Applied Corporate Finance: Aswath Damodaran

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Applied Corporate Finance

Aswath Damodaran
www.damodaran.com

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What is corporate finance?
Every decision that a business makes has financial implications, and
any decision which affects the finances of a business is a corporate
finance decision.
Defined broadly, everything that a business does fits under the rubric
of corporate finance.
3
The Traditional Accounting Balance Sheet
Assets Liabilities
Fixed Assets
Debt
Equity
Short-term liabilities of the firm
Intangible Assets
Long Lived Real Assets
Assets which are not physic al,
like patents & trademarks
Current Assets
Financ ial Investments Investments in securities &
assets of other firms
Short-lived Assets
Equity investment in firm
Debt obligations of firm
Current
Liabilties
Other
Liabilities
Other long-term obligations
The Balance Sheet
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The Financial View of the Firm
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
5
Tale of two companies
Assets Liabilities
Investments already
made
Debt
Equity
$ 7 billion
$ 11 billion Investments yet to
be made
$ 15 billion
$ 3 billion
Con Eds Financial Balance Sheet
Assets Liabilities
Investments already
made
Debt
Equity
$ 0.12 billion
$ 77 billion Investments yet to
be made
$ 6 billion
$ 71. 12 billion
EBays Financial Balance Sheet
6
First Principles
Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon
the stockholders characteristics.
Objective: Maximize the Value of the Firm
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The Objective in Decision Making
In traditional corporate finance, the objective in decision making is to
maximize the value of the firm.
A narrower objective is to maximize stockholder wealth. When the
stock is traded and markets are viewed to be efficient, the objective is
to maximize the stock price.
All other goals of the firm are intermediate ones leading to firm value
maximization, or operate as constraints on firm value maximization.
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The Classical Objective Function
STOCKHOLDERS
Maximize
stockholder
wealth

Hire & fire
managers
- Board
- Annual Meeting
BONDHOLDERS
Lend Money
Protect
bondholder
Interests
FINANCIAL MARKETS
SOCIETY Managers
Reveal
information
honestly and
on time
Markets are
efficient and
assess effect on
value
No Social Costs
Costs can be
traced to firm
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What can go wrong?
STOCKHOLDERS
Managers put
their interests
above stockholders

Have little control
over managers
BONDHOLDERS
Lend Money
Bondholders can
get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad
news or
provide
misleading
information
Markets make
mistakes and
can over react
Significant Social Costs
Some costs cannot be
traced to firm
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Whos on Board? The Disney Experience -
1997
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6Application Test: Who owns/runs your firm?
Look at: Bloomberg printout HDS for your firm
Looking at the top 15 stockholders in your firm, are top managers in
your firm also large stockholders in the firm?
Is there any evidence that the top stockholders in the firm play an
active role in managing the firm?
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Disneys top stockholders in 2003
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When traditional corporate financial theory
breaks down, the solution is:
To choose a different mechanism for corporate governance
To choose a different objective for the firm.
To maximize stock price, but reduce the potential for conflict and
breakdown:
Making managers (decision makers) and employees into stockholders
By providing information honestly and promptly to financial markets
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An Alternative Corporate Governance System
Germany and Japan developed a different mechanism for corporate
governance, based upon corporate cross holdings.
In Germany, the banks form the core of this system.
In Japan, it is the keiretsus
Other Asian countries have modeled their system after Japan, with family
companies forming the core of the new corporate families
At their best, the most efficient firms in the group work at bringing the
less efficient firms up to par. They provide a corporate welfare system
that makes for a more stable corporate structure
At their worst, the least efficient and poorly run firms in the group pull
down the most efficient and best run firms down. The nature of the
cross holdings makes its very difficult for outsiders (including
investors in these firms) to figure out how well or badly the group is
doing.
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Choose a Different Objective Function
Firms can always focus on a different objective function. Examples
would include
maximizing earnings
maximizing revenues
maximizing firm size
maximizing market share
maximizing EVA
The key thing to remember is that these are intermediate objective
functions.
To the degree that they are correlated with the long term health and value
of the company, they work well.
To the degree that they do not, the firm can end up with a disaster
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Maximize Stock Price, subject to ..
The strength of the stock price maximization objective function is its
internal self correction mechanism. Excesses on any of the linkages
lead, if unregulated, to counter actions which reduce or eliminate these
excesses
In the context of our discussion,
managers taking advantage of stockholders has lead to a much more active
market for corporate control.
stockholders taking advantage of bondholders has lead to bondholders
protecting themselves at the time of the issue.
firms revealing incorrect or delayed information to markets has lead to
markets becoming more skeptical and punitive
firms creating social costs has lead to more regulations, as well as investor
and customer backlashes.
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The Stockholder Backlash
Institutional investors such as Calpers and the Lens Funds have
become much more active in monitoring companies that they invest in
and demanding changes in the way in which business is done
Individuals like Michael Price specialize in taking large positions in
companies which they feel need to change their ways (Chase, Dow
Jones, Readers Digest) and push for change
At annual meetings, stockholders have taken to expressing their
displeasure with incumbent management by voting against their
compensation contracts or their board of directors
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In response, boards are becoming more
independent
Boards have become smaller over time. The median size of a board of
directors has decreased from 16 to 20 in the 1970s to between 9 and 11
in 1998. The smaller boards are less unwieldy and more effective than
the larger boards.
There are fewer insiders on the board. In contrast to the 6 or more
insiders that many boards had in the 1970s, only two directors in most
boards in 1998 were insiders.
Directors are increasingly compensated with stock and options in the
company, instead of cash. In 1973, only 4% of directors received
compensation in the form of stock or options, whereas 78% did so in
1998.
More directors are identified and selected by a nominating committee
rather than being chosen by the CEO of the firm. In 1998, 75% of
boards had nominating committees; the comparable statistic in 1973
was 2%.
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Disneys Board in 2003
Board Members Occupation
Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo ODonovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.
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The Counter Reaction
STOCKHOLDERS
Managers of poorly
run firms are put
on notice.

1. More activist
investors
2. Hostile takeovers
BONDHOLDERS
Protect themselves
1. Covenants
2. New Types
FINANCIAL MARKETS
SOCIETY Managers
Firms are
punished
for misleading
markets
Investors and
analysts become
more skeptical
Corporate Good Citizen Constraints
1. More laws
2. Investor/Customer Backlash
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Picking the Right Projects:
Investment Analysis
Let us watch well our beginnings, and results will manage
themselves
Alexander Clark
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First Principles
financing mix used - owners funds (equity) or borrowed money
(debt)
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The notion of a benchmark
Since financial resources are finite, there is a hurdle that projects have
to cross before being deemed acceptable.
This hurdle will be higher for riskier projects than for safer projects.
A simple representation of the hurdle rate is as follows:
Hurdle rate = Riskless Rate + Risk Premium
The two basic questions that every risk and return model in finance
tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?

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What is Risk?
Risk, in traditional terms, is viewed as a negative. Websters
dictionary, for instance, defines risk as exposing to danger or hazard.
The Chinese symbols for risk, reproduced below, give a much better
description of risk

The first symbol is the symbol for danger, while the second is the
symbol for opportunity, making risk a mix of danger and
opportunity.
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Risk and Return Models in Finance
The risk in an investment can be measured by the variance in actual returns around an
expected return
E(R)
Riskless Investment LowRisk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy Models
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Beta of asset relative to
Market portfolio (from
a regression)
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.
Betas of assets relative
to specified macro
economic factors (from
a regression)
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
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Who are Disneys marginal investors?
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Limitations of the CAPM
1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated precisely
- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be
a linear relationship between returns and betas
the only variable that should explain returns is betas
- The reality is that
the relationship between betas and returns is weak
Other variables (size, price/book value) seem to explain differences in returns
better.
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Why the CAPM persists
The CAPM, notwithstanding its many critics and limitations, has
survived as the default model for risk in equity valuation and corporate
finance. The alternative models that have been presented as better
models (APM, Multifactor model..) have made inroads in performance
evaluation but not in prospective analysis because:
The alternative models (which are richer) do a much better job than the
CAPM in explaining past return, but their effectiveness drops off when it
comes to estimating expected future returns (because the models tend to
shift and change).
The alternative models are more complicated and require more
information than the CAPM.
For most companies, the expected returns you get with the the alternative
models is not different enough to be worth the extra trouble of estimating
four additional betas.
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6Application Test: Who is the marginal investor
in your firm?
You can get information on insider and institutional holdings in your firm
from:
http://finance.yahoo.com/
Enter your companys symbol and choose profile.
Looking at the breakdown of stockholders in your firm, consider
whether the marginal investor is
a) An institutional investor
b) An individual investor
c) An insider
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Inputs required to use the CAPM -
The capital asset pricing model yields the following expected return:
Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market
Portfolio - Riskfree Rate)
To use the model we need three inputs:
(a) The current risk-free rate
(b) The expected market risk premium (the premium expected for investing
in risky assets (market portfolio) over the riskless asset)
(c) The beta of the asset being analyzed.
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The Riskfree Rate and Time Horizon
On a riskfree asset, the actual return is equal to the expected return.
Therefore, there is no variance around the expected return.
For an investment to be riskfree, i.e., to have an actual return be equal
to the expected return, two conditions have to be met
There has to be no default risk, which generally implies that the security
has to be issued by the government. Note, however, that not all
governments can be viewed as default free.
There can be no uncertainty about reinvestment rates, which implies that it
is a zero coupon security with the same maturity as the cash flow being
analyzed.
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Riskfree Rate in Practice
The riskfree rate is the rate on a zero coupon government bond
matching the time horizon of the cash flow being analyzed.
Theoretically, this translates into using different riskfree rates for each
cash flow - the 1 year zero coupon rate for the cash flow in year 1, the
2-year zero coupon rate for the cash flow in year 2 ...
Practically speaking, if there is substantial uncertainty about expected
cash flows, the present value effect of using time varying riskfree rates
is small enough that it may not be worth it.
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The Bottom Line on Riskfree Rates
Using a long term government rate (even on a coupon bond) as the
riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value.
For short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.
The riskfree rate that you use in an analysis should be in the same
currency that your cashflows are estimated in. In other words, if your
cashflows are in U.S. dollars, your riskfree rate has to be in U.S.
dollars as well.
Data Source: You can get riskfree rates for the US in a number of sites.
Try http://www.bloomberg.com/markets.
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Measurement of the risk premium
The risk premium is the premium that investors demand for investing
in an average risk investment, relative to the riskfree rate.
As a general proposition, this premium should be
greater than zero
increase with the risk aversion of the investors in that market
increase with the riskiness of the average risk investment
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What is your risk premium?
Assume that stocks are the only risky assets and that you are offered two
investment options:
a riskless investment (say a Government Security), on which you can
make 5%
a mutual fund of all stocks, on which the returns are uncertain
How much of an expected return would you demand to shift your money from the
riskless asset to the mutual fund?
a) Less than 5%
b) Between 5 - 7%
c) Between 7 - 9%
d) Between 9 - 11%
e) Between 11- 13%
f) More than 13%
Check your premium against the survey premium on my web site.
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Risk Aversion and Risk Premiums
If this were the capital market line, the risk premium would be a
weighted average of the risk premiums demanded by each and every
investor.
The weights will be determined by the magnitude of wealth that each
investor has. Thus, Warren Buffets risk aversion counts more towards
determining the equilibrium premium than yours and mine.
As investors become more risk averse, you would expect the
equilibrium premium to increase.
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Risk Premiums do change..
Go back to the previous example. Assume now that you are making the
same choice but that you are making it in the aftermath of a stock
market crash (it has dropped 25% in the last month). Would you
change your answer?
a) I would demand a larger premium
b) I would demand a smaller premium
c) I would demand the same premium
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Estimating Risk Premiums in Practice
Survey investors on their desired risk premiums and use the average
premium from these surveys.
Assume that the actual premium delivered over long time periods is
equal to the expected premium - i.e., use historical data
Estimate the implied premium in todays asset prices.
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The Survey Approach
Surveying all investors in a market place is impractical.
However, you can survey a few investors (especially the larger
investors) and use these results. In practice, this translates into surveys
of money managers expectations of expected returns on stocks over
the next year.
The limitations of this approach are:
there are no constraints on reasonability (the survey could produce
negative risk premiums or risk premiums of 50%)
they are extremely volatile
they tend to be short term; even the longest surveys do not go beyond one
year
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The Historical Premium Approach
This is the default approach used by most to arrive at the premium to
use in the model
In most cases, this approach does the following
it defines a time period for the estimation (1926-Present, 1962-Present....)
it calculates average returns on a stock index during the period
it calculates average returns on a riskless security over the period
it calculates the difference between the two
and uses it as a premium looking forward
The limitations of this approach are:
it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from year to
year, but it reverts back to historical averages)
it assumes that the riskiness of the risky portfolio (stock index) has not
changed in a systematic way across time.
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Historical Average Premiums for the United
States
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period T.Bills T.Bonds T.Bills T.Bonds
1928-2004 7.92% 6.53% 6.02% 4.84%
1964-2004 5.82% 4.34% 4.59% 3.47%
1994-2004 8.60% 5.82% 6.85% 4.51%
What is the right premium?
Go back as far as you can. Otherwise, the standard error in the estimate will be
large. (

Be consistent in your use of a riskfree rate.
Use arithmetic premiums for one-year estimates of costs of equity and
geometric premiums for estimates of long term costs of equity.
Data Source: Check out the returns by year and estimate your own historical
premiums by going to updated data on my web site.

