Finding the Right Financing Mix: The

Capital Structure Decision

Aswath Damodaran

Stern School of Business

Aswath Damodaran 2
 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 3
 The Choices in Financing

 There are only two ways in which a business can make money.
• The first is debt. The essence of debt is that you promise to make fixed
payments in the future (interest payments and repaying principal). If you
fail to make those payments, you lose control of your business.
• The other is equity. With equity, you do get whatever cash flows are left
over after you have made debt payments.
 The equity can take different forms:
• For very small businesses: it can be owners investing their savings
• For slightly larger businesses: it can be venture capital
• For publicly traded firms: it is common stock
 The debt can also take different forms
• For private businesses: it is usually bank loans
• For publicly traded firms: it can take the form of bonds

Aswath Damodaran 4
 The Financing Mix Question

 In deciding to raise financing for a business, is there an optimal mix of

debt and equity?
• If yes, what is the trade off that lets us determine this optimal mix?
• If not, why not?

Aswath Damodaran 5
 Measuring a firm’s 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.

Aswath Damodaran 6
 Costs and Benefits of Debt

 Benefits of Debt
• Tax Benefits
• Adds discipline to management
 Costs of Debt
• Bankruptcy Costs
• Agency Costs
• Loss of Future Flexibility

Aswath Damodaran 7
 Tax Benefits of Debt

 When you borrow money, you are allowed to deduct interest expenses
from your income to arrive at taxable income. This reduces your taxes.
When you use equity, you are not allowed to deduct payments to
equity (such as dividends) to arrive at taxable income.
 The dollar tax benefit from the interest payment in any year is a
function of your tax rate and the interest payment:
• Tax benefit each year = Tax Rate * Interest Payment

 Proposition 1: Other things being equal, the higher the marginal tax
rate of a business, the more debt it will have in its capital structure.

Aswath Damodaran 8
 The Effects of Taxes

You are comparing the debt ratios of real estate corporations, which pay the
corporate tax rate, and real estate investment trusts, which are not taxed, but
are required to pay 95% of their earnings as dividends to their stockholders.
Which of these two groups would you expect to have the higher debt ratios?
 The real estate corporations
 The real estate investment trusts
 Cannot tell, without more information

Aswath Damodaran 9
 Debt adds discipline to management

 If you are managers of a firm with no debt, and you generate high
income and cash flows each year, you tend to become complacent. The
complacency can lead to inefficiency and investing in poor projects.
There is little or no cost borne by the managers
 Forcing such a firm to borrow money can be an antidote to the
complacency. The managers now have to ensure that the investments
they make will earn at least enough return to cover the interest
expenses. The cost of not doing so is bankruptcy and the loss of such a
job.

Aswath Damodaran 10
 Debt and Discipline

Assume that you buy into this argument that debt adds discipline to management.
Which of the following types of companies will most benefit from debt adding
this discipline?
 Conservatively financed (very little debt), privately owned businesses
 Conservatively financed, publicly traded companies, with stocks held by
millions of investors, none of whom hold a large percent of the stock.
 Conservatively financed, publicly traded companies, with an activist and
primarily institutional holding.

Aswath Damodaran 11
 Bankruptcy Cost

 The expected bankruptcy cost is a function of two variables--

• the cost of going bankrupt
– direct costs: Legal and other Deadweight Costs
– indirect costs: Costs arising because people perceive you to be in financial
trouble
• the probability of bankruptcy, which will depend upon how uncertain you
are about future cash flows
 As you borrow more, you increase the probability of bankruptcy and
hence the expected bankruptcy cost.

Aswath Damodaran 12
 The Bankruptcy Cost Proposition

 Proposition 2: Other things being equal, the greater the indirect

bankruptcy cost and/or probability of bankruptcy in the operating
cashflows of the firm, the less debt the firm can afford to use.

Aswath Damodaran 13
 Debt & Bankruptcy Cost

Rank the following companies on the magnitude of bankruptcy costs from most to

least, taking into account both explicit and implicit costs:

 A Grocery Store

 An Airplane Manufacturer

 High Technology company

Aswath Damodaran 14
 Agency Cost

 An agency cost arises whenever you hire someone else to do something for
you. It arises because your interests(as the principal) may deviate from those
of the person you hired (as the agent).
 When you lend money to a business, you are allowing the stockholders to use
that money in the course of running that business. Stockholders interests are
different from your interests, because
• You (as lender) are interested in getting your money back
• Stockholders are interested in maximizing your wealth
 In some cases, the clash of interests can lead to stockholders
• Investing in riskier projects than you would want them to
• Paying themselves large dividends when you would rather have them keep the cash
in the business.
 Proposition 3: Other things being equal, the greater the agency problems
associated with lending to a firm, the less debt the firm can afford to use.

Aswath Damodaran 15
 Debt and Agency Costs

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

you perceive the greatest agency costs?

 A Large Pharmaceutical company

 A Large Regulated Electric Utility

Why?

Aswath Damodaran 16
 Loss of future financing flexibility

 When a firm borrows up to its capacity, it loses the flexibility of

financing future projects with debt.
 Proposition 4: Other things remaining equal, the more uncertain a firm
is about its future financing requirements and projects, the less debt the
firm will use for financing current projects.

Aswath Damodaran 17
 What managers consider important in deciding
on how much debt to carry...

 A survey of Chief Financial Officers of large U.S. companies provided

the following ranking (from most important to least important) for the
factors that they considered important in the financing decisions
Factor Ranking (0-5)
1. Maintain financial flexibility 4.55
2. Ensure long-term survival 4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price 3.99
5. Maintain financial independence 3.88
6. Maintain high debt rating 3.56
7. Maintain comparability with peer group 2.47

Aswath Damodaran 18
 Debt: Summarizing 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

Aswath Damodaran 19
 6Application Test: Would you expect your firm
to gain or lose from using a lot of debt?

 Considering, for your firm,

• The potential tax benefits of borrowing
• The benefits of using debt as a disciplinary mechanism
• The potential for expected bankruptcy costs
• The potential for agency costs
• The need for financial flexibility
 Would you expect your firm to have a high debt ratio or a low debt
ratio?
 Does the firm’s current debt ratio meet your expectations?

Aswath Damodaran 20
 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

Aswath Damodaran 21
 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.

Aswath Damodaran 22
 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

Aswath Damodaran 23
 What do firms look at in financing?

 Is there a financing hierarchy?

 Argument:
• There are some who argue that firms follow a financing hierarchy, with
retained earnings being the most preferred choice for financing, followed
by debt and that new equity is the least preferred choice.

Aswath Damodaran 24
 Rationale for Financing Hierarchy

 Managers value flexibility. External financing reduces flexibility more

than internal financing.
 Managers value control. Issuing new equity weakens control and new
debt creates bond covenants.

