Aswath Damodaran 1

Corporate Finance
Lecture Note Packet 2
Capital Structure, Dividend Policy and
Valuation
B40.2302
Aswath Damodaran
 Aswath Damodaran 2

Capital Structure: The Choices

and the Trade off
“Neither a borrower nor a lender be”
Someone who obviously hated this part of corporate finance
 First principles
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 The Choices in Financing
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 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.

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 Global Patterns in Financing…
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 And a much greater dependence on bank loans
outside the US…
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 Assessing the existing financing choices: Disney,
Aracruz and Tata Chemicals
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 The Transitional Phases..
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 The transitions that we see at firms – from fully owned

private businesses to venture capital, from private to public
and subsequent seasoned offerings are all motivated
primarily by the need for capital.
 In each transition, though, there are costs incurred by the
existing owners:
 When venture capitalists enter the firm, they will demand their fair
share and more of the ownership of the firm to provide equity.
 When a firm decides to go public, it has to trade off the greater access
to capital markets against the increased disclosure requirements (that
emanate from being publicly lists), loss of control and the transactions
costs of going public.
 When making seasoned offerings, firms have to consider issuance
costs while managing their relations with equity research analysts and
rat

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 Measuring a firm’s financing mix …
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 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.

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 The Financing Mix Question
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 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?
 What are the benefits of using debt instead of equity?
 What are the costs of using debt instead of equity?
 If not, why not?

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 Costs and Benefits of Debt
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 Benefits of Debt
 Tax Benefits
 Adds discipline to management
 Costs of Debt
 Bankruptcy Costs
 Agency Costs
 Loss of Future Flexibility

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 Tax Benefits of Debt
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 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.
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 The Effects of Taxes
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 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?
a. The real estate corporations
b. The real estate investment trusts
c. Cannot tell, without more information

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 Debt adds discipline to management
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 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.
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 Debt and Discipline
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 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?
a. Conservatively financed (very little debt), privately
owned businesses
b. Conservatively financed, publicly traded companies, with
stocks held by millions of investors, none of whom hold a
large percent of the stock.
c. Conservatively financed, publicly traded companies, with
an activist and primarily institutional holding.

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 Bankruptcy Cost
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 The expected bankruptcy cost is a function of two variables--

 the probability of bankruptcy, which will depend upon how uncertain
you are about future cash flows
 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
 Proposition 2: Firms with more volatile earnings and cash
flows will have higher probabilities of bankruptcy at any given
level of debt and for any given level of earnings.
 Proposition 3: Other things being equal, the greater the
indirect bankruptcy cost, the less debt the firm can afford to
use for any given level of debt.
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 Debt & Bankruptcy Cost
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 Rank the following companies on the magnitude of

bankruptcy costs from most to least, taking into
account both explicit and implicit costs:
a. A Grocery Store
b. An Airplane Manufacturer
c. High Technology company

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 Agency Cost
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 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 their 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 4: Other things being equal, the greater the agency problems
associated with lending to a firm, the less debt the firm can afford to use.

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 Debt and Agency Costs
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 Assume that you are a bank. Which of the following

businesses would you perceive the greatest agency
costs?
a. A Large technology firm
b. A Large Regulated Electric Utility
 Why?

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 Loss of future financing flexibility
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 When a firm borrows up to its capacity, it loses the

flexibility of financing future projects with debt.
 Proposition 5: 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.

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 What managers consider important in deciding
on how much debt to carry...
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 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
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 Debt: Summarizing the trade off
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 The Trade off for three companies..
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 Application Test: Would you expect your firm to
gain or lose from using a lot of debt?
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 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?

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 A Hypothetical Scenario
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Assume that you live in a world where

(a) There are no taxes
(b) Managers have stockholder interests at heart and do wha
t’s best for stockholders.
(c) No firm ever goes bankrupt
(d) Equity investors are honest with lenders; there is no
subterfuge or attempt to find loopholes in loan agreements.
(e) Firms know their future financing needs with certainty
What happens to the trade off between debt and
equity? How much should a firm borrow?
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 The Miller-Modigliani Theorem
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 In an environment, where there are no taxes, default risk or agency costs,

capital structure is irrelevant.
 If the Miller Modigliani theorem holds:
 A firm's value will be determined the quality of its investments and not
by its financing mix.
 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.

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 What do firms look at in financing?
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 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. In particular,
 Managers value flexibility. Managers value being able to use
capital (on new investments or assets) without restrictions on
that use or having to explain its use to others.
 Managers value control. Managers like being able to maintain
control of their businesses.
 With flexibility and control being key factors:
 Would you rather use internal financing (retained earnings) or
external financing?
 With external financing, would you rather use debt or equity?

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 Preference rankings long-term finance: Results
of a survey
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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

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 And the unsurprising consequences..
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 Financing Choices
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 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?
a. Nothing
b. Healthier than the average firm
c. In much more financial trouble than the average firm

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Capital Structure:
Finding the Right Financing Mix
You can have too much debt… or too little..
 The Big Picture..
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 Pathways to the Optimal
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 The Cost of Capital Approach: The optimal debt ratio is the

one that minimizes the cost of capital for a firm.
 The Enhanced Cost of Capital approach: The optimal debt
ratio is the one that generates the best combination of (low)
cost of capital and (high) operating income.
 The Adjusted Present Value Approach: The optimal debt ratio
is the one that maximizes the overall value of the firm.
 The Sector Approach: The optimal debt ratio is the one that
brings the firm closes to its peer group in terms of financing
mix.
 The Life Cycle Approach: The optimal debt ratio is the one
that best suits where the firm is in its life cycle.

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 I. The Cost of Capital Approach
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 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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 Measuring Cost of Capital
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 Recapping our discussion of cost of capital:

 The cost of debt is the market interest rate that the firm has to pay on its
long term borrowing today, net of tax benefits. It will be a function of:
(a) The long-term riskfree rate
(b) The default spread for the company, reflecting its credit risk
(c) The firm’s marginal tax rate
 The cost of equity reflects the expected return demanded by marginal
equity investors. If they are diversified, only the portion of the equity risk
that cannot be diversified away (beta or betas) will be priced into the cost
of equity.
 The cost of capital is the cost of each component weighted by its relative
market value.
 Cost of capital = Cost of equity (E/(D+E)) + After-tax cost of debt (D/(D+E))

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 Costs of Debt & Equity
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 An 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?
a. Yes
b. No
 Can equity ever be cheaper than debt?
a. Yes
b. No
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 Applying Cost of Capital Approach: The
Textbook Example
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Assume the firm has $200 million in cash flows, expected to grow 3% a year forever.

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 The U-shaped Cost of Capital Graph…
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 Current Cost of Capital: Disney
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 The beta for Disney’s stock in May 2009 was 0.9011. The T. bond
rate at that time was 3.5%. Using an estimated equity risk premium
of 6%, we estimated the cost of equity for Disney to be 8.91%:
Cost of Equity = 3.5% + 0.9011(6%) = 8.91%
 Disney’s bond rating in May 2009 was A, and based on this rating,
the estimated pretax cost of debt for Disney is 6%. Using a marginal
tax rate of 38%, the after-tax cost of debt for Disney is 3.72%.
After-Tax Cost of Debt = 6.00% (1 – 0.38) = 3.72%
 The cost of capital was calculated using these costs and the weights
based on market values of equity (45,193) and debt (16,682):
Cost of capital =

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 Mechanics of Cost of Capital Estimation
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 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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 Laying the groundwork:
1. Estimate the unlevered beta for the firm
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 To get to the unlevered beta, we can start with the levered beta (0.9011)
and work back to an unlevered beta:
Unlevered beta =

 Alternatively, we can back to the source and estimate it from the betas of
the businesses.

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 2. Get Disney’s current financials…
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 I. Cost of Equity
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Levered Beta = 0.7333 (1 + (1-.38) (D/E))

Cost of equity = 3.5% + Levered Beta * 6%

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 Estimating Cost of Debt
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Start with the current market value of the firm = 45,193 + $16,682 = $61,875 million
D/(D+E) 0.00% 10.00% Debt to capital
D/E 0.00% 11.11% D/E = 10/90 = .1111
$ Debt $0 $6,188 10% of $61,875

EBITDA $8,422 $8,422 Same as 0% debt

Depreciation $1,593 $1,593 Same as 0% debt
EBIT $6,829 $6,829 Same as 0% debt
Interest $0 $294 Pre-tax cost of debt * $ Debt

Pre-tax Int. cov ∞ 23.24 EBIT/ Interest Expenses

Likely Rating AAA AAA From Ratings table
Pre-tax cost of debt 4.75% 4.75% Riskless Rate + Spread

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 The Ratings Table
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T.Bond rate in early

2009 = 3.5%

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 A Test: Can you do the 30% level?
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D/(D + E) 10.00% 20.00% 30%  

D/E 11.11% 25.00%    
$ Debt $6,188 $12,375    
EBITDA $8,422 $8,422    
Depreciation $1,593 $1,593    
EBIT $6,829 $6,829    
Interest expense $294 $588    
Pretax int. cov 23.24 11.62    
Likely rating AAA AAA    
Pretax cost of debt 4.75% 4.75%    

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 Bond Ratings, Cost of Debt and Debt Ratios
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 Marginal tax rates and Taxable Income…
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 You need taxable income for interest to provide a tax savings. Note
that the EBIT at Disney is $6,829 million. As long as interest
expenses are less than $6,829 million, interest expenses remain
fully tax-deductible and earn the 38% tax benefit. At an 80% debt
ratio, the interest expenses are $6,683 million and the tax benefit is
therefore 38% of this amount.
 At a 90% debt ratio, however, the interest expenses balloon to
$7,518 million, which is greater than the EBIT of $6,829 million. We
consider the tax benefit on the interest expenses up to this
amount:
Maximum Tax Benefit = EBIT * Marginal Tax Rate = $6,829 million * 0.38 =
$2,595 million
Adjusted Marginal Tax Rate = Maximum Tax Benefit/Interest Expenses =
$2,595/$7,518 = 34.52%

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 Disney’s cost of capital schedule…
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 Disney: Cost of Capital Chart
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 Disney: Cost of Capital Chart: 1997
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Note the kink

in the cost of
capital graph
at 60% debt.
What is
causing it?

