Corporate Finance in A Day It Can Be Done : Stern School of Business

Corporate Finance in a Day It can be
done
Aswath Damodaran
Home Page: www.stern.nyu.edu/~adamodar
www.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html
E-Mail: [email protected]
Stern School of Business
Aswath Damodaran
A Financial View of the Firm
Figure 1.1: A Simple View of a Business (Firm)

Assets
Existing Investments
Generate cas hflow s today
Expected Value that w ill be

created by future investments
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Liabilities
Investments already
made
Debt
Investments yet to
be made
Equity
Borrow ed money
Ow ners funds
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
Aswath Damodaran
The Objective in Decision Making
In traditional corporate finance, the objective in decision making is to

maximize the value of the business you run (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
Hire & fire
managers
- Board
- Annual Meeting
Lend Money
BONDHOLDERS
Maximize
stockholder
wealth
Managers
Protect
bondholder
Interests
Reveal
information
honestly and
on time
No Social Costs
SOCIETY
Costs can be
traced to firm
Markets are
efficient and
assess effect on
value
FINANCIAL MARKETS
Aswath Damodaran
What can go wrong?

STOCKHOLDERS
Have little control
over managers
Lend Money
BONDHOLDERS
Managers put
their interests
above stockholders
Managers
Significant Social Costs

SOCIETY
Bondholders can
Some costs cannot be
get ripped off
traced to firm
Delay bad
Markets make
news or
mistakes and
provide
misleading can over react
information
FINANCIAL MARKETS
Aswath Damodaran
An Analysis of Disney
STOCKHOLDERS
Stockhold ers angry
over stock price
performance and
imp erial style.
Euro Disney has problems
meetings its debt oblig ations .
BONDHOLDERS
-27 Sell side

equity research
analysts follo w
the firm
- Heavy press
coverage
Board has been compos ed

of Eisners cronies and
has rubb er stamped his
decision s.
Potential hot spots includ e
Eisner
and Gang
a. Controversial movies
b. Theme park policies
c. ABC shows
SOCIETY
1. Custom er boycotts (theme parks)
2. FCC regul ation s
Heavily traded and

part of Dow 30 and
S&P 500 Indi ces.
FINANCIAL MARKETS
Aswath Damodaran
When traditional corporate financial theory breaks down, the

solution is:
To choose a different mechanism for corporate governance. Japan and

Germany have corporate governance systems which are not centered around
stockholders.
To choose a different objective - maximizing earnings, revenues or market
share, for instance.
To maximize stock price, but reduce the potential for conflict and breakdown:
Aswath Damodaran
Making managers (decision makers) and employees into stockholders

Providing lenders with prior commitments and legal protection
By providing information honestly and promptly to financial markets
By converting social costs into economic costs.
The Only Self Correcting Objective

STOCKHOLDERS
1. More activist
investors
2. Hostile takeovers
Protect themselves
BONDHOLDERS
1. Covenants
2. New Types
Managers of poorly
run firms are put
on notice.
Managers
Firms are
punished
for misleading
markets
Corporate Good Citizen Constraints

SOCIETY
1. More laws
2. Investor/Customer Backlash
Investors and
analysts become
more skeptical
FINANCIAL MARKETS
Aswath Damodaran
Looking at Disneys top stockholders
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10
6Application Test: Who owns/runs your firm?
The marginal investor in a company is an investor who owns a lot of stock and
trades a lot. Looking at the top stockholders in your firm, consider the
following:
Who is the marginal investor in this firm? (Is it an institutional investor or an

individual investor?)
Are managers significant stockholders in the firm? If yes, are their interests likely
to diverge from those of other stockholders in the firm?
How many analysts follow your company?

Can you think of any major social costs or benefits that your firm has created
in recent years?
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11
First Principles
hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the financing
mix used - owners funds (equity) or borrowed money (debt)
being financed.
stockholders.
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12
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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13
Models of Risk and Return
Step 1: Defining Risk

The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment
Low Risk Investment
High Risk Investment
E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
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.
Step 3: Measuring Market Risk
The CAPM
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:
Beta of asset relative to

