Corporate Finance: Lecture Note Packet 1 The Objective and ...

Corporate Finance: Lecture Note Packet 1 The Objective and ...

Applied Corporate Finance Aswath Damodaran www.damodaran.com 1 What is corporate finance? Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision. Defined broadly, everything that a business does fits under the rubric of corporate finance. 2 The Traditional Accounting Balance Sheet Fixed Short-term Intangible Long Assets Financial Investments Short-lived Equity Debt Current Other obligations Lived

Assets long-term which investment Assets Investments Assets liabilities Assets Real inare securities obligations of Assets not inSheet firm physical, of firm the & firm Liabilities Assets The Balance like patents assets Liabilties Liabilities of other & trademarks firms

3 The Financial View of the Firm Expected Assets Fixed Equity Debt Residual Growth Existing Claim inAssets Investments Claim Place Value on on cash thatcash will flows flows be Liabilities Assets Little orby Significant Generate created No cashflows future Role

role in investments management today Fixed Maturity Perpetual Includes long Lives lived (fixed) and Tax Deductible short-lived(working capital) assets 4 Tale of two companies Investments Equity Debt $Investments 7 billion 11 315 0.12 677 71.12 billion billion billion yet already to Balance Con Liabilities

Assets EBays Eds Financial Financial Balance Sheet Sheet made be made 5 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon

the stockholders characteristics. Objective: Maximize the Value of the Firm 6 The Objective in Decision Making In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization. 7 The Classical Objective Function STOCKHOLDERS Hire & fire managers - Board - Annual Meeting Lend Money BONDHOLDERS Maximize stockholder wealth

Managers Protect bondholder Interests Reveal information honestly and on time No Social Costs SOCIETY Costs can be traced to firm Markets are efficient and assess effect on value FINANCIAL MARKETS 8 What can go wrong? STOCKHOLDERS Have little control over managers Lend Money BONDHOLDERS Managers put their interests

above stockholders Managers Significant Social Costs SOCIETY Bondholders can Some costs cannot be get ripped off traced to firm Delay bad Markets make news or mistakes and provide misleading can over react information FINANCIAL MARKETS 9 Whos on Board? The Disney Experience 1997 10 Application Test: Who owns/runs your firm? Look at: Bloomberg printout HDS for your firm Looking at the top 15 stockholders in your firm, are top managers in your firm also large stockholders in the firm? Is there any evidence that the top stockholders in the firm play an active role in managing the firm? 11

Disneys top stockholders in 2003 12 When traditional corporate financial theory breaks down, the solution is: To choose a different mechanism for corporate governance To choose a different objective for the firm. To maximize stock price, but reduce the potential for conflict and breakdown: Making managers (decision makers) and employees into stockholders By providing information honestly and promptly to financial markets 13 An Alternative Corporate Governance System Germany and Japan developed a different mechanism for corporate governance, based upon corporate cross holdings. In Germany, the banks form the core of this system. In Japan, it is the keiretsus Other Asian countries have modeled their system after Japan, with family companies forming the core of the new corporate families At their best, the most efficient firms in the group work at bringing the less efficient firms up to par. They provide a corporate welfare system

that makes for a more stable corporate structure At their worst, the least efficient and poorly run firms in the group pull down the most efficient and best run firms down. The nature of the cross holdings makes its very difficult for outsiders (including investors in these firms) to figure out how well or badly the group is doing. 14 Choose a Different Objective Function Firms can always focus on a different objective function. Examples would include maximizing earnings maximizing revenues maximizing firm size maximizing market share maximizing EVA The key thing to remember is that these are intermediate objective functions. To the degree that they are correlated with the long term health and value of the company, they work well. To the degree that they do not, the firm can end up with a disaster 15

Maximize Stock Price, subject to .. The strength of the stock price maximization objective function is its internal self correction mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which reduce or eliminate these excesses In the context of our discussion, managers taking advantage of stockholders has lead to a much more active market for corporate control. stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the time of the issue. firms revealing incorrect or delayed information to markets has lead to markets becoming more skeptical and punitive firms creating social costs has lead to more regulations, as well as investor and customer backlashes. 16 The Stockholder Backlash Institutional investors such as Calpers and the Lens Funds have become much more active in monitoring companies that they invest in and demanding changes in the way in which business is done Individuals like Michael Price specialize in taking large positions in companies which they feel need to change their ways (Chase, Dow Jones, Readers Digest) and push for change

At annual meetings, stockholders have taken to expressing their displeasure with incumbent management by voting against their compensation contracts or their board of directors 17 In response, boards are becoming more independent Boards have become smaller over time. The median size of a board of directors has decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The smaller boards are less unwieldy and more effective than the larger boards. There are fewer insiders on the board. In contrast to the 6 or more insiders that many boards had in the 1970s, only two directors in most boards in 1998 were insiders. Directors are increasingly compensated with stock and options in the company, instead of cash. In 1973, only 4% of directors received compensation in the form of stock or options, whereas 78% did so in 1998. More directors are identified and selected by a nominating committee rather than being chosen by the CEO of the firm. In 1998, 75% of boards had nominating committees; the comparable statistic in 1973 was 2%. 18 Disneys Board in 2003

Board Members Reveta Bowers John Bryson Roy Disney Michael Eisner Judith Estrin Stanley Gold Robert Iger Monica Lozano George Mitchell Thomas S. Murphy Leo ODonovan Sidney Poitier Robert A.M. Stern Andrea L. Van de Kamp Raymond L. Watson Gary L. Wilson Occupation Head of school for the Center for Early Education, CEO and Chairman of Con Edison Head of Disney Animation CEO of Disney CEO of Packet Design (an internet company) CEO of Shamrock Holdings Chief Operating Officer, Disney Chief Operation Officer, La Opinion (Spanish newspaper) Chairman of law firm (Ve rner, Liipfert, et al.) Ex-CEO, Capital Cities ABC Professor of Theology, Georgetown University Actor, Writer and Director Senior Partner of Robert A.M. Stern Architects of New York Chairman of Sotheby's West Coast Chairman of Irvine Company (a real estate corporation) Chairman of the board, Northwest Airlines.

19 The Counter Reaction STOCKHOLDERS 1. More activist investors 2. Hostile takeovers Managers of poorly run firms are put on notice. Protect themselves BONDHOLDERS 1. Covenants 2. New Types Managers Firms are punished for misleading markets Corporate Good Citizen Constraints SOCIETY 1. More laws 2. Investor/Customer Backlash Investors and analysts become more skeptical FINANCIAL MARKETS

20 Picking the Right Projects: Investment Analysis Let us watch well our beginnings, and results will manage themselves Alexander Clark 21 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics.

22 The notion of a benchmark Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A simple representation of the hurdle rate is as follows: Hurdle rate = Riskless Rate + Risk Premium The two basic questions that every risk and return model in finance tries to answer are: How do you measure risk? How do you translate this risk measure into a risk premium? 23 What is Risk? Risk, in traditional terms, is viewed as a negative. Websters dictionary, for instance, defines risk as exposing to danger or hazard. The Chinese symbols for risk, reproduced below, give a much better description of risk The first symbol is the symbol for danger, while the second is the symbol for opportunity, making risk a mix of danger and

opportunity. 24 Risk and Return Models in Finance Riskless Low High Risk E(R) The Multi-Factor Proxy If Beta Since Betas In Equation Step there anAPM risk CAPM Risk that Risk of 1: 2: 3: efficient market of Models

is are asset Defining Differentiating Measuring asset assets Investment in is relating Investment Investment no specific anModels risk relative market, relative investment relative Risk affects to Market to investment between can Riskbe Rewarded (Firm measured

