt(Debt/(Debt+Equity))
=10.58%[32,595/(32595+8194)]+3.58%[8,194/(32595+8194)]=9.17%

Aswath Damodaran 55
 Mechanics of Cost of Capital Estimation

1.EstimatetheCostofEquityatdifferentlevelsofdebt:
Equitywillbecomeriskier>Betawillincrease>CostofEquitywill
increase.
Estimationwilluseleveredbetacalculation
2.EstimatetheCostofDebtatdifferentlevelsofdebt:
Defaultriskwillgoupandbondratingswillgodownasdebtgoesup>
CostofDebtwillincrease.
Toestimatingbondratings,wewillusetheinterestcoverageratio
(EBIT/Interestexpense)
3.EstimatetheCostofCapitalatdifferentlevelsofdebt
4.CalculatetheeffectonFirmValueandStockPrice.

Aswath Damodaran 56
 Ratings and Financial Ratios

AAA AA A BBB BB B CCC

EBITinterestcov.(x) 12.9 9.2 7.2 4.1 2.5 1.2 (0.9)
EBITDAinterestcov. 18.7 14.0 10.0 6.3 3.9 2.3 0.2
Fundsflow/totaldebt 89.7 67.0 49.5 32.2 20.1 10.5 7.4
Freeoper.cash 40.5 21.6 17.4 6.3 1.0 (4.0) (25.4)
flow/totaldebt(%)
Returnoncapital(%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8)
Oper.income/sales 30.9 25.2 17.9 15.8 14.4 11.2 5.0
(%)
Longterm 21.4 29.3 33.3 40.8 55.3 68.8 71.5
debt/capital(%)

Aswath Damodaran 57
 Synthetic Ratings

Thesyntheticratingforafirmcanbeestimatedby
Usingoneofthefinancialratiosspecifiedabove
Usingascorebaseduponallofthefinancialratiosspecifiedabove
Ifyouuseonlyonefinancialratio,youwanttopicktheratiothathas
thegreatestpowerinexplainingdifferencesinratings.
Formanufacturingfirms,thisistheinterestcoverageratio.
Ifyouwanttousemultipleratios,youhavetodeterminehowyouwill
weighteachratioincomingupwithascore.
Oneapproachusedisamultiplediscriminantanalysis,wheretheweights
arebaseduponhowwelltheratiospredictultimatedefault.(AltmanZ
scoreisoneexample).

Aswath Damodaran 58
 Process of Ratings and Rate Estimation

Weusethemedianinterestcoverageratiosforlargemanufacturing
firmstodevelopinterestcoverageratiorangesforeachratingclass.
Wethenestimateaspreadoverthelongtermbondrateforeach
ratingsclass,baseduponyieldsatwhichthesebondstradeinthe
marketplace.(Weusedasamplingof5corporatebondswithineach
ratingsclasstomaketheseestimates)

Aswath Damodaran 59
 Interest Coverage Ratios and Bond Ratings

IfInterestCoverageRatiois EstimatedBondRating
>8.50 AAA
6.508.50 AA
5.506.50 A+
4.255.50 A
3.004.25 A
2.503.00 BBB
2.002.50 BB
1.752.00 B+
1.501.75 B
1.251.50 B
0.801.25 CCC
0.650.80 CC
0.200.65 C
<0.20 D

Aswath Damodaran 60
 Spreads over long bond rate for ratings
classes: February 1999

Rating Spread InterestRateonDebt

AAA 0.20% 5.20%
AA 0.50% 5.50%
A+ 0.80% 5.80%
A 1.00% 6.00%
A 1.25% 6.25%
BBB 1.50% 6.50%
BB 2.00% 7.00%
B+ 2.50% 7.50%
B 3.25% 8.25%
B 4.25% 9.25%
CCC 5.00% 10.00%
CC 6.00% 11.00%
C 7.50% 12.50%
D 10.00% 15.00%

Aswath Damodaran 61
 Current Income Statement for Boeing: 1998

Sales&OtherOperatingRevenues $56,154.00
OperatingCosts&Expenses $52,917.00
EBITDA $3,237.00
Depreciation $1,517.00
EBIT $1,720.00
+ExtraordinaryIncome $130.00
EBITwithextraordinaryincome $1,850.00
InterestExpenses $453.00
EarningsbeforeTaxes $1,397.00
IncomeTaxes $277.00
NetEarnings(Loss) $1,120.00
AdjustedOperatingIncome(forleases)=$1,720million+Imputedinterest
expenseonoperatingleasedebt=$1,720+$31=$1,751million

Aswath Damodaran 62
 Estimating Cost of Equity

Toestimatethecostofequityateachdebtratio,wefirstestimatethe
leveredbetaateachdebtratio:
levered=unlevered[1+(1taxrate)(Debt/Equity)]
Theleveredbetaisusedinconjunctionwiththeriskfreerateandrisk
premiumtoestimateacostofequityateachdebtratio:
CostofEquity=Riskfreerate+Beta*RiskPremium

Aswath Damodaran 63
 Estimating Cost of Equity: Boeing at Different
Debt Ratios

UnleveredBeta=0.87(BottomupBeta,baseduponcomparablefirms)
Marketpremium=5.5% TreasuryBondrate=5.00% t=35%
DebtRatio Beta CostofEquity
0% 0.87 9.79%
10% 0.93 10.14%
20% 1.01 10.57%
30% 1.11 11.13%
40% 1.25 11.87%
50% 1.51 13.28%
60% 1.92 15.54%
70% 2.56 19.06%
80% 3.83 26.09%
90% 7.67 47.18%

Aswath Damodaran 64
 Estimating Cost of Debt

FirmValue=Marketvalueofdebt+MarketvalueofEquity= 32,595+8,194
D/(D+E) 0.00% 10.00% SecondIteration
D/E 0.00% 11.11%
$Debt $0 $4,079 $4,079

EBITDA $3,268 $3,268 $3,268

Depreciation $1,517 $1,517 $1,517
EBIT $1,751 $1,751 $1,751
InterestExpense $0 $212 $224
PretaxInt.cov 8.26 7.80
LikelyRating AAA AA AA
InterestRate 5.20% 5.50% 5.50%
Eff.TaxRate 35.00% 35.00% 35.00%
CostofDebt 3.38% 3.58%

Aswath Damodaran 65
 The Ratings Table

IfInterestCoverageRatiois EstimatedBondRating Defaultspread

>8.50 AAA 0.20%
6.508.50 AA 0.50%
5.506.50 A+ 0.80%
4.255.50 A 1.00%
3.004.25 A 1.25%
2.503.00 BBB 1.50%
2.002.50 BB 2.00%
1.752.00 B+ 2.50%
1.501.75 B 3.25%
1.251.50 B 4.25%
0.801.25 CCC 5.00%
0.650.80 CC 6.00%
0.200.65 C 7.50%
<0.20 D 10.00%

Aswath Damodaran 66
 A Test: Can you do the 20% level?