Market portfolio (from
a regression)
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The APM
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
Multi-Factor Models
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 asset relative

to unspecified market
factors (from a factor
analysis)
Betas of assets relative

to specified macro
economic factors (from
a regression)
Proxy Models
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)
14
The Riskfree Rate
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.
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.
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15
The Risk Premium: What is it?
The risk premium is the premium that investors demand for investing in
an average risk investment, relative to the riskfree rate.
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?
Less than 5%
Between 5 - 7%
Between 7 - 9%
Between 9 - 11%
Between 11 - 13%
More than 13%
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16
One way to estimate risk premiums: Look at history
Historical Period
1928-2003
1963-2003
1993-2003
Arithmetic average
Stocks Stocks T.Bills
T.Bonds
7.92%
6.54%
6.09%
4.70%
8.43%
4.87%
Geometric Average
Stocks Stocks T.Bills
T.Bonds
5.99%
4.82%
4.85%
3.82%
6.68%
3.57%
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.
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17
Estimating Beta
The beta of a stock measures the risk in a stock that cannot be diversified
away. It is determined by both how volatile a stock is and how it moves with
the market.
The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) Rj = a + b Rm
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.
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18
Beta Estimation in Practice: Bloomberg
32% of Disneys risk

comes from the market
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Using Betas to estimate Expected Returns: September 30,

1997
Disneys Beta = 1.40

Riskfree Rate = 7.00% (Long term Government Bond rate on 9/30/97)
Risk Premium = 5.50% (Approximate historical premium - 1928-1996)
Expected Return = 7.00% + 1.40 (5.50%) = 14.70%
As a potential investor in Disney, this is what you would require Disney to
make as a return to break even as an investor.
Managers at Disney need to make at least 14.70% as a return for their equity
investors to break even. In other words, Disneys cost of equity is 14.70%.
Aswath Damodaran
20
Application Test: Analyzing the Risk Regression

Using your Bloomberg risk and return print out, answer the following
questions:
What is your stocks beta?

If you were an investor in this stock, what would you require as a rate of return on
your stockholding?
As a manager at Disney, what is your cost of equity
Riskless Rate + Beta * Risk Premium
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Determinants of Betas
Beta of Equity (Levered Beta)
Beta of Firm (Unlevered Beta)

Natur e of product or
se rv ice offe r e d by
company:
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.
Ope rating Le v e rage (Fixe d

Costs as pe rce nt of total
costs):
Other things remaining equal
the greate r the propo rtion of
the co sts that are fixe d, the
higher the beta of the
company.
Implications
1. Cyclical co mpan ies should
have higher betas than noncyclical comp anies.
2. Luxury goods firms shou ld
have higher betas than basic
goods.
3. High priced goods/service
firms shou ld have higher betas
than low prices goods/services
firms.
4. Growth firms should h ave
higher betas.
Implications
1. Firms with high infrastructure
needs and rigid cost structure s
should have hig her beta s than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms sho uld have higher
betas than more mature firms.
Aswath Damodaran
Fina ncial Le v e r age :

Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the hig her its
equity beta will be
Implciations
Highly levered firms should have highe beta s
than firms with less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))
22
Bottom-up Betas: Estimating betas by looking at comparable

firms
Business
Creative Content
Retailing
Broadcasting
Theme Parks
Real Estate
Disney
Business
Creative Content
Retailing
Broadcasting
Theme Parks
Real Estate
Firm
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Unlevered
Beta
1.25
1.50
0.90
1.10
0.70
1.09
D/E Ratio
20.92%
20.92%
20.92%
20.92%
59.27%
21.97%
Levered
Beta
1.42
1.70
1.02
1.26
0.92
1.25
Estimated ValueComparable Firms

$ 22,167
Motion Picture and TV program producers
$ 2,217
High End Specialty Retailers
$ 18,842
TV Broadcasting companies
$ 16,625
Theme Park and Entertainment Complexes
$ 2,217
REITs specializing in hotel and vacation propertiers
$ 62,068
Riskfree
Rate
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
Risk
Premium
5.50%
5.50%
5.50%
5.50%
5.50%
5.50%
Cost of Equity
14.80%
16.35%
12.61%
13.91%
12.31%
13.85%
Unlevered Beta
Division Weight
1.25
35.71%
1.5
3.57%
0.9
30.36%
1.1
26.79%
0.7
3.57%
100.00%
23
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. To get to the cost of
capital, we need to
First estimate the cost of borrowing money