Std Error in estimate =
Annualized Std deviation in Stock prices
Number of years of historical data
)
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What about historical premiums for other
markets?
Historical data for markets outside the United States is available for
much shorter time periods. The problem is even greater in emerging
markets.
The historical premiums that emerge from this data reflects this and
there is much greater error associated with the estimates of the
premiums.
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One solution: Look at a countrys bond rating
and default spreads as a start
Ratings agencies such as S&P and Moodys assign ratings to countries
that reflect their assessment of the default risk of these countries. These
ratings reflect the political and economic stability of these countries
and thus provide a useful measure of country risk. In September 2004,
for instance, Brazil had a country rating of B2.
If a country issues bonds denominated in a different currency (say
dollars or euros), you can also see how the bond market views the risk
in that country. In September 2004, Brazil had dollar denominated C-
Bonds, trading at an interest rate of 10.01%. The US treasury bond rate
that day was 4%, yielding a default spread of 6.01% for Brazil.
Many analysts add this default spread to the US risk premium to come
up with a risk premium for a country. Using this approach would yield
a risk premium of 10.85% for Brazil, if we use 4.84% as the premium
for the US.
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Beyond the default spread
Country ratings measure default risk. While default risk premiums and
equity risk premiums are highly correlated, one would expect equity
spreads to be higher than debt spreads. If we can compute how much
more risky the equity market is, relative to the bond market, we could
use this information. For example,
Standard Deviation in Bovespa (Equity) = 36%
Standard Deviation in Brazil C-Bond = 28.2%
Default spread on C-Bond = 6.01%
Country Risk Premium for Brazil = 6.01% (36%/28.2%) = 7.67%
Note that this is on top of the premium you estimate for a mature
market. Thus, if you assume that the risk premium in the US is 4.84%,
the risk premium for Brazil would be 12.51%.
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Implied Equity Premiums
We can use the information in stock prices to back out how risk averse the market is and how much
of a risk premium it is demanding.

If you pay the current level of the index, you can expect to make a return of 7.87% on stocks (which
is obtained by solving for r in the following equation)

Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.87% - 4.22% =
3.65%

1211.92 =
38.13
(1+ r)
+
41.37
(1+ r)
2
+
44.89
(1+ r)
3
+
48.71
(1+ r)
4
+
52.85
(1+ r)
5
+
52.85(1.0422)
(r .0422)(1+ r)
5
January 1, 2005
S&P 500 is at 1211. 92
In 2004, dividends & stock
buybacks were 2.90% of
the index, generating 35.15
in c ashflows
Analysts expect earnings to grow 8. 5% a year for the next 5 years .
After year 5, we will assume that
earnings on the index will grow at
4. 22%, the same rate as the entire
ec onomy
38. 13 41. 37 44. 89 48. 71 52. 85
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Implied Premiums in the US
Implied Premium for US Equity Market
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
1
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47
6 Application Test: A Market Risk Premium
Based upon our discussion of historical risk premiums so far, the risk
premium looking forward should be:
a) About 7.92%, which is what the arithmetic average premium has been
since 1928, for stocks over T.Bills
b) About 4.84%, which is the geometric average premium since 1928, for
stocks over T.Bonds
c) About 3.7%, which is the implied premium in the stock market today
48
Estimating Beta
The standard procedure for estimating betas is to regress stock returns
(R
j
) against market returns (R
m
) -
R
j
= a + b R
m

where a is the intercept and b is the slope of the regression.
The slope of the regression corresponds to the beta of the stock, and
measures the riskiness of the stock.
49
Estimating Performance
The intercept of the regression provides a simple measure of
performance during the period of the regression, relative to the capital
asset pricing model.
R
j
= R
f
+ b (R
m
- R
f
)
= R
f
(1-b) + b R
m
........... Capital Asset Pricing Model
R
j
= a + b R
m
........... Regression Equation
If
a > R
f
(1-b) .... Stock did better than expected during regression period
a = R
f
(1-b) .... Stock did as well as expected during regression period
a < R
f
(1-b) .... Stock did worse than expected during regression period
The difference between the intercept and R
f
(1-b) is Jensen's alpha. If it
is positive, your stock did perform better than expected during the
period of the regression.
50
Firm Specific and Market Risk
The R squared (R
2
) of the regression provides an estimate of the
proportion of the risk (variance) of a firm that can be attributed to
market risk;
The balance (1 - R
2
) can be attributed to firm specific risk.
51
Setting up for the Estimation
Decide on an estimation period
Services use periods ranging from 2 to 5 years for the regression
Longer estimation period provides more data, but firms change.
Shorter periods can be affected more easily by significant firm-specific
event that occurred during the period (Example: ITT for 1995-1997)
Decide on a return interval - daily, weekly, monthly
Shorter intervals yield more observations, but suffer from more noise.
Noise is created by stocks not trading and biases all betas towards one.
Estimate returns (including dividends) on stock
Return = (Price
End
- Price
Beginning
+ Dividends
Period
)/ Price
Beginning
Included dividends only in ex-dividend month
Choose a market index, and estimate returns (inclusive of dividends)
on the index for each interval for the period.
52
Choosing the Parameters: Disney
Period used: 5 years
Return Interval = Monthly
Market Index: S&P 500 Index.
For instance, to calculate returns on Disney in December 1999,
Price for Disney at end of November 1999 = $ 27.88
Price for Disney at end of December 1999 = $ 29.25
Dividends during month = $0.21 (It was an ex-dividend month)
Return =($29.25 - $27.88 + $ 0.21)/$27.88= 5.69%
To estimate returns on the index in the same month
Index level (including dividends) at end of November 1999 = 1388.91
Index level (including dividends) at end of December 1999 = 1469.25
Return =(1469.25 - 1388.91)/ 1388.91 = 5.78%
53
Disneys Historical Beta
Figure 4.3: Disney versus S&P 500: 1999 - 2003
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%
S&P 500
D
i
s
n
e
y
Regression line
54
The Regression Output
Using monthly returns from 1999 to 2003, we ran a regression of
returns on Disney stock against the S*P 500. The output is below:
Returns
Disney
= 0.0467% + 1.01 Returns
S & P 500
(R squared= 29%)
(0.20)

55
Analyzing Disneys Performance
Intercept = 0.0467%
This is an intercept based on monthly returns. Thus, it has to be compared
to a monthly riskfree rate.
Between 1999 and 2003,
Monthly Riskfree Rate = 0.313% (based upon average T.Bill rate: 99-03)
Riskfree Rate (1-Beta) = 0.313% (1-1.01) = -..0032%
The Comparison is then between
Intercept versus Riskfree Rate (1 - Beta)
0.0467% versus 0.313%(1-1.01)=-0.0032%
Jensens Alpha = 0.0467% -(-0.0032%) = 0.05%
Disney did 0.05% better than expected, per month, between 1999 and
2003.
Annualized, Disneys annual excess return = (1.0005)
12
-1= 0.60%
56
A positive Jensens alpha Who is
responsible?
Disney has a positive Jensens alpha of 0.60% a year between 1999
and 2003. This can be viewed as a sign that management in the firm
did a good job, managing the firm during the period.
a) True
b) False
57
Estimating Disneys Beta
Slope of the Regression of 1.01 is the beta
Regression parameters are always estimated with error. The error is
captured in the standard error of the beta estimate, which in the case of
Disney is 0.20.
Assume that I asked you what Disneys true beta is, after this
regression.
What is your best point estimate?

What range would you give me, with 67% confidence?

What range would you give me, with 95% confidence?

58
The Dirty Secret of Standard Error
Distribution of Standard Errors: Beta Estimates for U.S. stocks
0
200
400
600
800
1000
1200
1400
1600
<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75
Standard Error in Beta Estimate
N
u
m
b
e
r

o
f

F
i
r
m
s

59
Breaking down Disneys Risk
R Squared = 29%
This implies that
29% of the risk at Disney comes from market sources
71%, therefore, comes from firm-specific sources
The firm-specific risk is diversifiable and will not be rewarded
60
The Relevance of R Squared
You are a diversified investor trying to decide whether you should invest
in Disney or Amgen. They both have betas of 1.01, but Disney has an
R Squared of 29% while Amgens R squared of only 14.5%. Which
one would you invest in?
a) Amgen, because it has the lower R squared
b) Disney, because it has the higher R squared
c) You would be indifferent
Would your answer be different if you were an undiversified investor?
61
Beta Estimation: Using a Service (Bloomberg)
Quic kTimeand a
TIFF (LZW) dec ompres sor
are needed to see this pi cture.

62
Estimating Expected Returns for Disney in
September 2004
Inputs to the expected return calculation
Disneys Beta = 1.01
Riskfree Rate = 4.00% (U.S. ten-year T.Bond rate)
Risk Premium = 4.82% (Approximate historical premium: 1928-2003)
Expected Return = Riskfree Rate + Beta (Risk Premium)
= 4.00% + 1.01(4.82%) = 8.87%
63
Use to a Potential Investor in Disney
As a potential investor in Disney, what does this expected return of 8.87%
tell you?
a) This is the return that I can expect to make in the long term on Disney, if
the stock is correctly priced and the CAPM is the right model for risk,
b) This is the return that I need to make on Disney in the long term to break
even on my investment in the stock
c) Both
Assume now that you are an active investor and that your research
suggests that an investment in Disney will yield 12.5% a year for the
next 5 years. Based upon the expected return of 8.87%, you would
a) Buy the stock
b) Sell the stock
64
How managers use this expected return
Managers at Disney
need to make at least 8.87% as a return for their equity investors to break
even.
this is the hurdle rate for projects, when the investment is analyzed from
an equity standpoint
In other words, Disneys cost of equity is 8.87%.
What is the cost of not delivering this cost of equity?
65
6 Application Test: Analyzing the Risk
Regression
Using your Bloomberg risk and return print out, answer the following
questions:
How well or badly did your stock do, relative to the market, during the
period of the regression? (You can assume an annualized riskfree rate of
4.8% during the regression period)
Intercept - (4.8%/n) (1- Beta) = Jensens Alpha
Where n is the number of return periods in a year (12 if monthly; 52 if weekly)
What proportion of the risk in your stock is attributable to the market?
What proportion is firm-specific?
What is the historical estimate of beta for your stock? What is the range on
this estimate with 67% probability? With 95% probability?
Based upon this beta, what is your estimate of the required return on this
stock?
Riskless Rate + Beta * Risk Premium
66
A Quick Test
You are advising a very risky software firm on the right cost of equity to
use in project analysis. You estimate a beta of 3.0 for the firm and
come up with a cost of equity of 18.46%. The CFO of the firm is
concerned about the high cost of equity and wants to know whether
there is anything he can do to lower his beta.
How do you bring your beta down?

Should you focus your attention on bringing your beta down?
a) Yes
b) No
67
Beta: Exploring Fundamentals
Beta = 1
Beta > 1
Beta = 0
Beta < 1
Real Networks: 3.24
Qwest Communications: 2.60
General Electric: 1.10
Microsoft: 1..25
Philip Morris: 0.65
Exxon Mobil: 0.40
Harmony Gold Mining: - 0.10
Enron: 0.95
68
Determinant 1: Product Type
Industry Effects: The beta value for a firm depends upon the
sensitivity of the demand for its products and services and of its costs
to macroeconomic factors that affect the overall market.
Cyclical companies have higher betas than non-cyclical firms
Firms which sell more discretionary products will have higher betas than
firms that sell less discretionary products
69
Determinant 2: Operating Leverage Effects
Operating leverage refers to the proportion of the total costs of the firm
that are fixed.
Other things remaining equal, higher operating leverage results in
greater earnings variability which in turn results in higher betas.
70
Measures of Operating Leverage
Fixed Costs Measure = Fixed Costs / Variable Costs
This measures the relationship between fixed and variable costs. The
higher the proportion, the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues
This measures how quickly the earnings before interest and taxes
changes as revenue changes. The higher this number, the greater the
operating leverage.
71
Disneys Operating Leverage: 1987- 2003

Year Net Sa les % Chang e
in Sa les
EBIT % Chang e
in EBIT
1987 2877 756
1988 3438 19.5 0 % 848 12.1 7 %
1989 4594 33.6 2 % 1177 38.8 0 %
1990 5844 27.2 1 % 1368 16.2 3 %
1991 6182 5.78% 1124 -17. 8 4%
1992 7504 21.3 8 % 1287 14 .5 0 %
1993 8529 13.6 6 % 1560 21.2 1 %
1994 100 5 5 17.8 9 % 1804 15.6 4 %
1995 121 1 2 20.4 6 % 2262 25.3 9 %
1996 187 3 9 54.7 1 % 3024 33.6 9 %
1997 224 7 3 19.9 3 % 3945 30.4 6 %
1998 229 7 6 2.24% 3843 -2.59%
1999 234 3 5 2.00% 3580 -6.84%
2000 254 1 8 8.46% 2525 -29. 4 7%
2001 251 7 2 -0.97% 2832 12.1 6 %
2002 253 2 9 0.62% 2384 -15. 8 2%
2003 270 6 1 6.84% 2713 13.8 0 %
1987 -20 0 3 15.8 3 % 10.0 9 %
1996 -20 0 3 11.7 3 % 4.42%

72
Reading Disneys Operating Leverage
Operating Leverage = % Change in EBIT/ % Change in Sales
= 10.09% / 15.83% = 0.64
This is lower than the operating leverage for other entertainment firms,
which we computed to be 1.12. This would suggest that Disney has
lower fixed costs than its competitors.
The acquisition of Capital Cities by Disney in 1996 may be skewing
the operating leverage. Looking at the changes since then:
Operating Leverage
1996-03
= 4.42%/11.73% = 0.38
Looks like Disneys operating leverage has decreased since 1996.
73
Determinant 3: Financial Leverage
As firms borrow, they create fixed costs (interest payments) that make
their earnings to equity investors more volatile.
This increased earnings volatility which increases the equity beta
74
Equity Betas and Leverage
The beta of equity alone can be written as a function of the unlevered
beta and the debt-equity ratio
|
L
= |
u
(1+ ((1-t)D/E))
where
|
L
= Levered or Equity Beta
|
u
= Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
75
Effects of leverage on betas: Disney
The regression beta for Disney is 1.01. This beta is a levered beta
(because it is based on stock prices, which reflect leverage) and the
leverage implicit in the beta estimate is the average market debt equity
ratio during the period of the regression (1999 to 2003)
The average debt equity ratio during this period was 27.5%.
The unlevered beta for Disney can then be estimated (using a marginal
tax rate of 37.3%)
= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
= 1.01 / (1 + (1 - 0.373)) (0.275)) = 0.8615
76
Disney : Beta and Leverage
Debt to Capital Debt/Equity Ratio Beta Effect of Leverage
0.00% 0.00% 0.86 0.00
10.00% 11.11% 0.92 0.06
20.00% 25.00% 1.00 0.14
30.00% 42.86% 1.09 0.23
40.00% 66.67% 1.22 0.36
50.00% 100.00% 1.40 0.54
60.00% 150.00% 1.67 0.81
70.00% 233.33% 2.12 1.26
80.00% 400.00% 3.02 2.16
90.00% 900.00% 5.72 4.86
77
Betas are weighted Averages
The beta of a portfolio is always the market-value weighted average of
the betas of the individual investments in that portfolio.
Thus,
the beta of a mutual fund is the weighted average of the betas of the stocks
and other investment in that portfolio
the beta of a firm after a merger is the market-value weighted average of
the betas of the companies involved in the merger.
78
Bottom-up versus Top-down Beta
The top-down beta for a firm comes from a regression
The bottom up beta can be estimated by doing the following:
Find out the businesses that a firm operates in
Find the unlevered betas of other firms in these businesses
Take a weighted (by sales or operating income) average of these
unlevered betas
Lever up using the firms debt/equity ratio
The bottom up beta will give you a better estimate of the true beta
when
the standard error of the beta from the regression is high (and) the beta for
a firm is very different from the average for the business
the firm has reorganized or restructured itself substantially during the
period of the regression
when a firm is not traded
79
Disneys business breakdown
Business
Comparab le
firms
Numbe r
of firms
Ave rag e
lev ere d
beta
Media n
D/E
Unle v er ed
beta
Cash/Firm
Value
Unle v er ed
beta
correct ed
for cash
Medi a
Networks
Rad ia and TV
br oadcasting
companies 24 1.22 20.4 5 % 1.07 6 8 0.75% 1.08 5 0
Parks an d
Resorts
Theme p a rk &
Entertainment
firms 9 1.58 120. 7 6% 0.88 5 3 2.77% 0.91 0 5
Studio
Entertainment
Movie
companies 11 1.16 27.9 6 % 0. 98 2 4 14.0 8 % 1.14 3 5
Consumer
Products
Toy a nd
apparel
retail ers;
Entertainment
software 77 1.06 9.18% 0.99 8 1 12.0 8 % 1.13 5 3