Specific) and by Unrewarded the variance Risk that Risk in actual affectsreturns all investments around an (Market Risk) expected Can 1. arbitrage Market most to differences returns nobe unspecified specified or private portfolio to diversified allopportunities return proxy investments, in macro information

returns market (from away in a diversified portfolio Cannot be diversified away since most assets 1.must 2. then a itfactors economic across variables regression) each no the transactions long come (from investment market (from factors periods afrom factor arisk (from cost ismust ofa small proportion of portfolio are affected by it. 2.regression)

the any analysis) macro a be regression) risk due optimal asset averages economic to market must diversified be out factors. riskacross investments in portfolio The marginal portfolio captured Market differences. Risk includes by Looking betas = investor Risk every for is assumed to hold a diversified portfolio. Thus, only market risk will be rewarded traded

relative exposures variables asset. tocorrelated factors ofEveryone and anythat priced. with will hold affect asset returns all toshould this investments. macro market then give portfolio Market economic us proxies Risk for factors. =this Risk risk. added by exposures

Market Risk any of= any investment to the to asset Captured market market by the portfolio: factorsVariable(s) Proxy 25 Who are Disneys marginal investors? 26 Limitations of the CAPM 1. The model makes unrealistic assumptions 2. The parameters of the model cannot be estimated precisely - Definition of a market index - Firm may have changed during the 'estimation' period' 3. The model does not work well - If the model is right, there should be a linear relationship between returns and betas the only variable that should explain returns is betas - The reality is that the relationship between betas and returns is weak Other variables (size, price/book value) seem to explain differences in returns

better. 27 Why the CAPM persists The CAPM, notwithstanding its many critics and limitations, has survived as the default model for risk in equity valuation and corporate finance. The alternative models that have been presented as better models (APM, Multifactor model..) have made inroads in performance evaluation but not in prospective analysis because: The alternative models (which are richer) do a much better job than the CAPM in explaining past return, but their effectiveness drops off when it comes to estimating expected future returns (because the models tend to shift and change). The alternative models are more complicated and require more information than the CAPM. For most companies, the expected returns you get with the the alternative models is not different enough to be worth the extra trouble of estimating four additional betas. 28 Application Test: Who is the marginal investor in your firm? You can get information on insider and institutional holdings in your firm from: http://finance.yahoo.com/ Enter your companys symbol and choose profile. Looking at the breakdown of stockholders in your firm, consider whether the marginal investor is An institutional investor

b) An individual investor c) An insider a) 29 Inputs required to use the CAPM The capital asset pricing model yields the following expected return: Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio - Riskfree Rate) To use the model we need three inputs: (a) The current risk-free rate (b) The expected market risk premium (the premium expected for investing in risky assets (market portfolio) over the riskless asset) (c) The beta of the asset being analyzed. 30 The Riskfree Rate and Time Horizon On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met There has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free. There can be no uncertainty about reinvestment rates, which implies that

it is a zero coupon security with the same maturity as the cash flow being analyzed. 31 Riskfree Rate in Practice The riskfree rate is the rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed. Theoretically, this translates into using different riskfree rates for each cash flow - the 1 year zero coupon rate for the cash flow in year 1, the 2-year zero coupon rate for the cash flow in year 2 ... Practically speaking, if there is substantial uncertainty about expected cash flows, the present value effect of using time varying riskfree rates is small enough that it may not be worth it. 32 The Bottom Line on Riskfree Rates Using a long term government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value. For short term analysis, it is entirely appropriate to use a short term government security rate as the riskfree rate.

The riskfree rate that you use in an analysis should be in the same currency that your cashflows are estimated in. In other words, if your cashflows are in U.S. dollars, your riskfree rate has to be in U.S. dollars as well. Data Source: You can get riskfree rates for the US in a number of sites. Try http://www.bloomberg.com/markets. 33 Measurement of the risk premium The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate. As a general proposition, this premium should be greater than zero increase with the risk aversion of the investors in that market increase with the riskiness of the average risk investment 34 What is your risk premium? Assume that stocks are the only risky assets and that you are offered two investment options: a riskless investment (say a Government Security), on which you can make 5% a mutual fund of all stocks, on which the returns are uncertain How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund? a) Less than 5% b) Between 5 - 7% c) Between 7 - 9% d) Between 9 - 11%

e) Between 11- 13% f) More than 13% Check your premium against the survey premium on my web site. 35 Risk Aversion and Risk Premiums If this were the capital market line, the risk premium would be a weighted average of the risk premiums demanded by each and every investor. The weights will be determined by the magnitude of wealth that each investor has. Thus, Warren Buffets risk aversion counts more towards determining the equilibrium premium than yours and mine. As investors become more risk averse, you would expect the equilibrium premium to increase. 36 Risk Premiums do change.. Go back to the previous example. Assume now that you are making the same choice but that you are making it in the aftermath of a stock market crash (it has dropped 25% in the last month). Would you change your answer? a) I would demand a larger premium b) I would demand a smaller premium c) I would demand the same premium 37

Estimating Risk Premiums in Practice Survey investors on their desired risk premiums and use the average premium from these surveys. Assume that the actual premium delivered over long time periods is equal to the expected premium - i.e., use historical data Estimate the implied premium in todays asset prices. 38 The Survey Approach Surveying all investors in a market place is impractical. However, you can survey a few investors (especially the larger investors) and use these results. In practice, this translates into surveys of money managers expectations of expected returns on stocks over the next year. The limitations of this approach are: there are no constraints on reasonability (the survey could produce negative risk premiums or risk premiums of 50%) they are extremely volatile they tend to be short term; even the longest surveys do not go beyond one year 39

The Historical Premium Approach This is the default approach used by most to arrive at the premium to use in the model In most cases, this approach does the following it defines a time period for the estimation (1926-Present, 1962-Present....) it calculates average returns on a stock index during the period it calculates average returns on a riskless security over the period it calculates the difference between the two and uses it as a premium looking forward The limitations of this approach are: it assumes that the risk aversion of investors has not changed in a systematic way across time. (The risk aversion may change from year to year, but it reverts back to historical averages) it assumes that the riskiness of the risky portfolio (stock index) has not changed in a systematic way across time. 40 Historical Average Premiums for the United States Arithmetic average Geometric Average Stocks Stocks - Stocks Stocks Historical Period T.Bills T.Bonds T.Bills T.Bonds 1928-2004

7.92% 6.53% 6.02% 4.84% 1964-2004 5.82% 4.34% 4.59% 3.47% 1994-2004 8.60% 5.82% 6.85% 4.51% What is the right premium? Go back as far as you can. Otherwise, the standard error in the estimate will be large. ( Std Error in estimate = Annualized Std deviation in Stock prices ) Number of years of historical data Be consistent in your use of a riskfree rate. Use arithmetic premiums for one-year estimates of costs of equity and geometric premiums for estimates of long term costs of equity. Data Source: Check out the returns by year and estimate your own historical premiums by going to updated data on my web site. 41 What about historical premiums for other markets?

Historical data for markets outside the United States is available for much shorter time periods. The problem is even greater in emerging markets. The historical premiums that emerge from this data reflects this and there is much greater error associated with the estimates of the premiums. 42 One solution: Look at a countrys bond rating and default spreads as a start Ratings agencies such as S&P and Moodys assign ratings to countries that reflect their assessment of the default risk of these countries. These ratings reflect the political and economic stability of these countries and thus provide a useful measure of country risk. In September 2004, for instance, Brazil had a country rating of B2. If a country issues bonds denominated in a different currency (say dollars or euros), you can also see how the bond market views the risk in that country. In September 2004, Brazil had dollar denominated CBonds, trading at an interest rate of 10.01%. The US treasury bond rate that day was 4%, yielding a default spread of 6.01% for Brazil. Many analysts add this default spread to the US risk premium to come up with a risk premium for a country. Using this approach would yield a risk premium of 10.85% for Brazil, if we use 4.84% as the premium for the US.