And then weight debt and equity in the proportions that they are used in financing.
The cost of debt for a firm is the rate at which it can borrow money today. It
should a be a direct function of how much risk of default a firm carries and
can be written as
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Cost of Debt = Riskfree Rate + Default Spread
24
Default Spreads and Bond Ratings
Many firms in the United States are rated by bond ratings agencies like
Standard and Poors and Moodys for default risk. If you have a rating, you
can estimate the default spread from it.
If your firm is not rated, you can estimate a synthetic rating 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
Based upon the relationship between interest coverage ratios and ratings, we
would estimate a rating of A for the firm.
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25
Interest Coverage Ratios, Ratings and Default Spreads
If Interest Coverage Ratio is
Estimated Bond Rating
Default Spread
> 8.50
6.50 - 8.50
5.50 - 6.50
4.25 - 5.50
3.00 - 4.25
2.50 - 3.00
2.00 - 2.50
1.75 - 2.00
1.50 - 1.75
1.25 - 1.50
0.80 - 1.25
0.65 - 0.80
0.20 - 0.65
< 0.20
AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D
0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%
Aswath Damodaran
26
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 table from previous page)
A pre-tax cost of debt for your firm
An after-tax cost of debt for your firm
Pre-tax cost of debt (1- tax rate)
Aswath Damodaran
27
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 $12,342 million, interest expenses of $479 million,
an average maturity of 3 years and a current cost of borrowing of 7.5% (from its
rating)
Estimated MV of Disney Debt =
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1
(1
3
(1.075) 12,342
479
3 $11,180
.075
(1.075)
Present value of an annuity

Of $479 mil for 3 years
Present value of
face value of debt
28
Estimating Cost of Capital: Disney
Equity
13.85%
$50 .88 Billion
82%
Debt
Cost of Equity =
Market Value of Equity = 675.13*75.38=
Equity/(Debt+Equity ) =
After-tax Cost of debt = 7.50% (1-.36) =
Market Value of Debt =
Debt/(Debt +Equity) =
4.80%
$ 11.18 Billion
18%
Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%
50.88/(50.88+11.18)
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11.18/(50.88+11.18)
29
Disneys Divisional Costs of Capital
Business
E/(D+E)
Creative Content
Retailing
Broadcasting
Theme Parks
Real Estate
Disney
82.70%
82.70%
82.70%
82.70%
62.79%
81.99%
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Cost of
Equity
14.80%
16.35%
12.61%
13.91%
12.31%
13.85%
D/(D+E)
17.30%
17.30%
17.30%
17.30%
37.21%
18.01%
After-tax
Cost of Debt
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
Cost of Capital
13.07%
14.36%
11.26%
12.32%
9.52%
12.22%
30
Application Test: Estimating a Cost of Capital
Estimate the debt ratio for your firm using