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 The cost of capital approach suggests that
Disney should do the following…
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 Disney currently has $16.68 billion in debt. The optimal

dollar debt (at 40%) is roughly $24.75 billion. Disney has
excess debt capacity of $ 8.07 billion.
 To move to its optimal and gain the increase in value,
Disney should borrow $ 8 billion and buy back stock.
 Given the magnitude of this decision, you should expect
to answer three questions:
1. Why should we do it?
2. What if something goes wrong?
3. What if we don’t want (or cannot ) buy back stock and want to
make investments with the additional debt capacity?

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 Why should we do it?
Effect on Firm Value – Full Valuation Approach
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Step 1: Estimate the cash flows to Disney as a firm

EBIT (1 – Tax Rate) = 6829 (1 – 0.38) = $4,234
+ Depreciation and amortization = $1,593
– Capital expenditures = $1,628
– Change in noncash working capital $0
Free cash flow to the firm = $4,199
Step 2: Back out the implied growth rate in the current market value
Value of firm = $ 61,875 =

Growth rate = (Firm Value * Cost of Capital – CF to Firm)/(Firm Value + CF to Firm)

= (61,875* 0.0751 – 4199)/(61,875 + 4,199) = 0.0068 or 0.68%
Step 3: Revalue the firm with the new cost of capital
Firm value =

The firm value increases by $1,790 million (63,665 – 61,875 = 1,790)

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 An Alternate Approach
Effect on Value: Capital Structure Isolation…
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 In this approach, we start with the current market value and isolate
the effect of changing the capital structure on the cash flow and the
resulting value.
 Firm Value before the change = 45,193 + $16,682 = $61,875 million
WACCb = 7.51% Annual Cost = 61,875 * 0.0751 = $4,646.82 million
WACCa = 7.32% Annual Cost = 61,875 * 0.0732 = $ 4,529.68 million
WACC = 0.19% Change in Annual Cost = $117.14 million
 If we assume a perpetual growth of 0.68% in firm value over time,
Increase in firm value =

The total number of shares outstanding before the buyback is 1856.732

million.
Change in Stock Price = $1,763/1856.732 = $ 0.95 per share

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 A Test: The Repurchase Price
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 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 $ 24.34 and there are 1856.732 million shares
outstanding).
 If we assume that investors are rational, i.e., that the investor
who sell their shares back want the same share of firm value
increase as those who remain:
 Increase in Value per Share = $1,763/1856.732 = $ 0.95
 New Stock Price = $24.34 + $0.95= $25.29
 Buying shares back $25.29 will leave you as a stockholder indifferent
between selling and not selling.
 What would happen to the stock price after the buyback if
you were able to buy stock back at $ 24.34?

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 Buybacks and Stock Prices
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 Assume that Disney does make a tender offer for it’s

shares but pays $27 per share. What will happen to
the value per share for the shareholders who do not
sell back?
a. The share price will drop below the pre-announcement
price of $24.34
b. The share price will be between $24.34 and the
estimated value (above) of $25.29
c. The share price will be higher than $25.29

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 2. What if something goes wrong?
The Downside Risk
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 Sensitivity to Assumptions
A. “What if” analysis
The optimal debt ratio is a function of our inputs on operating
income, tax rates and macro variables. We could focus on one or two key
variables – operating income is an obvious choice – and look at history for
guidance on volatility in that number and ask what if questions.
B. “Economic Scenario” Approach
We can develop possible scenarios, based upon macro variables,
and examine the optimal debt ratio under each one. For instance, we could
look at the optimal debt ratio for a cyclical firm under a boom economy, a
regular economy and an economy in recession.
 Constraint on Bond Ratings/ Book Debt Ratios
Alternatively, we can put constraints on the optimal debt ratio to reduce
exposure to downside risk. Thus, we could require the firm to have a
minimum rating, at the optimal debt ratio or to have a book debt ratio that is
less than a “specified” value.

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 Explore the past:
Disney’s Operating Income History
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Key questions:
What does a bad year look like for Disney?
How much volatility is there in operating income?

Recession Decline in Operating Income

2008-09 Drop of about 10%
2002 Drop of 15.82%
1991 Drop of 22.00%
1981-82 Increased

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What if?
Examining the sensitivity of the optimal debt ratio..
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 Constraints on Ratings
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 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
 a drop in ratings might affect operating income (indirect
bankruptcy costs)
 there is an ego factor associated with high ratings
 Caveat: Every Rating Constraint Has A Cost.
 Every rating constraint, if binding, will create a cost.
 Managers should be provided with an estimate of the cost of a
specified ratings constraint so that they can decide whether the
benefits exceed the costs.

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 Ratings Constraints for Disney
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 At its optimal debt ratio of 40%, Disney has an estimated

rating of A.
 If managers insisted on a AA rating, the optimal debt ratio for
Disney is then 30% and the cost of the ratings constraint is
fairly small:
 Cost of AA Rating Constraint = Value at 40% Debt – Value at 30% Debt
= $63,651 – $63,596 = $55 million
 If managers insisted on a AAA rating, the optimal debt ratio
would drop to 20% and the cost of the ratings constraint
would rise:
 Cost of AAA rating constraint = Value at 40% Debt – Value at 20% Debt
= $63,651 - $62,371 = $1,280 million

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 3. What if you do not buy back stock..
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 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.

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 Extension to a family group company:
Tata Chemical’s Optimal Capital Structure
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Actual

Optimal

Tata Chemical looks like it is over levered (34% actual versus 10% optimal), but it is
tough to tell without looking at the rest of the group.
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 Extension to a firm with volatile earnings:
Aracruz’s Optimal Debt Ratio
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Cost of debt includes
default spread for Brazil.

Using Aracruz’s actual operating income in 2008, an abysmal year, yields an optimal debt ratio of 0%.
Applying Aracruz’s average pretax operating margin between 2004 and 2008 of 27.24% to 2008 revenues of
$R 3,697 million to get a normalized operating income of R$ 1,007 million. That is the number used in
computing the optimal debt ratio in this table.

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 Extension to a private business
Optimal Debt Ratio for Bookscape
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No market value because it is a private firm. Hence, we estimated value:

Estimated Market Value of Equity (in ‘000s) = Net Income for Bookscape *
Average PE for Publicly Traded Book Retailers = 1,500 * 10 = $15,000
Estimated Market Value of Debt = PV of leases= $9.6 milliion
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 Limitations of the Cost of Capital approach
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 It is static: The most critical number in the entire

analysis is the operating income. If that changes, the
optimal debt ratio will change.
 It ignores indirect bankruptcy costs: The operating
income is assumed to stay fixed as the debt ratio and
the rating changes.
 Beta and Ratings: It is based upon rigid assumptions
of how market risk and default risk get borne as the
firm borrows more money and the resulting costs.

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 II. Enhanced Cost of Capital Approach
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 Distress cost affected operating income: In the

enhanced cost of capital approach, the indirect costs
of bankruptcy are built into the expected operating
income. As the rating of the firm declines, the
operating income is adjusted to reflect the loss in
operating income that will occur when customers,
suppliers and investors react.
 Dynamic analysis: Rather than look at a single
number for operating income, you can draw from a
distribution of operating income (thus allowing for
different outcomes).
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 Estimating the Distress Effect- Disney
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Rating Drop in EBITDA

A- or higher No effect Indirect bankruptcy costs
manifest themselves, when
A- 2.00% the rating drops to A- and
BBB 10.00% then start becoming larger
BB+ 20.00% as the rating drops below
B- 25.00% investment grade.
CCC 40.00%
D 50.00%

Aswath Damodaran
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 The Optimal Debt Ratio with Indirect
Bankruptcy Costs
70

The optimal debt ratio drops to 30% from the original computation
of 40%.
Aswath Damodaran
70
 Extending this approach to analyzing Financial
Service Firms
71

 Interest coverage ratio spreads, which are critical in determining

the bond ratings, have to be estimated separately for financial
service firms; applying manufacturing company spreads will result
in absurdly low ratings for even the safest banks and very low
optimal debt ratios.
 It is difficult to estimate the debt on a financial service company’s
balance sheet. Given the mix of deposits, repurchase agreements,
short-term financing, and other liabilities that may appear on a
financial service firm’s balance sheet, one solution is to focus only
on long-term debt, defined tightly, and to use interest coverage
ratios defined using only long-term interest expenses.
 Financial service firms are regulated and have to meet capital ratios
that are defined in terms of book value. If, in the process of moving
to an optimal market value debt ratio, these firms violate the book
capital ratios, they could put themselves in jeopardy.