43 Beyond the default spread Country ratings measure default risk. While default risk premiums and equity risk premiums are highly correlated, one would expect equity spreads to be higher than debt spreads. If we can compute how much more risky the equity market is, relative to the bond market, we could use this information. For example, Standard Deviation in Bovespa (Equity) = 36% Standard Deviation in Brazil C-Bond = 28.2% Default spread on C-Bond = 6.01% Country Risk Premium for Brazil = 6.01% (36%/28.2%) = 7.67% Note that this is on top of the premium you estimate for a mature market. Thus, if you assume that the risk premium in the US is 4.84%, the risk premium for Brazil would be 12.51%. 44 Implied Equity Premiums We can use the information in stock prices to back out how risk averse the market is and how much of a risk premium it is demanding. 38.13

January In Analysts After 52.85 48.71 44.89 41.37 2004, year 1, dividends expect 5, 2005 we earnings will & assume stock to grow that 8.5% a year for the next 5 years . S&P 500 on buybacks earnings iswere at the1211.92 2.90% index will of grow at the index, 4.22%, thegenerating same rate as 35.15

the entire in cashflows economy If you pay the current level of the index, you can expect to make a return of 7.87% on stocks (which is obtained by solving for r in the following equation) Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.87% - 4.22% = 3.65% 1211.92 = 38.13 41.37 44.89 48.71 52.85 52.85(1.0422) + + + + + (1+ r) (1+ r) 2 (1+ r) 3 (1 + r) 4 (1+ r) 5 (r .0422)(1+ r) 5 45 Implied Premiums in the US Implied Premium for US Equity Market 7.00%

6.00% 5.00% 4.00% 3.00% Implied Premium 2.00% 1.00% 0.00% 196019611962196319641965196619671968196919701971197219731974197519761977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004 Year 46 Application Test: A Market Risk Premium Based upon our discussion of historical risk premiums so far, the risk premium looking forward should be: a) About 7.92%, which is what the arithmetic average premium has been since 1928, for stocks over T.Bills b) About 4.84%, which is the geometric average premium since 1928, for stocks over T.Bonds c) About 3.7%, which is the implied premium in the stock market today 47

Estimating Beta The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) Rj = a + b Rm where a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. 48 Estimating Performance The intercept of the regression provides a simple measure of performance during the period of the regression, relative to the capital asset pricing model. Rj = Rf + b (Rm - Rf) = Rf (1-b) + b Rm Rj = a + b Rm ........... ........... Capital Asset Pricing Model Regression Equation If a > Rf (1-b) .... Stock did better than expected during regression period

a = Rf (1-b) .... Stock did as well as expected during regression period a < Rf (1-b) .... Stock did worse than expected during regression period The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is positive, your stock did perform better than expected during the period of the regression. 49 Firm Specific and Market Risk The R squared (R2) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market risk; The balance (1 - R2) can be attributed to firm specific risk. 50 Setting up for the Estimation Decide on an estimation period Services use periods ranging from 2 to 5 years for the regression Longer estimation period provides more data, but firms change. Shorter periods can be affected more easily by significant firm-specific event that occurred during the period (Example: ITT for 1995-1997) Decide on a return interval - daily, weekly, monthly

Shorter intervals yield more observations, but suffer from more noise. Noise is created by stocks not trading and biases all betas towards one. Estimate returns (including dividends) on stock Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning Included dividends only in ex-dividend month Choose a market index, and estimate returns (inclusive of dividends) on the index for each interval for the period. 51 Choosing the Parameters: Disney Period used: 5 years Return Interval = Monthly Market Index: S&P 500 Index. For instance, to calculate returns on Disney in December 1999, Price for Disney at end of November 1999 = $ 27.88 Price for Disney at end of December 1999 = $ 29.25

Dividends during month = $0.21 (It was an ex-dividend month) Return =($29.25 - $27.88 + $ 0.21)/$27.88= 5.69% To estimate returns on the index in the same month Index level (including dividends) at end of November 1999 = 1388.91 Index level (including dividends) at end of December 1999 = 1469.25 Return =(1469.25 - 1388.91)/ 1388.91 = 5.78% 52 Disneys Historical Beta Figure 4.3: Disney versus S&P 500: 1999 - 2003 30.00% 20.00% Regression line 10.00% 0.00% Disney -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%

-10.00% -20.00% -30.00% S&P 500 53 The Regression Output Using monthly returns from 1999 to 2003, we ran a regression of returns on Disney stock against the S*P 500. The output is below: ReturnsDisney = 0.0467% + 1.01 ReturnsS & P 500 (R squared= 29%) (0.20) 54 Analyzing Disneys Performance Intercept = 0.0467% This is an intercept based on monthly returns. Thus, it has to be compared to a monthly riskfree rate. Between 1999 and 2003,

Monthly Riskfree Rate = 0.313% (based upon average T.Bill rate: 99-03) Riskfree Rate (1-Beta) = 0.313% (1-1.01) = -..0032% The Comparison is then between Intercept versus Riskfree Rate (1 - Beta) 0.0467% versus 0.313%(1-1.01)=-0.0032% Jensens Alpha = 0.0467% -(-0.0032%) = 0.05% Disney did 0.05% better than expected, per month, between 1999 and 2003. Annualized, Disneys annual excess return = (1.0005)12-1= 0.60% 55 A positive Jensens alpha Who is responsible? Disney has a positive Jensens alpha of 0.60% a year between 1999 and 2003. This can be viewed as a sign that management in the firm did a good job, managing the firm during the period. a) True b) False 56 Estimating Disneys Beta

Slope of the Regression of 1.01 is the beta Regression parameters are always estimated with error. The error is captured in the standard error of the beta estimate, which in the case of Disney is 0.20. Assume that I asked you what Disneys true beta is, after this regression. What is your best point estimate? What range would you give me, with 67% confidence? What range would you give me, with 95% confidence? 57 The Dirty Secret of Standard Error Distribution of Standard Errors: Beta Estimates for U.S. stocks 1600 1400 Number of Firms 1200 1000 800 600 400 200 0 <.10 .10 - .20 .20 - .30 .30 - .40

.40 -.50 .50 - .75 > .75 Standard Error in Beta Estimate 58 Breaking down Disneys Risk R Squared = 29% This implies that 29% of the risk at Disney comes from market sources 71%, therefore, comes from firm-specific sources The firm-specific risk is diversifiable and will not be rewarded 59 The Relevance of R Squared You are a diversified investor trying to decide whether you should invest in Disney or Amgen. They both have betas of 1.01, but Disney has an R Squared of 29% while Amgens R squared of only 14.5%. Which one would you invest in? a) Amgen, because it has the lower R squared b) Disney, because it has the higher R squared c) You would be indifferent

Would your answer be different if you were an undiversified investor? 60 Beta Estimation: Using a Service (Bloomberg) QuickTime and a TIFF (LZW) decompressor are needed to see this picture. 61 Estimating Expected Returns for Disney in September 2004 Inputs to the expected return calculation Disneys Beta = 1.01 Riskfree Rate = 4.00% (U.S. ten-year T.Bond rate) Risk Premium = 4.82% (Approximate historical premium: 1928-2003) Expected Return = Riskfree Rate + Beta (Risk Premium) = 4.00% + 1.01(4.82%) = 8.87% 62 Use to a Potential Investor in Disney As a potential investor in Disney, what does this expected return of 8.87% tell you? a) This is the return that I can expect to make in the long term on Disney, if

the stock is correctly priced and the CAPM is the right model for risk, b) This is the return that I need to make on Disney in the long term to break even on my investment in the stock c) Both Assume now that you are an active investor and that your research suggests that an investment in Disney will yield 12.5% a year for the next 5 years. Based upon the expected return of 8.87%, you would a) Buy the stock b) Sell the stock 63 How managers use this expected return Managers at Disney need to make at least 8.87% as a return for their equity investors to break even. this is the hurdle rate for projects, when the investment is analyzed from an equity standpoint In other words, Disneys cost of equity is 8.87%. What is the cost of not delivering this cost of equity? 64 Application Test: Analyzing the Risk Regression Using your Bloomberg risk and return print out, answer the following

questions: How well or badly did your stock do, relative to the market, during the period of the regression? (You can assume an annualized riskfree rate of 4.8% during the regression period) Intercept - (4.8%/n) (1- Beta) = Jensens Alpha Where n is the number of return periods in a year (12 if monthly; 52 if weekly) What proportion of the risk in your stock is attributable to the market? What proportion is firm-specific? What is the historical estimate of beta for your stock? What is the range on this estimate with 67% probability? With 95% probability? Based upon this beta, what is your estimate of the required return on this stock? Riskless Rate + Beta * Risk Premium 65 A Quick Test You are advising a very risky software firm on the right cost of equity to use in project analysis. You estimate a beta of 3.0 for the firm and come up with a cost of equity of 18.46%. The CFO of the firm is concerned about the high cost of equity and wants to know whether there is anything he can do to lower his beta. How do you bring your beta down? Should you focus your attention on bringing your beta down? a) Yes b) No 66 Beta: Exploring Fundamentals Beta Networks: Real Qwest