The market value of equity
The book value of debt (lets assume it is equal to market value)
Debt Ratio = Debt/ (Debt + Equity)
Estimate the cost of capital for your firm using the costs of debt and equity
that you estimated earlier.
Cost of capital = Cost of Equity (1- Debt Ratio) + Cost of Debt (1- Debt Ratio)
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31
First Principles
hurdle rate.
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.
being financed.
stockholders.
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32
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:
Aswath Damodaran
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).
33
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
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34
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.
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35
The Full Picture: Earnings on Project
0 1
Revenues
Magic Kingdom
Second Theme Park
Resort & Properties
Total
$ 1,000
$ 1,400
$ 1,700
$ 200
$ 1,200
$ 250
$ 1,650
Operating Expenses
Magic Kingdom
Second Theme Park
Resort & Property
Total
$
$
$
$
600
150
750
Other Expenses
Depreciation & Amortization
Allocated G&A Costs
$
$
Operating Income
Taxes
Operating Income after Taxes
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10
$ 300
$ 2,000
$ 2,000
$ 500
$ 375
$ 2,875
$ 2,200
$ 550
$ 688
$ 3,438
$ 2,420
$ 605
$ 756
$ 3,781
$ 2,662
$ 666
$ 832
$ 4,159
$ 2,928
$ 732
$ 915
$ 4,575
$ 3,016
$ 754
$ 943
$ 4,713
$ 840
$ $ 188
$ 1,028
$ 1,020
$ $ 225
$ 1,245
$ 1,200
$ 300
$ 281
$ 1,781
$ 1,320
$ 330
$ 516
$ 2,166
$ 1,452
$ 363
$ 567
$ 2,382
$ 1,597
$ 399
$ 624
$ 2,620
$ 1,757
$ 439
$ 686
$ 2,882
$ 1,810
$ 452
$ 707
$ 2,969
375
200
$
$
378
220
$
$
369
242
$
$
319
266
$
$
302
293
$
$
305
322
$
$
305
354
$
$
305
390
$
$
$ (125)
$
(45)
$
(80)
$
$
$
25
9
16
$
$
$
144
52
92
$
$
$
509
183
326
$
$
$
677
244
433
$
$
$
772
278
494
$
$
$
880
317
563
$
$
$
998
359
639
$ 1,028
$ 370
$ 658
315
401
36
And The Accounting View of Return
Year
0
1
2
3
4
5
6
7
8
9
10
Average
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EBIT(1-t)
Beg BV
$0
($80)
$16
$92
$326
$433
$494
$563
$639
$658
$2,500
$3,500
$4,275
$4,604
$4,484
$4,525
$4,567
$4,564
$4,572
$4,609
Deprecn
$0
$0
$375
$378
$369
$319
$302
$305
$305
$305
$315
Cap Ex
$2,500
$1,000
$1,150
$706
$250
$359
$344
$303
$312
$343
$315
End BV
$2,500
$3,500
$4,275
$4,604
$4,484
$4,525
$4,567
$4,564
$4,572
$4,609
$4,609
Avge Bv
$3,000
$3,888
$4,439
$4,544
$4,505
$4,546
$4,566
$4,568
$4,590
$4,609
ROC
-2.06%
0.36%
2.02%
7.23%
9.53%
10.82%
12.33%
13.91%
14.27%
7.60%
37
Would lead use to conclude that...
Do not invest in this park. The return on capital of 7.60% is lower than the
cost of capital for theme parks of 12.32%; 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?
Yes
No
Aswath Damodaran
38
The cash flow view of this project..

+ Depreciation & Amortization
$
- $
- Capital Expenditures $
2,500$
- Change in Working Capital
$
- $
Cash Flow on Project
$
(2,500)
$
1
$
- $
1,000$
- $
(1,000)
$
2
3
(80)$
16 $
375$ 378 $
1,150$ 706 $
60 $
23 $
(915)
$ (335)$
9
639$
305$
343$
21 $
580$
10
658
315
315
7
651
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
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39
The incremental cash flows on the project
0
1
2
3
Cash Flow on Project
$ (2,500)
$ (1,000)
$
(915)
$ (335)$
- Sunk Costs
$
500
+ Non-incremental Allocated
$ Costs
- $ (1-t)- $
85$ 94 $
Incremental Cash Flow on$Project
(2,000)
$ (1,000)
$
(830)
$ (241)$
9
580$
10
651
166$
746$
171
822
To get from cash flow to incremental cash flows, we

Remove the sunk cost from the initial investment
add back the non-incremental allocated costs (in after-tax terms)
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The Incremental Cash Flows
0
+ Depreciation & Amortization
- Capital Expenditures
- Change in Working Capital
+ Non-incremental Allocated Expense(1-t)
Cashf low to Firm
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$ 2,000
$ 1,000
$ (2,000)
$ (1,000)
2
$
(80)
$ 375
$ 1,150
$
60
$
85
$ (830)
3
$
16
$ 378
$ 706
$
23
$
94
$ (241)
$
$
$
$
$
$
4
92
369
250
18
103
297
$
$
$
$
$
$
5
326
319
359
44
114
355
$
$
$
$
$
$
6
433
302
344
28
125
488
$
$
$
$
$
$
7
494
305
303
17
137
617
$
$
$
$
$
$
8
563
305
312
19
151
688
$
$
$
$
$
$
9
639
305
343
21
166
746
$
$
$
$
$
$
10
658
315
315
7
171
822
41
To Time-Weighted Cash Flows
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.
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Decision Rule: Accept if IRR > hurdle rate
42
Present Value Mechanics
Cash Flow Type

1. Simple CF
2. Annuity
3. Growing Annuity
4. Perpetuity
5. Growing Perpetuity
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Discounting Formula
CFn / (1+r)n
1
1
(1+ r)n
A
Compounding Formula
CF0 (1+r)n
n
(1 + r) - 1
A
(1 + g)n
1
(1 + r)n
A(1 + g)
r -g
A/r
A(1+g)/(r-g)
43
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 3%
(the inflation rate) forever, the present value at the end of year 9 of cash flows
after that can be written as:
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Terminal Value = CF in year 10/(Cost of Capital - Growth Rate)