Unlevered Beta
(1 - Cash/ Firm Value)
80
Disneys bottom up beta
Business
Disneys
Revenues EV/Sales
Estimated
Value
Firm Value
Proportion
Unlevered
beta
Media Networks $10,941 3.41 $37,278.62 49.25% 1.0850
Parks and Resorts $6,412 2.37 $15,208.37 20.09% 0.9105
Studio
Entertainment $7,364 2.63 $19,390.14 25.62% 1.1435
Consumer Products $2,344 1.63 $3,814.38 5.04% 1.1353
Disney $27,061 $75,691.51 100.00% 1.0674

EV/Sales =
(Market Value of Equity + Debt - Cash)
Sales
81
Disneys Cost of Equity
Business Unlevered Beta
D/E
Ratio
Lever ed
Beta
Cost of
Equit y
Medi a Networks 1.08 5 0 26.6 2 % 1.26 6 1 10.1 0 %
Parks an d
Resorts 0.91 0 5 26.6 2 % 1.06 2 5 9.12%
Studio
Entertainment 1.14 3 5 26.6 2 % 1.33 4 4 10.4 3 %
Consumer
Products 1.13 5 3 26.6 2 % 1.32 4 8 10.3 9 %
Disn ey 1.06 7 4 26.6 2 % 1.24 5 6 10.0 0 %

82
Discussion Issue
If you were the chief financial officer of Disney, what cost of equity
would you use in capital budgeting in the different divisions?
a) The cost of equity for Disney as a company
b) The cost of equity for each of Disneys divisions?
83
Estimating Betas for Non-Traded Assets
The conventional approaches of estimating betas from regressions do
not work for assets that are not traded.
There are two ways in which betas can be estimated for non-traded
assets
using comparable firms
using accounting earnings
84
Using comparable firms to estimate beta for
Bookscape
Assume that you are trying to estimate the beta for a independent
bookstore in New York City.
Firm Beta Debt Equity Cash
Books-A-Million 0.532 $45 $45 $5
Borders Group 0.844 $182 $1,430 $269
Barnes & Noble 0.885 $300 $1,606 $268
Courier Corp 0.815 $1 $285 $6
Info Holdings 0.883 $2 $371 $54
John Wiley &Son 0.636 $235 $1,662 $33
Scholastic Corp 0.744 $549 $1,063 $11
Sector 0.7627 $1,314 $6,462 $645
Unlevered Beta = 0.7627/(1+(1-.35)(1314/6462)) = 0.6737
Corrected for Cash = 0.6737 / (1 645/(1314+6462)) = 0.7346
85
Estimating Bookscape Levered Beta and Cost
of Equity
Since the debt/equity ratios used are market debt equity ratios, and the
only debt equity ratio we can compute for Bookscape is a book value
debt equity ratio, we have assumed that Bookscape is close to the
industry average debt to equity ratio of 20.33%.
Using a marginal tax rate of 40% (based upon personal income tax
rates) for Bookscape, we get a levered beta of 0.82.
Levered beta for Bookscape = 0.7346 (1 +(1-.40) (.2033)) = 0.82
Using a riskfree rate of 4% (US treasury bond rate) and a historical risk
premium of 4.82%:
Cost of Equity = 4% + 0.82 (4.82%) = 7.95%

86
Is Beta an Adequate Measure of Risk for a
Private Firm?
The owners of most private firms are not diversified. Beta measures
the risk added on to a diversified portfolio. Therefore, using beta to
arrive at a cost of equity for a private firm will
a) Under estimate the cost of equity for the private firm
b) Over estimate the cost of equity for the private firm
c) Could under or over estimate the cost of equity for the private firm
87
Total Risk versus Market Risk
Adjust the beta to reflect total risk rather than market risk. This
adjustment is a relatively simple one, since the R squared of the
regression measures the proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
In the Bookscape example, where the market beta is 0.82 and the
average R-squared of the comparable publicly traded firms is 16%,

Total Cost of Equity = 4% + 2.06 (4.82%) = 13.93%

Market Beta
R squared
=
0.82
.16
= 2.06
88
6 Application Test: Estimating a Bottom-up
Beta
Based upon the business or businesses that your firm is in right now,
and its current financial leverage, estimate the bottom-up unlevered
beta for your firm.

Data Source: You can get a listing of unlevered betas by industry on
my web site by going to updated data.

89
From Cost of Equity to Cost of Capital
The cost of capital is a composite cost to the firm of raising financing
to fund its projects.
In addition to equity, firms can raise capital from debt
90
What is debt?
General Rule: Debt generally has the following characteristics:
Commitment to make fixed payments in the future
The fixed payments are tax deductible
Failure to make the payments can lead to either default or loss of control
of the firm to the party to whom payments are due.
As a consequence, debt should include
Any interest-bearing liability, whether short term or long term.
Any lease obligation, whether operating or capital.

91
Estimating the Cost of Debt
If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used
as the interest rate.
If the firm is rated, use the rating and a typical default spread on bonds
with that rating to estimate the cost of debt.
If the firm is not rated,
and it has recently borrowed long term from a bank, use the interest rate
on the borrowing or
estimate a synthetic rating for the company, and use the synthetic rating to
arrive at a default spread and a cost of debt
The cost of debt has to be estimated in the same currency as the cost of
equity and the cash flows in the valuation.
92
Estimating Synthetic Ratings
The rating for a firm can be estimated using the financial
characteristics of the firm. In its simplest form, the rating can be
estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
For a firm, which has earnings before interest and taxes of $ 3,500
million and interest expenses of $ 700 million
Interest Coverage Ratio = 3,500/700= 5.00
In 2003, Bookscape had operating income of $ 2 million after interest
expenses of 500,000. The resulting interest coverage ratio is 4.00.
Interest coverage ratio = 2,000,000/500,000 = 4.00
93
Interest Coverage Ratios, Ratings and Default
Spreads: Small Companies
Interest Coverage Ratio Rating Typical default spread
> 12.5 AAA 0.35%
9.50 - 12.50 AA 0.50%
7.50 9.50 A+ 0.70%
6.00 7.50 A 0.85%
4.50 6.00 A- 1.00%
4.00 4.50 BBB 1.50%
3.50 - 4.00 BB+ 2.00%
3.00 3.50 BB 2.50%
2.50 3.00 B+ 3.25%
2.00 - 2.50 B 4.00%
1.50 2.00 B- 6.00%
1.25 1.50 CCC 8.00%
0.80 1.25 CC 10.00%
0.50 0.80 C 12.00%
< 0.65 D 20.00%
94
Synthetic Rating and Cost of Debt for
Bookscape
Rating based on interest coverage ratio = BBB
Default Spread based upon rating = 1.50%
Pre-tax cost of debt = Riskfree Rate + Default Spread = 4% + 1.50% =
5.50%
After-tax cost of debt = Pre-tax cost of debt (1- tax rate) = 5.50% (1-
.40) = 3.30%
95
Estimating Cost of Debt with rated companies
For the three publicly traded firms in our sample, we will use the
actual bond ratings to estimate the costs of debt:
S&P Rating Riskfree Rate Default Cost of Tax After-tax
Spread Debt Rate Cost of Debt
Disney BBB+ 4% ($) 1.25% 5.25% 37.3% 3.29%
Deutsche Bank AA- 4.05% (Eu) 1.00% 5.05% 38% 3.13%
Aracruz B+ 4% ($) 3.25% 7.25% 34% 4.79%
We computed the synthetic ratings for Disney and Aracruz using the
interest coverage ratios:
Disney: Coverage ratio = 2,805/758 =3.70 Synthetic rating = A-
Aracruz: Coverage ratio = 888/339= 2.62 Synthetic rating = BBB
Disneys synthetic rating is close to its actual rating. Aracruz has two
ratings one for its local currency borrowings of BBB- and one for its
dollar borrowings of B+.
96
6 Application Test: Estimating a Cost of Debt
Based upon your firms current earnings before interest and taxes, its
interest expenses, estimate
An interest coverage ratio for your firm
A synthetic rating for your firm (use the interest coverage table)
A pre-tax cost of debt for your firm
An after-tax cost of debt for your firm
97
Weights for Cost of Capital Calculation
The weights used in the cost of capital computation should be market
values.
There are three specious arguments used against market value
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 market value,
this is more a reflection of weakness than strength
Using book value rather than market value is a more conservative
approach to estimating debt ratios: For most companies, using book
values will yield a lower cost of capital than using market value weights.
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
return and cost of capital calculations, it does not make economic sense.
98
Estimating Market Value Weights
Market Value of Equity should include the following
Market Value of Shares outstanding
Market Value of Warrants outstanding
Market Value of Conversion Option in Convertible Bonds
Market Value of Debt is more difficult to estimate because few firms
have only publicly traded debt. There are two solutions:
Assume book value of debt is equal to market value
Estimate the market value of debt from the book value
For Disney, with book value of 13,100 million, interest expenses of $666
million, a current cost of borrowing of 5.25% and an weighted average
maturity of 11.53 years.

Estimated MV of Disney Debt =

666
(1
1
(1.0525)
11.53
.0525

(

(
(
(
(
+
13,100
(1.0525)
11.53
= $12, 915 million
99
Converting Operating Leases to Debt
The debt value of operating leases is the present value of the lease
payments, at a rate that reflects their risk.
In general, this rate will be close to or equal to the rate at which the
company can borrow.
100
Operating Leases at Disney
The pre-tax cost of debt at Disney is 5.25%
Year Commitment Present Value
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
6 9 $ 258.25 $ 704.93
Debt Value of leases = $ 1,752.85
Debt outstanding at Disney = $12,915 + $ 1,753= $14,668 million
101
6 Application Test: Estimating Market Value
Estimate the
Market value of equity at your firm and Book Value of equity
Market value of debt and book value of debt (If you cannot find the
average maturity of your debt, use 3 years): Remember to capitalize the
value of operating leases and add them on to both the book value and the
market value of debt.
Estimate the
Weights for equity and debt based upon market value
Weights for equity and debt based upon book value

102
Current Cost of Capital: Disney
Equity
Cost of Equity = Riskfree rate + Beta * Risk Premium
= 4% + 1.25 (4.82%) = 10.00%
Market Value of Equity = $55.101 Billion
Equity/(Debt+Equity ) = 79%
Debt
After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (4%+1.25%) (1-.373) = 3.29%
Market Value of Debt = $ 14.668 Billion
Debt/(Debt +Equity) = 21%
Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59%
55.101/
(55.101+14.668)
103
Disneys Divisional Costs of Capital
Business Cost of After-tax E/(D+E) D/(D+E) Cost of capital
Equity cost of debt
Media Networks 10.10% 3.29% 78.98% 21.02% 8.67%
Parks and Resorts 9.12% 3.29% 78.98% 21.02% 7.90%
Studio Entertainment 10.43% 3.29% 78.98% 21.02% 8.93%
Consumer Products 10.39% 3.29% 78.98% 21.02% 8.89%
Disney 10.00% 3.29% 78.98% 21.02% 8.59%
104
6 Application Test: Estimating Cost of Capital
Using the bottom-up unlevered beta that you computed for your firm,
and the values of debt and equity you have estimated for your firm,
estimate a bottom-up levered beta and cost of equity for your firm.

Based upon the costs of equity and debt that you have estimated, and
the weights for each, estimate the cost of capital for your firm.