Aswath Damodaran
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 An alternative approach based on Regulatory
Capital
72

 Rather than try to bend the cost of capital approach to breaking

point, we will adopt a different approach for financial service firms
where we estimate debt capacity based on regulatory capital.
 Consider a bank with $ 100 million in loans outstanding and a book
value of equity of $ 6 million. Furthermore, assume that the
regulatory requirement is that equity capital be maintained at 5%
of loans outstanding. Finally, assume that this bank wants to
increase its loan base by $ 50 million to $ 150 million and to
augment its equity capital ratio to 7% of loans outstanding.
Loans outstanding after Expansion = $ 150 million
* Equity/Capital ratio desired = 7%
= Equity after expansion = $10.5 million
Existing Equity = $ 6.0 million
New Equity needed = $ 4.5 million
This can come from retained earnings or from new equity issues.

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 Financing Strategies for a financial institution
73

 The Regulatory minimum strategy: In this strategy, financial service

firms try to stay with the bare minimum equity capital, as required
by the regulatory ratios. In the most aggressive versions of this
strategy, firms exploit loopholes in the regulatory framework to
invest in those businesses where regulatory capital ratios are set
too low (relative to the risk of these businesses).
 The Self-regulatory strategy: The objective for a bank raising equity
is not to meet regulatory capital ratios but to ensure that losses
from the business can be covered by the existing equity. In effect,
financial service firms can assess how much equity they need to
hold by evaluating the riskiness of their businesses and the
potential for losses.
 Combination strategy: In this strategy, the regulatory capital ratios
operate as a floor for established businesses, with the firm adding
buffers for safety where needed..

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 Deutsche Bank’s Financing Mix
74

 Deutsche Bank has generally been much more

conservative in its use of equity capital. In October 2008,
it raised its Tier 1 Capital Ratio to 10%, well above the
Basel 1 regulatory requirement of 6%.
 While its loss of 4.8 billion Euros in the last quarter of
2008 did reduce equity capital, Deutsche Bank was
confident (at least as of the first part of 2009) that it
could survive without fresh equity infusions or
government bailouts. In fact, Deutsche Bank reported
net income of 1.2 billion Euros for the first quarter of
2009 and a Tier 1 capital ratio of 10.2%.
 If the capital ratio had dropped below 10%, the firm
would have had to raise fresh equity.
Aswath Damodaran
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 Determinants of the Optimal Debt Ratio:
1. The marginal tax rate
75

 The primary benefit of debt is a tax benefit. The

higher the marginal tax rate, the greater the benefit
to borrowing:

Aswath Damodaran
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 2. Pre-tax Cash flow Return
76

 Firms that have more in operating income and cash flows,

relative to firm value (in market terms), should have higher
optimal debt ratios. We can measure operating income with
EBIT and operating cash flow with EBITDA.
Cash flow potential = EBITDA/ (Market value of equity + Debt)
 Disney, for example, has operating income of $6,829 million,

which is 11% of the market value of the firm of $61,875

million in the base case, and an optimal debt ratio of 40%.
Increasing the operating income to 15% of the firm value will
increase the optimal debt ratio to 60%.
 In general, growth firms will have lower cash flows, as a

percent of firm value, and lower optimal debt ratios.

Aswath Damodaran
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 3. Operating Risk
77

 Firms that face more risk or uncertainty in their

operations (and more variable operating income as a
consequence) will have lower optimal debt ratios than
firms that have more predictable operations.
 Operating risk enters the cost of capital approach in two
places:
 Unlevered beta: Firms that face more operating risk will tend to
have higher unlevered betas. As they borrow, debt will magnify
this already large risk and push up costs of equity much more
steeply.
 Bond ratings: For any given level of operating income, firms that
face more risk in operations will have lower ratings. The ratings
are based upon normalized income.

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 4. The only macro determinant:
Equity vs Debt Risk Premiums
78

Aswath Damodaran
78
 6 Application Test: Your firm’s optimal financing
mix
79

 Using the optimal capital structure spreadsheet

provided:
1. Estimate the optimal debt ratio for your firm
2. Estimate the new cost of capital at the optimal
3. Estimate the effect of the change in the cost of capital on
firm value
4. 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
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 III. The APV Approach to Optimal Capital
Structure
80

 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
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 Implementing the APV Approach
81

 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
81
 Estimating Expected Bankruptcy Cost
82

 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
82
 Ratings and Default Probabilities: Results from
Altman study of bonds
83

Rating Likelihood of Default

AAA 0.07%
AA 0.51%
A+ 0.60%
A 0.66%
Altman estimated these probabilities by
A- 2.50%
looking at bonds in each ratings class ten
BBB 7.54%
years prior and then examining the
BB 16.63%
proportion of these bonds that defaulted
B+ 25.00%
over the ten years.
B 36.80%
B- 45.00%
CCC 59.01%
CC 70.00%
C 85.00%
D 100.00%

Aswath Damodaran
83
 Disney: Estimating Unlevered Firm Value
84

Current Market Value of the Firm = = $45,193 + $16,682 = $ 61,875

- Tax Benefit on Current Debt = $16,682 * 0.38 = $ 6,339
+ Expected Bankruptcy Cost = 0.66% * (0.25 * 61,875) = $ 102
Unlevered Value of Firm = = $ 55,638
 Cost of Bankruptcy for Disney = 25% of firm value
 Probability of Bankruptcy = 0.66%, based on firm’s current
rating of A
 Tax Rate = 38%

Aswath Damodaran
84
 Disney: APV at Debt Ratios
85

The optimal debt ratio is 50%,

which is the point at which firm
value is maximized.

Aswath Damodaran
85
 IV. Relative Analysis
86

 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)

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86
 Comparing to industry averages
87

Aswath Damodaran
87
 Getting past simple averages
88

Step 1: Run a regression of debt ratios on the variables that

you believe determine debt ratios in the sector. For
example,
Debt Ratio = a + b (Tax rate) + c (Earnings Variability) + d
(EBITDA/Firm Value)
Check this regression for statistical significance (t statistics)
and predictive ability (R squared)
Step 2: Estimate the values of the proxies for the firm
under consideration. Plugging into the cross sectional
regression, we can obtain an estimate of predicted debt
ratio.
Step 3: Compare the actual debt ratio to the predicted debt
ratio.
Aswath Damodaran
88
 Applying the Regression Methodology:
Entertainment Firms
89

 Using a sample of 80 entertainment firms, we arrived at

the following regression:

 The R squared of the regression is 40%. This regression

can be used to arrive at a predicted value for Disney of:
 Predicted Debt Ratio = 0.049 + 0.543 (0.372) + 0.692
(0.1735) = 0.3710 or 37.10%
 Based upon the capital structure of other firms in the
entertainment industry, Disney should have a market
value debt ratio of 37.1%.
Aswath Damodaran
89
 Extending to the entire market
90

 Using 2008 data for firms listed on the NYSE, AMEX and NASDAQ
data bases. The regression provides the following results –
DFR = 0.327 - 0.064 Intangible % – 0.138 CLSH + 0.026 E/V – 0.878 GEPS
(25.45a) (2.16a) (2.88a) (1.25) (12.6a)
where,
DFR = Debt / ( Debt + Market Value of Equity)
Intangible % = Intangible Assets/ Total Assets (in book value terms)
CLSH = Closely held shares as a percent of outstanding shares
E/V = EBITDA/ (Market Value of Equity + Debt- Cash)
GEPS = Expected growth rate in EPS
 The regression has an R-squared of 13%.

Aswath Damodaran
90
 Applying the Regression
91

 Disney had the following values for these inputs in 2008. Estimate the
optimal debt ratio using the debt regression.
 Intangible Assets = 24%
 Closely held shares as percent of shares outstanding = 7.7%
 EBITDA/Value = 17.35%
 Expected growth in EPS = 6.5%
Optimal Debt Ratio
= 0.327 - 0.064 (0.24) – 0.138 (0.077) + 0.0.26 (0.1735) – 0.878 (0.065)
= 0.2891 or 28.91%
 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
91
 Summarizing the optimal debt ratios…
92

Aswath Damodaran
92
 Aswath Damodaran 93

Getting to the Optimal:

Timing and Financing Choices
You can take it slow.. Or perhaps not…
 Big Picture…
94

Aswath Damodaran
94
 Now that we have an optimal.. And an actual..
What next?
95

 At the end of the analysis of financing mix (using

whatever tool or tools you choose to use), you can
come to one of three conclusions:
1. The firm has the right financing mix
2. It has too little debt (it is under levered)
3. It has too much debt (it is over levered)
 The next step in the process is
 Deciding how much quickly or gradually the firm should
move to its optimal
 Assuming that it does, the right kind of financing to use in
making this adjustment

Aswath Damodaran
95
 A Framework for Getting to the Optimal
96

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
96
 Disney: Applying the Framework
97

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

Actual > Optimal Actual < Optimal

Overlevered Actual (26%) < Optimal (40%)

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

No. Large mkt cap & positive

Yes No Yes
Jensen’s 

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. ROC > Cost of capital No

Take good projects with 1. Pay off debt with retained
new equity or with retained earnings. Take good projects
earnings. 2. Reduce or eliminate dividends. With debt.
3. Issue new equity and pay off Do your stockholders like
debt. dividends?