D/(D+E) 0.00% 10.00% 20% SecondIteration

D/E 0.00% 11.11%
$Debt $0 $4,079

EBITDA $3,268 $3,268 $3,268

Depreciation $1,517 $1,517 $1,517
EBIT $1,751 $1,751 $1,751
InterestExpense $0 $224
PretaxInt.cov 7.80
LikelyRating AAA AA
InterestRate 5.20% 5.50%
Eff.TaxRate 35.00% 35.00%
CostofDebt 3.38% 3.58%

Aswath Damodaran 67
 Bond Ratings, Cost of Debt and Debt Ratios

0% 105 20% 30% 40% 50% 60% 70% 80% 90%

EBITDA $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268
Deprec iation $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517
EBIT $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751
Interest $ - $ 224 $ 510 $ 857 $ 1,632 $ 2,039 $ 2,692 $ 3,569 $ 4,079 $ 4,589
Pre-tax Int. c ov 7.80 3.43 2.04 1.07 0.86 0.65 0.49 0.43 0.38
Likely Rating AAA AA A- BB CCC CCC CC C C C
Interest Rate 5.20% 5.50% 6.25% 7.00% 10.00% 10.00% 11.00% 12.50% 12.50% 12.50%
Eff. Tax Rate 35.00% 35.00% 35.00% 35.00% 35.00% 30.05% 22.76% 17.17% 15.02% 13.36%
Cost of Debt 3.38% 3.58% 4.06% 4.55% 6.50% 7.00% 8.50% 10.35% 10.62% 10.83%

Aswath Damodaran 68
 Why does the tax rate change?

Youneedtaxableincomeforinteresttoprovideataxsavings
40% 50%
EBIT $ 1,751 $ 1,751
Interest Expense $ 1,632 $ 2,039
Coverage ratio 1.07 0.86
Rating CCC CCC
Interest rate 10.00% 10.00%
Tax Rate 35.00% 30.05%
Cost of Debt 6.50% 7.00%
Maximum Tax Benefit = 35% of $1,751 = $613 million
Tax Rate to use for cost of debt = 613/2039 = 30.05%

Aswath Damodaran 69
 Boeings Cost of Capital Schedule

Debt Ratio Beta Cost of Equity Cost of Debt Cost of Capital

0% 0.87 9.79% 3.38% 9.79%
10% 0.93 10.14% 3.58% 9.48%
20% 1.01 10.57% 4.06% 9.27%
30% 1.11 11.13% 4.55% 9.16%
40% 1.25 11.87% 6.50% 9.72%
50% 1.48 13.15% 7.00% 10.07%
60% 1.88 15.35% 8.50% 11.24%
70% 2.56 19.06% 10.35% 12.97%
80% 3.83 26.09% 10.62% 13.72%
90% 7.67 47.18% 10.83% 14.47%

Aswath Damodaran 70
 Boeing: Cost of Capital Chart

Costs of Equity, Debt and Capital: Boeing

50.00% 15.00%

45.00%

14.00%

40.00%

13.00%
35.00%

30.00%
12.00%

25.00%

20.00%
OptimalDebtRatio 11.00%

15.00%
10.00%

10.00%

9.00%

5.00%

0.00% 8.00%

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

Debt Ratio

Cost of Equity Cost of Debt (After-tax) Cost of Capital

Aswath Damodaran 71
 The Home Depot: Cost of Capital Schedule

Debt Ratio Beta Cost of Equity Rating Interest rate Tax Rate Cost of Debt (After-tax) Cost of Capital
0% 0.84 9.64% AAA 5.20% 35.00% 3.38% 9.64%
10% 0.90 9.98% A 6.00% 35.00% 3.90% 9.37%
20% 0.98 10.40% BB 7.00% 35.00% 4.55% 9.23%
30% 1.08 10.93% CCC 10.00% 35.00% 6.50% 9.60%
40% 1.27 11.96% CC 11.00% 24.95% 8.26% 10.48%
50% 1.54 13.47% C 12.50% 17.56% 10.30% 11.89%
60% 1.92 15.58% C 12.50% 14.63% 10.67% 12.64%
70% 2.57 19.11% C 12.50% 12.54% 10.93% 13.39%
80% 3.85 26.17% C 12.50% 10.98% 11.13% 14.14%
90% 7.70 47.34% C 12.50% 9.76% 11.28% 14.89%

Aswath Damodaran 72
 Effect of Moving to the Optimal on Firm Value

Reestimatefirmvalueateachdebtratio,usingthenewcostofcapital.
Forastablegrowthfirm,thiswouldbe
FirmValue=CFtoFirm(1+g)/(WACCg)
Forahighgrowthfirm,thiswouldrequirethatthecashflowsduringthe
highgrowthphasebeestimatedanddiscountedback.
Estimatetheannualsavingsinfinancingcostsfromthechangeincost
ofcapitalandcomputethepresentvalueofthesesavingsinperpetuity.
AnnualSavings=(CostofcapitalbeforeCostofcapitalafter)FirmValue
Ifyouassumenogrowthinfirmvalue,thiswouldyield
AnnualSaving/Costofcapitalafter
Ifyouassumeperpetualgrowthinsavings,thiswouldyield
AnnualSaving/(Costofcapitalafterg)

Aswath Damodaran 73
 But what growth rate do we use? One solution

Theestimateofgrowthusedinvaluingafirmcanclearlyhave
significantimplicationsforthefinalnumber.
Onewaytobypassthisestimationistoestimatethegrowthrate
impliedintodaysmarketvalue.Forinstance,
Boeingscurrentmarketvalue=32,595+8,194=$40,789million
Boeingsfreecashflowtothefirm=$1,176million
Boeingscurrentcostofcapital=9.17%
Assumingaperpetualgrowthmodel,
FirmValue=Cashflowtofirm(1+g)/(Costofcapitalg)
40,789=1,176(1+g)/(.0917g)
Solvingforg,
Impliedgrowthrate=.0611or6.11%