Aswath Damodaran 25
 Preference rankings long-term finance: Results
of a survey

Ranking Source Score

1 Retained Earnings 5.61
2 Straight Debt 4.88
3 Convertible Debt 3.02
4 External Common Equity 2.42
5 Straight Preferred Stock 2.22
6 Convertible Preferred 1.72

Aswath Damodaran 26
 Financing Choices

You are reading the Wall Street Journal and notice a tombstone ad for a company,
offering to sell convertible preferred stock. What would you hypothesize about
the health of the company issuing these securities?
 Nothing
 Healthier than the average firm
 In much more financial trouble than the average firm

Aswath Damodaran 27
 Measuring Cost of Capital

 It will depend upon:

• (a) the components of financing: Debt, Equity or Preferred stock
• (b) the cost of each component
 In summary, the cost of capital is the cost of each component weighted
by its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))

Aswath Damodaran 28
 Recapping the Measurement of cost of capital

 The cost of debt is the market interest rate that the firm has to pay on
its borrowing. It will depend upon three components
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate
 The cost of equity is
1. the required rate of return given the risk
2. inclusive of both dividend yield and price appreciation
 The weights attached to debt and equity have to be market value
weights, not book value weights.

Aswath Damodaran 29
 Costs of Debt & Equity

A recent article in an Asian business magazine argued that equity was cheaper
than debt, because dividend yields are much lower than interest rates on debt.
Do you agree with this statement
 Yes
 No
Can equity ever be cheaper than debt?
 Yes
 No

Aswath Damodaran 30
 Fallacies about Book Value

1. People will not lend on the basis of market value.

2. Book Value is more reliable than Market Value because it does not
change as much.
3. Using book value is more conservative than using market value.

Aswath Damodaran 31
 Issue: Use of Book Value

Many CFOs argue that using book value is more conservative than using
market value, because the market value of equity is usually much
higher than book value. Is this statement true, from a cost of capital
perspective? (Will you get a more conservative estimate of cost of
capital using book value rather than market value?)
 Yes
 No

Aswath Damodaran 32
 Why does the cost of capital matter?

 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.

Aswath Damodaran 33
 Applying Approach: The Textbook Example

D/(D+E) ke kd After-tax Cost of Debt WACC

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%

Aswath Damodaran 34
 WACC and Debt Ratios

Weighted Average Cost of Capital and Debt Ratios

11.40%
11.20%
11.00%
10.80%
10.60%
WACC

10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
20%

100%
10%

40%
30%

50%

60%

70%

80%

90%
0

Debt Ratio

Aswath Damodaran 35
 Current Cost of Capital: Disney

 Equity
• Cost of Equity = Riskfree rate + Beta * Risk Premium
= 7% + 1.25 (5.5%) = 13.85%
• Market Value of Equity = $50.88 Billion
• Equity/(Debt+Equity ) = 82%
 Debt
• After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (7% +0.50) (1-.36) = 4.80%
• Market Value of Debt = $ 11.18 Billion
• Debt/(Debt +Equity) = 18%
 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

50.88/(50.88
+11.18)

Aswath Damodaran 36
 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.

Aswath Damodaran 37
 Medians of Key Ratios : 1993-1995

AAA AA A BBB BB B CCC

Pretax Interest Coverage
13.50 9.67 5.76 3.94 2.14 1.51 0.96
EBITDA Interest Coverage
17.08 12.80 8.18 6.00 3.49 2.45 1.51
Funds from Operations / Total Debt
(%) 98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%
Free Operating Cashflow/ Total 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%
Debt (%)
Pretax Return on Permanent Capital 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%
(%)
Operating Income/Sales (%) 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%
Long Term Debt/ Capital 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%
Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%

Aswath Damodaran 38
 Process of Ratings and Rate Estimation

 We use the median interest coverage ratios for large manufacturing

firms to develop “interest coverage ratio” ranges for each rating class.
 We then estimate a spread over the long term bond rate for each ratings
class, based upon yields at which these bonds trade in the market
place.

Aswath Damodaran 39
 Interest Coverage Ratios and Bond Ratings

If Interest Coverage Ratio is Estimated Bond Rating

> 8.50 AAA
6.50 - 8.50 AA
5.50 - 6.50 A+
4.25 - 5.50 A
3.00 - 4.25 A–
2.50 - 3.00 BBB
2.00 - 2.50 BB
1.75 - 2.00 B+
1.50 - 1.75 B
1.25 - 1.50 B–
0.80 - 1.25 CCC
0.65 - 0.80 CC
0.20 - 0.65 C
< 0.20 D
For more detailed interest coverage ratios and bond ratings, try the ratings.xls
spreadsheet on my web site.
Aswath Damodaran 40
 Spreads over long bond rate for ratings
classes: 1996

Rating Coverage
Spread gt
AAA 0.20%
AA 0.50%
A+ 0.80%
A 1.00%
A- 1.25%
BBB 1.50%
BB 2.00%
B+ 2.50%
B 3.25%
B- 4.25%
CCC 5.00%
CC 6.00%
C 7.50%
D 10.00%

See http://www.bondsonline.com for latest spreads

Aswath Damodaran 41
 Current Income Statement for Disney: 1996

Revenues 18,739
-Operating Expenses 12,046
EBITDA 6,693
-Depreciation 1,134
EBIT 5,559
-Interest Expense 479
Income before taxes 5,080
-Taxes 847
Income after taxes 4,233
 Interest coverage ratio= 5,559/479 = 11.61
(Amortization from Capital Cities acquisition not considered)

Aswath Damodaran 42
 Estimating Cost of Equity

Current Beta = 1.25 Unlevered Beta = 1.09

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

Aswath Damodaran 43
 Disney: Beta, Cost of Equity and D/E Ratio

9.00 60.00%

8.00

50.00%

7.00

6.00 40.00%

Cost of Equity
5.00 Beta
Beta

30.00% Cost of Equity

4.00

3.00 20.00%

2.00

10.00%

1.00

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

Aswath Damodaran 44
 Estimating Cost of Debt

D/(D+E) 0.00% 10.00% Calculation Details Step

D/E 0.00% 11.11% = [D/(D+E)]/( 1 -[D/(D+E)])
$ Debt $0 $6,207 = [D/(D+E)]* Firm Value 1

EBITDA $6,693 $6,693 Kept constant as debt changes.