How different would your cost of capital have been, if you used book
value weights?
105
Choosing a Hurdle Rate
Either the cost of equity or the cost of capital can be used as a hurdle
rate, depending upon whether the returns measured are to equity
investors or to all claimholders on the firm (capital)
If returns are measured to equity investors, the appropriate hurdle rate
is the cost of equity.
If returns are measured to capital (or the firm), the appropriate hurdle
rate is the cost of capital.
106
Back to First Principles
financing mix used - owners funds (equity) or borrowed money
(debt)
107
Measuring Investment Returns

Show me the money
Jerry Maguire
108
First Principles
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
109
Measures of return: earnings versus cash
flows
Principles Governing Accounting Earnings Measurement
Accrual Accounting: Show revenues when products and services are sold
or provided, not when they are paid for. Show expenses associated with
these revenues rather than cash expenses.
Operating versus Capital Expenditures: Only expenses associated with
creating revenues in the current period should be treated as operating
expenses. Expenses that create benefits over several periods are written
off over multiple periods (as depreciation or amortization)
To get from accounting earnings to cash flows:
you have to add back non-cash expenses (like depreciation)
you have to subtract out cash outflows which are not expensed (such as
capital expenditures)
you have to make accrual revenues and expenses into cash revenues and
expenses (by considering changes in working capital).
110
Measuring Returns Right: The Basic Principles
Use cash flows rather than earnings. You cannot spend earnings.
Use incremental cash flows relating to the investment decision, i.e.,
cashflows that occur as a consequence of the decision, rather than total
cash flows.
Use time weighted returns, i.e., value cash flows that occur earlier
more than cash flows that occur later.
The Return Mantra: Time-weighted, Incremental Cash Flow
Return
111
Earnings versus Cash Flows: A Disney Theme
Park
The theme parks to be built near Bangkok, modeled on Euro Disney in
Paris, will include a Magic Kingdom to be constructed, beginning
immediately, and becoming operational at the beginning of the second
year, and a second theme park modeled on Epcot Center at Orlando to
be constructed in the second and third year and becoming operational
at the beginning of the fifth year.
The earnings and cash flows are estimated in nominal U.S. Dollars.
112
Earnings on Project
Now (0) 1 2 3 4 5 6 7 8 9 10
Magic King d om $0 $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
Seco n d The me Pa rk $0 $0 $0 $300 $500 $550 $605 $666 $732 $747
Resort & Prop erties $0 $250 $350 $500 $625 $688 $756 $832 $915 $933
Total Revenues $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
Magic Kingdom: Operating
Expenses $0 $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
Epcot II: Operating
Expenses $0 $0 $0 $180 $300 $330 $363 $399 $439 $448
Resort & Prop erty:
Operating Expenses $0 $188 $263 $375 $469 $516 $567 $624 $6 86 $700
Depreciation & Amortization $0 $537 $508 $430 $359 $357 $358 $361 $366 $369
Allocated G&A Costs $0 $188 $263 $375 $469 $516 $567 $624 $686 $700
Operating Income $0 -$262 -$123 $120 $329 $399 $473 $554 $641 $657
Taxes $0 -$98 -$46 $45 $1 23 $149 $177 $206 $239 $245
Operating Incom e aft er
Taxes -$164 -$77 $75 $206 $250 $297 $347 $402 $412

113
And the Accounting View of Return
Year
After -tax
Operating
Income
BV of
Capital:
Beginning
BV of
Capital:
Ending
Ave r age BV
of Capital ROC
1 $0 $2,5 0 0 $3,5 0 0 $3,0 0 0 NA
2 -$165 $3,5 0 0 $4,2 9 4 $3,8 9 7 -4.22%
3 -$77 $4,2 9 4 $4,6 1 6 $4,4 5 5 -1.73%
4 $75 $4,6 1 6 $4,5 2 4 $4,5 7 0 1.65%
5 $20 6 $4,5 2 4 $4,4 8 4 $4,5 0 4 4.58%
6 $251 $4,4 8 4 $4,4 6 4 $4,4 7 4 5.60%
7 $297 $4,4 6 4 $4,4 8 1 $4,4 7 2 6.64%
8 $347 $4,4 8 1 $4,5 1 8 $4,4 9 9 7.72%
9 $402 $4,5 1 8 $4,5 7 5 $4,5 4 7 8.83%
10 $412 $4,5 7 5 $4,6 1 7 $4,5 9 6 8.97%
$175 $4,3 0 1 4.23%

114
Should there be a risk premium for foreign
projects?
The exchange rate risk should be diversifiable risk (and hence should
not command a premium) if
the company has projects is a large number of countries (or)
the investors in the company are globally diversified.
For Disney, this risk should not affect the cost of capital used. Consequently,
we would not adjust the cost of capital for Disneys investments in other
mature markets (Germany, UK, France)
The same diversification argument can also be applied against political
risk, which would mean that it too should not affect the discount rate.
It may, however, affect the cash flows, by reducing the expected life or
cash flows on the project.
For Disney, this is the risk that we are incorporating into the cost of
capital when it invests in Thailand (or any other emerging market)
115
Estimating a hurdle rate for the theme park
We did estimate a cost of equity of 9.12% for the Disney theme park
business in the last chapter, using a bottom-up levered beta of 1.0625
for the business.
This cost of equity may not adequately reflect the additional risk
associated with the theme park being in an emerging market.
To counter this risk, we compute the cost of equity for the theme park
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%.
Cost of Equity in US $= 4% + 1.0625 (4.82% + 3.30%) = 12.63%
Cost of Capital in US $ = 12.63% (.7898) + 3.29% (.2102) = 10.66%
116
Would lead us to conclude that...
Do not invest in this park. The return on capital of 4.23% is lower
than the cost of capital for theme parks of 10.66%; This would
suggest that the project should not be taken.
Given that we have computed the average over an arbitrary period of
10 years, while the theme park itself would have a life greater than 10
years, would you feel comfortable with this conclusion?
a) Yes
b) No
117
From Project to Firm Return on Capital: Disney
in 2003
Just as a comparison of project return on capital to the cost of capital
yields a measure of whether the project is acceptable, a comparison
can be made at the firm level, to judge whether the existing projects of
the firm are adding or destroying value.
Disney, in 2003, had earnings before interest and taxes of $2,713
million, had a book value of equity of $23,879 million and a book
value of debt of 14,130 million. With a tax rate of 37.3%, we get
Return on Capital = 2713(1-.373)/ (23879+14130) = 4.48%
Cost of Capital for Disney= 8.59%
Excess Return = 4.48%-8.59% = -4.11%
This can be converted into a dollar figure by multiplying by the capital
invested, in which case it is called economic value added
EVA = (..0448- .0859) (23879+14130) = - $1,562 million
118
6 Application Test: Assessing Investment
Quality
For the most recent period for which you have data, compute the after-
tax return on capital earned by your firm, where after-tax return on
capital is computed to be
After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of Equity)
previous year
For the most recent period for which you have data, compute the return
spread earned by your firm:
Return Spread = After-tax ROC - Cost of Capital
For the most recent period, compute the EVA earned by your firm
EVA = Return Spread * ((BV of debt + BV of Equity)
previous year
119
The cash flow view of this project..

To get from income to cash flow, we
added back all non-cash charges such as depreciation
subtracted out the capital expenditures
subtracted out the change in non-cash working capital
0 1 2 3 4 5 6
Operating Income after Taxes -$165 -$77 $75 $206 $251
+ Depreciation & Amortization $537 $508 $430 $359 $357
- Capital Expenditures $2,500 $1,000 $1,269 $805 $301 $287 $321
- Change in Working Capital $0 $0 $63 $25 $38 $31 $16
Cashflow to Firm -$2,500 -$1,000 -$960 -$399 $166 $247 $271
120
The incremental cash flows on the project

To get from cash flow to incremental cash flows, we
Taken out of the sunk costs from the initial investment
Added back the non-incremental allocated costs (in after-tax terms)

Now (0) 1 2 3 4 5 6 7 8 9 10
Operating Income aft er Taxes
-$165 -$77 $75 $206 $251 $297 $347 $402 $412
+ Depreciation & Amortization
$537 $508 $430 $359 $357 $358 $361 $366 $369
- Capital Expenditures
$2,500 $1,000 $1,269 $805 $301 $287 $321 $358 $379 $403 $406
- Change in Working Capital
$0 $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
+ Non-incremental Allocated Expense (1-t)
$0 $78 $110 $157 $196 $216 $237 $261 $287 $293
+ Sunk Costs
500
Cashflow to Firm
-$2,000 -$1,000 -$880 -$289 $324 $443 $486 $517 $571 $631 $663

$ 500 million has already been spent
2/3rd of allocated G&A is fixed.
Add back this amount (1-t)
121
To Time-Weighted Cash Flows
Incremental cash flows in the earlier years are worth more than
incremental cash flows in later years.
In fact, cash flows across time cannot be added up. They have to be
brought to the same point in time before aggregation.
This process of moving cash flows through time is
discounting, when future cash flows are brought to the present
compounding, when present cash flows are taken to the future
The discounting and compounding is done at a discount rate that will
reflect
Expected inflation: Higher Inflation -> Higher Discount Rates
Expected real rate: Higher real rate -> Higher Discount rate
Expected uncertainty: Higher uncertainty -> Higher Discount Rate
122
Present Value Mechanics
Cash Flow Type Discounting Formula Compounding Formula
1. Simple CF CF
n
/ (1+r)
n
CF
0
(1+r)
n

2. Annuity

3. Growing Annuity

4. Perpetuity A/r
5. Growing Perpetuity Expected Cashflow next year/(r-g)
A
1 -
1
(1+ r)
n
r

(

(
(
A
(1 + r)
n
- 1
r

(

(
A(1 + g)
1 -
(1 + g)
n
(1 + r)
n
r - g

(

(
(
(
123
Discounted cash flow measures of return
Net Present Value (NPV): The net present value is the sum of the
present values of all cash flows from the project (including initial
investment).
NPV = Sum of the present values of all cash flows on the project, including
the initial investment, with the cash flows being discounted at the
appropriate hurdle rate (cost of capital, if cash flow is cash flow to the
firm, and cost of equity, if cash flow is to equity investors)
Decision Rule: Accept if NPV > 0
Internal Rate of Return (IRR): The internal rate of return is the
discount rate that sets the net present value equal to zero. It is the
percentage rate of return, based upon incremental time-weighted cash
flows.
Decision Rule: Accept if IRR > hurdle rate
124
Closure on Cash Flows
In a project with a finite and short life, you would need to compute a
salvage value, which is the expected proceeds from selling all of the
investment in the project at the end of the project life. It is usually set
equal to book value of fixed assets and working capital
In a project with an infinite or very long life, we compute cash flows
for a reasonable period, and then compute a terminal value for this
project, which is the present value of all cash flows that occur after the
estimation period ends..
Assuming the project lasts forever, and that cash flows after year 9
grow 2% (the inflation rate) forever, the present value at the end of
year 10 of cash flows after that can be written as:
Terminal Value in year 10= CF in year 11/(Cost of Capital - Growth Rate)
=663 (1.02) /(.1066-.02) = $ 7,810 million
125
Which yields a NPV of..
Year
Annual
Cashf lo w
Terminal
Value
Present
Value
0 -$2, 0 00 -$2, 0 00
1 -$1, 0 00 -$904
2 -$880 -$719
3 -$289 -$213
4 $324 $216
5 $443 $267
6 $486 $265
7 $517 $254
8 $571 $254
9 $631 $254
10 $663 $7,8 1 0 $3,0 7 6
$749

126
Which makes the argument that..
The project should be accepted. The positive net present value
suggests that the project will add value to the firm, and earn a return in
excess of the cost of capital.
By taking the project, Disney will increase its value as a firm by $749
million.
127
The IRR of this project
Figure 5.5: NPV Profile for Disney Theme Park
-$3,000.00
-$2,000.00
-$1,000.00
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
Discount Rate
N
P
V
Int ernal Rat e of Return
128
The IRR suggests..
The project is a good one. Using time-weighted, incremental cash
flows, this project provides a return of 11.97%. This is greater than the
cost of capital of 10.66%.
The IRR and the NPV will yield similar results most of the time,
though there are differences between the two approaches that may
cause project rankings to vary depending upon the approach used.
129
Currency Choices and NPV
The analysis was done in dollars. Would the conclusions have been
any different if we had done the analysis in Thai Baht?
a) Yes
b) No
130
Disney Theme Park: Thai Baht NPV
NPV = 31,542 Bt/42.09 Bt = $ 749 Million
NPV is equal to NPV in dollar terms
Year Cashflow ($) Bt/$ Cashflow (Bt) Present Value
0 -2000 42.09 -84180 -84180
1 -1000 45.39 -45391 -38034
2 -880 48.95 -43075 -30243
3 -289 52.79 -15262 -8979
4 324 56.93 18420 9080
5 443 61.40 27172 11223
6 486 66.21 32187 11140
7 517 71.40 36920 10707
8 571 77.01 43979 10687
9 631 83.04 52412 10671
10 8474 89.56 758886 129470
31542
Inflation rate in Thailand = 10%
Inflation rate in US = 2%
Bt/$ in year 1 = 42.09 (1.10/1.02) = 45.39
131
The Role of Sensitivity Analysis
Our conclusions on a project are clearly conditioned on a large number
of assumptions about revenues, costs and other variables over very
long time periods.
To the degree that these assumptions are wrong, our conclusions can
also be wrong.
One way to gain confidence in the conclusions is to check to see how
sensitive the decision measure (NPV, IRR..) is to changes in key
assumptions.
132
Side Costs and Benefits
Most projects considered by any business create side costs and benefits
for that business.
The side costs include the costs created by the use of resources that the
business already owns (opportunity costs) and lost revenues for other
projects that the firm may have.
The benefits that may not be captured in the traditional capital
budgeting analysis include project synergies (where cash flow benefits
may accrue to other projects) and options embedded in projects
(including the options to delay, expand or abandon a project).
The returns on a project should incorporate these costs and benefits.
133
First Principles
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
134
Finding the Right Financing Mix: The
Capital Structure Decision
135
First Principles
136
St age 2
Rapid Expansion
St age 1
St art-up
St age 4
Mat ure Growt h
St age 5
Decline
Financing Choices across the life cycle
External
Financing
Revenues
Earnings
Owners Equit y
Bank Debt
Venture Capit al
Common St ock
Debt Retire debt
Repurchase st ock
External funding
needs
High, but
constrained by
infrast ruct ure
High, relative
t o firm value.
Moderat e, relat ive
t o firm value.
Declining, as a
percent of firm
value
Internal financing
Low, as project s dry
up.
Common st ock
Warrant s
Convert ibles
St age 3
High Growt h
Negat ive or
low
Negat ive or
low
Low, relat ive to
funding needs
High, relative t o
funding needs
More than funding needs
Accessing private equit y Inital Public offering Seasoned equity issue Bond issues
Financing
Transitions
Growt h st age
$ Revenues/
Earnings
Time
137
Measuring a firms financing mix
The simplest measure of how much debt and equity a firm is using
currently is to look at the proportion of debt in the total financing. This
ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
Debt includes all interest bearing liabilities, short term as well as long
term.
Equity can be defined either in accounting terms (as book value of
equity) or in market value terms (based upon the current price). The
resulting debt ratios can be very different.
138
Debt: Summarizing the Trade Off
Advantages of Borrowing Disadvantages of Borrowing
1. Tax Benefit:
Higher tax rates --> Higher tax benefit
1. Bankruptcy Cost:
Higher business risk --> Higher Cost
2. Added Discipline:
Greater the separation between managers
and stockholders --> Greater the benefit
2. Agency Cost:
Greater the separation between stock-
holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
139
A Hypothetical Scenario
Assume you operate in an environment, where
(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know their future financing needs
140
The Miller-Modigliani Theorem
In an environment, where there are no taxes, default risk or agency
costs, capital structure is irrelevant.
The value of a firm is independent of its debt ratio.
141
Implications of MM Theorem
Leverage is irrelevant. A firm's value will be determined by its project
cash flows.
The cost of capital of the firm will not change with leverage. As a firm
increases its leverage, the cost of equity will increase just enough to
offset any gains to the leverage
142
Pathways to the Optimal
The Cost of Capital Approach: The optimal debt ratio is the one that
minimizes the cost of capital for a firm.
The Sector Approach: The optimal debt ratio is the one that brings the
firm closes to its peer group in terms of financing mix.
143
I. The Cost of Capital Approach
Value of a Firm = Present Value of Cash Flows to the Firm, discounted
back at the cost of capital.
If the cash flows to the firm are held constant, and the cost of capital is
minimized, the value of the firm will be maximized.
144
Applying Cost of Capital Approach: The
Textbook Example
D/(D+E) ke kd After-tax Cost of DebtWACC
0 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%
145
WACC and Debt Ratios
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
W
A
C
C