Aswath Damodaran 74
 Change in Firm Value for Boeing: Firm
Valuation Approach

Boeingsfreecashflowtothefirm=$1,176million
Boeingsimpliedgrowthrate=6.11%
Newcostofcapital=9.16%
Boeingsnewfirmvalue=1,176*1.0611/(.0916.0611)
=$40,990million
Boeingscurrentfirmvalue=$40,789million
Changeinfirmvalue=$40,990$40,789=$201million

Aswath Damodaran 75
 Effect on Firm Value on Boeing: Annual
Savings Approach

FirmValuebeforethechange=32,595+8,194=$40,789million
WACCb=9.17% AnnualCost=$62,068*12.22%=$7,583million
WACCa=9.16% AnnualCost=$62,068*11.64%=$7,226million
WACC=0.01% ChangeinAnnualCost =$6.14million
Ifthereisnogrowthinthefirmvalue,(ConservativeEstimate)
Increaseinfirmvalue=$6.14/.0916=$67million
ChangeinStockPrice=$67/1010.7=$0.07pershare
Ifthereisgrowth(of6.11%)infirmvalueovertime,
Increaseinfirmvalue=$6.14/(.0916.0611)=$206million
ChangeinStockPrice=$206/1010.7=$0.20pershare

Aswath Damodaran 76
 Effect on Firm Value of Moving to the Optimal:
The Home Depot

FirmValuebeforethechange=85,668+4,081=$89,749million
WACCb=9.51% AnnualCost=$89,749*9.51%=$8,537million
WACCa=9.23% AnnualCost=$89,749*9.23%=$8,281million
WACC=0.28% ChangeinAnnualCost =$256million
Ifthereisgrowth(of6%)infirmvalueovertime,
Increaseinfirmvalue=$256(1.06)/(.0923.06)=$8,406million
ChangeinStockPrice=$8,406/1478.63=$5.69pershare

Aswath Damodaran 77
 A Test: The Repurchase Price

LetussupposethattheCFOofTheHomeDepotapproachedyou
aboutbuyingbackstock.Hewantstoknowthemaximumpricethat
heshouldbewillingtopayonthestockbuyback.(Thecurrentpriceis
$57.94)Assumingthatfirmvaluewillgrowby6%ayear,estimate
themaximumprice.

Whatwouldhappentothestockpriceafterthebuybackifyouwere
abletobuystockbackat$57.94?

Aswath Damodaran 78
 The Downside Risk

DoingWhatifanalysisonOperatingIncome
A.StandardDeviationApproach
StandardDeviationInPastOperatingIncome
StandardDeviationInEarnings(IfOperatingIncomeIsUnavailable)
ReduceBaseCaseByOneStandardDeviation(OrMore)
B.PastRecessionApproach
LookAtWhatHappenedToOperatingIncomeDuringTheLastRecession.
(HowMuchDidItDropIn%Terms?)
ReduceCurrentOperatingIncomeBySameMagnitude
ConstraintonBondRatings

Aswath Damodaran 79
 Boeings Operating Income History

Year EBITDA %Change

1989 $1,217 19.54%
1990 $2,208 81.46%
1991 $2,785 26.15%
1992 $2,988 7.30%
1993 $2,722 8.91%
1994 $2,302 15.42%
1995 $1,998 13.21%
1996 $3,750 87.69%
1997 $2,301 38.64%
1998 $3,106 34.98%

Aswath Damodaran 80
 Boeing: Operating Income and Optimal Capital
Structure

%DropinEBITDA EBITDA OptimalDebtRatio

0% $3,268 30%

5% $3,105 20%

10% $2,941 20%

15% $2,778 10%

20% $2,614 0%

Aswath Damodaran 81
 Constraints on Ratings

Managementoftenspecifiesa'desiredRating'belowwhichtheydo
notwanttofall.
Theratingconstraintisdrivenbythreefactors
itisonewayofprotectingagainstdownsideriskinoperatingincome(so
donotdoboth)
adropinratingsmightaffectoperatingincome
thereisanegofactorassociatedwithhighratings
Caveat:EveryRatingConstraintHasACost.
ProvideManagementWithAClearEstimateOfHowMuchTheRating
ConstraintCostsByCalculatingTheValueOfTheFirmWithoutThe
RatingConstraintAndComparingToTheValueOfTheFirmWithThe
RatingConstraint.

Aswath Damodaran 82
 Ratings Constraints for Boeing

AssumethatBoeingimposesaratingconstraintofBBBorgreater.
TheoptimaldebtratioforBoeingisthen20%(seenextpage)
Thecostofimposingthisratingconstraintcanthenbecalculatedas
follows:
Valueat30%Debt =$41,003million
Valueat20%Debt =$39,416million
CostofRatingConstraint =$1,587million

Aswath Damodaran 83
 What if you do not buy back stock..

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

Aswath Damodaran 84
 Analyzing Financial Service Firms

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

Aswath Damodaran 85
 Long Term Interest Coverage Ratios for
Financial Service Firms

LongTermInterestCoverageRatio Ratingis Spreadis OperatingIncomeDecline

<0.25 D 12.00% 50%
0.250.50 C 9.00% 40%
0.500.75 CC 7.50% 40%
0.750.90 CCC 6.00% 40%
0.901.00 B 5.00% 25%
1.001.25 B 4.00% 20%
1.251.50 B+ 3.00% 20%
1.502.00 BB 2.50% 20%
2.002.25 BBB 2.00% 10%
2.253.00 A 1.50% 5%
3.003.90 A 1.25% 5%
3.904.85 A+ 1.00% 5%
4.856.65 AA 0.70% 5%
>6.65 AAA 0.30% 0%

Aswath Damodaran 86
 J.P. Morgan: Optimal Capital Structure

DebtRatio CostofCapital FirmValue

0% 12.39% $19,333
10% 11.97% $20,315
20% 11.54% $20,332
30% 11.19% $21,265
40% 10.93% $20,858
50% 10.80% $18,863
60% 10.68% $19,198
70% 11.06% $13,658
80% 13.06% $10,790
90% 15.76% $7,001

Aswath Damodaran 87
 Analyzing Companies after Abnormal Years

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

Aswath Damodaran 88
 Analyzing a Private Firm

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

Aswath Damodaran 89
 Estimating the Optimal Debt Ratio for a Private
Software Firm