Depreciation $1,134 $1,134 "
EBIT $5,559 $5,559
Interest $0 $447 = Interest Rate * $ Debt 2
Taxable Income $5,559 $5,112 = EBIT - Interest
Tax $2,001 $1,840 = Tax Rate * Taxable Income
Net Income $3,558 $3,272 = Taxable Income - Tax

Pre-tax Int. cov ∞ 12.44 = EBIT/Int. Exp 3

Likely Rating AAA AAA Based upon interest coverage 4
Interest Rate 7.20% 7.20% Interest rate for given rating 5
Eff. Tax Rate 36.00% 36.00% See notes on effective tax rate
After-tax kd 4.61% 4.61% =Interest Rate * (1 - Tax Rate)
Firm Value = 50,888+11,180= $62,068
Aswath Damodaran 45
 The Ratings Table

If Interest Coverage Ratio is Estimated Bond Rating Default spread

> 8.50 AAA 0.20%
6.50 - 8.50 AA 0.50%
5.50 - 6.50 A+ 0.80%
4.25 - 5.50 A 1.00%
3.00 - 4.25 A– 1.25%
2.50 - 3.00 BBB 1.50%
2.00 - 2.50 BB 2.00%
1.75 - 2.00 B+ 2.50%
1.50 - 1.75 B 3.25%
1.25 - 1.50 B– 4.25%
0.80 - 1.25 CCC 5.00%
0.65 - 0.80 CC 6.00%
0.20 - 0.65 C 7.50%
< 0.20 D 10.00%

Aswath Damodaran 46
 A Test: Can you do the 20% level?

D/(D+E) 0.00% 10.00% 20.00% Second Iteration

D/E 0.00% 11.11%
$ Debt $0 $6,207
EBITDA $6,693 $6,693
Depreciation $1,134 $1,134
EBIT $5,559 $5,559
Interest Expense $0 $447
Pre-tax Int. cov ∞ 12.44
Likely Rating AAA AAA
Interest Rate 7.20% 7.20%
Eff. Tax Rate 36.00% 36.00%
Cost of Debt 4.61% 4.61%

Aswath Damodaran 47
 Bond Ratings, Cost of Debt and Debt Ratios

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%
D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%
$ Debt $0 $6,207 $12,414 $18,621 $24,827 $31,034 $37,241 $43,448 $49,655 $55,862
EBITDA $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693 $6,693
Depreciation $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134 $1,134
EBIT $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559 $5,559
Interest $0 $447 $968 $1,536 $2,234 $3,181 $4,469 $5,214 $5,959 $7,262
Taxable Income $5,559 $5,112 $4,591 $4,023 $3,325 $2,378 $1,090 $345 ($400) ($1,703)
Tax $2,001 $1,840 $1,653 $1,448 $1,197 $856 $392 $124 ($144) ($613)
Pre-tax Int. cov • 12.44 5.74 3.62 2.49 1.75 1.24 1.07 0.93 0.77
Likely Rating AAA AAA A+ A- BB B CCC CCC CCC CC
Interest Rate 7.20% 7.20% 7.80% 8.25% 9.00% 10.25% 12.00% 12.00% 12.00% 13.00%
Eff. Tax Rate 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 33.59% 27.56%
Cost of debt 4.61% 4.61% 4.99% 5.28% 5.76% 6.56% 7.68% 7.68% 7.97% 9.42%

Aswath Damodaran 48
 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 70% and 80%
70% Debt Ratio 80% Debt Ratio
EBIT $ 5,559 m $ 5,559 m
Interest Expense $ 5,214 m $ 5,959 m
Tax Savings $ 1,866 m 5559*.36 = $ 2,001m
Effective Tax Rate 36.00% 2001/5959 = 33.59%
Pre-tax interest rate 12.00% 12.00%
After-tax Interest Rate 7.68% 7.97%
 You can deduct only $5,559million of the $5,959 million of the
interest expense at 80%. Therefore, only 36% of $ 5,559 is considered
as the tax savings.

Aswath Damodaran 49
 Cost of Debt

Aswath Damodaran 50
 Disney’s Cost of Capital Schedule

Debt Ratio Cost of Equity AT Cost of Debt Cost of Capital

0.00% 13.00% 4.61% 13.00%
10.00% 13.43% 4.61% 12.55%
20.00% 13.96% 4.99% 12.17%
30.00% 14.65% 5.28% 11.84%
40.00% 15.56% 5.76% 11.64%
50.00% 16.85% 6.56% 11.70%
60.00% 18.77% 7.68% 12.11%
70.00% 21.97% 7.68% 11.97%
80.00% 28.95% 7.97% 12.17%
90.00% 52.14% 9.42% 13.69%

Aswath Damodaran 51
 Disney: Cost of Capital Chart

Aswath Damodaran 52
 Effect on Firm Value

 Firm Value before the change = 50,888+11,180= $ 62,068

WACCb = 12.22% Annual Cost = $62,068 *12.22%= $7,583 million
WACCa = 11.64% Annual Cost = $62,068 *11.64% = $7,226 million
WACC = 0.58% Change in Annual Cost = $ 357 million
 If there is no growth in the firm value, (Conservative Estimate)
• Increase in firm value = $357 / .1164 = $3,065 million
• Change in Stock Price = $3,065/675.13= $4.54 per share
 If there is growth (of 7.13%) in firm value over time,
• Increase in firm value = $357 * 1.0713 /(.1164-.0713) = $ 8,474
• Change in Stock Price = $8,474/675.13 = $12.55 per share
Implied Growth Rate obtained by
Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula
$62,068 = $2,947(1+g)/(.1222-g): Solve for g

Aswath Damodaran 53
 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 $ 75.38)
Assuming that firm value will grow by 7.13% 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 $ 75.38?

Aswath Damodaran 54
 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

Aswath Damodaran 55
 Disney’s Operating Income: History
Year Operating Income Change in Operating Income

1981 $ 119.35
1982 $ 141.39 18.46%
1983 $ 133.87 -5.32%
1984 $ 142.60 6.5%
1985 $ 205.60 44.2%
1986 $ 280.58 36.5%
1987 $ 707.00 152.0%
1988 $ 789.00 11.6%
1989 $ 1,109.00 40.6%
1990 $ 1,287.00 16.1%
1991 $ 1,004.00 -22.0%
1992 $ 1,287.00 28.2%
1993 $ 1,560.00 21.2%
1994 $ 1,804.00 15.6%
1995 $ 2,262.00 25.4%
1996 $ 3,024.00 33.7%

Aswath Damodaran 56
 Disney: Effects of Past Downturns

Recession Decline in Operating Income

1991 Drop of 22.00%
1981-82 Increased
Worst Year Drop of 26%

 The standard deviation in past operating income is about 39%.

Aswath Damodaran 57
 Disney: The Downside Scenario

Aswath Damodaran 58
 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.

Aswath Damodaran 59
 Ratings Constraints for Disney

 Assume that Disney imposes a rating constraint of BBB or greater.