General Microsoft: Philip Exxon Harmony Enron: >Morris: = < Mobil: Communications: 0 1 0.95 Electric: Gold 1..25 0.40 0.65 Mining: 3.24 1.10 - 0.10 2.60 67 Determinant 1: Product Type Industry Effects: The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market. Cyclical companies have higher betas than non-cyclical firms Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products

68 Determinant 2: Operating Leverage Effects Operating leverage refers to the proportion of the total costs of the firm that are fixed. Other things remaining equal, higher operating leverage results in greater earnings variability which in turn results in higher betas. 69 Measures of Operating Leverage Fixed Costs Measure = Fixed Costs / Variable Costs This measures the relationship between fixed and variable costs. The higher the proportion, the higher the operating leverage. EBIT Variability Measure = % Change in EBIT / % Change in Revenues This measures how quickly the earnings before interest and taxes changes as revenue changes. The higher this number, the greater the operating leverage. 70 Disneys Operating Leverage: 1987- 2003 Year Net Sales 1987 1988 1989 1990

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1987-2003 1996-2003 2877 3438 4594 5844 6182 7504 8529 10055 12112 18739 22473 22976 23435 25418 25172 25329 27061 % Change

in Sales 19.50% 33.62% 27.21% 5.78% 21.38% 13.66% 17.89% 20.46% 54.71% 19.93% 2.24% 2.00% 8.46% -0.97% 0.62% 6.84% 15.83% 11.73% EBIT 756 848 1177 1368 1124 1287 1560 1804 2262 3024 3945 3843 3580 2525

2832 2384 2713 % Change in EBIT 12.17% 38.80% 16.23% -17.84% 14.50% 21.21% 15.64% 25.39% 33.69% 30.46% -2.59% -6.84% -29.47% 12.16% -15.82% 13.80% 10.09% 4.42% 71 Reading Disneys Operating Leverage Operating Leverage

= % Change in EBIT/ % Change in Sales = 10.09% / 15.83% = 0.64 This is lower than the operating leverage for other entertainment firms, which we computed to be 1.12. This would suggest that Disney has lower fixed costs than its competitors. The acquisition of Capital Cities by Disney in 1996 may be skewing the operating leverage. Looking at the changes since then: Operating Leverage1996-03 = 4.42%/11.73% = 0.38 Looks like Disneys operating leverage has decreased since 1996. 72 Determinant 3: Financial Leverage As firms borrow, they create fixed costs (interest payments) that make their earnings to equity investors more volatile. This increased earnings volatility which increases the equity beta 73 Equity Betas and Leverage The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio L = u (1+ ((1-t)D/E)) where L = Levered or Equity Beta u = Unlevered Beta t = Corporate marginal tax rate

D = Market Value of Debt E = Market Value of Equity 74 Effects of leverage on betas: Disney The regression beta for Disney is 1.01. This beta is a levered beta (because it is based on stock prices, which reflect leverage) and the leverage implicit in the beta estimate is the average market debt equity ratio during the period of the regression (1999 to 2003) The average debt equity ratio during this period was 27.5%. The unlevered beta for Disney can then be estimated (using a marginal tax rate of 37.3%) = Current Beta / (1 + (1 - tax rate) (Average Debt/Equity)) = 1.01 / (1 + (1 - 0.373)) (0.275)) = 0.8615 75 Disney : Beta and Leverage Debt to Capital 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%

Debt/Equity Ratio 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00% Beta 0.86 0.92 1.00 1.09 1.22 1.40 1.67 2.12 3.02 5.72 Effect of Leverage 0.00 0.06 0.14 0.23 0.36 0.54 0.81 1.26 2.16

4.86 76 Betas are weighted Averages The beta of a portfolio is always the market-value weighted average of the betas of the individual investments in that portfolio. Thus, the beta of a mutual fund is the weighted average of the betas of the stocks and other investment in that portfolio the beta of a firm after a merger is the market-value weighted average of the betas of the companies involved in the merger. 77 Bottom-up versus Top-down Beta The top-down beta for a firm comes from a regression The bottom up beta can be estimated by doing the following: Find out the businesses that a firm operates in Find the unlevered betas of other firms in these businesses Take a weighted (by sales or operating income) average of these unlevered betas Lever up using the firms debt/equity ratio The bottom up beta will give you a better estimate of the true beta when

the standard error of the beta from the regression is high (and) the beta for a firm is very different from the average for the business the firm has reorganized or restructured itself substantially during the period of the regression when a firm is not traded 78 Disneys business breakdown Unlevered Beta (1 - Cash/ Firm Value) Unle vered Average beta Numbe r levered Media n Unle vered Cash/Firm correct ed for cash of firms beta D/E beta Value Business Comparab le firms Medi a Networks Radia and TV br oadcasting

companies 24 1.22 Parks an d Resorts Theme p ark & Entertainment firms 9 1.58 11 1.16 27.96% 77 1.06 9.18% Studio Movie Entertainment companies Consumer Products

Toy and apparel retail ers; Entertainment software 20.45% 1.0768 0.75% 1.0850 120.76% 0.8853 2.77% 0.9105 0.9824 14.08% 1.1435 0.9981 12.08% 1.1353 79

Disneys bottom up beta EV/Sales = (Market Value of Equity + Debt - Cash) Sales Business Media Networks Parks and Resorts Studio Entertainment Consumer Products Disney Disneys Revenues $10,941 $6,412 $7,364 $2,344 $27,061 Estimated EV/Sales Value 3.41 $37,278.62 2.37 $15,208.37 2.63 1.63 $19,390.14

$3,814.38 $75,691.51 Firm Value Proportion 49.25% 20.09% Unlevered beta 1.0850 0.9105 25.62% 5.04% 100.00% 1.1435 1.1353 1.0674 80 Disneys Cost of Equity Business Medi a Networks Parks an d Resorts Studio Entertainment Consumer Products Disn e y

D/E Unlevered Beta Ratio 1.08 5 0 26.6 2 % Lever e d Beta 1.26 6 1 Cost of Equit y 10.1 0 % 0.91 0 5 26.6 2 % 1.06 2 5 9.12% 1.14 3 5 26.6 2 % 1.33 4 4 10.4 3 % 1.13 5 3 1.06 7 4 26.6 2 % 26.6 2 %

1.32 4 8 1.24 5 6 10.3 9 % 10.0 0 % 81 Discussion Issue If you were the chief financial officer of Disney, what cost of equity would you use in capital budgeting in the different divisions? a) The cost of equity for Disney as a company b) The cost of equity for each of Disneys divisions? 82 Estimating Betas for Non-Traded Assets The conventional approaches of estimating betas from regressions do not work for assets that are not traded. There are two ways in which betas can be estimated for non-traded assets using comparable firms using accounting earnings 83 Using comparable firms to estimate beta for Bookscape Assume that you are trying to estimate the beta for a independent

bookstore in New York City. Firm Beta Debt Equity Cash Books-A-Million 0.532 $45 $45 $5 Borders Group 0.844 $182 $1,430 $269 Barnes & Noble 0.885 $300 $1,606 $268 Courier Corp 0.815 $1 $285 $6 Info Holdings 0.883 $2 $371 $54 John Wiley &Son 0.636 $235 $1,662 $33 Scholastic Corp 0.744 $549 $1,063

$11 Sector 0.7627 $1,314 $6,462 $645 Unlevered Beta = 0.7627/(1+(1-.35)(1314/6462)) = 0.6737 Corrected for Cash = 0.6737 / (1 645/(1314+6462)) = 0.7346 84 Estimating Bookscape Levered Beta and Cost of Equity Since the debt/equity ratios used are market debt equity ratios, and the only debt equity ratio we can compute for Bookscape is a book value debt equity ratio, we have assumed that Bookscape is close to the industry average debt to equity ratio of 20.33%. Using a marginal tax rate of 40% (based upon personal income tax rates) for Bookscape, we get a levered beta of 0.82. Levered beta for Bookscape = 0.7346 (1 +(1-.40) (.2033)) = 0.82 Using a riskfree rate of 4% (US treasury bond rate) and a historical risk premium of 4.82%: Cost of Equity = 4% + 0.82 (4.82%) = 7.95% 85 Is Beta an Adequate Measure of Risk for a Private Firm?