We first estimate the market value of the firm using the average
Value/EBITDA multiple of 21.8 for the software industry and the
EBITDAforInfoSoftof$3million:
FirmValue=$3million*21.8=$65.4million
We then estimate a synthetic rating for the firm, using its current
interest coverage ratio and the ratings table designed for smaller and
riskierfirms.ThecurrentinterestcoverageratioforInfoSoftwas:
InterestCoverageRatio=EBIT/InterestExpense=$2million/$
315,000=6.35

Aswath Damodaran 90
 Interest Coverage Ratios, Spreads and Ratings:
Small Firms

InterestCoverageRatio Rating SpreadoverTBondRate

>12.5 AAA 0.20%
9.5012.50 AA 0.50%
7.59.5 A+ 0.80%
6.07.5 A 1.00%
4.56.0 A 1.25%
3.54.5 BBB 1.50%
3.03.5 BB 2.00%
2.53.0 B+ 2.50%
2.02.5 B 3.25%
1.52.0 B 4.25%
1.251.5 CCC 5.00%
0.81.25 CC 6.00%
0.50.8 C 7.50%
<0.5 D 10.00%

Aswath Damodaran 91
 Optimal Debt Ratio for InfoSoft

DebtRatio Beta CostofEquity Rating Interestrate CostofDebt(Aftertax) CostofCapital

0% 1.43 12.87% AAA 5.20% 3.02% 12.87%
10% 1.52 13.38% A 6.25% 3.63% 12.40%
20% 1.64 14.01% B 9.25% 5.37% 12.28%
30% 1.82 15.02% CC 11.00% 7.00% 12.61%
40% 2.16 16.86% C 12.50% 9.50% 13.91%
50% 2.63 19.48% D 15.00% 12.60% 16.04%
60% 3.29 23.10% D 15.00% 13.00% 17.04%
70% 4.39 29.13% D 15.00% 13.29% 18.04%
80% 6.58 41.20% D 15.00% 13.50% 19.04%
90% 13.16 77.40% D 15.00% 13.67% 20.04%

Aswath Damodaran 92
 Determinants of Optimal Debt Ratios

FirmSpecificFactors
1.TaxRate
Highertaxrates >HigherOptimalDebtRatio
Lowertaxrates >LowerOptimalDebtRatio
2.Cashflowgeneration=EBITDA/MVofFirm
HigherPretaxReturns >HigherOptimalDebtRatio
LowerPretaxReturns >LowerOptimalDebtRatio
3.VarianceinEarnings[Showsupwhenyoudo'whatif'analysis]
HigherVariance >LowerOptimalDebtRatio
LowerVariance >HigherOptimalDebtRatio
MacroEconomicFactors
1.DefaultSpreads
Higher >LowerOptimalDebtRatio
Lower >HigherOptimalDebtRatio

Aswath Damodaran 93
 Application Test: Your firms optimal
financing mix

Usingtheoptimalcapitalstructurespreadsheetprovided:
Estimatetheoptimaldebtratioforyourfirm
Estimatethenewcostofcapitalattheoptimal
Estimatetheeffectofthechangeinthecostofcapitalonfirmvalue
Estimatetheeffectonthestockprice
Intermsofthemechanics,whatwouldyouneedtodotogettothe
optimalimmediately?

Aswath Damodaran 94
 III. The APV Approach to Optimal Capital
Structure

Intheadjustedpresentvalueapproach,thevalueofthefirmiswritten
asthesumofthevalueofthefirmwithoutdebt(theunleveredfirm)
andtheeffectofdebtonfirmvalue
FirmValue=UnleveredFirmValue+(TaxBenefitsofDebtExpected
BankruptcyCostfromtheDebt)
Theoptimaldollardebtlevelistheonethatmaximizesfirmvalue

Aswath Damodaran 95
 Implementing the APV Approach

Step1:Estimatetheunleveredfirmvalue.Thiscanbedoneinoneof
twoways:
Estimatingtheunleveredbeta,acostofequitybasedupontheunlevered
betaandvaluingthefirmusingthiscostofequity(whichwillalsobethe
costofcapital,withanunleveredfirm)
Alternatively,UnleveredFirmValue=CurrentMarketValueofFirmTax
BenefitsofDebt(Current)+ExpectedBankruptcycostfromDebt
Step2:Estimatethetaxbenefitsatdifferentlevelsofdebt.Thesimplest
assumptiontomakeisthatthesavingsareperpetual,inwhichcase
Taxbenefits=DollarDebt*TaxRate
Step3:Estimateaprobabilityofbankruptcyateachdebtlevel,and
multiplybythecostofbankruptcy(includingbothdirectandindirect
costs)toestimatetheexpectedbankruptcycost.

Aswath Damodaran 96
 Estimating Expected Bankruptcy Cost

ProbabilityofBankruptcy
Estimatethesyntheticratingthatthefirmwillhaveateachlevelofdebt
Estimatetheprobabilitythatthefirmwillgobankruptovertime,atthat
levelofdebt(Usestudiesthathaveestimatedtheempiricalprobabilities
ofthisoccurringovertimeAltmandoesanupdateeveryyear)
CostofBankruptcy
Thedirectbankruptcycostistheeasiercomponent.Itisgenerally
between510%offirmvalue,baseduponempiricalstudies
Theindirectbankruptcycostismuchtougher.Itshouldbehigherfor
sectorswhereoperatingincomeisaffectedsignificantlybydefaultrisk
(likeairlines)andlowerforsectorswhereitisnot(likegroceries)

Aswath Damodaran 97
 Ratings and Default Probabilities

Rating DefaultRisk
AAA 0.01%
AA 0.28%
A+ 0.40%
A 0.53%
A 1.41%
BBB 2.30%
BB 12.20%
B+ 19.28%
B 26.36%
B 32.50%
CCC 46.61%
CC 52.50%
C 60%
D 75%

Aswath Damodaran 98
 Boeing: Estimating Unlevered Firm Value

Value of Boeing in 1999 = Value of Equity + Value of Debt =

$32,595+$8,194=$40,789
PVofTaxSavingsfromExistingDebt =ExistingDebt*TaxRate
=$8,194*0.35 =$2,868million
Based upon Boeings currentratingof AA, weestimate a probability
ofbankruptcyof0.28%.Thebankruptcycostisassumedtobe30%of
thefirmvalue,priortothetaxsavings.
PVofExpectedBankruptcyCost =ProbabilityofDefault*Bankruptcy
cost=0.28%*(0.30*(40,7892,868)) =$32
ValueofBoeingasanUnleveredFirm

=MarketValuePVofTaxSavings+ExpectedBankruptcyCosts
=$40,789+$2,868$32=$37,953million