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

1
0
%

2
0
%

3
0
%

4
0
%

5
0
%

6
0
%

7
0
%

8
0
%

9
0
%

1
0
0
%

146
Equity
= 4% + 1.25 (4.82%) = 10.00%
Debt
= (4%+1.25%) (1-.373) = 3.29%
Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59%
55.101/
(55.101+14.668)
147
Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
Equity will become riskier -> Beta will increase -> Cost of Equity will
increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt goes up -> Cost
of Debt will increase.
To estimating bond ratings, we will use the interest coverage ratio
(EBIT/Interest expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.
148
Estimating Cost of Equity
Unlevered Beta = 1.0674 (Bottom up beta based upon Disneys businesses)
Market premium = 4.82% T.Bond Rate = 4.00% Tax rate=37.3%
Debt Ratio D/E Ratio Levered Beta Cost of Equity
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%
149
Estimating Cost of Debt
Start with the current market value of the firm = 55,101 + 14668 = $69, 769 mil
D/(D+E) 0.00% 10.00% Debt to capital
D/E 0.00% 11.11% D/E = 10/90 = .1111
$ Debt $0 $6,977 10% of $69,769

EBITDA $3,882 $3,882 Same as 0% debt
Depreciation $1,077 $1,077 Same as 0% debt
EBIT $2,805 $2,805 Same as 0% debt
Interest $0 $303 Pre-tax cost of debt * $ Debt

Pre-tax Int. cov 9.24 EBIT/ Interest Expenses
Likely Rating AAA AAA From Ratings table
Pre-tax cost of debt 4.35% 4.35% Riskless Rate + Spread
150
The Ratings Table
Interest Co v era ge
Ratio
Rati n
g
Typical de f ault
spread
Market inte rest rat e
on d ebt
> 8.5 AAA 0.35% 4.35%
6.50 - 6.50 AA 0.50% 4.50%
5.50 6.50 A+ 0.70% 4.70%
4.25 5.50 A 0.85% 4.85%
3.00 4.25 A- 1.00% 5.00%
2.50 3.00 BBB 1.50% 5.50%
2.05 - 2. 5 0 BB+ 2.00% 6.0 0%
1.90 2.00 BB 2.50% 6.50%
1.75 1.90 B+ 3.25% 7.25%
1.50 - 1.75 B 4.00% 8.00%
1.25 1.50 B- 6.00% 10.0 0 %
0.80 1.25 CCC 8.00% 12.0 0 %
0.65 0.80 CC 10.0 0 % 14.0 0 %
0.20 0.65 C 12.0 0 % 16.0 0 %
< 0.20 D 20.0 0 % 24.0 0 %

151
A Test: Can you do the 20% level?
D/(D+E) 0.00% 10.00% 20.00% 2nd Iteration 3rd?
D/E 0.00% 11.11% 25.00%
$ Debt $0 $6,977 $13,954

EBITDA $3,882 $3,882 $3,882
Depreciation $1,077 $1,077 $1,077
EBIT $2,805 $2,805 $2,805
Interest $0 $303 $ 606 .0485*13954=676

Pre-tax Int. cov 9.24 4.62 2805/676=4.15
Likely Rating AAA AAA A A-
Cost of debt 4.35% 4.35% 4.85% 5.00%
152
Bond Ratings, Cost of Debt and Debt Ratios
Debt
Ratio Debt
Interest
expense
Interest
Cove rag e
Ratio
Bond
Rating
Interest
rate on
debt
Tax
Rate
Cost of
Debt
(af ter -tax)
0% $0 $0 AAA 4.35% 37.3 0 % 2.73%
10% $6,9 7 7 $303 9.24 AAA 4.35% 37.3 0 % 2.73%
20% $13, 9 54 $698 4.0 2 A- 5.00% 37.3 0 % 3.14%
30% $20, 9 31 $1,2 5 6 2.23 BB+ 6.00% 37.3 0 % 3.76%
40% $27, 9 08 $3,3 4 9 0.84 CCC 12.0 0 % 31.2 4 % 8.25%
50% $34, 8 85 $5,5 8 2 0.50 C 16.0 0 % 18.7 5 % 13.0 0 %
60% $41, 8 61 $6,6 9 8 0.42 C 16.0 0 % 15.6 2 % 13.5 0 %
70% $48, 8 38 $7,8 1 4 0.36 C 16 .0 0 % 13.3 9 % 13.8 6 %
80% $55, 8 15 $8,9 3 0 0.31 C 16.0 0 % 11.7 2 % 14.1 3 %
90% $62, 7 92 $10, 0 47 0.28 C 16.0 0 % 10.4 1 % 14.3 3 %

153
Stated versus Effective Tax Rates
You need taxable income for interest to provide a tax savings
In the Disney case, consider the interest expense at 30% and 40%
30% Debt Ratio 40% Debt Ratio
EBIT $ 2,805 m $ 2,805 m
Interest Expense $ 1,256 m $ 3,349 m
Tax Savings $ 1,256*.373=468 2,805*.373 = $ 1,046
Tax Rate 37.30% 1,046/3,349= 31.2%
Pre-tax interest rate 6.00% 12.00%
After-tax Interest Rate 3.76% 8.25%
You can deduct only $2,805 million of the $3,349 million of the
interest expense at 40%. Therefore, only 37.3% of $ 2,805 million is
considered as the tax savings.
154
Disneys Cost of Capital Schedule
Debt Ratio Cost of Equity Cost of Debt (after-tax) Cost of Capital
0% 9.15% 2.73% 9.15%
10% 9.50% 2.73% 8.83%
20% 9.95% 3.14% 8.59%
30% 10.53% 3.76% 8.50%
40% 11.50% 8.25% 10.20%
50% 13.33% 13.00% 13.16%
60% 15.66% 13.50% 14.36%
70% 19.54% 13.86% 15.56%
80% 27.31% 14.13% 16.76%
90% 50.63% 14.33% 17.96%
155
Disney: Cost of Capital Chart
Figure 8.3: Disney Cost of Capital at different Debt Ratios
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio
C
o
s
t
s

o
f

d
e
b
t

a
n
d

e
q
u
i
t
y
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
C
o
s
t

o
f

C
a
p
i
t
a
l
Cost of Equity After-tax Cost of Debt Cost of Capital
Optimal Debt ratio is at this point
Cost of equity
climbs as
levered beta
increases
After-tax cost of debt increases as
interest coverage ratio deteriorates
and with it the synthetic rating.
156
Effect on Firm Value
Firm Value before the change = 55,101+14,668= $ 69,769
WACC
b
= 8.59% Annual Cost = $69,769 *8.59%= $5,993 million
WACC
a
= 8.50% Annual Cost = $69,769 *8.50% = $5,930 million
A WACC = 0.09% Change in Annual Cost = $ 63 million
If there is no growth in the firm value, (Conservative Estimate)
Increase in firm value = $63 / .0850= $ 741 million
Change in Stock Price = $741/2047.6= $0.36 per share
If we assume a perpetual growth of 4% in firm value over time,
Increase in firm value = $63 /(.0850-.04) = $ 1,400 million
Change in Stock Price = $1,400/2,047.6 = $ 0.68 per share
Implied Growth Rate obtained by
Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula
$69,769 = $1,722(1+g)/(.0859-g): Solve for g -> Implied growth = 5.98%
157
A Test: The Repurchase Price
Let us suppose that the CFO of Disney approached you about buying
back stock. He wants to know the maximum price that he should be
willing to pay on the stock buyback. (The current price is $ 26.91)
Assuming that firm value will grow by 4% a year, estimate the
maximum price.

What would happen to the stock price after the buyback if you were
able to buy stock back at $ 26.91?
158
The Downside Risk
Doing What-if analysis on Operating Income
A. Standard Deviation Approach
Standard Deviation In Past Operating Income
Standard Deviation In Earnings (If Operating Income Is Unavailable)
Reduce Base Case By One Standard Deviation (Or More)
B. Past Recession Approach
Look At What Happened To Operating Income During The Last Recession.
(How Much Did It Drop In % Terms?)
Reduce Current Operating Income By Same Magnitude
Constraint on Bond Ratings
159
Disneys Operating Income: History
Year EBIT % Chang e
in EBIT
1987 756
1988 848 12.1 7 %
1989 1177 38.8 0 %
1990 1368 16.2 3 %
1991 1124 -17. 8 4%
1992 1287 14.5 0 %
1993 1560 21.2 1 %
1994 1804 15.6 4 %
1995 2262 25.3 9 %
1996 3024 33.6 9 %
1997 3945 30.4 6 %
1998 3843 -2.59%
1999 3580 -6.84%
2000 2525 -29. 4 7%
2001 2832 12.1 6 %
2002 2384 -15. 8 2%
2003 2713 13.8 0 %

160
Disney: Effects of Past Downturns
Recession Decline in Operating Income
2002 Drop of 15.82%
1991 Drop of 22.00%
1981-82 Increased
Worst Year Drop of 29.47%

The standard deviation in past operating income is about 20%.
161
Disney: The Downside Scenario
% Drop in EBITDA EBIT Optimal Debt Ratio
0% $ 2,805 30%
5% $ 2,665 20%
10% $ 2,524 20%
15% $ 2385 20%
20% $ 2,245 20%

162
Constraints on Ratings
Management often specifies a 'desired Rating' below which they do not
want to fall.
The rating constraint is driven by three factors
it is one way of protecting against downside risk in operating income (so
do not do both)
a drop in ratings might affect operating income
there is an ego factor associated with high ratings
Caveat: Every Rating Constraint Has A Cost.
Provide Management With A Clear Estimate Of How Much The Rating
Constraint Costs By Calculating The Value Of The Firm Without The
Rating Constraint And Comparing To The Value Of The Firm With The
Rating Constraint.
163
Ratings Constraints for Disney
At its optimal debt ratio of 30%, Disney has an estimated rating of
BB+.
Assume that Disney imposes a rating constraint of A or greater.
The optimal debt ratio for Disney is then 20% (see next page)
The cost of imposing this rating constraint can then be calculated as
follows:
Value at 30% Debt = $ 71,239 million
- Value at 20% Debt = $ 69,837 million
Cost of Rating Constraint = $ 1,376 million
164
Effect of Ratings Constraints: Disney
Debt Ratio Rating Firm Value
0% AAA $62,279
10% AAA $66,397
20% A- $69,837
30% BB+ $71,239
40% CCC $51,661
50% C $34,969
60% C $30,920
70% C $27,711
80% C $25,105
90% C $22,948
165
What if you do not buy back stock..
The optimal debt ratio is ultimately a function of the underlying
riskiness of the business in which you operate and your tax rate.
Will the optimal be different if you invested in projects instead of
buying back stock?
No. As long as the projects financed are in the same business mix that the
company has always been in and your tax rate does not change
significantly.
Yes, if the projects are in entirely different types of businesses or if the tax
rate is significantly different.
166
Analyzing Financial Service Firms
The interest coverage ratios/ratings relationship is likely to be different
for financial service firms.
The definition of debt is messy for financial service firms. In general,
using all debt for a financial service firm will lead to high debt ratios.
Use only interest-bearing long term debt in calculating debt ratios.
The effect of ratings drops will be much more negative for financial
service firms.
There are likely to regulatory constraints on capital
167
Interest Coverage ratios, ratings and Operating
income
Long Term Interest Coverage Ratio Rating is Spread is Operating Income Decline
< 0.05 D 16.00% -50.00%
0.05 0.10 C 14.00% -40.00%
0.10 0.20 CC 12.50% -40.00%
0.20 - 0.30 CCC 10.50% -40.00%
0.30 0.40 B- 6.25% -25.00%
0.40 0.50 B 6.00% -20.00%
0.50 0.60 B+ 5.75% -20.00%
0.60 0.75 BB 4.75% -20.00%
0.75 0.90 BB+ 4.25% -20.00%
0.90 1.20 BBB 2.00% -20.00%
1.20 1.50 A- 1.50% -17.50%
1.50 2.00 A 1.40% -15.00%
2.00 2.50 A+ 1.25% -10.00%
2.50 3.00 AA 0.90% -5.00%
> 3.00 AAA 0.70% 0.00%

168
Deutsche Bank: Optimal Capital Structure
Debt
Ratio Beta
Cost of
Equity
Bond
Rating
Interest
rate on debt
Tax
Rate
Cost of Debt
(af ter-tax) WACC
Firm
Value (G)
0% 0.44 6.15% AAA 4.75% 38.00% 2.95% 6.15% $111,034
10% 0.47 6.29% AAA 4.75% 38.00% 2.95% 5.96% $115,498
20% 0.50 6.48% AAA 4.75% 38.00% 2.95% 5.77% $120,336
30% 0.55 6.71% AAA 4.75% 38.00% 2.95% 5.58% $125,597
40% 0.62 7.02% AAA 4.75% 38.00% 2.95% 5.39% $131,339
50% 0.71 7.45% A+ 5.30% 38.00% 3.29% 5.37% $118,770
60% 0.84 8.10% A 5.45% 38.00% 3.38% 5.27% $114,958
70% 1.07 9.19% A 5.45% 38.00% 3.38% 5.12% $119,293
80% 1.61 11.83% BB+ 8.30% 32.43% 5.61% 6.85% $77,750
90% 3.29 19.91% BB 8.80% 27.19% 6.41% 7.76% $66,966