Yes
Pay Dividends No
Buy back stock
Aswath Damodaran
97
 6 Application Test: Getting to the Optimal
98

 Based upon your analysis of both the firm’s capital

structure and investment record, what path would
you map out for the firm?
a. Immediate change in leverage
b. Gradual change in leverage
c. No change in leverage
 Would you recommend that the firm change its
financing mix by
a. Paying off debt/Buying back equity
b. Take projects with equity/debt
Aswath Damodaran
98
 The Mechanics of Changing Debt Ratio over
time… quickly…
99

Aswath Damodaran
99
 The mechanics of changing debt ratios over
time… gradually…
100

 To change debt ratios over time, you use the same mix of
tools that you used to change debt ratios gradually:
 Dividends and stock buybacks: Dividends and stock buybacks will
reduce the value of equity.
 Debt repayments: will reduce the value of debt.
 The complication of changing debt ratios over time is
that firm value is itself a moving target.
 If equity is fairly valued today, the equity value should change
over time to reflect the expected price appreciation:
 Expected Price appreciation = Cost of equity – Dividend Yield
 Debt will also change over time, in conjunction as firm value
changes.

Aswath Damodaran
100
 Designing Debt: The Fundamental Principle
101

 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.

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101
 Firm with mismatched debt
102

Aswath Damodaran
102
 Firm with matched Debt
103

Aswath Damodaran
103
 Design the perfect financing instrument
104

 The perfect financing instrument will

 Have all of the tax advantages of debt
 While preserving the flexibility offered by equity

Aswath Damodaran
104
 Ensuring that you have not crossed the line
drawn by the tax code
105

 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.

Aswath Damodaran
105
 While keeping equity research analysts, ratings
agencies and regulators applauding
106

 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.

Aswath Damodaran
106
 Debt or Equity: The Strange Case of Trust
Preferred
107

 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 give these
shareholders voting rights
 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
107
 Debt, Equity and Quasi Equity
108

 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. A firm that is under levered, but has a rating constraint
that would be violated if it moved to its optimal
b. A firm that is over levered that is unable to issue debt
because of the rating agency concerns.

Aswath Damodaran
108
 Soothe bondholder fears
109

 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.

Aswath Damodaran
109
 And do not lock in market mistakes that work
against you
110

 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
110
 Designing Debt: Bringing it all together
111
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
Aswath Damodaran 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 111
 Approaches for evaluating Asset Cash Flows
112

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
 Estimate expected 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
112
 I. Intuitive Approach - Disney
113

Aswath Damodaran
113
 6 Application Test: Choosing your Financing
Type
114

 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
a. Duration (long term or short term)
b. Currency
c. Fixed or Floating rate
d. Straight or Convertible

Aswath Damodaran
114
 II. Project Specific Financing
115

 With project specific financing, you match the

financing choices to the project being funded. The
benefit is that the the debt is truly customized to the
project.
 Project specific financing makes the most sense
when you have a few large, independent projects to
be financed. It becomes both impractical and costly
when firms have portfolios of projects with
interdependent cashflows.

Aswath Damodaran
115
 Duration of Disney Theme Park
116

Duration of the Project = 58,375/2,877 = 20.29 years

Aswath Damodaran
116
 The perfect theme park debt…
117

 The perfect debt for this theme park would have a

duration of roughly 20 years and be in a mix of Latin
American currencies (since it is located in Brazil),
reflecting where the visitors to the park are coming
from.
 If possible, you would tie the interest payments on
the debt to the number of visitors at the park.

Aswath Damodaran
117
 III. Firm-wide financing
118

 Rather than look at individual projects, you could consider the firm to be a
portfolio of projects. The firm’s past history should then provide clues as to
what type of debt makes the most sense.
 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.
 This analysis is useful in determining the coupon/interest payment
structure of the debt.
 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
118
 Disney: Historical Data
119

Aswath Damodaran
119
 The Macroeconomic Data
120

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120
 I. Sensitivity to Interest Rate Changes
121

 How sensitive is the firm’s value and operating

income to changes in the level of interest rates?
 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
121
 Firm Value versus Interest Rate Changes
122

 Regressing changes in firm value against changes in

interest rates over this period yields the following
regression –
Change in Firm Value = 0.1949 - 2.94 (Change in Interest Rates)
(2.89) (0.50)
T statistics are in brackets.
 The coefficient on the regression (-2.94) measures
how much the value of Disney as a firm changes for
a unit change in interest rates.

Aswath Damodaran
122
 Why the coefficient on the regression is
duration..
123

 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 –

 The duration of a bond measures how much the price of the

bond changes for a unit change in interest rates.
 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
123
 Duration: Comparing Approaches
124

Aswath Damodaran
124
 Operating Income versus Interest Rates
125

 Regressing changes in operating cash flow against

changes in interest rates over this period yields the
following regression –
Change in Operating Income = 0.1958 + 6.59 (Change in Interest Rates)
(2.74) (1.06)
Conclusion: Disney’s operating income, unlike its
firm value, has moved with interest rates.
 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
125
 II. Sensitivity to Changes in GDP/ GNP
126

 How sensitive is the firm’s value and operating income

to changes in the GNP/GDP?
 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
126
 Regression Results
127

 Regressing changes in firm value against changes in the

GDP over this period yields the following regression –
Change in Firm Value = 0.0826 + 8.89 (GDP Growth)
(0.65) (2.36)
Conclusion: Disney is sensitive to economic growth
 Regressing changes in operating cash flow against
changes in GDP over this period yields the following
regression –
Change in Operating Income = 0.04 + 6.06 (GDP Growth)
(0.22) (1.30)
Conclusion: Disney’s operating income is sensitive to
economic growth as well.

Aswath Damodaran
127
 III. Sensitivity to Currency Changes
128

 How sensitive is the firm’s value and operating

income to changes in exchange rates?
 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
128
 Regression Results
129

 Regressing changes in firm value against changes in the dollar

over this period yields the following regression –
Change in Firm Value = 0.17 -2.04 (Change in Dollar)
(2.63) (0.80)
Conclusion: Disney’s value is sensitive to exchange rate changes,
decreasing as the dollar strengthens.
 Regressing changes in operating cash flow against changes in

the dollar over this period yields the following regression –

Change in Operating Income = 0.19 -1.57( Change in Dollar)
(2.42) (1.73)
Conclusion: Disney’s operating income is also impacted by the
dollar. A stronger dollar seems to hurt operating income.

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 IV. Sensitivity to Inflation
130

 How sensitive is the firm’s value and operating

income to changes in the inflation rate?
 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.
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 Regression Results
131

 Regressing changes in firm value against changes in inflation

over this period yields the following regression –
Change in Firm Value = 0.18 + 2.71 (Change in Inflation Rate)
(2.90) (0.80)
Conclusion: Disney’s firm value does seem to increase with
inflation, but not by much (statistical significance is low)
 Regressing changes in operating cash flow against changes in
inflation over this period yields the following regression –
Change in Operating Income = 0.22 +8.79 ( Change in Inflation Rate)
(3.28) (2.40)
Conclusion: Disney’s operating income seems to increase in
periods when inflation increases, suggesting that Disney does
have pricing power.

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 Summarizing…
132

 Looking at the four macroeconomic regressions, we

would conclude that
 Disney’s assets collectively have a duration of about 3
years
 Disney is increasingly affected by economic cycles
 Disney is hurt by a stronger dollar
 Disney’s operating income tends to move with inflation
 All of the regression coefficients have substantial
standard errors associated with them. One way to
reduce the error (a la bottom up betas) is to use
sector-wide averages for each of the coefficients.
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132
 Bottom-up Estimates
133
These weights
reflect the
estimated values
of the businesses

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133
 Recommendations for Disney
134

 The debt issued should be long term and should have duration of
about 5 years.
 A significant portion of the debt should be floating rate debt,
reflecting Disney’s capacity to pass inflation through to its
customers and the fact that operating income tends to increase as
interest rates go up.
 Given Disney’s sensitivity to a stronger dollar, a portion of the debt
should be in foreign currencies. The specific currency used and the
magnitude of the foreign currency debt should reflect where
Disney makes its revenues. Based upon 2008 numbers at least, this
would indicate that about 20% of the debt should be in Euros and
about 10% of the debt in Japanese Yen reflecting Disney’s larger
exposures in Europe and Asia. As its broadcasting businesses
expand into Latin America, it may want to consider using either
Mexican Peso or Brazilian Real debt as well.

Aswath Damodaran
134
 Analyzing Disney’s Current Debt
135

 Disney has $16 billion in debt with a face-value weighted

average maturity of 5.38 years. Allowing for the fact that the
maturity of debt is higher than the duration, this would
indicate that Disney’s debt is of the right maturity.
 Of the debt, about 10% is yen denominated debt but the rest
is in US dollars. Based on our analysis, we would suggest that
Disney increase its proportion of debt in other currencies to
about 20% in Euros and about 5% in Chinese Yuan.
 Disney has no convertible debt and about 24% of its debt is
floating rate debt, which is appropriate given its status as a
mature company with significant pricing power. In fact, we
would argue for increasing the floating rate portion of the
debt to about 40%.

Aswath Damodaran
135
 Adjusting Debt at Disney
136

 It can swap some of its existing fixed rate, dollar debt for
floating rate, foreign currency debt. Given Disney’s
standing in financial markets and its large market
capitalization, this should not be difficult to do.
 If Disney is planning new debt issues, either to get to a
higher debt ratio or to fund new investments, it can use
primarily floating rate, foreign currency debt to fund
these new investments. Although it may be mismatching
the funding on these investments, its debt matching will
become better at the company level.