 The optimal debt ratio for Disney is then 30% (see next page)
 The cost of imposing this rating constraint can then be calculated as
follows:
Value at 40% Debt = $ 70,542 million
- Value at 30% Debt = $ 67,419 million
Cost of Rating Constraint = $ 3,123 million

Aswath Damodaran 60
 Effect of A Ratings Constraint: Disney

Debt Ratio Rating Firm Value

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

Aswath Damodaran 61
 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.

Aswath Damodaran 62
 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

Aswath Damodaran 63
 Interest Coverage ratios, ratings and Operating
income
Interest Coverage Ratio Rating is Spread is Operating Income Decline

< 0.05 D 10.00% -50.00%

0.05 - 0.10 C 7.50% -40.00%

0.10 - 0.20 CC 6.00% -40.00%

0.20 - 0.30 CCC 5.00% -40.00%

0.30 - 0.40 B- 4.25% -25.00%

0.40 - 0.50 B 3.25% -20.00%

0.50 - 0.60 B+ 2.50% -20.00%

0.60 - 0.80 BB 2.00% -20.00%

0.80 - 1.00 BBB 1.50% -20.00%

1.00 - 1.50 A- 1.25% -17.50%

1.50 - 2.00 A 1.00% -15.00%

2.00 - 2.50 A+ 0.80% -10.00%

2.50 - 3.00 AA 0.50% -5.00%

> 3.00 AAA 0.20% 0.00%

Aswath Damodaran 64
 Deutsche Bank: Optimal Capital Structure
Debt Cost of Cost of Debt WACC Firm Value

Ratio Equity

0% 10.13% 4.24% 10.13% DM 124,288.85

10% 10.29% 4.24% 9.69% DM 132,558.74

20% 10.49% 4.24% 9.24% DM 142,007.59

30% 10.75% 4.24% 8.80% DM 152,906.88

40% 11.10% 4.24% 8.35% DM 165,618.31

50% 11.58% 4.24% 7.91% DM 165,750.19

60% 12.30% 4.40% 7.56% DM 162,307.44

70% 13.51% 4.57% 7.25% DM 157,070.00

80% 15.92% 4.68% 6.92% DM 151,422.87

90% 25.69% 6.24% 8.19% DM 30,083.27

Aswath Damodaran 65
 Analyzing Companies after Abnormal Years

 The operating income that should be used to arrive at an optimal debt

ratio is a “normalized” operating income
 A normalized operating income is the income that this firm would
make in a normal year.
• For a cyclical firm, this may mean using the average operating income
over an economic cycle rather than the latest year’s income
• For a firm which has had an exceptionally bad or good year (due to some
firm-specific event), this may mean using industry average returns on
capital to arrive at an optimal or looking at past years
• For any firm, this will mean not counting one time charges or profits

Aswath Damodaran 66
 Analyzing Aracruz Cellulose’s Optimal Debt
Ratio

 In 1996, Aracruz had earnings before interest and taxes of only 15

million BR, and claimed depreciation of 190 million Br. Capital
expenditures amounted to 250 million BR.
 Aracruz had debt outstanding of 1520 million BR. While the nominal
rate on this debt, especially the portion that is in Brazilian Real, is
high, we will continue to do the analysis in real terms, and use a
current real cost of debt of 5.5%, which is based upon a real riskfree
rate of 5% and a default spread of 0.5%.
 The corporate tax rate in Brazil is estimated to be 32%.
 Aracruz had 976.10 million shares outstanding, trading 2.05 BR per
share. The beta of the stock is estimated, using comparable firms, to be
0.71.

Aswath Damodaran 67
 Setting up for the Analysis

 Current Cost of Capital

Current Cost of Equity = 5% + 0.71 (7.5%) = 10.33%
Market Value of Equity = 2.05 BR * 976.1 = 2,001 million BR
Current Cost of Capital
= 10.33% (2001/(2001+1520)) + 5.5% (1-.32) (1520/(2001+1520) = 7.48%
 1996 was a poor year for Aracruz, both in terms of revenues and
operating income. In 1995, Aracruz had earnings before interest and
taxes of 271 million BR. We will use this as our normalized EBIT.

Aswath Damodaran 68
 Aracruz’s Optimal Debt Ratio

Debt Beta Cost of Rating Cost of AT Cost Cost of Firm Value

Ratio Equity Debt of Debt Capital
0.00% 0.47 8.51% AAA 5.20% 3.54% 8.51% 2,720 BR
10.00% 0.50 8.78% AAA 5.20% 3.54% 8.25% 2,886 BR
20.00% 0.55 9.11% AA 5.50% 3.74% 8.03% 3,042 BR
30.00% 0.60 9.53% A 6.00% 4.08% 7.90% 3,148 BR
40.00% 0.68 10.10% A- 6.25% 4.25% 7.76% 3,262 BR
50.00% 0.79 10.90% BB 7.00% 4.76% 7.83% 3,205 BR
60.00% 0.95 12.09% B- 9.25% 6.29% 8.61% 2,660 BR
70.00% 1.21 14.08% CCC 10.00% 6.80% 8.98% 2,458 BR
80.00% 1.76 18.23% CCC 10.00% 6.92% 9.18% 2,362 BR
90.00% 3.53 31.46% CCC 10.00% 7.26% 9.68% 2,149 BR

Aswath Damodaran 69
 Analyzing a Private Firm

 The approach remains the same with important caveats

• It is far more difficult estimating firm value, since the equity and the debt
of private firms do not trade
• Most private firms are not rated.
• If the cost of equity is based upon the market beta, it is possible that we
might be overstating the optimal debt ratio, since private firm owners
often consider all risk.

Aswath Damodaran 70
 Estimating the Optimal Debt Ratio for a Private
Bookstore

 Adjusted EBIT = EBIT + Imputed Interest on Op. Lease Exp.

= $ 2,000,000 + $ 252,000 = $ 2,252,000
 While Bookscape has no debt outstanding, the present value of the
operating lease expenses of $ 3.36 million is considered as debt.
 To estimate the market value of equity, we use a multiple of 22.41
times of net income. This multiple is the average multiple at which
comparable firms which are publicly traded are valued.
Estimated Market Value of Equity = Net Income * Average PE
= 1,160,000* 22.41 = 26,000,000
 The interest rates at different levels of debt will be estimated based
upon a “synthetic” bond rating. This rating will be assessed using
interest coverage ratios for small firms which are rated by S&P.