= 822/(.1232-.03) = $ 8,821 million
44
Which yields a NPV of..
Year
Incremental CF
0
$
(2,000)
1
$
(1,000)
2
$
(830)
3
$
(241)
4
$
297
5
$
355
6
$
488
7
$
617
8
$
688
9
$
746
Net Present Value of Projec t =
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Terminal Value
8,821
PV at 12.32%
$
(2,000)
$
(890)
$
(658)
$
(170)
$
187
$
198
$
243
$
273
$
272
$
3,363
$
818
45
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 $818 million.
Aswath Damodaran
46
The IRR of this project
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47
The IRR suggests..
The project is a good one. Using time-weighted, incremental cash flows, this
project provides a return of 15.32%. This is greater than the cost of capital of
12.32%.
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.
Aswath Damodaran
48
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.
Aswath Damodaran
49
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.
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50
First Principles
hurdle rate.
Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
stockholders.
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51
Debt: The Trade-Off
Advantages of Borrowing
Disadvantages of Borrowing
1. Tax Benefit:
1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit
Higher business risk --> Higher Cost
2. Added Discipline:
2. Agency Cost:
Greater the separation between managers
Greater the separation between stock-
and stockholders --> Greater the benefit
holders & lenders --> Higher Cost

3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
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52
A Hypothetical Scenario
Assume you operate in an environment, where
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(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
53
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.
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54
An Alternate Vie : The cost of capital can change as you

change your financing mix
The trade-off between debt and equity becomes more complicated when there
are both tax advantages and bankruptcy risk to consider. When debt has a tax
advantage and increases default risk, the firm value will change as the
financing mix changes. The optimal financing mix is the one that maximizes
firm value.
The cost of capital has embedded in it, both the tax advantages of debt
(through the use of the after-tax cost of debt) and the increased default risk
(through the use of a cost of equity and the cost of debt)
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.
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55
The Cost of Capital: The Textbook Example
Aswath Damodaran
D/(D+E)
ke
kd
After-tax Cost of DebtWACC
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%
56
WACC and Debt Ratios
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
11.40%
11.20%
11.00%
10.80%
10.60%
10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
0
WACC
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
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57
Current Cost of Capital: Disney
Equity
13.85%
$50.88 Billion
82%
Debt
Cost of Equity =
Market Value of Equity =
Equity/(Debt+Equity ) =
After-tax Cost of debt = 7.50% (1-.36) =
Market Value of Debt =
Debt/(Debt +Equity) =
4.80%
$ 11.18 Billion
18%
Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%
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58
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.
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59
Estimating Cost of Equity from Betas: Disney at different

debt ratios
Current Beta = 1.25 Unlevered Beta = 1.09
Market premium = 5.5%
T.Bond Rate = 7.00%
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
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D/E Ratio
0%
11%
25%
43%
67%
100%
150%
233%
400%
900%
Beta
1.09
1.17
1.27
1.39
1.56
1.79
2.14
2.72
3.99
8.21
t=36%
Cost of Equity
13.00%
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%
60
Bond Ratings, Cost of Debt and Debt Ratios: Disney at

different debt ratios
D/(D+E)
D/E
$ Debt
EBITDA
Depreciation
EBIT
Interest
Taxable Income
Tax
Pre-tax Int. cov
Likely Rating
Interest Rate
Eff. Tax Rate
Cost of debt
0.00%
0.00%
$0
$6,693
$1,134
$5,559
$0
$5,559
$2,001
AAA
7.20%
36.00%
4.61%
Aswath Damodaran
WORKSHEET FOR
10.00%
20.00%
11.11%
25.00%
$6,207
$12,414
$6,693
$6,693
$1,134
$1,134
$5,559
$5,559
$447
$968
$5,112
$4,591
$1,840
$1,653
12.44
5.74
AAA
A+
7.20%
7.80%
36.00%
36.00%
4.61%
4.99%
ESTIMATING RATINGS/INTEREST RATES