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 Debt Design for other firms..
137

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 Aswath Damodaran 138

Returning Cash to the Owners:

Dividend Policy
“Companies don’t have cash. They hold cash for
their stockholders.”
 First Principles
139

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139
 Steps to the Dividend Decision…
140

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140
 I. Dividends are sticky
141

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141
 The last quarter of 2008 put stickiness to the
test.. Number of S&P 500 companies that…
142

Quarter Dividend Increase Dividend initiated Dividend decrease Dividend suspensions

Q1 2007 102 1 1 1
Q2 2007 63 1 1 5
Q3 2007 59 2 2 0
Q4 2007 63 7 4 2
Q1 2008 93 3 7 4
Q2 2008 65 0 9 0
Q3 2008 45 2 6 8
Q4 2008 32 0 17 10

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 II. Dividends tend to follow earnings
143

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143
II. Are affected by tax laws…

In 2003 In the last quarter of 2012

 As the possibility of tax rates
reverting back to pre-2003
levels rose, 233 companies
paid out $31 billion in
dividends.
 Of these companies, 101
had insider holdings in
excess of 20% of the
outstanding stock.
 IV. More and more firms are buying back stock,
rather than pay dividends...
145

Aswath Damodaran
145
 V. And there are differences across countries…
146

Aswath Damodaran
146
 Measures of Dividend Policy
147

 Dividend Payout = Dividends/ Net Income

 Measures the percentage of earnings that the company
pays in dividends
 If the net income is negative, the payout ratio cannot be
computed.
 Dividend Yield = Dividends per share/ Stock price
 Measures the return that an investor can make from
dividends alone
 Becomes part of the expected return on the investment.

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 Dividend Payout Ratios
148

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148
 Dividend Yields: January 2013
149

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150 Aswath Damodaran
 Dividend Yields and Payout Ratios: Growth
Classes
151

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 Dividend Policy: Disney, Tata, Aracruz and
Deutsche Bank
152

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152
 Three Schools Of Thought On Dividends
153

1. If
(a) there are no tax disadvantages associated with
dividends
(b) companies can issue stock, at no cost, to raise equity,
whenever needed
Dividends do not matter, and dividend policy does not affect value.
2. If dividends create a tax disadvantage for investors
(relative to capital gains)
Dividends are bad, and increasing dividends will reduce value
3. If stockholders like dividends or dividends operate as a
signal of future prospects,
Dividends are good, and increasing dividends will increase value

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153
 The balanced viewpoint
154

 If a company has excess cash, and few good

investment opportunities (NPV>0), returning money
to stockholders (dividends or stock repurchases) is
good.
 If a company does not have excess cash, and/or has
several good investment opportunities (NPV>0),
returning money to stockholders (dividends or stock
repurchases) is bad.

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154
 The Dividends don’t matter school
The Miller Modigliani Hypothesis
155

 The Miller-Modigliani Hypothesis: Dividends do not affect value

 Basis:
 If a firm's investment policies (and hence cash flows) don't change, the value of the
firm cannot change as it changes dividends.
 If a firm pays more in dividends, it will have to issue new equity to fund the same
projects. By doing so, it will reduce expected price appreciation on the stock but it
will be offset by a higher dividend yield.
 If we ignore personal taxes, investors have to be indifferent to receiving either
dividends or capital gains.
 Underlying Assumptions:
(a) There are no tax differences to investors between dividends and capital gains.
(b) If companies pay too much in cash, they can issue new stock, with no flotation
costs or signaling consequences, to replace this cash.
(c) If companies pay too little in dividends, they do not use the excess cash for bad
projects or acquisitions.

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155
 II. The Dividends are “bad” school: And the
evidence to back them up…
156

Aswath Damodaran
156
 What do investors in your stock think about
dividends? Clues on the ex-dividend day!
157

 Assume that you are the owner of a stock that is approaching an ex-
dividend day and you know that dollar dividend with certainty. In
addition, assume that you have owned the stock for several years.

Initial buy Pb Pa
At $P
Ex-dividend day
Dividend = $ D

P = Price at which you bought the stock a “while” back

Pb= Price before the stock goes ex-dividend
Pa=Price after the stock goes ex-dividend
D = Dividends declared on stock
to, tcg = Taxes paid on ordinary income and capital gains respectively

Aswath Damodaran
157
 Cashflows from Selling around Ex-Dividend Day
158

 The cash flows from selling before ex-dividend day are:

Pb - (Pb - P) tcg
 The cash flows from selling after ex-dividend day are:
Pa - (Pa - P) tcg + D(1-to)
 Since the average investor should be indifferent between
selling before the ex-dividend day and selling after the
ex-dividend day -
Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)
 Some basic algebra leads us to the following:

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158
 Intuitive Implications
159

 The relationship between the price change on the ex-

dividend day and the dollar dividend will be determined by
the difference between the tax rate on dividends and the tax
rate on capital gains for the typical investor in the stock.
Tax Rates Ex-dividend day behavior
If dividends and capital gains are Price change = Dividend
taxed equally
If dividends are taxed at a higher Price change < Dividend
rate than capital gains
If dividends are taxed at a lower Price change > Dividend
rate than capital gains

Aswath Damodaran
159
 The empirical evidence…
160

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160
 Dividend Arbitrage
161

 Assume that you are a tax exempt investor, and that

you know that the price drop on the ex-dividend day
is only 90% of the dividend. How would you exploit
this differential?
a. Invest in the stock for the long term
b. Sell short the day before the ex-dividend day, buy on the
ex-dividend day
c. Buy just before the ex-dividend day, and sell after.
d. ______________________________________________

Aswath Damodaran
161
 Example of dividend capture strategy with tax
factors
162

 XYZ company is selling for $50 at close of trading May 3.

On May 4, XYZ goes ex-dividend; the dividend amount is
$1. The price drop (from past examination of the data) is
only 90% of the dividend amount.
 The transactions needed by a tax-exempt U.S. pension
fund for the arbitrage are as follows:
 1. Buy 1 million shares of XYZ stock cum-dividend at $50/share.
 2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50
- 1* 0.90)
 3. Collect dividend on stock.
 Net profit = - 50 million + 49.10 million + 1 million =
$0.10 million

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162
 Two bad reasons for paying dividends
1. The bird in the hand fallacy
163

 Argument: Dividends now are more certain than

capital gains later. Hence dividends are more
valuable than capital gains. Stocks that pay dividends
will therefore be more highly valued than stocks that
do not.
 Counter: The appropriate comparison should be
between dividends today and price appreciation
today. The stock price drops on the ex-dividend day.

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163
 2. We have excess cash this year…
164

 Argument: The firm has excess cash on its hands this

year, no investment projects this year and wants to
give the money back to stockholders.
 Counter: So why not just repurchase stock? If this is
a one-time phenomenon, the firm has to consider
future financing needs. The cost of raising new
financing in future years, especially by issuing new
equity, can be staggering.

Aswath Damodaran
164
 The Cost of Raising Capital
165

Aswath Damodaran
165
 Three “good” reasons for paying dividends…
166

 Clientele Effect: The investors in your company like

dividends.
 The Signalling Story: Dividends can be signals to the
market that you believe that you have good cash
flow prospects in the future.
 The Wealth Appropriation Story: Dividends are one
way of transferring wealth from lenders to equity
investors (this is good for equity investors but bad for
lenders)

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166
 1. The Clientele Effect
The “strange case” of Citizen’s Utility
167

Class A
shares pay
cash
dividend

Class B
shares offer
the same
amount as a
stock
dividend &
can be
converted to
class A
Aswath Damodaran shares 167
 Evidence from Canadian firms
168

Company Premium for cash dividend shares

Consolidated Bathurst + 19.30%
Donfasco + 13.30%
Dome Petroleum + 0.30%
Imperial Oil +12.10%
Newfoundland Light & Power + 1.80%
Royal Trustco + 17.30%
Stelco + 2.70%
TransAlta +1.10%
Average across companies + 7.54%

Aswath Damodaran
168
 A clientele based explanation
169

 Basis: Investors may form clienteles based upon their

tax brackets. Investors in high tax brackets may
invest in stocks which do not pay dividends and
those in low tax brackets may invest in dividend
paying stocks.
 Evidence: A study of 914 investors' portfolios was
carried out to see if their portfolio positions were
affected by their tax brackets. The study found that
 (a) Older investors were more likely to hold high dividend
stocks and
 (b) Poorer investors tended to hold high dividend stocks

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169
Results from Regression: Clientele Effect

Dividend Y ieldt = a + b t + c Aget + d Incomet + e Differential Tax Ratet + t

Variable C oefficient I mplies
Constant 4.22%
Beta Coefficient -2.145 Higher beta stocks pay lower dividends.
Age/100 3.131 Firms with older investors pay higher
dividends.
Income/1000 -3.726 Firms with wealthier investors pay lower
dividends.
Differential Tax Rate -2.849 If ordinary income is taxed at a higher rate
than capital gains, the firm pays less
dividends.
 Dividend Policy and Clientele
171

 Assume that you run a phone company, and that you have
historically paid large dividends. You are now planning to
enter the telecommunications and media markets. Which of
the following paths are you most likely to follow?
a. Courageously announce to your stockholders that you plan to
cut dividends and invest in the new markets.
b. Continue to pay the dividends that you used to, and defer
investment in the new markets.
c. Continue to pay the dividends that you used to, make the
investments in the new markets, and issue new stock to cover
the shortfall
d. Other

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171
 2. Dividends send a signal”
Increases in dividends are good news..
172

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172
An Alternative Story..Increasing dividends is
bad news…
Both dividend increases and decreases are
becoming less informative…
3. Dividend increases may be good for
stocks… but bad for bonds..

EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES

0.5

0
t:- -12 -9 -6 -3 0 3 6 9 12 15
-0.5 15 CAR (Div Up)
CAR
-1 CAR (Div down)

-1.5

-2
Day (0: Announcement date)
 What managers believe about dividends…
176

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176
 Aswath Damodaran 177

Assessing Dividend Policy:

Or how much cash is too much?
It is my cash and I want it now…
 The Big Picture…
178

Aswath Damodaran
178
 Assessing Dividend Policy
179

 Approach 1: The Cash/Trust Nexus

 Assess how much cash a firm has available to pay in
dividends, relative what it returns to stockholders. Evaluate
whether you can trust the managers of the company as
custodians of your cash.
 Approach 2: Peer Group Analysis
 Pick a dividend policy for your company that makes it
comparable to other firms in its peer group.

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179
 I. The Cash/Trust Assessment
180

Step 1: How much did the the company actually pay

out during the period in question?
Step 2: How much could the company have paid out
during the period under question?
Step 3: How much do I trust the management of this
company with excess cash?
 How well did they make investments during the period in
question?
 How well has my stock performed during the period in
question?
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180
 How much has the company returned to
stockholders?
181

 As firms increasing use stock buybacks, we have to

measure cash returned to stockholders as not only
dividends but also buybacks.
 For instance, for the four companies we are
analyzing the cash returned looked as follows.

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181
 A Measure of How Much a Company Could have
Afforded to Pay out: FCFE
182

 The Free Cashflow to Equity (FCFE) is a measure of how much

cash is left in the business after non-equity claimholders
(debt and preferred stock) have been paid, and after any
reinvestment needed to sustain the firm’s assets and future
growth.
Net Income
+ Depreciation & Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs
- Principal Repayments
+ Proceeds from New Debt Issues
= Free Cash flow to Equity

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182
 Disney’s FCFE
183

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183
 Comparing Payout Ratios to Cash Returned
Ratios.. Disney
184

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184
 Estimating FCFE when Leverage is Stable
185

Net Income
- (1- ) (Capital Expenditures - Depreciation)
- (1- ) Working Capital Needs
= Free Cash flow to Equity
 = Debt/Capital Ratio
Proceeds from new debt issues = Principal
Repayments +  (Capital Expenditures - Depreciation +
Working Capital Needs)

Aswath Damodaran
185
 An Example: FCFE Calculation
186

 Consider the following inputs for Microsoft in 1996. In

1996, Microsoft’s FCFE was:
 Net Income = $2,176 Million
 Capital Expenditures = $494 Million
 Depreciation = $ 480 Million
 Change in Non-Cash Working Capital = $ 35 Million
 Debt Ratio(DR) = 0%
FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (1-
DR)
= $ 2,176 - (494 - 480) (1-0) - $ 35 (1-0)
= $ 2,127 Million
Aswath Damodaran
186
 Microsoft: Dividends?
187

 By this estimation, Microsoft could have paid $ 2,127

Million in dividends/stock buybacks in 1996. They
paid no dividends and bought back no stock.
 Where will the $2,127 million show up in Microsoft’s
balance sheet?

Aswath Damodaran
187
 FCFE for a Bank?
188

 To estimate the FCFE for a bank, we redefine reinvestment as investment

in regulatory capital. Since any dividends paid deplete equity capital and
retained earnings increase that capital, the FCFE is:
FCFEBank= Net Income – Increase in Regulatory Capital (Book Equity)
 As a simple example, consider a bank with $ 10 billion in loans
outstanding and book equity (Tier 1 capital) of $ 750 million. Assume that
the bank wants to maintain its existing capital ratio of 7.5%, intends to
grow its loan base by 10% (to $11 billion) and expects to generate $ 150
million in net income next year.
FCFE = $150 million – (11,000-10,000)* (.075) = $75 million
 If this bank wants to increase its regulatory capital ratio to 8% (for
precautionary purposes) while increasing its loan base to $ 11 billion
FCFE = $ 150 million – ($ 880 - $750) = $20 million

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188
 Deutsche Bank’s FCFE
189

Aswath Damodaran
189
 Dividends versus FCFE: Cash Deficit versus
Buildup
190

Aswath Damodaran
190
 The Consequences of Failing to pay FCFE
191

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191
 6 Application Test: Estimating your firm’s FCFE
192

 In General, If cash flow statement

used
Net Income Net Income
+ Depreciation & Amortization + Depreciation & Amortization
- Capital Expenditures + Capital Expenditures
- Change in Non-Cash Working Capital + Changes in Non-cash WC
- Preferred Dividend + Preferred Dividend
- Principal Repaid + Increase in LT Borrowing
+ New Debt Issued + Decrease in LT Borrowing
+ Change in ST Borrowing
= FCFE = FCFE
 Compare to
Dividends (Common) Common Dividend
+ Stock Buybacks Stock Buybacks

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192
 A Practical Framework for Analyzing Dividend
Policy
193

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 - Depr’n) (1-DR) + Equity Repurchase
- Chg Working Capital (1-DR)
= FCFE

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

Do you trust managers in the company with What investment opportunities does the
your cash? firm have?
Look at past project choice: Look at past project choice:
Compare ROE to Cost of Equity Compare ROE to Cost of Equity
ROC to WACC ROC to WACC

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

Give managers the Force managers to Firm should Firm should deal
flexibility to keep justify holding cash cut dividends with its investment
cash and set or return cash to and reinvest problem first and
dividends stockholders more then cut dividends

Aswath Damodaran
193
 A Dividend Matrix
194

Aswath Damodaran
194
 More on Microsoft
195

 Microsoft had accumulated a cash balance of $ 43 billion by

2003 by paying out no dividends while generating huge FCFE.
At the end of 2003, there was no evidence that
 Microsoft was being penalized for holding such a large cash balance
 Stockholders were becoming restive about the cash balance. There
was no hue and cry demanding more dividends or stock buybacks.
 Why?

 In 2004, Microsoft announced a huge special dividend of $ 33

billion and made clear that it would try to return more cash
to stockholders in the future. What do you think changed?

Aswath Damodaran
195
 Case 1: Disney in 2003
196

 FCFE versus Dividends

 Between 1994 & 2003, Disney generated $969 million in FCFE each
year.
 Between 1994 & 2003, Disney paid out $639 million in dividends and
stock buybacks each year.
 Cash Balance
 Disney had a cash balance in excess of $ 4 billion at the end of 2003.
 Performance measures
 Between 1994 and 2003, Disney has generated a return on equity, on
it’s projects, about 2% less than the cost of equity, on average each
year.
 Between 1994 and 2003, Disney’s stock has delivered about 3% less
than the cost of equity, on average each year.
 The underperformance has been primarily post 1996 (after the Capital
Cities acquisition).

Aswath Damodaran
196
 Can you trust Disney’s management?
197

 Given Disney’s track record between 1994 and 2003, if

you were a Disney stockholder, would you be
comfortable with Disney’s dividend policy?
a. Yes
b. No
 Does the fact that the company is run by Michael Eisner,
the CEO for the last 10 years and the initiator of the Cap
Cities acquisition have an effect on your decision.
a. Yes
b. No

Aswath Damodaran
197
 The Bottom Line on Disney Dividends in 2003
198

 Disney could have afforded to pay more in dividends

during the period of the analysis.
 It chose not to, and used the cash for acquisitions
(Capital Cities/ABC) and ill fated expansion plans
(Go.com).
 While the company may have flexibility to set its
dividend policy a decade ago, its actions over that
decade have frittered away this flexibility.
 Bottom line: Large cash balances would not be tolerated
in this company. Expect to face relentless pressure to pay
out more dividends.

Aswath Damodaran
198
 Following up: Disney in 2009
199

 Between 2004 and 2008, Disney made significant changes:

 It replaced its CEO, Michael Eisner, with a new CEO, Bob Iger, who at
least on the surface seemed to be more receptive to stockholder
concerns.
 It’s stock price performance improved (positive Jensen’s alpha)
 It’s project choice improved (ROC moved from being well below cost of
capital to above)
 The firm also shifted from cash returned < FCFE to cash
returned > FCFE and avoided making large acquisitions.
 If you were a stockholder in 2009 and Iger made a plea to
retain cash in Disney to pursue investment opportunities,
would you be more receptive?
a. Yes
b. No
Aswath Damodaran
199
 Case 2: Aracruz Celulose - Assessment of
dividends paid in 2003
200

 FCFE versus Dividends

 Between 1999 and 2003, Aracruz generated $37 million in FCFE
each year.
 Between 1999 and 2003, Aracruz paid out $80 million in
dividends and stock buybacks each year.
 Performance measures
 Between 1999 and 2003, Aracruz has generated a return on
equity, on it’s projects, about 1.5% more than the cost of equity,
on average each year.
 Between 1999 and 2003, Aracruz’s stock has delivered about 2%
more than the cost of equity, on average each year.