Aswath Damodaran 99
 Tax Benefits at Debt Ratios

DebtRatio $Debt TaxRate TaxBenefits

0%$0 35.00% $0
10% $4,079 35.00% $1,428
20% $8,158 35.00% $2,855
30% $12,237 35.00% $4,283
40% $16,316 35.00% $5,710
50% $20,394 30.05% $6,128
60% $24,473 22.76% $5,571
70% $28,552 17.17% $4,903
80% $32,631 15.02% $4,903
90% $36,710 13.36% $4,903
TaxBenefitscappedwheninterestexpensesexceedEBIT

Aswath Damodaran 100

 Expected Bankruptcy Costs

DebtRatio BondRating ProbabilityofDefault ExpectedBankruptcyCost

0% AA 0.28% $32
10% AA 0.28% $32
20% A 1.41% $161
30% BB 12.20% $1,389
40% CCC 50.00% $5,693
50% CCC 50.00% $5,693
60% CC 65.00% $7,401
70% C 80.00% $9,109
80% C 80.00% $9,109
90% C 80.00% $9,109

Aswath Damodaran 101

 Boeing: APV at Debt Ratios

DebtRatio UnleveredValue TaxBenefits Bankruptcy Valueof Costs

LeveredFirm
0% $37,953 $0 $32 $37,921
10% $37,953 $1,428 $32 $39,349
20% $37,953 $2,855 $161 $40,648
30% $37,953 $4,283 $1,389 $40,847
40% $37,953 $5,710 $5,693 $37,970
50% $37,953 $6,128 $5,693 $38,388
60% $37,953 $5,571 $7,401 $36,123
70% $37,953 $4,903 $9,109 $33,747
80% $37,953 $4,903 $9,109 $33,747
90% $37,953 $4,903 $9,109 $33,747

Exp.Bk.Cst:ExpectedBankruptcycost

Aswath Damodaran 102

 Relative Analysis

Thesafestplaceforanyfirmtobeisclosetotheindustryaverage.
Subjectiveadjustmentscanbemadetotheseaveragestoarriveatthe
rightdebtratio.
Highertaxrates>Higherdebtratios(Taxbenefits)
Lowerinsiderownership>Higherdebtratios(Greaterdiscipline)
Morestableincome>Higherdebtratios(Lowerbankruptcycosts)
Moreintangibleassets>Lowerdebtratios(Moreagencyproblems)

Aswath Damodaran 103

 Examining Industry Averages

Boeing Aerospace
MarketDebtRatio 18.97% 23.94%
BookDebtRatio 36.15% 38.94%
HomeDepot BuildingSupplies
MarketDebtRatio 1.65% 27.09%
BookDebtRatio 15.31% 29.95%

Aswath Damodaran 104

 The Home Depots Comparables

Company Name Market D/(D+E) Net Plant/Total Assets Cap Ex/Total Assets
Building Materials 47.23% 34.74% 3.90%
Catalina Lighting 51.17% 28.21% 1.95%
Cont'l Materials Corp 19.74% 36.02% 0.22%
Eagle Hardware 12.02% 52.54% 8.88%
Emc o Limited 39.04% 22.64% 4.23%
Fastenal Co. 1.21% 27.82% 13.97%
Home Depot 1.65% 57.97% 13.19%
HomeBase Inc . 40.76% 36.15% 3.07%
Hughes S upply 37.97% 11.19% 2.94%
Lowe's Cos. 5.14% 57.58% 14.81%
National Home Centers 81.27% 47.40% 0.65%
Westburne Inc . 5.87% 11.19% 2.09%
White Cap Industries 13.04% 7.83% 3.08%
Wolohan Lumber 23.40% 28.21% 3.42%

Aswath Damodaran 105

 Examining the Determinants of Capital
Structure: Home Improvement Business

Usingasampleofhomeimprovementfirms,wearrivedatthe
followingregression:
Debt=0.174+0.50(NetPlant/FirmValue)1.39(CapExp/Assets)
(1.61) (2.86) (1.42)
TheRsquaredoftheregressionis60%.Thisregressioncanbeusedto
arriveatapredictedvalueforTheHomeDepotof:
DFRHomeDepot=0.174+0.50(0.0699)1.39(0.1319)=0.0256or2.56%
Baseduponthecapitalstructureofotherfirmsinthehome
improvementindustry,theHomeDepotshouldhaveamarketvalue
debtratioof2.56%.

Aswath Damodaran 106

 Cross Sectional Regression: 1998 Data

Using1998datafor3000firmslistedontheNYSE,AMEXand
NASDAQdatabases,wecategorizedfirmsbySICcode.The
regressionacrossthesesectorsprovidesthefollowingresults
DFR=0.16080.3411OISTD+.2153CLSH0.3159CPXFR+1.4185E/V
(26.41a) (3.15a) (1.95b) (1.68b) (8.21a)
where,
DFR =Debt/(Debt+MarketValueofEquity)
OISTD =StandardDeviationinOperatingIncome(previous5years)
CLSH =Closelyheldsharesasapercentofoutstandingshares
CPXFR =CapitalExpenditures/TotalAssets
E/V =EBITDA/FirmValue
TheRsquaredoftheregressionis57%.

Aswath Damodaran 107

 Applying the Market Regression

Boeing TheHomeDepot
StandardDeviationinOperatingIncome 25.35% 24.06%
InsiderHoldingsaspercentofoutstandingstock 1% 23%
CapitalExpenditures/TotalAssets 4.32% 13.19%
EBITDA/FirmValue 7.94% 3.38%

PredictedDebtRatio 17.55% 13.45%

Aswath Damodaran 108

 Reconciling the Different Analysis

Boeing TheHomeDepot

ActualDebtRatio

Withoutoperatingleases 18.97% 1.65%

Withoperatingleases 20.09% 4.55%

Optimal

I.OperatingIncome 28.41% 17.56%

II.CostofCapital

Withnoconstraints 30.00% 20.00%

WithBBBconstraint 20.00% 15.00%

III.ReturnDifferential 20.00% 30.00%

IV.APV 30.00% 20.00%

V.Comparable

ToIndustry 22.56% 2.56%

ToMarket 17.55% 13.45%

Aswath Damodaran 109

 Analytical Conclusions

Boeingisclosetoitsoptimaldebtratio.
TheHomeDepotisunderlevered.EvenwithaBBBratingconstraint,
theHomeDepotcanaffordtoborrowsignificantlymorethanitdoes
now.