The owners of most private firms are not diversified. Beta measures the risk added on to a diversified portfolio. Therefore, using beta to arrive at a cost of equity for a private firm will a) Under estimate the cost of equity for the private firm b) Over estimate the cost of equity for the private firm c) Could under or over estimate the cost of equity for the private firm 86 Total Risk versus Market Risk Adjust the beta to reflect total risk rather than market risk. This adjustment is a relatively simple one, since the R squared of the regression measures the proportion of the risk that is market risk. Total Beta = Market Beta / Correlation of the sector with the market In the Bookscape example, where the market beta is 0.82 and the average R-squared of the comparable publicly traded firms is 16%, Market Beta R squared = 0.82 .16 = 2.06 Total Cost of Equity = 4% + 2.06 (4.82%) = 13.93%

87 Application Test: Estimating a Bottom-up Beta Based upon the business or businesses that your firm is in right now, and its current financial leverage, estimate the bottom-up unlevered beta for your firm. Data Source: You can get a listing of unlevered betas by industry on my web site by going to updated data. 88 From Cost of Equity to Cost of Capital The cost of capital is a composite cost to the firm of raising financing to fund its projects. In addition to equity, firms can raise capital from debt 89 What is debt? General Rule: Debt generally has the following characteristics: Commitment to make fixed payments in the future The fixed payments are tax deductible Failure to make the payments can lead to either default or loss of control

of the firm to the party to whom payments are due. As a consequence, debt should include Any interest-bearing liability, whether short term or long term. Any lease obligation, whether operating or capital. 90 Estimating the Cost of Debt If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate. If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated, and it has recently borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation. 91

Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses For a firm, which has earnings before interest and taxes of $ 3,500 million and interest expenses of $ 700 million Interest Coverage Ratio = 3,500/700= 5.00 In 2003, Bookscape had operating income of $ 2 million after interest expenses of 500,000. The resulting interest coverage ratio is 4.00. Interest coverage ratio = 2,000,000/500,000 = 4.00 92 Interest Coverage Ratios, Ratings and Default Spreads: Small Companies Interest Coverage Ratio > 12.5 9.50 - 12.50 7.50 9.50 6.00 7.50 4.50 6.00 4.00 4.50 3.50 - 4.00 3.00 3.50 2.50 3.00 2.00 - 2.50 1.50 2.00 1.25 1.50

0.80 1.25 0.50 0.80 < 0.65 Rating AAA AA A+ A ABBB BB+ BB B+ B BCCC CC C D Typical default spread 0.35% 0.50% 0.70% 0.85% 1.00% 1.50% 2.00% 2.50% 3.25% 4.00% 6.00% 8.00% 10.00% 12.00% 20.00%

93 Synthetic Rating and Cost of Debt for Bookscape Rating based on interest coverage ratio = BBB Default Spread based upon rating = 1.50% Pre-tax cost of debt = Riskfree Rate + Default Spread = 4% + 1.50% = 5.50% After-tax cost of debt = Pre-tax cost of debt (1- tax rate) = 5.50% (1-.40) = 3.30% 94 Estimating Cost of Debt with rated companies For the three publicly traded firms in our sample, we will use the actual bond ratings to estimate the costs of debt: S&P Rating Disney BBB+ Deutsche Bank AAAracruz B+ Riskfree Rate 4% ($)

4.05% (Eu) 4% ($) Default Spread 1.25% 1.00% 3.25% Cost of Debt 5.25% 5.05% 7.25% Tax After-tax Rate Cost of Debt 37.3% 3.29% 38% 3.13% 34% 4.79% We computed the synthetic ratings for Disney and Aracruz using the interest coverage ratios: Disney: Coverage ratio = 2,805/758 =3.70 Synthetic rating = A Aracruz: Coverage ratio = 888/339= 2.62 Synthetic rating = BBB Disneys synthetic rating is close to its actual rating. Aracruz has two ratings one for its local currency borrowings of BBB- and one for its dollar borrowings of B+. 95 Application Test: Estimating a Cost of Debt

Based upon your firms current earnings before interest and taxes, its interest expenses, estimate An interest coverage ratio for your firm A synthetic rating for your firm (use the interest coverage table) A pre-tax cost of debt for your firm An after-tax cost of debt for your firm 96 Weights for Cost of Capital Calculation The weights used in the cost of capital computation should be market values. There are three specious arguments used against market value Book value is more reliable than market value because it is not as volatile: While it is true that book value does not change as much as market value, this is more a reflection of weakness than strength Using book value rather than market value is a more conservative approach to estimating debt ratios: For most companies, using book values will yield a lower cost of capital than using market value weights. Since accounting returns are computed based upon book value, consistency requires the use of book value in computing cost of capital: While it may seem consistent to use book values for both accounting return and cost of capital calculations, it does not make economic sense. 97

Estimating Market Value Weights Market Value of Equity should include the following Market Value of Shares outstanding Market Value of Warrants outstanding Market Value of Conversion Option in Convertible Bonds Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt. There are two solutions: Assume book value of debt is equal to market value Estimate the market value of debt from the book value For Disney, with book value of 13,100 million, interest expenses of $666 million, a current cost of borrowing of 5.25% and an weighted average maturity of 11.53 years. Estimated MV of Disney Debt = 1 (1 (1.0525)11.53 666 .0525 + 13,100 = $12, 915 million (1.0525)11.53

98 Converting Operating Leases to Debt The debt value of operating leases is the present value of the lease payments, at a rate that reflects their risk. In general, this rate will be close to or equal to the rate at which the company can borrow. 99 Operating Leases at Disney The pre-tax cost of debt at Disney is 5.25% Year Commitment Present Value 1 $ 271.00 $ 257.48 2 $ 242.00 $ 218.46 3 $ 221.00 $

189.55 4 $ 208.00 $ 169.50 5 $ 275.00 $ 212.92 6 9 $ 258.25 $ 704.93 Debt Value of leases = $ 1,752.85 Debt outstanding at Disney = $12,915 + $ 1,753= $14,668 million 100 Application Test: Estimating Market Value Estimate the Market value of equity at your firm and Book Value of equity Market value of debt and book value of debt (If you cannot find the average maturity of your debt, use 3 years): Remember to capitalize the value of operating leases and add them on to both the book value and the market value of debt.