169
Determinants of Optimal Debt Ratios
Firm Specific Factors
1. Tax Rate
Higher tax rates - - > Higher Optimal Debt Ratio
Lower tax rates - - > Lower Optimal Debt Ratio
2. Pre-Tax CF on Firm = EBITDA / MV of Firm
Higher Pre-tax CF - - > Higher Optimal Debt Ratio
Lower Pre-tax CF - - > Lower Optimal Debt Ratio
3. Variance in Earnings [ Shows up when you do 'what if' analysis]
Higher Variance - - > Lower Optimal Debt Ratio
Lower Variance - - > Higher Optimal Debt Ratio
Macro-Economic Factors
1. Default Spreads
Higher - - > Lower Optimal Debt Ratio
Lower - - > Higher Optimal Debt Ratio
170
6 Application Test: Your firms optimal
financing mix
Using the optimal capital structure spreadsheet provided:
Estimate the optimal debt ratio for your firm
Estimate the new cost of capital at the optimal
Estimate the effect of the change in the cost of capital on firm value
Estimate the effect on the stock price
In terms of the mechanics, what would you need to do to get to the
optimal immediately?
171
II. Relative Analysis
I. Industry Average with Subjective Adjustments
The safest place for any firm to be is close to the industry average
Subjective adjustments can be made to these averages to arrive at the
right debt ratio.
Higher tax rates -> Higher debt ratios (Tax benefits)
Lower insider ownership -> Higher debt ratios (Greater discipline)
More stable income -> Higher debt ratios (Lower bankruptcy costs)
More intangible assets -> Lower debt ratios (More agency problems)
172
Comparing to industry averages
Disney Entertainment Aracruz
Paper and Pulp (Emerging
Market)
Market Debt Ratio 21.02% 19.56% 30.82% 27.71%
Book Debt Ratio 35.10% 28.86% 43.12% 49.00%

173
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? Is the firm a takeover target?
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
Take good projects with
new equity or with retained
earnings.
No
1. Pay off debt with retained
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
Yes
No
projects?
Yes
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.
174
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? Is the firm a takeover target?
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
new equity or with retained
earnings.
No
1. Pay off debt with retained
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
Yes
No
projects?
Yes
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends
No
Buy back stock
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.
175
6 Application Test: Getting to the Optimal
Based upon your analysis of both the firms capital structure and
investment record, what path would you map out for the firm?
Immediate change in leverage
Gradual change in leverage
No change in leverage
Would you recommend that the firm change its financing mix by
Paying off debt/Buying back equity
Take projects with equity/debt
176
Designing Debt: The Fundamental Principle
The objective in designing debt is to make the cash flows on debt
match up as closely as possible with the cash flows that the firm makes
on its assets.
By doing so, we reduce our risk of default, increase debt capacity and
increase firm value.
177
Design the perfect financing instrument
The perfect financing instrument will
Have all of the tax advantages of debt
While preserving the flexibility offered by equity

Duration Currency Effect of Inflation
Uncertainty about Future
Growth Patterns
Cyclicality &
Other Effects
Def ine Debt
Characteristics
Duration/
Maturity
Currency
Mix
Fixed vs. Floating Rate
* More floating rate
- if CF move with
inflation
- with greater uncertainty
on future
Straight v ersus
Conv ertible
- Convertible if
cash flows low
now but high
exp. growth
Special Features
on Debt
- Options to make
cash flows on debt
match cash flows
on assets
Start with the
Cash Flows
on Assets/
Projects
Commodity Bonds
Catastrophe Notes
Design debt to have cash f lows that match up to cash flows on the assets f inanced
178
Ensuring that you have not crossed the line
drawn by the tax code
All of this design work is lost, however, if the security that you have
designed does not deliver the tax benefits.
In addition, there may be a trade off between mismatching debt and
getting greater tax benefits.

Overlay tax
preferences
Deductibility of cash flows
for tax purposes
Differences in tax rates
across different locales
If tax advantages are large enough, you might override results of previous step
Zero Coupons
179
While keeping equity research analysts,
ratings agencies and regulators applauding
Ratings agencies want companies to issue equity, since it makes them
safer. Equity research analysts want them not to issue equity because it
dilutes earnings per share. Regulatory authorities want to ensure that
you meet their requirements in terms of capital ratios (usually book
value). Financing that leaves all three groups happy is nirvana.

Consider
ratings agency
& analyst concerns
Analyst Concerns
- Effect on EPS
- Value relative to comparables
Ratings Agenc y
- Effect on Ratios
- Ratios relative to comparables
Regulatory Concerns
- Measures used
Can securities be designed that can make these diff erent entities happy?
Operating Leases
MIPs
Surplus Notes
180
Debt or Equity: The Strange Case of Trust
Preferred
Trust preferred stock has
A fixed dividend payment, specified at the time of the issue
That is tax deductible
And failing to make the payment can cause ? (Can it cause default?)
When trust preferred was first created, ratings agencies treated it as
equity. As they have become more savvy, ratings agencies have started
giving firms only partial equity credit for trust preferred.

181
Debt, Equity and Quasi Equity
Assuming that trust preferred stock gets treated as equity by ratings
agencies, which of the following firms is the most appropriate firm to
be issuing it?
A firm that is under levered, but has a rating constraint that would be
violated if it moved to its optimal
A firm that is over levered that is unable to issue debt because of the
rating agency concerns.
182
Soothe bondholder fears
There are some firms that face skepticism from bondholders when they
go out to raise debt, because
Of their past history of defaults or other actions
They are small firms without any borrowing history
Bondholders tend to demand much higher interest rates from these
firms to reflect these concerns.

Factor in agency
conflicts between stock
and bond holders
Observability of Cash Flows
by Lenders
- Less observable cash flows
lead to more conflic ts
Type of Assets financed
- Tangible and liquid assets
create less agency problems
Existing Debt covenants
- Restrictions on Financ ing
If agency problems are substantial, consider issuing convertible bonds
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LYONs
183
And do not lock in market mistakes that work
against you
Ratings agencies can sometimes under rate a firm, and markets can
under price a firms stock or bonds. If this occurs, firms should not
lock in these mistakes by issuing securities for the long term. In
particular,
Issuing equity or equity based products (including convertibles), when
equity is under priced transfers wealth from existing stockholders to the
new stockholders
Issuing long term debt when a firm is under rated locks in rates at levels
that are far too high, given the firms default risk.
What is the solution
If you need to use equity?
If you need to use debt?
184
Designing Debt: Bringing it all together
Duration Currency Effect of Inflation
Uncertainty about Future
Growth Patterns
Cyclicality &
Other Effects
Define Debt
Characteristics
Duration/
Maturity
Currency
Mix
Fixed vs. Floating Rate
* More floating rate
- if CF move with
inflation
- with greater uncertainty
on future
Straight versus
Convertible
- Convertible if
cash flows low
now but high
exp. growth
Special Features
on Debt
- Options to make
cash flows on debt
match cash flows
on assets
Start with the
Cash Flows
on Assets/
Projects
Overlay tax
preferences
Deductibility of cash flows
for tax purposes
Differences in tax rates
across different locales
Consider
ratings agency
& analyst concerns
Analyst Concerns
- Effect on EPS
- Value relative to comparables
Ratings Agency
- Effect on Ratios
- Ratios relative to comparables
Regulatory Concerns
- Measures used
Factor in agency
conflicts between stock
and bond holders
Observability of Cash Flows
by Lenders
- Less observable cash flows
lead to more conflicts
Type of Assets financed
- Tangible and liquid assets
create less agency problems
Existing Debt covenants
- Restrictions on Financing
Consider Information
Asymmetries
Uncertainty about Future Cashflows
- When there is more uncertainty, it
may be better to use short term debt
Credibility & Quality of the Firm
- Firms with credibility problems
will issue more short term debt
If agency problems are substantial, consider issuing convertible bonds
Can securities be designed that can make these different entities happy?
If tax advantages are large enough, you might override results of previous step
Zero Coupons
Operating Leases
MIPs
Surplus Notes
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LYONs
Commodity Bonds
Catastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
185
The Right Debt for Disney
Business Project Cash Flow Characteristics Type of Financing
Movies Projects are likely to
1. Be short term
2. Have cash outflows primaril y in dollars (since Disney makes most of
its movies in the U.S.) but cashinflows could have a substantial
foreign currency component (because o f overseassales)
3. Have net cash flows that ar e heavily driven by whether the movie is a
hit, which is often difficult to predict.
Debt should be
1. Short term
2. Primarily dollar debt.
3. If possible, tied to the success
of movies. (Lion King or
Nemo Bonds)
Broadcasting Projects are likely to be
1. Short term
2. Primarily in dollars, though foreign component is growing
3. Driven by advertising revenues and show success
Debt should be
1. Short term
2. Primarily dollar debt
3. If possible, linked to network
ratings.
Theme Parks Projects are likely to be
1. Very long term
2. Primarily in dollars, but a significant proportion of revenues come
from foreign tourists, who are likely to stay away if the dollar
strengthens
3. Affected by success of movie and broadcasting divisions.
Debt should be
1. Long term
2. Mix of currencies, based upon
tourist make up.

Consumer Products Projects are likely to be short to medium term and linked to the success of
the movie division. Most of Disneys product offerings are derived from
their movie productions.
Debt should be
a. Medium term
b. Dollar debt.

186
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
than the duration, this would indicate that Disneys debt is far too long
term for its existing business mix.
Of the debt, about 12% is Euro debt and no yen denominated debt.
Based upon our analysis, a larger portion of Disneys debt should be in
foreign currencies.
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
analysis would indicate that Disney should be using more of it.
187
Adjusting Debt at Disney
It can swap some of its existing long term, fixed rate, dollar debt with
shorter term, floating rate, foreign currency debt. Given Disneys
standing in financial markets and its large market capitalization, this
should not be difficult to do.
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
debt matching will become better at the company level.

188
Returning Cash to the Owners:
Dividend Policy
189
First Principles
190
Steps to the Dividend Decision
Cashflow
from
Operations
Cashflows to Debt
(Principal repaid,
Interest
Expenses)
Cashflows from
Operations to
Equity Investors
Reinvestment back
into the business
Cash available
for return to
stockholders
Cash held back
by the company
Cash Paid out
Stock Buybacks
Dividends
How much did you borrow?
How good are your investment choices?
What is a reasonable cash balance?
What do your
stockholders prefer?
191
I. Dividends are sticky
192
II. Dividends tend to follow earnings
Dividends and Earnings on U.S. companies - 1960 - 2004
0.00
10.00
20.00
30.00
40.00
50.00
60.00
1
9
6
0
1
9
6
1
1
9
6
2
1
9
6
3
1
9
6
4
1
9
6
5
1
9
6
6
1
9
6
7
1
9
6
8
1
9
6
9
1
9
7
0
1
9
7
1
1
9
7
2
1
9
7
3
1
9
7
4
1
9
7
5
1
9
7
6
1
9
7
7
1
9
7
8
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
Year
D
i
v
i
d
e
n
d
s

&

E
a
r
n
i
n
g
s
Earnings
Dividends
193
III. More and more firms are buying back stock,
rather than pay dividends...
Stock Buybacks and Dividends: Aggregate for US Firms - 1989-2002
$-
$50,000.00
$100,000.00
$150,000.00
$200,000.00
$250,000.00
$300,000.00
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Year
$

D
i
v
i
d
e
n
d
s

&

B
u
y
b
a
c
k
s
Stock Buybacks Dividends
194
IV. But the change in dividend tax law in 2003
may cause a shift back to dividends
195
Measures of Dividend Policy
Dividend Payout:
measures the percentage of earnings that the company pays in dividends
= Dividends / Earnings
Dividend Yield :
measures the return that an investor can make from dividends alone
= Dividends / Stock Price
196
Dividend Payout Ratios: January 2005
0
50
100
150
200
250
300
0-10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% 90-100% >100%
Payout Ratio: US companies in January 2005
197
Dividend Yields in the United States: January
2005
0
20
40
60
80
100
120
140
0-
0.2%
02-
0.4%
0.4-
0.6%
0.6-
0.8%
0.8-
1%
1-
1.2%
1.2-
1.4%
1.4-
1.6%
1.6-
1.8%
1.8-
2%
2-
2.2%
2.2-
2.4%
2.4-
2.6%
2.6-
2.8%
2.8-
3%
3-
3.5%
3.5-
4%
4-
4.5%
4.5-
5%
>5%
Dividend Yields: US companies in January 2005
5362 companies paid no dividends in 2004
1729 companies paid dividends
198
Three Schools Of Thought On Dividends
1. If
(a) there are no tax disadvantages associated with dividends
(b) companies can issue stock, at no cost, to raise equity, whenever needed
Dividends do not matter, and dividend policy does not affect value.
2. If dividends have a tax disadvantage,
Dividends are bad, and increasing dividends will reduce value
3. If stockholders like dividends, or dividends operate as a signal of future prospects,
Dividends are good, and increasing dividends will increase value
199
The balanced viewpoint
If a company has excess cash, and few good investment opportunities
(NPV>0), returning money to stockholders (dividends or stock
repurchases) is good.
If a company does not have excess cash, and/or has several good
investment opportunities (NPV>0), returning money to stockholders
(dividends or stock repurchases) is bad.
200
Assessing Dividend Policy
Approach 1: The Cash/Trust Nexus
Assess how much cash a firm has available to pay in dividends, relative
what it returns to stockholders. Evaluate whether you can trust the
managers of the company as custodians of your cash.
Approach 2: Peer Group Analysis
Pick a dividend policy for your company that makes it comparable to
other firms in its peer group.
201
I. The Cash/Trust Assessment
Step 1: How much could the company have paid out during the period
under question?
Step 2: How much did the the company actually pay out during the
period in question?
Step 3: How much do I trust the management of this company with
excess cash?
How well did they make investments during the period in question?
How well has my stock performed during the period in question?
202
A Measure of How Much a Company Could
have Afforded to Pay out: FCFE
The Free Cashflow to Equity (FCFE) is a measure of how much cash
is left in the business after non-equity claimholders (debt and preferred
stock) have been paid, and after any reinvestment needed to sustain the
firms assets and future growth.
Net Income
+ Depreciation & Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs
- Principal Repayments
+ Proceeds from New Debt Issues
= Free Cash flow to Equity
203
Estimating FCFE when Leverage is Stable
Net Income
- (1- o) (Capital Expenditures - Depreciation)
- (1- o) Working Capital Needs
= Free Cash flow to Equity
o = Debt/Capital Ratio
For this firm,
Proceeds from new debt issues = Principal Repayments + o (Capital
Expenditures - Depreciation + Working Capital Needs)
204
An Example: FCFE Calculation
Consider the following inputs for Microsoft in 1996. In 1996,
Microsofts FCFE was:
Net Income = $2,176 Million
Capital Expenditures = $494 Million
Depreciation = $ 480 Million
Change in Non-Cash Working Capital = $ 35 Million
Debt Ratio = 0%
FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (!-DR)
= $ 2,176 - (494 - 480) (1-0) - $ 35 (1-0)
= $ 2,127 Million

205
Microsoft: Dividends?
By this estimation, Microsoft could have paid $ 2,127 Million in
dividends/stock buybacks in 1996. They paid no dividends and bought
back no stock. Where will the $2,127 million show up in Microsofts
balance sheet?