Aswath Damodaran 71
 Interest Coverage Ratios, Spreads and
Ratings: Small Firms

Interest Coverage Ratio Rating Spread over T Bond Rate

> 12.5 AAA 0.20%
9.50-12.50 AA 0.50%
7.5 - 9.5 A+ 0.80%
6.0 - 7.5 A 1.00%
4.5 - 6.0 A- 1.25%
3.5 - 4.5 BBB 1.50%
3.0 - 3.5 BB 2.00%
2.5 - 3.0 B+ 2.50%
2.0 - 2.5 B 3.25%
1.5 - 2.0 B- 4.25%
1.25 - 1.5 CCC 5.00%
0.8 - 1.25 CC 6.00%
0.5 - 0.8 C 7.50%
< 0.5 D 10.00%

Aswath Damodaran 72
 Optimal Debt Ratio for Bookscape

Debt Ratio Beta Cost of Equity Bond Rating Interest Rate AT Cost of Debt Cost of Capital Firm Value
0% 1.03 12.65% AA 7.50% 4.35% 12.65% $26,781
10% 1.09 13.01% AA 7.50% 4.35% 12.15% $29,112
20% 1.18 13.47% BBB 8.50% 4.93% 11.76% $31,182
30% 1.28 14.05% B+ 9.50% 5.51% 11.49% $32,803
40% 1.42 14.83% B- 11.25% 6.53% 11.51% $32,679
50% 1.62 15.93% CC 13.00% 7.54% 11.73% $31,341
60% 1.97 17.84% CC 13.00% 7.96% 11.91% $30,333
70% 2.71 21.91% C 14.50% 10.18% 13.70% $22,891
80% 4.07 29.36% C 14.50% 10.72% 14.45% $20,703
90% 8.13 51.72% C 14.50% 11.14% 15.20% $18,872

Aswath Damodaran 73
 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 Returns on Firm = (Operating Income) / MV of Firm
• Higher Pre-tax Returns - - > Higher Optimal Debt Ratio
• Lower Pre-tax Returns - - > 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
Aswath Damodaran 74
 6 Application Test: Your firm’s 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?

Aswath Damodaran 75
 The APV Approach to Optimal Capital Structure

 In the adjusted present value approach, the value of the firm is written
as the sum of the value of the firm without debt (the unlevered firm)
and the effect of debt on firm value
 Firm Value = Unlevered Firm Value + (Tax Benefits of Debt -
Expected Bankruptcy Cost from the Debt)
 The optimal dollar debt level is the one that maximizes firm value

Aswath Damodaran 76
 Implementing the APV Approach

 Step 1: Estimate the unlevered firm value. This can be done in one of
two ways:
• Estimating the unlevered beta, a cost of equity based upon the unlevered
beta and valuing the firm using this cost of equity (which will also be the
cost of capital, with an unlevered firm)
• Alternatively, Unlevered Firm Value = Current Market Value of Firm -
Tax Benefits of Debt (Current) + Expected Bankruptcy cost from Debt
 Step 2: Estimate the tax benefits at different levels of debt. The
simplest assumption to make is that the savings are perpetual, in which
case
• Tax benefits = Dollar Debt * Tax Rate
 Step 3: Estimate a probability of bankruptcy at each debt level, and
multiply by the cost of bankruptcy (including both direct and indirect
costs) to estimate the expected bankruptcy cost.

Aswath Damodaran 77
 Estimating Expected Bankruptcy Cost

 Probability of Bankruptcy
• Estimate the synthetic rating that the firm will have at each level of debt
• Estimate the probability that the firm will go bankrupt over time, at that
level of debt (Use studies that have estimated the empirical probabilities
of this occurring over time - Altman does an update every year)
 Cost of Bankruptcy
• The direct bankruptcy cost is the easier component. It is generally
between 5-10% of firm value, based upon empirical studies
• The indirect bankruptcy cost is much tougher. It should be higher for
sectors where operating income is affected significantly by default risk
(like airlines) and lower for sectors where it is not (like groceries)

Aswath Damodaran 78
 Ratings and Default Probabilities

Rating Default Risk

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

Aswath Damodaran 79
 Disney: Estimating Unlevered Firm Value

Current Value of the Firm = 50,888 + 11,180 = $62,068

- Tax Benefit on Current Debt = 11,180 * .36 = $4,025
+ Expected Bankruptcy Cost = 0.28% of .25*(62,068-4025) = $41
Unlevered Value of Firm = $58,084

Cost of Bankruptcy for Disney = 25% of firm value

Probability of Bankruptcy = 0.28%, based on firm’s current rating
Tax Rate = 36%
Market Value of Equity = $ 50,888
Market Value of Debt = $ 11,180

Aswath Damodaran 80
 Disney: APV at Debt Ratios

D/ $ Debt Tax Rate Unlevered Tax Rating Prob. Exp Value of

(D+E) Firm Value Benefit Default Bk Cst Firm
0% $0 36.00% $58,084 $0 AAA 0.01% $2 $58,083
10% $6,207 36.00% $58,084 $2,234 AAA 0.01% $2 $60,317
20% $12,414 36.00% $58,084 $4,469 A+ 0.40% $62 $62,491
30% $18,621 36.00% $58,084 $6,703 A- 1.41% $219 $64,569
40% $24,827 36.00% $58,084 $8,938 BB 12.20% $1,893 $65,129
50% $31,034 36.00% $58,084 $11,172 B 26.36% $4,090 $65,166
60% $37,241 36.00% $58,084 $13,407 CCC 50.00% $7,759 $63,732
70% $43,448 36.00% $58,084 $15,641 CCC 50.00% $7,759 $65,967
80% $49,655 33.59% $58,084 $16,677 CCC 50.00% $7,759 $67,003
90% $55,862 27.56% $58,084 $15,394 CC 65.00% $10,086 $63,392
Exp. Bk. Cst: Expected Bankruptcy cost

Aswath Damodaran 81
 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)

Aswath Damodaran 82
 Disney’s Comparables

Company Name Market Debt Ratio Book Debt Ratio

Disney (Walt) 18.19% 43.41%
Time Warner 29.39% 68.34%
Westinghouse Electric 26.98% 51.97%
Viacom Inc. 'A' 48.14% 46.54%
Gaylord Entertainm. 'A' 13.92% 41.47%
Belo (A.H.) 'A' Corp. 23.34% 63.04%
Evergreen Media 'A' 16.77% 39.45%
Tele-Communications Intl Inc 23.28% 34.60%
King W orld Productions 0.00% 0.00%
Jacor Communications 30.91% 57.91%
LIN Television 19.48% 71.66%
Regal Cinemas 4.53% 15.24%
Westwood One 11.40% 60.03%
United Television 4.51% 15.11%
Average of Large Firms 19.34% 43.48%

Aswath Damodaran 83
 II. Regression Methodology

 Step 1: Run a regression of debt ratios on proxies for benefits and

costs. For example,
DEBT RATIO = a + b (TAX RATE) + c (EARNINGS
VARIABILITY) + d (EBITDA/Firm Value)
 Step 2: Estimate the proxies for the firm under consideration. Plugging
into the crosssectional regression, we can obtain an estimate of
predicted debt ratio.
 Step 3: Compare the actual debt ratio to the predicted debt ratio.