30.00%
40.00%
50.00%
60.00%
70.00%
42.86%
66.67% 100.00% 150.00% 233.33%
$18,621
$24,827
$31,034
$37,241
$43,448
$6,693
$6,693
$6,693
$6,693
$6,693
$1,134
$1,134
$1,134
$1,134
$1,134
$5,559
$5,559
$5,559
$5,559
$5,559
$1,536
$2,234
$3,181
$4,469
$5,214
$4,023
$3,325
$2,378
$1,090
$345
$1,448
$1,197
$856
$392
$124
3.62
2.49
1.75
1.24
1.07
ABB
B
CCC
CCC
8.25%
9.00%
10.25%
12.00%
12.00%
36.00%
36.00%
36.00%
36.00%
36.00%
5.28%
5.76%
6.56%
7.68%
7.68%
80.00%
400.00%
$49,655
$6,693
$1,134
$5,559
$5,959
($400)
($144)
0.93
CCC
12.00%
33.59%
7.97%
90.00%
900.00%
$55,862
$6,693
$1,134
$5,559
$7,262
($1,703)
($613)
0.77
CC
13.00%
27.56%
9.42%
61
Disneys Cost of Capital Schedule
Debt Ratio
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
Aswath Damodaran
Cost of Equity
13.00%
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%
AT Cost of Debt
4.61%
4.61%
4.99%
5.28%
5.76%
6.56%
7.68%
7.68%
7.97%
9.42%
Cost of Capital
13.00%
12.55%
12.17%
11.84%
11.64%
11.70%
12.11%
11.97%
12.17%
13.69%
62
Disney: Cost of Capital Chart
14.00%
13.50%
13.00%
12.50%
12.00%
11.50%
11.00%
0.
0
0%
10.50%
Aswath Damodaran
63
A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal

Overlevered
Actual < Optimal

Underlevered
Is the firm under bankruptcy threat?

Yes
No
Reduce Debt quickly

1. Equity for Debt swap
2. Sell Assets; use cash
to pay off debt
3. Renegotiate with lenders
Does the firm have good

projects?
ROE > Cost of Equity
ROC > Cost of Capital
Yes
No
Take good projects with
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.
No
projects?
Yes
debt.
No
Do your stockholders like

dividends?
Yes
Pay Dividends
Aswath Damodaran
No
Buy back stock
64
Disney: Applying the Framework

Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal

Overlevered
Actual < Optimal

Underlevered
Is the firm under bankruptcy threat?

Yes
No
Reduce Debt quickly

1. Equity for Debt swap
2. Sell Assets; use cash
to pay off debt
3. Renegotiate with lenders

projects?
Yes
No
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.
No
projects?
Yes
debt.
No
Do your stockholders like

dividends?
Yes
Pay Dividends
Aswath Damodaran
No
Buy back stock
65
Application Test: Estimating the Optimal Debt Ratio for

your firm
What is the optimal debt ratio for your firm and how does it compare to the
optimal debt ratio?
How much lower will your cost of capital be if you move to the optimal?
What is the best path for your firm to get to its optimal?
Aswath Damodaran
66
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.
Aswath Damodaran
67
Design the perfect financing instrument
The perfect financing instrument will
Start with the

Cash Flows
on Assets/
Projects
Def ine Debt

Characteristics
Have all of the tax advantages of debt

While preserving the flexibility offered by equity
Duration
Duration/
Maturity
Currency
Effect of Inflation
Uncertainty about Future
Currency
Mix
Fixed vs. Floating Rate

* More floating rate
- if CF move w ith
inflation
- w ith greater uncertainty
on future
Grow th Patterns
Straight v ersus
Conv ertible
- Convertible if
cash flow s low
now but high
exp. growth
Cyclicality &
Other Effects
Special Features
on Debt
- Options to make
cash flow s on debt
match cash flow s
on as sets
Commodity Bonds
Catastrophe Notes
Design debt to have cash f lows that match up to cash flows on the assets f inanced
Aswath Damodaran
68
Coming up with the financing details: Intuitive Approach

Business
Project Cash Flow Characteristics
Type of Financing
Creative
Projects are likely to
Debt should be
Content
1. be short term
1. short term
2. have cash outflows are primarily in dollars (but cash inflows
2. primarily dollar
could have a substantial foreign currency component

3. have net cash flows which are heavily driven by whether the
3. if possible, tied to the

success of movies.
movie or T.V series is a hit

Retailing
Projects are likely to be
Debt should be in the form
1. medium term (tied to store life)
of operating leases.
2. primarily in dollars (most in US still)

3. cyclical
Broadcasting
Debt should be
1. short term
1. short term
2. primarily in dollars, though foreign component is growing
2. primarily dollar debt
3. driven by advertising revenues and show success
3. if possible, linked to
network ratings.
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69
Financing Details: Other Divisions
Theme Parks
Debt should be
1. very long term
1. long term
2. primarily in dollars, but a significant proportion of revenues
2. mix of currencies, based
come from foreign tourists.
upon tourist make up.
3. affected by success of movie and broadcasting divisions.