206
Dividends versus FCFE: U.S.
0
50
100
150
200
250
300
N
u
m
b
e
r

o
f

f
i
r
m
s
0

-
5
%
5
-
1
0
%
1
0
-
1
5
%
1
5
-
2
0
%
2
0
-
2
5
%
2
5
-
3
0
%
3
0
-
3
5
%
3
5
-
4
0
%
4
0
-
4
5
%
4
5
-
5
0
%
5
0
-
5
5
%
5
5
-
6
0
%
6
0
-
6
5
%
6
5
-
7
0
%
7
0
-
7
5
%
7
5
-
8
0
%
8
0
-
8
5
%
8
5
-
9
0
%
9
0
-
9
5
%
9
5
-
1
0
0
%
>
1
0
0
%
D
i
v
i
d
e
n
d
s

w
i
t
h

n
e
g
a
t
i
v
e

F
C
F
E
Dividends/FCFE
Figure 11.2: Dividends paid as % of FCFE
207
The Consequences of Failing to pay FCFE
Chrysler: FCFE, Dividends and Cash Balance
($500)
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
C
a
s
h

F
l
o
w
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
C
a
s
h

B
a
l
a
n
c
e
= Free CF to Equity = Cash to Stockholders Cumulated Cash
208
6 Application Test: Estimating your firms
FCFE
In General, If cash flow statement used
Net Income Net Income
+ Depreciation & Amortization + Depreciation & Amortization
- Capital Expenditures + Capital Expenditures
- Change in Non-Cash Working Capital + Changes in Non-cash WC
- Preferred Dividend + Preferred Dividend
- Principal Repaid + Increase in LT Borrowing
+ New Debt Issued + Decrease in LT Borrowing
+ Change in ST Borrowing
= FCFE = FCFE
Compare to
Dividends (Common) -Common Dividend
+ Stock Buybacks - Decrease in Capital Stock
+ Increase in Capital Stock

209
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
Firm has poor
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 should deal
with its investment
problem first and
then cut dividends
210
A Dividend Matrix
211
Disney: An analysis of FCFE from 1994-2003
Year
Net
Income Depreciation
Capital
Expenditures
Change in
non-cash
WC
FCFE
(before
debt CF)
Net CF
from Debt
FCFE
(after
Debt CF)
1994 $1,110.40 $1,608.30 $1,026.11 $654.10 $1,038.49 $551.10 $1,589.59
1995 $1,380.10 $1,853.00 $896.50 ($270.70) $2,607.30 $14.20 $2,621.50
1996 $1,214.00 $3,944.00 $13,464.00 $617.00 ($8,923.00) $8,688.00 ($235.00)
1997 $1,966.00 $4,958.00 $1,922.00 ($174.00) $5,176.00 ($1,641.00) $3,535.00
1998 $1,850.00 $3,323.00 $2,314.00 $939.00 $1,920.00 $618.00 $2,538.00
1999 $1,300.00 $3,779.00 $2,134.00 ($363.00) $3,308.00 ($176.00) $3,132.00
2000 $920.00 $2,195.00 $2,013.00 ($1,184.00) $2,286.00 ($2,118.00) $168.00
2001 ($158.00) $1,754.00 $1,795.00 $244.00 ($443.00) $77.00 ($366.00)
2002 $1,236.00 $1,042.00 $1,086.00 $27.00 $1,165.00 $1,892.00 $3,057.00
2003 $1,267.00 $1,077.00 $1,049.00 ($264.00) $1,559.00 ($1,145.00) $414.00
Average $1,208.55 $2,553.33 $2,769.96 $22.54 $969.38 $676.03 $1,645.41

212
Disneys Dividends and Buybacks from 1994
to 2003

Disney
Year Dividends (in $) Equit y Repurchases (in
$)
Cash to Equit y
1994
$153 $571
$724
1995
$180 $349
$529
1996
$271 $462
$733
1997
$342 $633
$975
1998
$412 $30
$442
1999
$0 $19
$19
2000
$434 $166
$600
2001
$438 $1,073
$1,511
2002
$428 $0
$428
2003
$429 $0
$429
Average
$ 308.70 $ 330.30
$ 639

213
Disney: Dividends versus FCFE
Disney paid out $ 330 million less in dividends (and stock buybacks)
than it could afford to pay out (Dividends and stock buybacks were
$639 million; FCFE before net debt issues was $969 million). How
much cash do you think Disney accumulated during the period?

214
Disneys track record on projects and
stockholder wealth
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Year
Figure 11.3: ROE, Return on Stock and Cost of Equity: Disney
ROE Return on Stock Cost of Equity
Disney acquired Cap
Cities in 1996
215
Can you trust Disneys management?
Given Disneys track record over the last 10 years, if you were a
Disney stockholder, would you be comfortable with Disneys dividend
policy?
Yes
No
216
The Bottom Line on Disney Dividends
Disney could have afforded to pay more in dividends during the period
of the analysis.
It chose not to, and used the cash for acquisitions (Capital Cities/ABC)
and ill fated expansion plans (Go.com).
While the company may have flexibility to set its dividend policy a
decade ago, its actions over that decade have frittered away this
flexibility.
Bottom line: Large cash balances will not be tolerated in this company.
Expect to face relentless pressure to pay out more dividends.
217
Aracruz: Dividends and FCFE: 1998-2003

Year
Net
Income Depreciation
Capital
Expenditures
Change in
non-cash
WC
FCFE
(before net
Debt CF)
Net Debt
Cashflow
FCFE
(after net
Debt CF)
1998 $3.45 $152.80 $88.31 $76.06 ($8.11) $174.27 $166.16
1999 $90.77 $158.83 $56.47 $2.18 $190.95 ($604.48) ($413.53)
2000 $201.71 $167.96 $219.37 $12.30 $138.00 ($292.07) ($154.07)
2001 $18.11 $162.57 $421.49 ($56.76) ($184.06) $318.24 $134.19
2002 $111.91 $171.50 $260.70 ($5.63) $28.34 $36.35 $64.69
2003 $148.09 $162.57 $421.49 ($7.47) ($103.37) $531.20 $427.83
Average $95.67 $162.70 $244.64 $3.45 $10.29 $27.25 $37.54

218
Aracruz: Cash Returned to Stockholders
Year Net Income Dividends Payout Ratio FCFE Cash returned to
Stockholders
Cash Returned/FCFE
1998 $3.45 $24.39 707.51% $166.16 $50.79 30.57%
1999 $90.77 $18.20 20.05% ($413.53) $18.20 NA
2000 $201.71 $57.96 28.74% ($154.07) $80.68 NA
2001 $18.11 $63.17 348.87% $134.19 $63.17 47.08%
2002 $111.91 $73.80 65.94% $64.69 $75.98 117.45%
2003 $148.09 $109.31 73.81% $427.83 $112.31 26.25%
1998-
2003
$574.04 $346.83 60.42% $225.27 $401.12 178.07%

219
Aracruz: Stock and Project Returns
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
1998 1999 2000 2001 2002 2003 1998-2003
Figure 11.4: ROE, Return on Stock and Cost of Equity: Aracruz
ROE Return on stock Cost of Equity
220
Aracruz: Its your call..
Assume that you are a large stockholder in Aracruz. They have been
paying more in dividends than they have available in FCFE. Their
project choice has been acceptable and your stock has performed well
over the period. Would you accept a cut in dividends?
Yes
No

221
Mandated Dividend Payouts
There are many countries where companies are mandated to pay out a
certain portion of their earnings as dividends. Given our discussion of
FCFE, what types of companies will be hurt the most by these laws?
Large companies making huge profits
Small companies losing money
High growth companies that are losing money
High growth companies that are making money
222
BP: Dividends- 1983-92
1 2 3 4 5 6 7 8 9 10
Net Income $1,256.00 $1,626.00 $2,309.00 $1,098.00 $2,076.00 $2,140.00 $2,542.00 $2,946.00 $712.00 $947.00
- (Cap. Exp - Depr)*(1-DR) $1,499.00 $1,281.00 $1,737.50 $1,600.00 $580.00 $1,184.00 $1,090.50 $1,975.50 $1,545.50 $1,100.00
Working Capital*(1-DR) $369.50 ($286.50) $678.50 $82.00 ($2,268.00) ($984.50) $429.50 $1,047.50 ($305.00) ($415.00)
= Free CF to Equity ($612.50) $631.50 ($107.00) ($584.00) $3,764.00 $1,940.50 $1,022.00 ($77.00) ($528.50) $262.00
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
+ Equity Repurchases
= Cash to Stockholders $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
Dividend Ratios
Payout Ratio 66.16% 58.36% 46.73% 119.67% 67.00% 91.64% 68.69% 64.32% 296.63% 177.93%
Cash Paid as % of FCFE -135.67% 150.28% -1008.41% -225.00% 36.96% 101.06% 170.84% -2461.04% -399.62% 643.13%
Performance Ratios
1. Accounting Measure
ROE 9.58% 12.14% 19.82% 9.25% 12.43% 15.60% 21.47% 19.93% 4.27% 7.66%
Required rate of return 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%
223
BP: Summary of Dividend Policy
Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity $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
Dividend Payout Ratio 84.77%
Cash Paid as % of FCFE 262.00%
ROE - Required return -1.67% 11.49% 20.90% -21.59%
224
BP: Just Desserts!
225
The Limited: Summary of Dividend Policy:
1983-1992
Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity ($34.20) $109.74 $96.89 ($242.17)
Dividends $40.87 $32.79 $101.36 $5.97
Dividends+Repurchases $40.87 $32.79 $101.36 $5.97
Dividend Payout Ratio 18.59%
Cash Paid as % of FCFE -119.52%
ROE - Required return 1.69% 19.07% 29.26% -19.84%
226
Growth Firms and Dividends
High growth firms are sometimes advised to initiate dividends because
its increases the potential stockholder base for the company (since
there are some investors - like pension funds - that cannot buy stocks
that do not pay dividends) and, by extension, the stock price. Do you
agree with this argument?
Yes
No
Why?
227
Summing up
228
Valuation
Aswath Damodaran
229
First Principles
230
Discounted Cashflow Valuation: Basis for
Approach

where,
n = Life of the asset
CF
t
= Cashflow in period t
r = Discount rate reflecting the riskiness of the estimated cashflows
Value =
CF
t
(1+ r)
t
t =1
t = n
231
Equity Valuation
The value of equity is obtained by discounting expected cashflows to
equity, i.e., the residual cashflows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of equity,
i.e., the rate of return required by equity investors in the firm.

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
The dividend discount model is a specialized case of equity valuation,
and the value of a stock is the present value of expected future
dividends.

Value of Equity =
CF to Equity
t
(1+ k
e
)
t
t=1
t=n
232
Firm Valuation
The value of the firm is obtained by discounting expected cashflows to
the firm, i.e., the residual cashflows after meeting all operating
expenses and taxes, but prior to debt payments, at the weighted
average cost of capital, which is the cost of the different components of
financing used by the firm, weighted by their market value
proportions.

where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital
Value of Firm =
CF to Firm
t
(1+ WACC)
t
t=1
t=n
233
Generic DCF Valuation Model
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
CF
1
CF
2
CF
3
CF
4
CF
5
Forever
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value
CF
n
.........
Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity
Value
Firm: Value of Firm
Equity: Value of Equity
DISCOUNTED CASHFLOW VALUATION
Length of Period of High Growth
234
Estimating Inputs:
I. Discount Rates
Critical ingredient in discounted cashflow valuation. Errors in
estimating the discount rate or mismatching cashflows and discount
rates can lead to serious errors in valuation.
At an intuitive level, the discount rate used should be consistent with
both the riskiness and the type of cashflow being discounted.
The cost of equity is the rate at which we discount cash flows to equity
(dividends or free cash flows to equity). The cost of capital is the rate
at which we discount free cash flows to the firm.
235
Reviewing Disneys Costs of Equity & Debt

Disneys Cost of Debt (based upon rating) = 5.25%
Disneys tax rate = 37.3%
Business Unlevered Beta
D/E
Ratio
Lever ed
Beta
Cost of
Equit y
Medi a Networks 1.08 5 0 26.6 2 % 1.26 6 1 10.1 0 %
Parks an d
Resorts 0.91 0 5 26.6 2 % 1.06 2 5 9.12%
Studio
Entertainment 1.14 3 5 26.6 2 % 1.33 4 4 10.4 3 %
Consumer
Products 1.13 5 3 26.6 2 % 1.32 4 8 10.3 9 %
Disn ey 1.06 7 4 26.6 2 % 1.24 5 6 10.0 0 %