Aswath Damodaran
200
 Aracruz: Its your call..
201

 Aracruz’s managers have asked you for permission to cut dividends

(to more manageable levels). Are you likely to go along?
a. Yes
b. No
 The reasons for Aracruz’s dividend problem lie in it’s equity
structure. Like most Brazilian companies, Aracruz has two classes of
shares - common shares with voting rights and preferred shares
without voting rights. However, Aracruz has committed to paying
out 35% of its earnings as dividends to the preferred stockholders.
If they fail to meet this threshold, the preferred shares get voting
rights. If you own the preferred shares, would your answer to the
question above change?
a. Yes
b. No

Aswath Damodaran
201
 Mandated Dividend Payouts
202

 Assume now that the government decides to mandate a

minimum dividend payout for all companies. Given our
discussion of FCFE, what types of companies will be hurt
the most by such a mandate?
a. Large companies making huge profits
b. Small companies losing money
c. High growth companies that are losing money
d. High growth companies that are making money
 What if the government mandates a cap on the dividend
payout ratio (and a requirement that all companies
reinvest a portion of their profits)?
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 Aracruz: Ready to reassess?
203

 In 2008, Aracruz had a catastrophic year, with losses

in excess of a billion. The reason for the losses,
though, was speculation on the part of the
company’s managers on currency derivatives. The
FCFE in 2008 was -$1.226 billion but the company
still had to pay out $448 million in dividends. As
owners of the non-voting, dividend receiving shares,
would you reassess your unwillingness to accept
dividend cuts now?
a. Yes
b. No
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 Case 3: BP: Summary of Dividend Policy: 1982-
1991
204

Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity $571.10 $1,382.29 $3,764.00 ($612.50)
Dividends $1,496.30 $448.77 $2,112.00 $831.00
Dividends+Repurchases $1,496.30 $448.77 $2,112.00 $831.00

Dividend Payout Ratio 84.77%

Cash Paid as % of FCFE 262.00%

ROE - Required return -1.67% 11.49% 20.90% -21.59%

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 BP: Just Desserts!
205

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 Managing changes in dividend policy
206

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 Case 4: The Limited: Summary of Dividend
Policy: 1983-1992
207

Summary of calculations
Average Standard Deviation Maximum Minimum
Free CF to Equity ($34.20) $109.74 $96.89 ($242.17)
Dividends $40.87 $32.79 $101.36 $5.97
Dividends+Repurchases $40.87 $32.79 $101.36 $5.97

Dividend Payout Ratio 18.59%

Cash Paid as % of FCFE -119.52%

ROE - Required return 1.69% 19.07% 29.26% -19.84%

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 Growth Firms and Dividends
208

 High growth firms are sometimes advised to initiate

dividends because its increases the potential
stockholder base for the company (since there are
some investors - like pension funds - that cannot buy
stocks that do not pay dividends) and, by extension,
the stock price. Do you agree with this argument?
a. Yes
b. No
 Why?

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 5. Tata Chemicals: The Cross Holding Effect:
2009
209

Much of the cash held back

was invested in other Tata
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companies. 209
 Summing up…
210

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 Application Test: Assessing your firm’s dividend
policy
211

 Compare your firm’s dividends to its FCFE, looking at the

last 5 years of information.

 Based upon your earlier analysis of your firm’s project

choices, would you encourage the firm to return more
cash or less cash to its owners?

 If you would encourage it to return more cash, what

form should it take (dividends versus stock buybacks)?

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 II. The Peer Group Approach - Disney
212

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 Peer Group Approach: Deutsche Bank
213

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 Peer Group Approach: Aracruz and Tata
Chemicals
214

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 Going beyond averages… Looking at the market
215

 Regressing dividend yield and payout against expected growth across all
US companies in January 2009 yields:

PYT = Dividend Payout Ratio = Dividends/Net Income

YLD = Dividend Yield = Dividends/Current Price
ROE – Return on Equity
EGR = Expected growth rate in earnings over next 5 years (analyst estimates)
STD = Standard deviation in equity values
INS = Insider holdings as a percent of outstanding stock

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 Using the market regression on Disney
216

 To illustrate the applicability of the market regression in analyzing the

dividend policy of Disney, we estimate the values of the independent
variables in the regressions for the firm.
 Insider holdings at Disney (as % of outstanding stock) = 7.70%
 Standard Deviation in Disney stock prices = 19.30%
 Disney’s ROE = 13.05%
 Expected growth in earnings per share (Analyst estimates) = 14.50%
 Substituting into the regression equations for the dividend payout ratio
and dividend yield, we estimate a predicted payout ratio:
 Predicted Payout = 0.683 – 0.185 (.1305) -1.07 (.1930) – 0.313 (.145) =0.4069
 Predicted Yield = 0.039 – 0.039 (.1930) – 0.010 (.077) – 0.093 (.145) = .0172
 Based on this analysis, Disney with its dividend yield of 1.67% and a
payout ratio of approximately 20% is paying too little in dividends. This
analysis, however, fails to factor in the huge stock buybacks made by
Disney over the last few years.

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 Aswath Damodaran 217

Valuation
Cynic: A person who knows the price of everything but the value of nothing..
Oscar Wilde
 First Principles
218

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 Three approaches to valuation
219

 Intrinsic valuation: The value of an asset is a function of

its fundamentals – cash flows, growth and risk. In
general, discounted cash flow models are used to
estimate intrinsic value.
 Relative valuation: The value of an asset is estimated
based upon what investors are paying for similar assets.
In general, this takes the form of value or price multiples
and comparing firms within the same business.
 Contingent claim valuation: When the cash flows on an
asset are contingent on an external event, the value can
be estimated using option pricing models.

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 Discounted Cashflow Valuation: Basis for
Approach
220

where,
n = Life of the asset
r = Discount rate reflecting the riskiness of the estimated
cashflows

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 Equity Valuation
221

 The value of equity is obtained by discounting expected cashflows

to equity, i.e., the residual cashflows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of
equity, i.e., the rate of return required by equity investors in the
firm.

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

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 Firm Valuation
222

 The value of the firm is obtained by discounting expected

cashflows to the firm, i.e., the residual cashflows after
meeting all operating expenses and taxes, but prior to debt
payments, at the weighted average cost of capital, which is
the cost of the different components of financing used by the
firm, weighted by their market value proportions.

where,
CF to Firm t = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital

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 Choosing a Cash Flow to Discount
223

 When you cannot estimate the free cash flows to equity

or the firm, the only cash flow that you can discount is
dividends. For financial service firms, it is difficult to
estimate free cash flows. For Deutsche Bank, we will be
discounting dividends.
 If a firm’s debt ratio is not expected to change over time,
the free cash flows to equity can be discounted to yield
the value of equity. For Aracruz, we will discount free
cash flows to equity.
 If a firm’s debt ratio might change over time, free cash
flows to equity become cumbersome to estimate. Here,
we would discount free cash flows to the firm. For
Disney, we will discount the free cash flow to the firm.
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 The Ingredients that determine value.
224

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 I. Estimating Cash Flows
225

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 Dividends and Modified Dividends for Deutsche
Bank
226

 In 2007, Deutsche Bank paid out dividends of 2,146 million Euros on net
income of 6,510 million Euros. In early 2008, we valued Deutsche Bank
using the dividends it paid in 2007. We are assuming the dividends are
not only reasonable but sustainable.
 In early 2009, in the aftermath of the crisis, Deutsche Bank’s dividend
policy was in flux. The net income had plummeted and capital ratios were
being reassessed. To forecast future dividends, we first forecast net
income (ROE* Asset Base) and then estimated the investments in
regulatory capital:

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 Estimating FCFE : Tata Chemicals
227

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 Estimating FCFF: Disney
228

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 II. Discount Rates
229

 Critical ingredient in discounted cashflow valuation.

Errors in estimating the discount rate or mismatching
cashflows and discount rates can lead to serious
errors in valuation.
 At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of
cashflow being discounted.
 The cost of equity is the rate at which we discount
cash flows to equity (dividends or free cash flows to
equity). The cost of capital is the rate at which we
discount free cash flows to the firm.
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 Cost of Equity: Deutsche Bank
2008 versus 2009
230

 In early 2008, we estimated a beta of 1.162 for Deutsche Bank,

which used in conjunction with the Euro risk-free rate of 4% (in
January 2008) and a risk premium of 4.50% (the mature market risk
premium in early 2008), yielded a cost of equity of 9.23%.
Cost of Equity Jan 2008 = Riskfree Rate Jan 2008 + Beta* Mature Market Risk
Premium
= 4.00% + 1.162 (4.5%) = 9.23%
(We used the same beta for early 2008 and early 2009. We could have looked
at the betas for banks in early 2008 and used that number instead)
 In early 2009, the Euro riskfree rate had dropped to 3.6% and the
equity risk premium had risen to 6% for mature markets:
Cost of equity Jan 2009 = Riskfree Rate Jan 2009 + Beta (Equity Risk Premium)
= 3.6% + 1.162 (6%) = 10.572%

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 Cost of Equity: Tata Chemicals
231

 We will be valuing Tata Chemicals in rupee terms.