Aswath Damodaran 110

 A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal Actual < Optimal

Overlevered Underlevered

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No Yes No

Reduce Debt quickly Increase leverage

1. Equity for Debt swap Does the firm have good quickly Does the firm have good
2. Sell Assets; use cash projects? 1. Debt/Equity swaps projects?
to pay off debt ROE > Cost of Equity 2. Borrow money& ROE > Cost of Equity
3. Renegotiate with lenders ROC > Cost of Capital buy shares. ROC > Cost of Capital

Yes No
Yes No
Take good projects with 1. Pay off debt with retained
new equity or with retained earnings. Take good projects with
earnings. 2. Reduce or eliminate dividends. debt.
3. Issue new equity and pay off Do your stockholders like
debt. dividends?

Yes
Pay Dividends No
Buy back stock
Aswath Damodaran 111
 The Home Depot: Applying the Framework

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal Actual < Optimal

Overlevered Underlevered

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No Yes No

Reduce Debt quickly Increase leverage

1. Equity for Debt swap Does the firm have good quickly Does the firm have good
2. Sell Assets; use cash projects? 1. Debt/Equity swaps projects?
to pay off debt ROE > Cost of Equity 2. Borrow money& ROE > Cost of Equity
3. Renegotiate with lenders ROC > Cost of Capital buy shares. ROC > Cost of Capital

Yes No
Yes No
Take good projects with 1. Pay off debt with retained
new equity or with retained earnings. Take good projects with
earnings. 2. Reduce or eliminate dividends. debt.
3. Issue new equity and pay off Do your stockholders like
debt. dividends?

Yes
Pay Dividends No
Buy back stock
Aswath Damodaran 112
 Application Test: Getting to the Optimal

Baseduponyouranalysisofboththefirmscapitalstructureand
investmentrecord,whatpathwouldyoumapoutforthefirm?
Immediatechangeinleverage
Gradualchangeinleverage
Nochangeinleverage
Wouldyourecommendthatthefirmchangeitsfinancingmixby
Payingoffdebt/Buyingbackequity
Takeprojectswithequity/debt

Aswath Damodaran 113

 Designing Debt: The Fundamental Principle

Theobjectiveindesigningdebtistomakethecashflowsondebt
matchupascloselyaspossiblewiththecashflowsthatthefirm
makesonitsassets.
Bydoingso,wereduceourriskofdefault,increasedebtcapacityand
increasefirmvalue.

Aswath Damodaran 114

 Firm with mismatched debt

Firm Value

Value of Debt

Aswath Damodaran 115

 Firm with matched Debt

Firm Value

Value of Debt

Aswath Damodaran 116

 Design the perfect financing instrument

Theperfectfinancinginstrumentwill
Haveallofthetaxadvantagesofdebt
Whilepreservingtheflexibilityofferedbyequity

Startwiththe
CashFlows Cyclicality&
GrowthPatterns OtherEffects
onAssets/ Duration Currency EffectofInflation
Projects UncertaintyaboutFuture

Fixedvs.FloatingRate Straightversus SpecialFeatures CommodityBonds

*Morefloatingrate Convertible onDebt CatastropheNotes
Duration/ Currency
DefineDebt ifCFmovewith Convertibleif Optionstomake
Maturity Mix
Characteristics inflation cashflowslow cashflowsondebt
withgreateruncertainty nowbuthigh matchcashflows
onfuture exp.growth onassets

Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced

Aswath Damodaran 117

 Ensuring that you have not crossed the line
drawn by the tax code

Allofthisdesignworkislost,however,ifthesecuritythatyouhave
designeddoesnotdeliverthetaxbenefits.
Inaddition,theremaybeatradeoffbetweenmismatchingdebtand
gettinggreatertaxbenefits.

Deductibilityofcashflows Differencesintaxrates
Overlaytax fortaxpurposes acrossdifferentlocales ZeroCoupons
preferences
Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep

Aswath Damodaran 118

 While keeping equity research analysts, ratings
agencies and regulators applauding

Ratingsagencieswantcompaniestoissueequity,sinceitmakesthem
safer.Equityresearchanalystswantthemnottoissueequitybecause
itdilutesearningspershare.Regulatoryauthoritieswanttoensurethat
youmeettheirrequirementsintermsofcapitalratios(usuallybook
value).Financingthatleavesallthreegroupshappyisnirvana.

Consider AnalystConcerns RatingsAgency RegulatoryConcerns

ratingsagency EffectonEPS EffectonRatios Measuresused OperatingLeases
&analystconcerns Valuerelativetocomparables Ratiosrelativetocomparables MIPs
SurplusNotes

Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?

Aswath Damodaran 119

 Debt or Equity: The Strange Case of Trust
Preferred

Trustpreferredstockhas
Afixeddividendpayment,specifiedatthetimeoftheissue
Thatistaxdeductible
Andfailingtomakethepaymentcancause?(Canitcausedefault?)
Whentrustpreferredwasfirstcreated,ratingsagenciestreateditas
equity.Astheyhavebecomemoresavvy,ratingsagencieshave
startedgivingfirmsonlypartialequitycreditfortrustpreferred.

Aswath Damodaran 120

 Debt, Equity and Quasi Equity

Assumingthattrustpreferredstockgetstreatedasequitybyratings
agencies,whichofthefollowingfirmsisthemostappropriatefirmto
beissuingit?
Afirmthatisunderlevered,buthasaratingconstraintthatwouldbe
violatedifitmovedtoitsoptimal
Afirmthatisoverleveredthatisunabletoissuedebtbecauseofthe
ratingagencyconcerns.

Aswath Damodaran 121

 Soothe bondholder fears

Therearesomefirmsthatfaceskepticismfrombondholderswhen
theygoouttoraisedebt,because
Oftheirpasthistoryofdefaultsorotheractions
Theyaresmallfirmswithoutanyborrowinghistory
Bondholderstendtodemandmuchhigherinterestratesfromthese
firmstoreflecttheseconcerns.
ObservabilityofCashFlows TypeofAssetsfinanced
byLenders Tangibleandliquidassets ExistingDebtcovenants Convertibiles
Factorinagency RestrictionsonFinancing PuttableBonds
Lessobservablecashflows createlessagencyproblems
conflictsbetweenstock RatingSensitive
leadtomoreconflicts
andbondholders Notes
LYONs
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds

Aswath Damodaran 122

 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?