Estimate the Weights for equity and debt based upon market value Weights for equity and debt based upon book value 101 Current Cost of Capital: Disney Equity Cost of Equity = Riskfree rate + Beta * Risk Premium = 4% + 1.25 (4.82%) = 10.00% Market Value of Equity = $55.101 Billion Equity/(Debt+Equity ) = 79% Debt After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t) = (4%+1.25%) (1-.373) = 3.29% Market Value of Debt = $ 14.668 Billion Debt/(Debt +Equity) = 21% Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59% 55.101/ (55.101+14.668) 102

Disneys Divisional Costs of Capital Business Cost of Equity Media Networks 10.10% Parks and Resorts 9.12% Studio Entertainment 10.43% Consumer Products 10.39% Disney 10.00% After-tax cost of debt 3.29% 3.29% 3.29% 3.29% 3.29% E/(D+E) D/(D+E) Cost of capital 78.98% 78.98% 78.98% 78.98% 78.98%

21.02% 21.02% 21.02% 21.02% 21.02% 8.67% 7.90% 8.93% 8.89% 8.59% 103 Application Test: Estimating Cost of Capital Using the bottom-up unlevered beta that you computed for your firm, and the values of debt and equity you have estimated for your firm, estimate a bottom-up levered beta and cost of equity for your firm. Based upon the costs of equity and debt that you have estimated, and the weights for each, estimate the cost of capital for your firm. How different would your cost of capital have been, if you used book value weights? 104 Choosing a Hurdle Rate

Either the cost of equity or the cost of capital can be used as a hurdle rate, depending upon whether the returns measured are to equity investors or to all claimholders on the firm (capital) If returns are measured to equity investors, the appropriate hurdle rate is the cost of equity. If returns are measured to capital (or the firm), the appropriate hurdle rate is the cost of capital. 105 Back to First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. 106 Measuring Investment Returns Show me the money Jerry Maguire 107 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. 108 Measures of return: earnings versus cash flows Principles Governing Accounting Earnings Measurement Accrual Accounting: Show revenues when products and services are sold or provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses. Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization) To get from accounting earnings to cash flows: you have to add back non-cash expenses (like depreciation) you have to subtract out cash outflows which are not expensed (such as capital expenditures) you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital). 109 Measuring Returns Right: The Basic Principles

Use cash flows rather than earnings. You cannot spend earnings. Use incremental cash flows relating to the investment decision, i.e., cashflows that occur as a consequence of the decision, rather than total cash flows. Use time weighted returns, i.e., value cash flows that occur earlier more than cash flows that occur later. The Return Mantra: Time-weighted, Incremental Cash Flow Return 110 Earnings versus Cash Flows: A Disney Theme Park The theme parks to be built near Bangkok, modeled on Euro Disney in Paris, will include a Magic Kingdom to be constructed, beginning immediately, and becoming operational at the beginning of the second year, and a second theme park modeled on Epcot Center at Orlando to be constructed in the second and third year and becoming operational at the beginning of the fifth year. The earnings and cash flows are estimated in nominal U.S. Dollars. 111 Earnings on Project Magic King d om Seco n d The m e Pa rk Resort & Prop e rties Total Revenues Magic Kingdom: Operating

Expenses Epcot II: Operating Expenses Resort & Prop e rty: Operating Expenses Depreciation & Amortization Allocated G&A Costs Operating Income Taxes Operating Incom e aft e r Taxes Now (0) 1 $0 $0 $0 2 $1,0 0 0 $0 $250 $1,2 5 0 3 $1,4 0 0 $0 $350 $1,7 5 0 4 $1,7 0 0 $300 $500 $2,5 0 0

5 $2,0 0 0 $500 $625 $3,1 2 5 6 $2,2 0 0 $550 $688 $3,4 3 8 7 $2,4 2 0 $605 $756 $3,7 8 1 8 $2,6 6 2 $666 $832 $4,1 5 9 9 $2,9 2 8 $732 $915 $4,5 7 5 10 $2,9 8 7 $747 $933

$4,6 6 7 $0 $600 $840 $1,0 2 0 $1,2 0 0 $1,3 2 0 $1,4 5 2 $1,5 9 7 $1,7 5 7 $1,7 9 2 $0 $0 $0 $180 $300 $330 $363 $399 $439 $448 $0 $0 $0 $0 $0

$188 $537 $188 -$262 -$98 $263 $508 $263 -$123 -$46 $375 $430 $375 $120 $45 $469 $359 $469 $329 $1 23 $516 $357 $516 $399 $149 $567 $358 $567 $473

$177 $624 $361 $624 $554 $206 $6 86 $366 $686 $641 $239 $700 $369 $700 $657 $245 -$164 -$77 $75 $206 $250 $297 $347 $402

$412 112 And the Accounting View of Return Year 1 2 3 4 5 6 7 8 9 10 After -tax Operating Income $0 -$165 -$77 $75 $206 $251 $297 $347 $402 $412 $175 BV of

Capital: Beginning $2,500 $3,500 $4,294 $4,616 $4,524 $4,484 $4,464 $4,481 $4,518 $4,575 BV of Capital: Ending $3,500 $4,294 $4,616 $4,524 $4,484 $4,464 $4,481 $4,518 $4,575 $4,617 Ave rage BV of Capital $3,000 $3,897 $4,455 $4,570 $4,504 $4,474

$4,472 $4,499 $4,547 $4,596 $4,301 ROC NA -4.22% -1.73% 1.65% 4.58% 5.60% 6.64% 7.72% 8.83% 8.97% 4.23% 113 Should there be a risk premium for foreign projects? The exchange rate risk should be diversifiable risk (and hence should not command a premium) if the company has projects is a large number of countries (or) the investors in the company are globally diversified. For Disney, this risk should not affect the cost of capital used. Consequently, we would not adjust the cost of capital for Disneys investments in other mature markets (Germany, UK, France)

The same diversification argument can also be applied against political risk, which would mean that it too should not affect the discount rate. It may, however, affect the cash flows, by reducing the expected life or cash flows on the project. For Disney, this is the risk that we are incorporating into the cost of capital when it invests in Thailand (or any other emerging market) 114 Estimating a hurdle rate for the theme park We did estimate a cost of equity of 9.12% for the Disney theme park business in the last chapter, using a bottom-up levered beta of 1.0625 for the business. This cost of equity may not adequately reflect the additional risk associated with the theme park being in an emerging market. To counter this risk, we compute the cost of equity for the theme park using a risk premium that includes a country risk premium for Thailand: The rating for Thailand is Baa1 and the default spread for the country bond is 1.50%. Multiplying this by the relative volatility of 2.2 of the equity market in Thailand (strandard deviation of equity/standard devaiation of country bond) yields a country risk premium of 3.3%. Cost of Equity in US $= 4% + 1.0625 (4.82% + 3.30%) = 12.63% Cost of Capital in US $ = 12.63% (.7898) + 3.29% (.2102) = 10.66% 115

Would lead us to conclude that... Do not invest in this park. The return on capital of 4.23% is lower than the cost of capital for theme parks of 10.66%; This would suggest that the project should not be taken. Given that we have computed the average over an arbitrary period of 10 years, while the theme park itself would have a life greater than 10 years, would you feel comfortable with this conclusion? a) Yes b) No 116 From Project to Firm Return on Capital: Disney in 2003 Just as a comparison of project return on capital to the cost of capital yields a measure of whether the project is acceptable, a comparison can be made at the firm level, to judge whether the existing projects of the firm are adding or destroying value. Disney, in 2003, had earnings before interest and taxes of $2,713 million, had a book value of equity of $23,879 million and a book value of debt of 14,130 million. With a tax rate of 37.3%, we get Return on Capital = 2713(1-.373)/ (23879+14130) = 4.48% Cost of Capital for Disney= 8.59% Excess Return = 4.48%-8.59% = -4.11%

This can be converted into a dollar figure by multiplying by the capital invested, in which case it is called economic value added EVA = (..0448- .0859) (23879+14130) = - $1,562 million 117 Application Test: Assessing Investment Quality For the most recent period for which you have data, compute the aftertax return on capital earned by your firm, where after-tax return on capital is computed to be After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of Equity) previous year For the most recent period for which you have data, compute the return spread earned by your firm: Return Spread = After-tax ROC - Cost of Capital For the most recent period, compute the EVA earned by your firm EVA = Return Spread * ((BV of debt + BV of Equity) previous year 118 The cash flow view of this project.. 0 1 Operating Income after Taxes + Depreciation & Amortization

- Capital Expenditures $2,500 $1,000 - Change in Working Capital $0 $0 Cashflow to Firm -$2,500 -$1,000 2 -$165 $537 $1,269 $63 -$960 3 -$77 $508 $805 $25 -$399 4 $75 $430 $301 $38 $166 5 $206 $359 $287 $31 $247