Aswath Damodaran 84
 Applying the Regression Methodology:
Entertainment Firms

 Using a sample of 50 entertainment firms, we arrived at the following

regression:
Debt Ratio = - 0.1067 + 0.69 Tax Rate+ 0.61 EBITDA/Value- 0.07 OI
(0.90) (2.58) (2.21) (0.60)
 The R squared of the regression is 27.16%. This regression can be
used to arrive at a predicted value for Disney of:
Predicted Debt Ratio = - 0.1067 + 0.69 (.4358) + 0.61 (.0837) - 0.07
(.2257) = .2314
 Based upon the capital structure of other firms in the entertainment
industry, Disney should have a market value debt ratio of 23.14%.

Aswath Damodaran 85
 Cross Sectional Regression: 1996 Data

 Using 1996 data for 2929 firms listed on the NYSE, AMEX and
NASDAQ data bases. The regression provides the following results –
DFR =0.1906- 0.0552 PRVAR -.1340 CLSH - 0.3105 CPXFR + 0.1447 FCP
(37.97a) (2.20a) (6.58a) (8.52a) (12.53a)
where,
DFR = Debt / ( Debt + Market Value of Equity)
PRVAR = Variance in Firm Value
CLSH = Closely held shares as a percent of outstanding shares
CPXFR = Capital Expenditures / Book Value of Capital
FCP= Free Cash Flow to Firm / Market Value of Equity
 While the coefficients all have the right sign and are statistically
significant, the regression itself has an R-squared of only 13.57%.

Aswath Damodaran 86
 An Aggregated Regression

 One way to improve the predictive power of the regression is to

aggregate the data first and then do the regression. To illustrate with
the 1994 data, the firms are aggregated into two-digit SIC codes, and
the same regression is re-run.
DFR =0.2370- 0.1854 PRVAR +.1407 CLSH + 1.3959 CPXF -.6483 FCP
(6.06a) (1.96b) (1.05a) (5.73a) (3.89a)
 The R squared of this regression is 42.47%.

Data Source: For the latest regression, go to updated data on my web site
and click on the debt regression.

Aswath Damodaran 87
 Applying the Regression

Lets check whether we can use this regression. Disney had the following values
for these inputs in 1996. Estimate the optimal debt ratio using the debt
regression.
Variance in Firm Value = .04
Closely held shares as percent of shares outstanding = 4% (.04)
Capital Expenditures as fraction of firm value = 6.00%(.06)
Free Cash Flow as percent of Equity Value = 3% (.03)
Optimal Debt Ratio
=0.2370- 0.1854 ( ) +.1407 ( ) + 1.3959( ) -.6483 ( )
What does this optimal debt ratio tell you?

Why might it be different from the optimal calculated using the weighted average
cost of capital?

Aswath Damodaran 88
 A Framework for Getting to the Optimal

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

Actual > Optimal Actual < Optimal

Overlevered Underlevered

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

Yes No Yes No

Reduce Debt quickly Increase leverage

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

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

Yes
Pay Dividends No
Buy back stock
Aswath Damodaran 89
 Disney: Applying the Framework

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

Actual > Optimal Actual < Optimal

Overlevered Underlevered

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

Yes No Yes No

Reduce Debt quickly Increase leverage

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

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

Yes
Pay Dividends No
Buy back stock
Aswath Damodaran 90
 6 Application Test: Getting to the Optimal

 Based upon your analysis of both the firm’s 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

Aswath Damodaran 91
 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 92
 Firm with mismatched debt

Aswath Damodaran 93
 Firm with matched Debt

Aswath Damodaran 94
 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

Start with the

Cash Flows Cyclicality &
on Assets/
Growth Patterns Other Effects
Duration Currency Effect of Inflation
Projects Uncertainty about Future

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
Duration/ Currency * More floating rate Convertible on Debt Catastrophe Notes
Define Debt Maturity Mix - if CF move with - Convertible if - Options to make
Characteristics inflation cash flows low cash flows on debt
- with greater uncertainty now but high match cash flows
on future exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed

Aswath Damodaran 95
 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.

Deductibility of cash flows Differences in tax rates

Overlay tax for tax purposes across different locales Zero Coupons
preferences
If tax advantages are large enough, you might override results of previous step

Aswath Damodaran 96
 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 Analyst Concerns Ratings Agency Regulatory Concerns

ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?

Aswath Damodaran 97
 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.

Aswath Damodaran 98
 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.

Aswath Damodaran 99
 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.
Observability of Cash Flows Type of Assets financed
by Lenders - Tangible and liquid assets Existing Debt covenants Convertibiles
Factor in agency - Less observable cash flows create less agency problems - Restrictions on Financing Puttable Bonds
conflicts between stock Rating Sensitive
and bond holders lead to more conflicts
Notes
If agency problems are substantial, consider issuing convertible bonds LYONs

Aswath Damodaran 100

 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 firm’s 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 firm’s default risk.
 What is the solution
• If you need to use equity?
• If you need to use debt?

Aswath Damodaran 101

 Designing Debt: Bringing it all together

Start with the Cyclicality &

Cash Flows Duration Currency Effect of Inflation
Growth Patterns Other Effects
on Assets/ Uncertainty about Future
Projects

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
Duration/ Currency * More floating rate Convertible on Debt Catastrophe Notes
Define Debt Maturity Mix - if CF move with - Convertible if - Options to make
Characteristics inflation
- with greater uncertainty
cash flows low
now but high
cash flows on debt
match cash flows
on future exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed

Deductibility of cash flows Differences in tax rates

Overlay tax for tax purposes across different locales Zero Coupons
preferences
If tax advantages are large enough, you might override results of previous step

Consider Analyst Concerns Ratings Agency Regulatory Concerns

ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?