Aswath Damodaran 123

 Designing Debt: Bringing it all together
Startwiththe Cyclicality&
CashFlows Duration Currency EffectofInflation
GrowthPatterns OtherEffects
onAssets/ UncertaintyaboutFuture
Projects

Fixedvs.FloatingRate Straightversus SpecialFeatures CommodityBonds

Duration/ Currency *Morefloatingrate Convertible onDebt CatastropheNotes
DefineDebt Maturity Mix ifCFmovewith Convertibleif Optionstomake
Characteristics inflation
withgreateruncertainty
cashflowslow
nowbuthigh
cashflowsondebt
matchcashflows
onfuture exp.growth onassets

Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced

Deductibilityofcashflows Differencesintaxrates
Overlaytax fortaxpurposes acrossdifferentlocales ZeroCoupons
preferences
Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep

Consider AnalystConcerns RatingsAgency RegulatoryConcerns

ratingsagency EffectonEPS EffectonRatios Measuresused OperatingLeases
&analystconcerns Valuerelativetocomparables Ratiosrelativetocomparables MIPs
SurplusNotes

Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?

ObservabilityofCashFlows TypeofAssetsfinanced
byLenders Tangibleandliquidassets ExistingDebtcovenants Convertibiles
Factorinagency Lessobservablecashflows createlessagencyproblems RestrictionsonFinancing PuttableBonds
conflictsbetweenstock leadtomoreconflicts RatingSensitive
andbondholders Notes
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds LYONs

ConsiderInformation UncertaintyaboutFutureCashflows Credibility&QualityoftheFirm

Asymmetries Whenthereismoreuncertainty,it Firmswithcredibilityproblems
Aswath Damodaran maybebettertouseshorttermdebt willissuemoreshorttermdebt 124
 Approaches for evaluating Asset Cash Flows

I.IntuitiveApproach
Aretheprojectstypicallylongtermorshortterm?Whatisthecashflow
patternonprojects?
Howmuchgrowthpotentialdoesthefirmhaverelativetocurrentprojects?
Howcyclicalarethecashflows?Whatspecificfactorsdeterminethecash
flowsonprojects?
II.ProjectCashFlowApproach
Projectcashflowsonatypicalprojectforthefirm
Doscenarioanalysesonthesecashflows,basedupondifferentmacro
economicscenarios
III.HistoricalData
OperatingCashFlows
FirmValue

Aswath Damodaran 125

 Coming up with the financing details: Intuitive
Approach - The Home Depot

Historically,theHomeDepotstypicalprojecthasbeenanewhome
improvementproductsstoreofroughly100,000squarefeet,witha
fairlylonglifeandasubstantialrealestateinvestment.
Theconstructionofthestoretakesarelativelyshorttime(12years),
andthestoresstartgeneratingcashflowsimmediately.
Inaddition,mostofthegrowthforthefirmsinceitsinceptionhas
comefromtheUnitedStates.

Aswath Damodaran 126

 The Home Depot: The Right Debt

It should be long term, with a life roughly matching the life of the
store.
The debt should have a fixed rate or fixed payments each year,
becausethestoresstarttogeneratecashflowsimmediatelyandthere
isanabsenceofpricingpowerinthisbusiness.IftheHomeDepothad
more pricing power, it could consider using floating rate debt, since
cashflowsaremorelikelytomovewithinflation.
The debt should be in U.S. dollars, at least for new stores in the
UnitedStates.
Ifpossible,thevalueofthedebtshouldbetiedtothevalueofthereal
estateunderlyingthestore

Aswath Damodaran 127

 Application Test: Choosing your Financing
Type

Baseduponthebusinessthatyourfirmisin,andthetypical
investmentsthatitmakes,whatkindoffinancingwouldyouexpect
yourfirmtouseintermsof
Duration(longtermorshortterm)
Currency
FixedorFloatingrate
StraightorConvertible

Aswath Damodaran 128

 Quantitative Approach

1.OperatingCashFlows
Thequestionofhowsensitiveafirmsassetcashflowsaretoavarietyof
factors,suchasinterestrates,inflation,currencyratesandtheeconomy,can
bedirectlytestedbyregressingchangesintheoperatingincomeagainst
changesinthesevariables.
ChangeinOperatingIncome(t)=a+bChangeinMacroEconomic
Variable(t)
Thisanalysisisusefulindeterminingthecoupon/interestpaymentstructure
ofthedebt.
2.FirmValue
Thefirmvalueisclearlyafunctionofthelevelofoperatingincome,butit
alsoincorporatesotherfactorssuchasexpectedgrowth&costofcapital.
Thefirmvalueanalysisisusefulindeterminingtheoverallstructureofthe
debt,particularlymaturity.

Aswath Damodaran 129

 Historical Data

Period Operating FirmValue ChangeinLTBond Changein Changein Changein

Income Rate GDP Inflation Currency
1998 $2,661 $90,845 1.03% 4.22% 0.10% 4.38%
1997 $2,016 $45,603 0.63% 3.83% 1.55% 9.80%
1996 $1,534 $25,034 0.80% 3.90% 0.78% 6.73%
1995 $1,232 $22,251 2.09% 2.06% 0.19% 3.55%
1994 $1,039 $22,654 1.92% 3.27% 0.00% 6.29%
1993 $744 $18,538 0.83% 2.38% 0.19% 0.61%
1992 $549 $22,513 0.02% 3.61% 0.19% 5.83%
1991 $382 $13,282 1.26% 0.43% 2.83% 2.67%
1990 $266 $5,595 0.12% 0.21% 1.15% 5.88%
1989 $185 $3,116

Aswath Damodaran 130

 Sensitivity to Interest Rate Changes

Theanswertothisquestionisimportantbecauseit
itprovidesameasureofthedurationofthefirmsprojects
itprovidesinsightintowhetherthefirmshouldbeusingfixedorfloating
ratedebt.

Aswath Damodaran 131

 Firm Value versus Interest Rate Changes

Regressingchangesinfirmvalueagainstchangesininterestratesover
thisperiodyieldsthefollowingregression
ChangeinFirmValue=0.51 7.49(ChangeinInterestRates)
(2.68) (0.46)
Tstatisticsareinbrackets.
Conclusion:Theduration(interestratesensitivity)ofTheHome
Depotsassetvaluesisabout7.49years.Consequently,itsdebtshould
haveatleastaslongaduration.

Aswath Damodaran 132

 Why the coefficient on the regression is
duration..

Thedurationofastraightbondorloanissuedbyacompanycanbe
writtenintermsofthecoupons(interestpayments)onthebond(loan)
andthefacevalueofthebondtobe
t = N t * Coupon
dP/P

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

DurationofBond = =
dr/r t =N Coupon FaceValue

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

Holdingotherfactorsconstant,thedurationofabondwillincrease
withthematurityofthebond,anddecreasewiththecouponrateon
thebond.