6 $251 $357 $321 $16 $271 To get from income to cash flow, we added back all non-cash charges such as depreciation subtracted out the capital expenditures subtracted out the change in non-cash working capital 119 The incremental cash flows on the project $ 500 million has already been spent Now (0) 1 Operating Income after Taxes $537 $508 $430 $359 $357 $358 $361 $366 $369 + Depreciation & ortization Am - CapitalExpenditures - ChangeniWorkingCapital $2,500 $1,000 $1,269 $805 $301 $287 $321 $358 $379 $403 $406 $0 + Non -incrementa

l Allocated Expense (1-t) + Sun k Costs Cashflow to Firm 2 3 4 5 6 7 8 9 10 -$165 -$77 $75 $206 $251 $297 $347 $402 $412 $0 $63 $25 $38 $31 $16 $17 $19 $21 $5 $0 $78 $110 $157 $196 $216 $237 $261 $287 $293 500

-$2,000 -$1,000 -$880 -$289 $324 $443 $486 $517 $571 $631 $663 2/3rd of allocated G&A is fixed. Add back this amount (1-t) To get from cash flow to incremental cash flows, we Taken out of the sunk costs from the initial investment Added back the non-incremental allocated costs (in after-tax terms) 120 To Time-Weighted Cash Flows Incremental cash flows in the earlier years are worth more than incremental cash flows in later years. In fact, cash flows across time cannot be added up. They have to be brought to the same point in time before aggregation. This process of moving cash flows through time is discounting, when future cash flows are brought to the present compounding, when present cash flows are taken to the future The discounting and compounding is done at a discount rate that will reflect Expected inflation: Higher Inflation -> Higher Discount Rates Expected real rate: Higher real rate -> Higher Discount rate Expected uncertainty: Higher uncertainty -> Higher Discount Rate 121

Present Value Mechanics Cash Flow Type 1. Simple CF 2. Annuity 3. Growing Annuity Discounting Formula CFn / (1+r)n Compounding Formula CF0 (1+r)n 1 1 n (1+ r) A r (1 + g)n 1 (1 + r)n A(1 + g) r -g (1 + r)n - 1

A r 4. Perpetuity A/r 5. Growing Perpetuity Expected Cashflow next year/(r-g) 122 Discounted cash flow measures of return Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment). NPV = Sum of the present values of all cash flows on the project, including the initial investment, with the cash flows being discounted at the appropriate hurdle rate (cost of capital, if cash flow is cash flow to the firm, and cost of equity, if cash flow is to equity investors) Decision Rule: Accept if NPV > 0 Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the net present value equal to zero. It is the percentage rate of return, based upon incremental time-weighted cash

flows. Decision Rule: Accept if IRR > hurdle rate 123 Closure on Cash Flows In a project with a finite and short life, you would need to compute a salvage value, which is the expected proceeds from selling all of the investment in the project at the end of the project life. It is usually set equal to book value of fixed assets and working capital In a project with an infinite or very long life, we compute cash flows for a reasonable period, and then compute a terminal value for this project, which is the present value of all cash flows that occur after the estimation period ends.. Assuming the project lasts forever, and that cash flows after year 9 grow 2% (the inflation rate) forever, the present value at the end of year 10 of cash flows after that can be written as: Terminal Value in year 10= CF in year 11/(Cost of Capital - Growth Rate) =663 (1.02) /(.1066-.02) = $ 7,810 million 124 Which yields a NPV of.. Year 0 1 2 3 4

5 6 7 8 9 10 Annual Cashflo w -$2,000 -$1,000 -$880 -$289 $324 $443 $486 $517 $571 $631 $663 Terminal Value $7,810 Present Value -$2,000 -$904 -$719 -$213 $216 $267 $265

$254 $254 $254 $3,076 $749 125 Which makes the argument that.. The project should be accepted. The positive net present value suggests that the project will add value to the firm, and earn a return in excess of the cost of capital. By taking the project, Disney will increase its value as a firm by $749 million. 126 The IRR of this project Figure 5.5: NPV Profile for Disney Theme Park $4,000.00 $3,000.00 $2,000.00 Internal Rate of Return $1,000.00 NPV $0.00 8%

9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30% -$1,000.00 -$2,000.00 -$3,000.00 Discount Rate 127 The IRR suggests.. The project is a good one. Using time-weighted, incremental cash flows, this project provides a return of 11.97%. This is greater than the cost of capital of 10.66%. The IRR and the NPV will yield similar results most of the time, though there are differences between the two approaches that may cause project rankings to vary depending upon the approach used. 128 Currency Choices and NPV The analysis was done in dollars. Would the conclusions have been any different if we had done the analysis in Thai Baht? a) Yes b) No 129

Disney Theme Park: Thai Baht NPV Inflation rate in Thailand = 10% Inflation rate in US = 2% Bt/$ in year 1 = 42.09 (1.10/1.02) = 45.39 Year 0 1 2 3 4 5 6 7 8 9 10 Cashflow ($) -2000 -1000 -880 -289 324 443 486 517 571 631 8474 Bt/$ 42.09

45.39 48.95 52.79 56.93 61.40 66.21 71.40 77.01 83.04 89.56 Cashflow (Bt) Present Value -84180 -84180 -45391 -38034 -43075 -30243 -15262 -8979 18420 9080 27172 11223 32187 11140 36920 10707 43979 10687 52412 10671 758886 129470 31542

NPV = 31,542 Bt/42.09 Bt = $ 749 Million NPV is equal to NPV in dollar terms 130 The Role of Sensitivity Analysis Our conclusions on a project are clearly conditioned on a large number of assumptions about revenues, costs and other variables over very long time periods. To the degree that these assumptions are wrong, our conclusions can also be wrong. One way to gain confidence in the conclusions is to check to see how sensitive the decision measure (NPV, IRR..) is to changes in key assumptions. 131 Side Costs and Benefits Most projects considered by any business create side costs and benefits for that business.

The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have. The benefits that may not be captured in the traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay, expand or abandon a project). The returns on a project should incorporate these costs and benefits. 132 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics.

133 Finding the Right Financing Mix: The Capital Structure Decision 134 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm 135 Owners

Earnings Revenues Venture Retire Debt External Moderate, Declining, Internal Common Stage Low, High, More Accessing Inital Seasoned Bond Financing $Growth Time Negative Revenues/ as relative Public than issues 35412relative but debt stage Capital projects financing

Equity funding stock equity or relative private funding asoffering to atoChoices dry issue equity needs across the life cycle Financing Earnings Rapid Start-up Mature Decline Financing Bank Common Repurchase needs constrained to percent up. Warrants High low funding Transitions

firmGrowth Debt Expansion value. Growth of needs Stock firm by stock infrastructure value Convertibles 136 Measuring a firms financing mix The simplest measure of how much debt and equity a firm is using currently is to look at the proportion of debt in the total financing. This ratio is called the debt to capital ratio: Debt to Capital Ratio = Debt / (Debt + Equity) Debt includes all interest bearing liabilities, short term as well as long term. Equity can be defined either in accounting terms (as book value of equity) or in market value terms (based upon the current price). The resulting debt ratios can be very different. 137

Debt: Summarizing the Trade Off Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit: 1. Bankruptcy Cost: Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost 2. Added Discipline: 2. Agency Cost: Greater the separation between managers Greater the separation between stock- and stockholders --> Greater the benefit holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost 138 A Hypothetical Scenario Assume you operate in an environment, where

(a) there are no taxes (b) there is no separation between stockholders and managers. (c) there is no default risk (d) there is no separation between stockholders and bondholders (e) firms know their future financing needs 139 The Miller-Modigliani Theorem In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. The value of a firm is independent of its debt ratio. 140 Implications of MM Theorem Leverage is irrelevant. A firm's value will be determined by its project cash flows. The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage 141 Pathways to the Optimal

The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm. The Sector Approach: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of financing mix. 142 I. The Cost of Capital Approach Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized. 143 Applying Cost of Capital Approach: The Textbook Example D/(D+E) ke kd After-tax Cost of Debt WACC 0 10.50%

8% 4.80% 10.50% 10% 11% 8.50% 5.10% 10.41% 20% 11.60% 9.00% 5.40% 10.36% 30% 12.30% 9.00% 5.40% 10.23% 40% 13.10% 9.50%