Real Estate
Debt should be
1. long term
1. long term
2. primarily in dollars.
2. dollars
3. affected by real estate values in the area
3. real-estate linked
(Mortgage Bonds)
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70
First Principles
hurdle rate.
being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
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71
Dividends are sticky..
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72
Dividends tend to follow earnings
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73
More and more firms are buying back stock, rather than pay
dividends...
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74
Questions to Ask in Dividend Policy Analysis
How much could the company have paid out during the period under
question?
How much did the the company actually pay out during the period in
question?
How much do I trust the management of this company with excess cash?
Aswath Damodaran
How well did they make investments during the period in question?
How well has my stock performed during the period in question?
75
Measuring Potential Dividends
Aswath Damodaran
76
How much can you return to stockholders?

Disneys Free Cashflow to Equity
Year
Net Income Capital Expenditures Depreciation Change in Working Capital Net
1992
$817
$544
$317
$106
1993
$889
$794
$364
($211)
1994
$1,110
$1,026
$410
($654)
1995
$1,380
$897
$470
($271)
1996
$1,214
$1,746
$1,134
$617
Average $1,082
$1,001
$539
($82)
Aswath Damodaran
Debt Issued
($54)
$68
$686
$82
($133)
$130
FCFE
$642
$316
$526
$764
$1,086
$667
77
How much did your return? Disneys Dividends and

Buybacks from 1992 to 1996
Year
1992
1993
1994
1995
1996
Average
Aswath Damodaran
FCFE
$725
$400
$143
$829
$1,218
$667
Dividends + Stock Buybacks

$105
$160
$724
$529
$733
$450
78
Can you trust Disneys management?
During the period 1992-1996, Disney had
an average return on equity of 21.07% on projects taken

earned an average return on 21.43% for its stockholders
a cost of equity of 19.09%
Disney has taken good projects and earned above-market returns for its
stockholders during the period.
If you were a Disney stockholder, would you be comfortable with Disneys
dividend policy?
Yes
No
Aswath Damodaran
79
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 the ABC acquisition.
The excess returns that Disney earned on its projects and its stock over the
period provide it with some dividend flexibility. The trend in these returns,
however, suggests that this flexibility will be rapidly depleted.
The flexibility will clearly not survive if the ABC acquisition does not work
out.
Aswath Damodaran
80
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
Aswath Damodaran
What investment opportunities does the

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

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

of poor project
choice
Firm has good

projects
Give managers the

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

projects
Firm should deal

with its investment
problem first and
then cut dividends
81
Application Test: Analyzing your companys dividend

policy
How much could your firm have returned to its stockholders last year?
How much did it actually return?
Given the cash balance that it has accumulated and its history, do you trust the
management of this company with your cash?
Aswath Damodaran
82
First Principles
hurdle rate.
being financed.
stockholders.
Aswath Damodaran
83
Disney: Inputs to Valuation
Length of Period
Revenues
High Growth Phase
Transition Phase
5 years
5 years
Stable Growth Phase

Foreverafter 10 years
Current Revenues: $ 18,739; Continues to grow at same rate Grow s at stable grow thrate
Expected to grow at same rate a as operating earnings
operating earnings
Pre-tax Operating Margin
29.67% of revenues,based upon Increases gradually to 32% of Stable margin is as sumed to be

1996 EBIT of $ 5,559 million.
revenues, due to ec onomies of 32%.

sc ale.
Tax Rate
36%
36%
36%
Return on Capital
20% (approximately1996 level)
Declines linearly to 16%
Stable ROC of 16%
Working Capital
5% of Revenues
5% of Revenues
5% of Revenues
ReinvestmentRate
50% of after-tax operating Declines to 31.25% as ROC
(Net Cap Ex + Working Capital income; Depreciation in 1996 is and grow thrates drop:
Investments/EBIT)
$ 1,134 million, and is as sumed ReinvestmentRate = g/ROC
to grow at same rate as earnings
31.25% of after-tax operating

income; this is es timated from
the grow thrate of 5%
Reinvestmentrate = g/ROC
ExpectedGrow thRate in EBIT
ROC * Reinvestment Rate = Linear decline to Stable Grow th 5%, based upon overall nominal
20% * .5 = 10%
Rate
ec onomicgrow th
Debt/Capital Ratio
18%
Increaseslinearly to 30%
Risk Parameters
Beta = 1.25, ke = 13.88%

Cost of Debt = 7.5%
(Long Term Bond Rate = 7%)
Beta decreases linearly to 1.00; Stable beta is 1.00.