Observability of Cash Flows Type of Assets financed

by Lenders - Tangible and liquid assets Existing Debt covenants Convertibiles
Factor in agency - Less observable cash flows create less agency problems - Restrictions on Financing Puttable Bonds
conflicts between stock lead to more conflicts Rating Sensitive
and bond holders Notes
If agency problems are substantial, consider issuing convertible bonds LYONs

Consider Information Uncertainty about Future Cashflows Credibility & Quality of the Firm
Asymmetries - When there is more uncertainty, it - Firms with credibility problems
may be better to use short term debt will issue more short term debt
Aswath Damodaran 102
 Approaches for evaluating Asset Cash Flows

 I. Intuitive Approach
• Are the projects typically long term or short term? What is the cash flow
pattern on projects?
• How much growth potential does the firm have relative to current
projects?
• How cyclical are the cash flows? What specific factors determine the cash
flows on projects?
 II. Project Cash Flow Approach
• Project cash flows on a typical project for the firm
• Do scenario analyses on these cash flows, based upon different macro
economic scenarios
 III. Historical Data
• Operating Cash Flows
• Firm Value
Aswath Damodaran 103
 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. if possible, tied to the
3. have net cash flows which are heavily driven by whether 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 Projects are likely to be 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.
Aswath Damodaran 104
 Financing Details: Other Divisions

Theme Parks Projects are likely to be 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 Projects are likely to be 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)

Aswath Damodaran 105

 6 Application Test: Choosing your Financing
Type

 Based upon the business that your firm is in, and the typical
investments that it makes, what kind of financing would you expect
your firm to use in terms of
• Duration (long term or short term)
• Currency
• Fixed or Floating rate
• Straight or Convertible

Aswath Damodaran 106

 II. QUANTITATIVE APPROACH

1. Operating Cash Flows

• The question of how sensitive a firm’s asset cash flows are to a variety of
factors, such as interest rates, inflation, currency rates and the economy,
can be directly tested by regressing changes in the operating income
against changes in these variables.
• Change in Operating Income(t)= a + b Change in Macro Economic
Variable(t)
• This analysis is useful in determining the coupon/interest payment
structure of the debt.
2. Firm Value
• The firm value is clearly a function of the level of operating income, but it
also incorporates other factors such as expected growth & cost of capital.
• The firm value analysis is useful in determining the overall structure of
the debt, particularly maturity.

Aswath Damodaran 107

 The Historical Data

Year Firm Value % Change Operating Income % Change

1981 $ 1,707 $ 119.35
1982 $ 2,108 23.46% $ 141.39 18.46%
1983 $ 1,817 -13.82% $ 133.87 -5.32%
1984 $ 2,024 11.4% $ 142.60 6.5%
1985 $ 3,655 80.6% $ 205.60 44.2%
1986 $ 5,631 54.1% $ 280.58 36.5%
1987 $ 8,371 48.7% $ 707.00 152.0%
1988 $ 9,195 9.8% $ 789.00 11.6%
1989 $ 16,015 74.2% $ 1,109.00 40.6%
1990 $ 14,963 -6.6% $ 1,287.00 16.1%
1991 $ 17,122 14.4% $ 1,004.00 -22.0%
1992 $ 24,771 44.7% $ 1,287.00 28.2%
1993 $ 25,212 1.8% $ 1,560.00 21.2%
1994 $ 26,506 5.1% $ 1,804.00 15.6%
1995 $ 33,858 27.7% $ 2,262.00 25.4%
1996 $ 39,561 16.8% $ 3,024.00 33.7%

Aswath Damodaran 108

 The Macroeconomic Data

Long Bond Rate

Change in Interest Rate Real GNP GNP Growth Weighted Dollar Change in Dollar Inflation Rate Change in Inflation Rate
13.98% 3854 115.65 8.90%
10.47% -3.51% 3792 -1.6% 123.14 6.48% 3.80% -5.10%
11.80% 1.33% 4047 6.7% 128.65 4.47% 3.80% 0.00%
11.51% -0.29% 4216 4.2% 138.89 8.0% 4.00% 0.20%
8.99% -2.52% 4350 3.2% 125.95 -9.3% 3.80% -0.20%
7.22% -1.77% 4431 1.9% 112.89 -10.4% 1.20% -2.60%
8.86% 1.64% 4633 4.6% 95.88 -15.1% 4.40% 3.20%
9.14% 0.28% 4789 3.4% 95.32 -0.6% 4.40% 0.00%
7.93% -1.21% 4875 1.8% 102.26 7.3% 4.60% 0.20%
8.07% 0.14% 4895 0.4% 96.25 -5.9% 6.10% 1.50%
6.70% -1.37% 4894 0.0% 98.82 2.7% 3.10% -3.00%
6.69% -0.01% 5061 3.4% 104.58 5.8% 2.90% -0.20%
5.79% -0.90% 5219 3.1% 105.22 0.6% 2.70% -0.20%
7.82% 2.03% 5416 3.8% 98.6 -6.3% 2.70% 0.00%
5.57% -2.25% 5503 1.6% 95.1 -3.5% 2.50% -0.20%
6.42% 0.85% 5679 3.2% 101.5 6.7% 3.30% 0.80%

Aswath Damodaran 109

 Sensitivity to Interest Rate Changes

 The answer to this question is important because it

• it provides a measure of the duration of the firm’s projects
• it provides insight into whether the firm should be using fixed or floating
rate debt.

Aswath Damodaran 110

 Firm Value versus Interest Rate Changes

 Regressing changes in firm value against changes in interest rates over

this period yields the following regression –
Change in Firm Value = 0.22 - 7.43 ( Change in Interest Rates)
(3.09) (1.69)
T statistics are in brackets.
 Conclusion: The duration (interest rate sensitivity) of Disney’s asset
values is about 7.43 years. Consequently, its debt should have at least
as long a duration.

Aswath Damodaran 111

 Regression Constraints

Which of the following aspects of this regression would bother you the
most?
 The low R-squared of only 10%
 The fact that Disney today is a very different firm from the firm
captured in the data from 1981 to 1996
 Both
 Neither

Aswath Damodaran 112

 Why the coefficient on the regression is
duration..

 The duration of a straight bond or loan issued by a company can be

written in terms of the coupons (interest payments) on the bond (loan)
and the face value of the bond to be –
t = N t * Coupon 
dP/P



t =1 (1 + r)
t
t  N * Face Value
(1 + r) N



Duration of Bond = =
dr/r t =N Coupon Face Value 



t =1 (1+ r)
t 
t
(1+ r) N 



 Holding other factors constant, the duration of a bond will increase

with the maturity of the bond, and decrease with the coupon rate on the
bond.

Aswath Damodaran 113

 Duration of a Firm’s Assets

 This measure of duration can be extended to any asset with expected

cash flows on it. Thus, the duration of a project or asset can be
estimated in terms of the pre-debt operating cash flows on that project.
t = N t * CF N * Terminal Value 
 t
 
dPV/PV 
t =1 (1 + r) t
(1+ r) N 

Duration of Project/Asset = = t = N 
 CFt t  Terminal Value
dr/r


t =1 (1 + r) (1+ r) N 


where,
CFt = After-tax operating cash flow on the project in year t
Terminal Value = Salvage Value at the end of the project lifetime
N = Life of the project
 The duration of any asset provides a measure of the interest rate risk
embedded in that asset.