(That is a choice. Any company can be valued in any
currency).
 Earlier, we estimated a beta for equity of 0.945 for
Tata Chemical’s operating assets . With a nominal
rupee risk-free rate of 4 percent and an equity risk
premium of 10.51% for India (also estimated in
Chapter 4), we arrive at a cost of equity of 13.93%.
Cost of Equity = 4% + 0.945 (10.51%) = 13.93%

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 Current Cost of Capital: Disney
232

 The beta for Disney’s stock in May 2009 was 0.9011. The T. bond
rate at that time was 3.5%. Using an estimated equity risk premium
of 6%, we estimated the cost of equity for Disney to be 8.91%:
Cost of Equity = 3.5% + 0.9011(6%) = 8.91%
 Disney’s bond rating in May 2009 was A, and based on this rating,
the estimated pretax cost of debt for Disney is 6%. Using a marginal
tax rate of 38%, the after-tax cost of debt for Disney is 3.72%.
After-Tax Cost of Debt = 6.00% (1 – 0.38) = 3.72%
 The cost of capital was calculated using these costs and the weights
based on market values of equity (45,193) and debt (16,682):
Cost of capital =

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 But costs of equity and capital can and should
change over time…
233

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 III. Expected Growth
234

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 Estimating growth in EPS: Deutsche Bank in
January 2008
235

 In 2007, Deutsche Bank reported net income of 6.51 billion Euros on a book value
of equity of 33.475 billion Euros at the start of the year (end of 2006), and paid
out 2.146 billion Euros as dividends.
Return on Equity =

Retention Ratio =

 If Deutsche Bank maintains the return on equity (ROE) and retention ratio that it
delivered in 2007 for the long run:
Expected Growth Rate Existing Fundamentals = 0.6703 * 0.1945 = 13.04%
 If we replace the net income in 2007 with average net income of $3,954 million,
from 2003 to 2007:
Normalized Return on Equity =
Normalized Retention Ratio =
Expected Growth Rate Normalized Fundamentals = 0.4572 * 0.1181 = 5.40%

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 Estimating growth in Net Income: Tata
Chemicals
236

Normalized Equity Reinvestment Rate =

Normalized Return on Equity =

Expected Growth in Net Income = 63.62% * 17.34% = 11.03%

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 ROE and Leverage
237

 A high ROE, other things remaining equal, should yield a

higher expected growth rate in equity earnings.
 The ROE for a firm is a function of both the quality of its
investments and how much debt it uses in funding these
investments. In particular
ROE = ROC + D/E (ROC - i (1-t))
where,
ROC = (EBIT (1 - tax rate)) / (Book Value of Capital)
BV of Capital = BV of Debt + BV of Equity - Cash
D/E = Debt/ Equity ratio
i = Interest rate on debt
t = Tax rate on ordinary income.

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 Decomposing ROE
238

 Assume that you are analyzing a company with a 15% return

on capital, an after-tax cost of debt of 5% and a book debt to
equity ratio of 100%. Estimate the ROE for this company.

 Now assume that another company in the same sector has

the same ROE as the company that you have just analyzed
but no debt. Will these two firms have the same growth rates
in earnings per share if they have the same dividend payout
ratio?

 Will they have the same equity value?

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 Estimating Growth in EBIT: Disney
The Reinvestment Rate
239

 We begin by estimating the reinvestment rate and return on

capital for Disney in 2008 using the numbers from the latest
financial statements.
Reinvestment Rate2008 =

 We include $516 million in acquisitions made during 2008 in

capital expenditures, but this is a volatile item. Disney does
not make large acquisitions every year, but it does so
infrequently - $ 7.5 billion to buy Pixar in 2006 and $ 11.5
billion to buy Capital Cities in 1996. Averaging out acquisitions
from 1994-2008, we estimate an average annual value of
$1,761 million for acquisitions over this period:
Reinvestment Rate Normalized =

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 Estimating Growth in Disney
ROC and Expected Growth
240

 We compute the return on capital, using operating

income in 2008 and capital invested at the start of
2008 (end of 2007):
Return on Capital2008 =
 If Disney maintains its 2008 normalized reinvestment
rate of 53.72% and return on capital of 9.91% for the
next few years, its growth rate will be 5.32 percent.

Expected Growth Rate = 53.72% * 9.91% = 5.32%

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 IV. Getting Closure in Valuation
241

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

 When a firm’s cash flows grow at a “constant” rate forever, the present
value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate forever.
 This “constant” growth rate is called a stable growth rate and cannot be
higher than the growth rate of the economy in which the firm operates.

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 Getting to stable growth…
242

 A key assumption in all discounted cash flow models is the period

of high growth, and the pattern of growth during that period. In
general, we can make one of three assumptions:
 there is no high growth, in which case the firm is already in stable growth
 there will be high growth for a period, at the end of which the growth rate
will drop to the stable growth rate (2-stage)
 there will be high growth for a period, at the end of which the growth rate
will decline gradually to a stable growth rate(3-stage)
 The assumption of how long high growth will continue will depend
upon several factors including:
 the size of the firm (larger firm -> shorter high growth periods)
 current growth rate (if high -> longer high growth period)
 barriers to entry and differential advantages (if high -> longer growth
period)

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 Choosing a Growth Period: Examples
243

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243
 Estimating Stable Period Inputs: Disney
244

 Respect the cap: The growth rate forever is assumed to be 3%. This is set lower
than the riskfree rate (3.5%).
 Think about stable period excess returns: The return on capital for Disney will drop
from its high growth period level of 9.91% to a stable growth return of 9%. This is
still higher than the cost of capital of 7.95% but the competitive advantages that
Disney has are unlikely to dissipate completely by the end of the 10th year.
 Reinvest to grow: The expected growth rate in stable growth will be 3%. In
conjunction with the return on capital of 9%, this yields a stable period
reinvestment rate of 33.33%:
 Reinvestment Rate = Growth Rate / Return on Capital = 3% /9% = 33.33%
 Adjust risk and cost of capital: The beta for the stock will drop to one, reflecting
Disney’s status as a mature company.
 Cost of Equity = Riskfree Rate + Beta * Risk Premium = 3.5% + 6% = 9.5%
 The debt ratio for Disney will stay at 26.73%. Since we assume that the cost of debt remains
unchanged at 6%, this will result in a cost of capital of 7.95%
 Cost of capital = 9.5% (.733) + 6% (1-.38) (.267) = 7.95%

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 V. From firm value to equity value per share
245

Approach used To get to equity value per share

Discount dividends per share at the cost Present value is value of equity per share
of equity
Discount aggregate FCFE at the cost of Present value is value of aggregate equity.
equity Subtract the value of equity options given
to managers and divide by number of
shares.
Discount aggregate FCFF at the cost of PV = Value of operating assets
capital + Cash & Near Cash investments
+ Value of minority cross holdings
-Debt outstanding
= Value of equity
-Value of equity options
=Value of equity in common stock
/ Number of shares

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 Valuing Deutsche Bank in early 2008
246

 To value Deutsche Bank, we started with the normalized income over the
previous five years (3,954 million Euros) and the dividends in 2008 (2,146
million Euros). We assumed that the payout ratio and ROE, based on
these numbers will continue for the next 5 years:
 Payout ratio = 2,146/3954 = 54.28%

 Expected growth rate = (1-.5428) * .1181 = 0.054 or 5.4%

 Cost of equity = 9.23%

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 Deutsche Bank in stable growth
247

 At the end of year 5, the firm is in stable growth. We assume that the cost
of equity drops to 8.5% (as the beta moves to 1) and that the return on
equity also drops to 8.5 (to equal the cost of equity).
Stable Period Payout Ratio = 1 – g/ROE = 1 – 0.03/0.085 = 0.6471 or 64.71%
Expected Dividends in Year 6 = Expected Net Income 5 *(1+gStable)* Stable Payout Ratio
= €5,143 (1.03) * 0.6471 = €3,427 million
Terminal Value =

PV of Terminal Value =

 Value of equity = €9,653+ €40,079 = €49,732 million Euros

 Value of equity per share=

Stock was trading at 89 Euros per share at the time of the analysis.

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 What does the valuation tell us? One of three
possibilities…
248

 Stock is under valued: This valuation would suggest

that Deutsche Bank is significantly overvalued, given
our estimates of expected growth and risk.
 Dividends may not reflect the cash flows generated
by Deutsche Bank. The FCFE could have been
significantly lower than the dividends paid.
 Estimates of growth and risk are wrong: It is also
possible that we have over estimated growth or
under estimated risk in the model, thus reducing our
estimate of value.

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 Valuing Tata Chemicals in early 2009:
The high growth period
249

 We used the normalized return on equity of 17.34% (see earlier

table) and the current book value of equity (Rs 35,717 million) to
estimate net income:
Normalized Net Income = 35,717 *.1734 = Rs, 6,193 million
(We removed interest income from cash to arrive at the normalized return on
equity)
 We use the average equity reinvestment rate of 63.62 percent and
the normalized return on equity of 17.34% to estimate growth:
Expected Growth in Net Income = 63.62% * 17.34% = 11.03%
 We assume that the current cost of equity (see earlier page) of
13.93% will hold for the next 5 years.

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 Stable growth and value….
250

 After year five, we will assume that the beta will increase to 1 and that
the equity risk premium will decline to 7.5 percent (we assumed India
country risk would drop). The resulting cost of equity is 11.5 percent.
Cost of Equity in Stable Growth = 4% + 1(7.5%) = 11.5%
 We will assume that the growth in net income will drop to 4% and that
the return on equity will rise to 11.5% (which is also the cost of equity).
Equity Reinvestment Rate Stable Growth = 4%/11.5% = 34.78%
FCFE in Year 6 = 10,449(1.04)(1 – 0.3478) = Rs 7,087 million
Terminal Value of Equity = 7,087/(0.115 – 0.04) = Rs 94,497 million
 To value equity in the firm today
Value of equity = PV of FCFE during high growth + PV of terminal value + Cash
= 10,433 + 94,497/1.13935 +1,759 = Rs 61,423 million
Dividing by 235.17 million shares yields a value of equity per share of Rs 261, about
20% higher than the stock price of Rs 222 per share.

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 Disney: Inputs to Valuation
251

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 Ways of changing value…
254

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255 Aswath Damodaran
 First Principles
256

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