236
Equity
= 4% + 1.25 (4.82%) = 10.00%
Debt
= (4%+1.25%) (1-.373) = 3.29%
Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59%
55.101/
(55.101+14.668)
237
II. Estimating Cash Flows
Cash Flows
To Equity To Firm
The Strict View
Dividends +
Stock Buybacks
The Broader View
Net Income
- Net Cap Ex (1-Debt Ratio)
- Chg WC (1 - Debt Ratio)
= Free Cashflow to Equity
EBIT (1-t)
- ( Cap Ex - Depreciation)
- Change in Working Capital
= Free Cashflow to Firm
238
Estimating FCFF in 2003: Disney
EBIT = $ 2,805 Million Tax rate = 37.30%
Capital spending = $ 1,735 Million
Depreciation = $ 1,254 Million
Increase in Non-cash Working capital = $ 454 Million
Estimating FCFF
EBIT * (1 - tax rate) $1,759 : 2805 (1-.373)
- Net Capital Expenditures $481 : (1735 - 1254)
-Change in Working Capital $454
Free Cashflow to Firm $824
Total Reinvestment = Net Cap Ex + Change in WC = 481 + 454 = 935
Reinvestment Rate =935/1759 = 53.18%
239
III. Expected Growth
Expected Growth
Net Income Operating Income
Retention Ratio=
1 - Dividends/Net
Income
Return on Equity
Net Income/Book Value of
Equity
X
Reinvestment
Rate = (Net Cap
Ex + Chg in
WC/EBIT(1-t)
Return on Capital =
EBIT(1-t)/Book Value of
Capital
X
240
Estimating Growth in EBIT: Disney
We begin by estimating the reinvestment rate and return on capital for
Disney in 2003, using the numbers from the latest financial statements.
We did convert operating leases into debt and adjusted the operating
income and capital expenditure accordingly.
Reinvestment Rate
2003
= (Cap Ex Depreciation + Chg in non-cash WC)/
EBIT (1-t) = (1735 1253 + 454)/(2805(1-.373)) = 53.18%
Return on capital
2003
= EBIT (1-t)
2003
/ (BV of Debt
2002
+ BV of
Equity
2002
) = 2805 (1-.373)/ (15,883+23,879) = 4.42%
Expected Growth Rate from existing fundamentals = 53.18% * 4.42% =
2.35%
We will assume that Disney will be able to earn a return on capital of
12% on its new investments and that the reinvestment rate will be
53.18% for the immediate future.
Expected Growth Rate in operating income = Return on capital *
Reinvestment Rate = 12% * .5318 = 6.38%
241
IV. Getting Closure in Valuation
A publicly traded firm potentially has an infinite life. The value is
therefore the present value of cash flows forever.

Since we cannot estimate cash flows forever, we estimate cash flows
for a growth period and then estimate a terminal value, to capture the
value at the end of the period:

Value =
CF
t
(1+ r)
t
t = 1
t =
Value =
CF
t
(1 + r)
t
+
Terminal Value
(1 + r)
N
t = 1
t = N
242
Stable Growth and Terminal Value
When a firms cash flows grow at a constant rate forever, the present
value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
This constant growth rate is called a stable growth rate and cannot be
higher than the growth rate of the economy in which the firm operates.
While companies can maintain high growth rates for extended periods,
they will all approach stable growth at some point in time.
When they do approach stable growth, the valuation formula above can
be used to estimate the terminal value of all cash flows beyond.
243
Growth Patterns
A key assumption in all discounted cash flow models is the period of
high growth, and the pattern of growth during that period. In general,
we can make one of three assumptions:
there is no high growth, in which case the firm is already in stable growth
there will be high growth for a period, at the end of which the growth rate
will drop to the stable growth rate (2-stage)
there will be high growth for a period, at the end of which the growth rate
will decline gradually to a stable growth rate(3-stage)
The assumption of how long high growth will continue will depend
upon several factors including:
the size of the firm (larger firm -> shorter high growth periods)
current growth rate (if high -> longer high growth period)
barriers to entry and differential advantages (if high -> longer growth
period)
244
Firm Characteristics as Growth Changes
Variable High Growth Firms tend to Stable Growth Firms tend to
Risk be above-average risk be average risk
Dividend Payout pay little or no dividends pay high dividends
Net Cap Ex have high net cap ex have low net cap ex
Return on Capital earn high ROC (excess return) earn ROC closer to WACC
Leverage have little or no debt higher leverage

245
Estimating Stable Growth Inputs
Start with the fundamentals:
Profitability measures such as return on equity and capital, in stable
growth, can be estimated by looking at
industry averages for these measure, in which case we assume that this firm in
stable growth will look like the average firm in the industry
cost of equity and capital, in which case we assume that the firm will stop
earning excess returns on its projects as a result of competition.
Leverage is a tougher call. While industry averages can be used here as
well, it depends upon how entrenched current management is and whether
they are stubborn about their policy on leverage (If they are, use current
leverage; if they are not; use industry averages)
Use the relationship between growth and fundamentals to estimate
payout and net capital expenditures.
246
Estimating Stable Period Inputs: Disney
The beta for the stock will drop to one, reflecting Disneys status as a mature
company. This will lower the cost of equity for the firm to 8.82%.
Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4% + 4.82% = 8.82%
The debt ratio for Disney will rise to 30%. This is the optimal we computed
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
unchanged at 5.25%, this will result in a cost of capital of 7.16%
Cost of capital = 8.82% (.70) + 5.25% (1-.373) (.30) = 7.16%
The return on capital for Disney will drop from its high growth period level of
12% to a stable growth return of 10%. This is still higher than the cost of
capital of 7.16% but the competitive advantages that Disney has are unlikely to
dissipate completely by the end of the 10
th
year. The expected growth rate in
stable growth will be 4%. In conjunction with the return on capital of 10%,
this yields a stable period reinvestment rate of 40%:
Reinvestment Rate = Growth Rate / Return on Capital = 4% /10% = 40%
247
Disney: Inputs to Valuation
High Growth Phase Transition Phase Stable Growth Phase
Length of Period 5 years 5 years Forever after 10 years
Tax Rate 37.3% 37.3% 37.3%
Return on Capital 12% (last years return o n
capital was 4.42%)
Declines linearly to 10% Stable ROC of 10%
Reinvestment Rate
(Net Cap Ex + Working Capital
Investments/EBIT)
53.18% (Last years
reinvestment rate)
Declines to 40% as ROC an d
growth rates drop:
Reinvestment Rate = g/ROC
40% of afte r-tax operating
income, estimated from stabl e
growth rate of 4% and return
on capital of 10%.
Reinvestment rate = 4/10 =40%
Expected Growth Rate i n EBIT ROC * Reinvestment Rate =
12%*0.5318 = 6.38%
Linear decline t o Stable
Growth Rate of 4%
4%: Set to riskfree rate
Debt/Capital Ratio 21% (Existing debt ratio) Increases linearly to 30% Stable debt ratio of 30%
Risk Parameters Beta = 1.25, k
e
= 10%
Cost of Debt = 5.25%
Cost of capital = 8.59%
Beta decreases linearly to 1.00;
Cost of debt stays at 5.25%
Cost of capital drops t o 7.16%
Beta = 1.00; k
e
= 8.82%
Cost of debt stays at 5.25%

248
Disney: FCFF Estimates
Year
Ex pe ct ed
Gro wth EBIT
EBIT (1-
t )
Rei nv es t m en t
Rat e Rei nv es t m en t FCFF
Cur re nt $ 2, 80 5
1 6. 3 8 % $ 2, 98 4 $ 1, 87 1 5 3. 1 8 % $ 9 9 4.92 $ 8 7 6.06
2 6. 3 8 % $ 3, 17 4 $ 1, 99 0 5 3. 1 8 % $ 1, 05 8. 4 1 $ 9 3 1.96
3 6. 3 8 % $ 3, 37 7 $ 2, 11 7 5 3. 1 8 % $ 1, 12 5. 9 4 $ 9 9 1.43
4 6. 3 8 % $ 3, 59 2 $ 2, 25 2 5 3. 1 8 % $ 1, 19 7. 7 9 $ 1, 05 4. 7 0
5 6. 3 8 % $ 3, 82 2 $ 2, 39 6 5 3. 1 8 % $ 1, 27 4. 2 3 $ 1, 12 2. 0 0
6 5. 9 0 % $ 4, 04 7 $ 2, 53 8 5 0. 5 4 % $ 1, 28 2. 5 9 $ 1, 25 5. 1 3
7 5. 4 3 % $ 4, 26 7 $ 2, 67 5 4 7. 9 1 % $ 1, 28 1. 7 1 $ 1, 39 3. 7 7
8 4. 9 5 % $ 4, 47 8 $ 2, 80 8 4 5. 2 7 % $ 1, 27 1. 1 9 $ 1, 53 6. 8 0
9 4. 4 8 % $ 4, 67 9 $ 2, 93 4 4 2. 6 4 % $ 1, 25 0. 7 8 $ 1, 68 2. 9 0
1 0 4. 0 0 % $ 4, 86 6 $ 3, 05 1 4 0. 0 0 % $ 1, 22 0. 4 1 $ 1, 83 0. 6 2

249
Disney: Costs of Capital and Present Value
Year Co st of c apital FCFF PV of FCFF
1 8. 5 9 % $ 8 7 6.06 $ 8 0 6.74
2 8. 5 9 % $ 9 3 1.96 $ 7 9 0.31
3 8. 5 9 % $ 9 9 1.43 $ 7 7 4.21
4 8. 5 9 % $ 1, 05 4. 7 0 $ 7 5 8.45
5 8. 5 9 % $ 1, 12 2. 0 0 $ 7 4 3.00
6 8. 3 1 % $ 1, 25 5. 1 3 $ 7 6 7.42
7 8. 0 2 % $ 1, 39 3. 7 7 $ 7 8 8.91
8 7. 7 3 % $ 1, 53 6. 8 0 $ 8 0 7.42
9 7. 4 5 % $ 1, 68 2. 9 0 $ 8 2 2.90
1 0 7. 1 6 % $ 1, 83 0. 6 2 $ 8 3 5.31
PV of cashflows du ring hig h gro wt h = $ 7, 89 4. 6 6

250
Disney: Terminal Value and Firm Value
Terminal Value
FCFF
11
= EBIT
11
(1-t) (1- Reinvestment Rate
Stable Growth
)/
= 4866 (1.04) (1-.40) = $1,903.84 million
Terminal Value = FCFF
11
/ (Cost of capital
Stable Growth
g)
= 1903.84/ (.0716 - .04) = $60,219.11 million
Value of firm
PV of cashflows during the high growth phase =$ 7,894.66
PV of terminal value =$ 27,477.81
+ Cash and Marketable Securities =$ 1,583.00
+ Non-operating Assets (Holdings in other companies) =$ 1,849.00
Value of the firm =$ 38,804.48
251
From Firm to Equity Value: What do you
subtract out?
The first thing you have to subtract out is the debt that you computed (and
used in estimating the cost of capital). If you have capitalized operating leases,
you should continue to treat operating leases as debt in this stage in the
process.
This is also your last chance to consider other potential liabilities that may be
faced by the firm including
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.
252
From Equity Value to Equity Value per share:
The Effect of Options
When there are warrants and employee options outstanding, the
estimated value of these options has to be subtracted from the value of
the equity, before we divide by the number of shares outstanding.
There are two alternative approaches that are used in practice:
One is to divide the value of equity by the fully diluted number of shares
outstanding rather than by the actual number. This approach will
underestimate the value of the equity, because it fails to consider the cash
proceeds from option exercise.
The other shortcut, which is called the treasury stock approach, adds the
expected proceeds from the exercise of the options (exercise price
multiplied by the number of options outstanding) to the numerator before
dividing by the number of shares outstanding. While this approach will
yield a more reasonable estimate than the first one, it does not include the
time value of the options outstanding.
253
Valuing Disneys options
At the end of 2003, Disney had 219 million options outstanding, with a
weighted average exercise price of $26.44 and weighted average life of
6 years.
Using the current stock price of $26.91, an estimated standard
deviation of 40, a dividend yield of 1.21%. a riskfree rate of 4% and
the Black-Scholes option pricing model we arrived at a value of
$2,129 million.
Since options expenses are tax-deductible, we used the tax rate of
37.30% to estimate the value of the employee options:
Value of employee options = 2129 (1- .373) = $1334.67 million
254
Disney: Value of Equity per Share
Subtracting out the market value of debt (including operating leases) of
$14,668.22 million and the value of the equity options (estimated to be
worth $1,334.67 million in illustration 12.10) yields the value of the
common stock:
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
arrive at a value per share o $11.14, well below the market price of $
26.91 at the time of this valuation.
255
Current Cashflow to Firm
EBIT(1-t) : 1,759
- Nt CpX 481
- Chg WC 454
= FCFF $ 824
Reinvestment Rate=(481+454)/1759
= 53.18%
Expected Growth
in EBIT (1-t)
.5318*.12=.0638
6.38%
Stable Growth
g = 4%; Beta = 1.00;
ROC= 10%
Reinvestment Rate=g/ROC
=4/ 10= 40%
Terminal Value
10
= 1,904/(.0716-.04) = 60,219
Cost of Equity
10%
Cost of Debt
(4.00%+1.25%)(1-.373)
= 3.29%
Weights
E = 79% D = 21%
Discount at Cost of Capital (WACC) = 10.00% (.79) + 3.29% (0.21) = 8.59
Op. Assets 35,373
+ Cash: 3,432
+Other Inv
- Debt 14,668
=Equity 24,136
- Options 1,335
=Equity CS 22,802
Value/Sh $11. 14
Riskfree Rate:
Riskfree Rate= 4%
+
Beta
1.2456
X
Mature market
premium
4%
Unlevered Beta for
Sectors: 1.0674
Firms D/E
Ratio: 24.77%
Disney: Valuation
Reinvestment Rate
53.18%%
Return on Capital
12%
Term Yr
3089
- 864
= 2225
Disney was trading at about
$ 26 at the time of this
valuation.
Cashflows
EBIT (1-t ) $1,871 $1,990 $2,117 $2,252 $2,396 $2,538 $2,675 $2,808 $2,934 $3,051
- Reinvestment $995 $1,058 $1,126 $1,198 $1,274 $1,283 $1,282 $1,271 $1,251 $1,220
FCFF $876 $932 $991 $1,055 $1,122 $1,255 $1,394 $1,537 $1,683 $1,831
In transition phase,
debt ratio increases to 30% and cost
of capital decreases to 7.16%
Growth drops to 4%
256
257
258
First Principles

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