Cost of debt stays at 7.5%
Cost of debt stays at 7.5%
Aswath Damodaran
Stable debt ratio of 30%
84
Disney: A Valuation
Reinvestme nt Rate
50.00%
Cashflow to Firm
EBIT(1-t) :
3,558
- Nt CpX
612
- Chg WC
617
= FCFF
2 ,329
57,817
- 11,180= 46,637
Per Share: 69.0 8
1,966
2,163
2,379
2,617
Expe cted Growth

in EBIT (1 -t)
.50*.20 = .10
10.00 %
Retu rn on Capital
20%
Stable Growth
g = 5%; Beta = 1 .00;
D/(D+E) = 30 %; ROC=16%
Reinvestme nt Rate=31 .25%
Terminal Value10= 6255/(.1 019-.05) = 120,52

ROC drops to 16%
Reinv. rate drops to 31.25%
2,879 3,370
3,932
4,552 5,228 5,957
Fore ver
Discount at Cost of Capital (WACC) = 13.85 % (0.82) + 4.8% (0.1 8) = 12.22%
Cost of Equity
13.85%
Risk fre e Rate :

Governmen t Bond
Rate = 7%
Cost of De bt
(7 %+ 0.50 %)(1-.36)
= 4.80%
Be ta
1.25
Unlevered Beta for

Sectors: 1.09
Aswath Damodaran
Tran sition
Beta drops to 1.0 0
Debt ratio rises to 30%
Weights
E = 82% D = 18%
Risk Pre mium

5.5%
Firms D/E
Historical US
Ratio: 21.95% Premium
5.5%
Country Risk
Premium
0%
85
Aswath Damodaran
86
First Principles
hurdle rate.
being financed.
stockholders.
Aswath Damodaran
87

Corporate Finance in A Day It Can Be Done : Stern School of Business

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Corporate Finance in a Day It can be

Stern School of Business

A Financial View of the Firm

Figure 1.1: A Simple View of a Business (Firm)

Expected Value that w ill be

Objective: Maximize the Value of the Firm

The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to

The Classical Objective Function

What can go wrong?

Significant Social Costs

-27 Sell side

Board has been compos ed

Heavily traded and

When traditional corporate financial theory breaks down, the

To choose a different mechanism for corporate governance. Japan and

Making managers (decision makers) and employees into stockholders

The Only Self Correcting Objective

Corporate Good Citizen Constraints

Looking at Disneys top stockholders

6Application Test: Who owns/runs your firm?

Who is the marginal investor in this firm? (Is it an institutional investor or an

How many analysts follow your company?

Risk, in traditional terms, is viewed as a negative. Websters dictionary, for

Models of Risk and Return

Step 1: Defining Risk

Risk that is specific to investment (Firm Specific)

Beta of asset relative to

Betas of asset relative

Betas of assets relative

The Riskfree Rate

For an investment to be riskfree, i.e., to have an actual return be equal to the

The Risk Premium: What is it?

a riskless investment (say a Government Security), on which you can make 5%

One way to estimate risk premiums: Look at history

What is the right premium?

Be consistent in your use of a riskfree rate.

Beta Estimation in Practice: Bloomberg

32% of Disneys risk

Using Betas to estimate Expected Returns: September 30,

Disneys Beta = 1.40

Application Test: Analyzing the Risk Regression

What is your stocks beta?

Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta)

Ope rating Le v e rage (Fixe d

Fina ncial Le v e r age :

Bottom-up Betas: Estimating betas by looking at comparable

Estimated ValueComparable Firms

From Cost of Equity to Cost of Capital

First estimate the cost of borrowing money

Cost of Debt = Riskfree Rate + Default Spread

Default Spreads and Bond Ratings

Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is

Estimated Bond Rating

Application Test: Estimating a Cost of Debt

Estimating Market Value Weights