Aswath Damodaran 114

 Duration of Disney Theme Park

Year FCFF Terminal Value Total FCFF PV of FCFF PV * t

1 ($39,078 Bt) ($39,078 Bt) (31,180 Bt) -31180.4
2 ($36,199 Bt) ($36,199 Bt) (23,046 Bt) -46092.4
3 ($11,759 Bt) ($11,759 Bt) (5,973 Bt) -17920
4 16,155 Bt 16,155 Bt 6,548 Bt 26193.29
5 21,548 Bt 21,548 Bt 6,969 Bt 34844.55
6 33,109 Bt 33,109 Bt 8,544 Bt 51264.53
7 46,692 Bt 46,692 Bt 9,614 Bt 67299.02
8 58,169 Bt 58,169 Bt 9,557 Bt 76454.39
9 70,423 Bt 838,720 Bt 909,143 Bt 119,182 Bt 1072635
Sum 100,214 Bt 1,233,498
Duration of the Project = 1,233,498/100,214 = 12.30 years

Aswath Damodaran 115

 Duration: Comparing Approaches

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

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

Aswath Damodaran 116

 Operating Income versus Interest Rates

 Regressing changes in operating cash flow against changes in interest

rates over this period yields the following regression –
Change in Operating Income = 0.31 - 4.99 ( Change in Interest Rates)
(2.90) (0.78)
• Conclusion: Disney’s operating income, like its firm value, has been very
sensitive to interest rates, which confirms our conclusion to use long term
debt.
 Generally speaking, the operating cash flows are smoothed out more
than the value and hence will exhibit lower duration that the firm
value.

Aswath Damodaran 117

 Sensitivity to Changes in GNP

 The answer to this question is important because

• it provides insight into whether the firm’s cash flows are cyclical and
• whether the cash flows on the firm’s debt should be designed to protect
against cyclical factors.
 If the cash flows and firm value are sensitive to movements in the
economy, the firm will either have to issue less debt overall, or add
special features to the debt to tie cash flows on the debt to the firm’s
cash flows.

Aswath Damodaran 118

 Regression Results

 Regressing changes in firm value against changes in the GNP over this
period yields the following regression –
Change in Firm Value = 0.31 - 1.71 ( GNP Growth)
(2.43) (0.45)
• Conclusion: Disney is only mildly sensitive to cyclical movements in the
economy.
 Regressing changes in operating cash flow against changes in GNP
over this period yields the following regression –
Change in Operating Income = 0.17 + 4.06 ( GNP Growth)
(1.04) (0.80)
• Conclusion: Disney’s operating income is slightly more sensitive to the
economic cycle. This may be because of the lagged effect of GNP growth
on operating income.

Aswath Damodaran 119

 Sensitivity to Currency Changes

 The answer to this question is important, because

• it provides a measure of how sensitive cash flows and firm value are to
changes in the currency
• it provides guidance on whether the firm should issue debt in another
currency that it may be exposed to.
 If cash flows and firm value are sensitive to changes in the dollar, the
firm should
• figure out which currency its cash flows are in;
• and issued some debt in that currency

Aswath Damodaran 120

 Regression Results

 Regressing changes in firm value against changes in the dollar over

this period yields the following regression –
Change in Firm Value = 0.26 - 1.01 ( Change in Dollar)
(3.46) (0.98)
• Conclusion: Disney’s value has not been very sensitive to changes in the
dollar over the last 15 years.
 Regressing changes in operating cash flow against changes in the
dollar over this period yields the following regression –
Change in Operating Income = 0.26 - 3.03 ( Change in Dollar)
(3.14) (2.59)
• Conclusion: Disney’s operating income has been much more significantly
impacted by the dollar. A stronger dollar seems to hurt operating income.

Aswath Damodaran 121

 Sensitivity to Inflation

 The answer to this question is important, because

• it provides a measure of whether cash flows are positively or negatively
impacted by inflation.
• it then helps in the design of debt; whether the debt should be fixed or
floating rate debt.
 If cash flows move with inflation, increasing (decreasing) as inflation
increases (decreases), the debt should have a larger floating rate
component.

Aswath Damodaran 122

 Regression Results

 Regressing changes in firm value against changes in inflation over this

period yields the following regression –
Change in Firm Value = 0.26 - 0.22 (Change in Inflation Rate)
(3.36) (0.05)
• Conclusion: Disney’s firm value does not seem to be affected too much
by changes in the inflation rate.
 Regressing changes in operating cash flow against changes in inflation
over this period yields the following regression –
Change in Operating Income = 0.32 + 10.51 ( Change in Inflation Rate)
(3.61) (2.27)
• Conclusion: Disney’s operating income seems to increase in periods when
inflation increases. However, this increase in operating income seems to
be offset by the increase in discount rates leading to a much more muted
effect on value.
Aswath Damodaran 123
 Bottom-up Estimates

Busine ss Comp arab le Firm s Divisi on Weigh t Duration Cyclicali ty Inflati on Curren cy
Creative Content Moti on Pi ctu re an d TV prog ram p roducers 35 .71% -3.34 1.39 2.30 -1.86
Reta ilin g High End Specialty Re tail ers 3.57% -5.50 2.63 2.10 -0.75
Broa dca stin g TV Broad cas ting co mpan ies 30 .36% -4.50 0.70 3.03 -1.15
Th eme Parks Th eme Park and Entertainm ent Co mple xes 26 .79% -10 .47 0.22 0.72 -2.54
Real Esta te REITs spe cia lizing in hote l an d vacatio n p ropertiers 3.57% -8.46 0.89 -0.08 0.97
Dis ney 10 0.00 % -5.86 0.89 2.00 -1.69

Aswath Damodaran 124

 Analyzing Disney’s Current Debt

Description Amount Duration Non-US $ Floating Rate

Commercial paper $4,185 0.50 0 0
US $ notes & debentures $4,399 14.00 0 0
Dual Currency notes $1,987 1.20 1000 0
Senior notes $1,099 2.50 0 0
Other $672 5.00 0 0
Total $12,342 5.85 1000 0

Aswath Damodaran 125

 Financing Recommendations

 The duration of the debt is almost exactly the duration estimated using
the bottom-up approach, though it is lower than the duration estimated
from the firm-specific regression.
 Less than 10% of the debt is non-dollar debt and it is primarily in
Japanese yen, Australian dollars and Italian lire, and little of the debt is
floating rate debt.
 Based on our analysis, we would recommend more non-dollar debt
issues, with a shift towards floating rate debt, at least in those sectors
where Disney retains significant pricing power.

Aswath Damodaran 126