Aswath Damodaran 133

 Duration of a Firms Assets

Thismeasureofdurationcanbeextendedtoanyassetwithexpected
cashflowsonit.Thus,thedurationofaprojectorassetcanbe
estimatedintermsofthepredebtoperatingcashflowsonthatproject.
t = N t * CF N * TerminalValue
dPV/PV

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


DurationofProject/Asset = = t =N
dr CFt TerminalValue

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



where,
CFt=Aftertaxoperatingcashflowontheprojectinyeart
TerminalValue=SalvageValueattheendoftheprojectlifetime
N=Lifeoftheproject
Thedurationofanyassetprovidesameasureoftheinterestraterisk
embeddedinthatasset.

Aswath Damodaran 134

 Duration: Comparing Approaches

P/r=
Traditional Duration Percentage Change Regression:
Measures in Value for a P = a + b (r)
percentage change in
Interest Rates

Uses: Uses:
1. Projected Cash Flows 1. Historical data on changes in
Assumes: firm value (market) and interest
1. Cash Flows are unaffected by rates
changes in interest rates Assumes:
2. Changes in interest rates are 1. Past project cash flows are
small. similar to future project cash
flows.
2. Relationship between cash
flows and interest rates is
stable.
3. Changes in market value
reflect changes in the value of
the firm.

Aswath Damodaran 135

 Operating Income versus Interest Rates

ChangeinOperatingIncome=0.36+2.55(ChangeinInterestRates)
(11.28) (0.95)
Generallyspeaking,theoperatingcashflowsaresmoothedoutmore
thanthevalueandhencewillexhibitlowerdurationthatthefirm
value.

Aswath Damodaran 136

 Sensitivity to Changes in GNP

Theanswertothisquestionisimportantbecause
itprovidesinsightintowhetherthefirmscashflowsarecyclicaland
whetherthecashflowsonthefirmsdebtshouldbedesignedtoprotect
againstcyclicalfactors.
Ifthecashflowsandfirmvaluearesensitivetomovementsinthe
economy,thefirmwilleitherhavetoissuelessdebtoverall,oradd
specialfeaturestothedebttotiecashflowsonthedebttothefirms
cashflows.

Aswath Damodaran 137

 Regression Results

RegressingchangesinfirmvalueagainstchangesintheGNPoverthis
periodyieldsthefollowingregression
ChangeinFirmValue=0.74 7.82(GDPGrowth)
(2.05) (0.65)
Conclusion:TheHomeDepotiscountercyclical(?)
RegressingchangesinoperatingcashflowagainstchangesinGNP
overthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.41 2.25(GNPGrowth)
(6.86) (1.14)
Conclusion:TheHomeDepotsoperatingincomeisslightlylesssensitive
totheeconomiccycle,butalsocountercyclical.

Aswath Damodaran 138

 Sensitivity to Currency Changes

Theanswertothisquestionisimportant,because
itprovidesameasureofhowsensitivecashflowsandfirmvalueareto
changesinthecurrency
itprovidesguidanceonwhetherthefirmshouldissuedebtinanother
currencythatitmaybeexposedto.
Ifcashflowsandfirmvaluearesensitivetochangesinthedollar,the
firmshould
figureoutwhichcurrencyitscashflowsarein;
andissuedsomedebtinthatcurrency

Aswath Damodaran 139

 Regression Results

Regressingchangesinfirmvalueagainstchangesinthedollarover
thisperiodyieldsthefollowingregression
ChangeinFirmValue= 0.52 +1.13(ChangeinDollar)
(2.86) (0.34)
Conclusion:TheHomeDepotsvaluehasnotbeenverysensitiveto
changesinthedollaroverthelast15years.
Regressingchangesinoperatingcashflowagainstchangesinthe
dollaroverthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.35 0.14(ChangeinDollar)
(10.83) (0.24)
Conclusion:TheHomeDepotsoperatingincomehasalsobeen
unaffectedbychangesinexchangerates.

Aswath Damodaran 140

 Sensitivity to Inflation

Theanswertothisquestionisimportant,because
itprovidesameasureofwhethercashflowsarepositivelyornegatively
impactedbyinflation.
itthenhelpsinthedesignofdebt;whetherthedebtshouldbefixedor
floatingratedebt.
Ifcashflowsmovewithinflation,increasing(decreasing)asinflation
increases(decreases),thedebtshouldhavealargerfloatingrate
component.

Aswath Damodaran 141

 Regression Results

Regressingchangesinfirmvalueagainstchangesininflationoverthis
periodyieldsthefollowingregression
ChangeinFirmValue =0.45 23.39(ChangeinInflationRate)
(2.78) (1.68)
Conclusion:TheHomeDepotsfirmvalueisnegativelyaffectedby
increasesininflation.
Regressingchangesinoperatingcashflowagainstchangesininflation
overthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=1.40 1.40(ChangeinInflationRate)
(10.37)(0.50)
Conclusion:TheHomeDepotsoperatingincomeisalsonegatively
affectedbyincreasesininflation,thoughtheeffectissmaller.

Aswath Damodaran 142

 Bottom-up Estimates

ChangeinFirmValueversus
InterestRates GDPGrowth Inflation Currency
BuildingSupplies 6.56 0.73 5.11 1.93

Onabottomupbasis,
TheHomeDepotshouldhavedebt
Withadurationof6.56years
Thatisunaffectedbyeconomiccycles
Isisfixedrate(Valuedoesnotincreaseasinflationgoesup)
Indollars

Aswath Damodaran 143

 Analyzing The Home Depots Current Debt

TheHomeDepotsexistingdebtisalmostentirelyintheformoflongterm
leasesonU.S.stores.
Consequently,itsexistingdebtisinlinewithwhatyouwouldexpectthe
HomeDepottohave.

Aswath Damodaran 144

 Analyzing Boeings existing debt

ExistingDebt Optimal
Duration 7.55 9.05
FloatingRateComponent 12% Low
ForeignCurrencyDebt 8% 47.24%
ConvertibleDebt 0% 0%

Boeingshouldincreaseitsproportionofforeigncurrencydebtand
increasethematurityofitsdebtshortly.

Theoptimaldebtratioswereestimatedbaseduponbottomupestimates
fortheaerospaceanddefensebusinesses.

Aswath Damodaran 145