5.70% 10.14% 50% 14% 10.50% 6.30% 10.15% 60% 15% 12% 7.20% 10.32% 70% 16.10% 13.50% 8.10% 10.50% 80%

17.20% 15% 9.00% 10.64% 90% 18.40% 17% 10.20% 11.02% 100% 19.70% 19% 11.40% 11.40% 144 WACC and Debt Ratios 100% 90%

80% 70% 60% 50% 40% 30% 20% 10% 11.40% 11.20% 11.00% 10.80% 10.60% 10.40% 10.20% 10.00% 9.80% 9.60% 9.40% 0 WACC Weighted Average Cost of Capital and Debt Ratios Debt Ratio

145 Current Cost of Capital: Disney Equity Cost of Equity = Riskfree rate + Beta * Risk Premium = 4% + 1.25 (4.82%) = 10.00% Market Value of Equity = $55.101 Billion Equity/(Debt+Equity ) = 79% Debt After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t) = (4%+1.25%) (1-.373) = 3.29% Market Value of Debt = $ 14.668 Billion Debt/(Debt +Equity) = 21% Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59% 55.101/ (55.101+14.668) 146 Mechanics of Cost of Capital Estimation 1. Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Beta will increase -> Cost of Equity will

increase. Estimation will use levered beta calculation 2. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense) 3. Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price. 147 Estimating Cost of Equity Unlevered Beta = 1.0674 (Bottom up beta based upon Disneys businesses) Market premium = 4.82% T.Bond Rate = 4.00% Tax rate=37.3% Debt Ratio D/E Ratio Levered Beta Cost of Equity 0.00% 0.00% 1.0674 9.15% 10.00% 11.11% 1.1418 9.50% 20.00% 25.00% 1.2348 9.95%

30.00% 42.86% 1.3543 10.53% 40.00% 66.67% 1.5136 11.30% 50.00% 100.00% 1.7367 12.37% 60.00% 150.00% 2.0714 13.98% 70.00% 233.33% 2.6291 16.67% 80.00% 400.00% 3.7446 22.05% 90.00% 900.00% 7.0911 38.18% 148 Estimating Cost of Debt Start with the current market value of the firm = 55,101 + 14668 = $69, 769 mil D/(D+E) 0.00%

10.00% Debt to capital D/E 0.00% 11.11% D/E = 10/90 = .1111 $ Debt $0 $6,977 10% of $69,769 EBITDA Depreciation EBIT Interest $3,882 $1,077 $2,805 $0 $3,882 $1,077 $2,805 $303 Same as 0% debt Same as 0% debt Same as 0% debt Pre-tax cost of debt * $ Debt Pre-tax Int. cov Likely Rating Pre-tax cost of debt

AAA 4.35% 9.24 AAA 4.35% EBIT/ Interest Expenses From Ratings table Riskless Rate + Spread 149 The Ratings Table Interest Co verage Ratin Ratio g > 8.5 AAA 6.50 - 6.50 AA 5.50 6.50 A+ 4.25 5.50 A 3.00 4.25 A2.50 3.00 BBB 2.05 - 2.50 BB+ 1.90 2.00 BB 1.75 1.90 B+ 1.50 - 1.75

B 1.25 1.50 B0.80 1.25 CCC 0.65 0.80 CC 0.20 0.65 C < 0.20 D Typical de fault spread 0.35% 0.50% 0.70% 0.85% 1.00% 1.50% 2.00% 2.50% 3.25% 4.00% 6.00% 8.00% 10.00% 12.00% 20.00% Market inte rest rate on d ebt 4.35% 4.50% 4.70% 4.85%

5.00% 5.50% 6.00% 6.50% 7.25% 8.00% 10.00% 12.00% 14.00% 16.00% 24.00% 150 A Test: Can you do the 20% level? D/(D+E) 0.00% 10.00% 20.00% 2nd Iteration 3rd? D/E $ Debt 0.00% $0 11.11% $6,977 25.00% $13,954

EBITDA Depreciation EBIT Interest $3,882 $1,077 $2,805 $0 $3,882 $1,077 $2,805 $303 $3,882 $1,077 $2,805 $ 606 .0485*13954=676 Pre-tax Int. cov Likely Rating AAA Cost of debt 4.35% 9.24 AAA 4.35% 4.62 2805/676=4.15 A A4.85% 5.00% 151

Bond Ratings, Cost of Debt and Debt Ratios Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Interest Interest Coverage Debt expense Ratio $0 $0 $6,977 $303 9.24 $13,954 $698 4.02 $20,931 $1,256 2.23 $27,908 $3,349 0.84 $34,885 $5,582 0.50 $41,861 $6,698 0.42 $48,838 $7,814 0.36

$55,815 $8,930 0.31 $62,792 $10,047 0.28 Interest Bond rate on debt Rating AAA 4.35% AAA 4.35% A5.00% BB+ 6.00% CCC 12.00% C 16.00% C 16.00% C 16.00% C 16.00% C 16.00% Cost of Tax Debt Rate (after -tax) 37.30% 2.73% 37.30% 2.73%

37.30% 3.14% 37.30% 3.76% 31.24% 8.25% 18.75% 13.00% 15.62% 13.50% 13.39% 13.86% 11.72% 14.13% 10.41% 14.33% 152 Stated versus Effective Tax Rates You need taxable income for interest to provide a tax savings In the Disney case, consider the interest expense at 30% and 40% 30% Debt Ratio EBIT $ 2,805 m Interest Expense $ 1,256 m Tax Savings $ 1,256*.373=468 Tax Rate 37.30% Pre-tax interest rate 6.00% After-tax Interest Rate 3.76% 40% Debt Ratio $ 2,805 m $ 3,349 m

2,805*.373 = $ 1,046 1,046/3,349= 31.2% 12.00% 8.25% You can deduct only $2,805 million of the $3,349 million of the interest expense at 40%. Therefore, only 37.3% of $ 2,805 million is considered as the tax savings. 153 Disneys Cost of Capital Schedule Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Cost of Equity 9.15% 9.50% 9.95% 10.53% 11.50% 13.33% 15.66% 19.54% 27.31% 50.63%

Cost of Debt (after-tax) 2.73% 2.73% 3.14% 3.76% 8.25% 13.00% 13.50% 13.86% 14.13% 14.33% Cost of Capital 9.15% 8.83% 8.59% 8.50% 10.20% 13.16% 14.36% 15.56% 16.76% 17.96% 154 Disney: Cost of Capital Chart Figure 8.3: Disney Cost of Capital at different Debt Ratios 60.00% 20.00% 18.00% 50.00%

16.00% 14.00% 40.00% Cost of equity climbs as levered beta increases Optimal Debt ratio is at this point 12.00% 30.00% 10.00% 8.00% Costs of debt and equity 20.00% Cost of Capital 6.00% 4.00% 10.00% After-tax cost of debt increases as interest coverage ratio deteriorates and with it the synthetic rating. 0.00%

2.00% 0.00% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt Ratio Cost of Equity After-tax Cost of Debt Cost of Capital 155 Effect on Firm Value

Firm Value before the change = 55,101+14,668= $ 69,769 WACCb = 8.59% WACCa = 8.50% WACC = 0.09% Annual Cost = $69,769 *8.59%= $5,993 million Annual Cost = $69,769 *8.50% = $5,930 million Change in Annual Cost = $ 63 million If there is no growth in the firm value, (Conservative Estimate) Increase in firm value = $63 / .0850= $ 741 million Change in Stock Price = $741/2047.6= $0.36 per share If we assume a perpetual growth of 4% in firm value over time, Increase in firm value = $63 /(.0850-.04) = $ 1,400 million Change in Stock Price = $1,400/2,047.6 = $ 0.68 per share Implied Growth Rate obtained by Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula $69,769 = $1,722(1+g)/(.0859-g): Solve for g -> Implied growth = 5.98% 156 A Test: The Repurchase Price Let us suppose that the CFO of Disney approached you about buying back stock. He wants to know the maximum price that he should be willing to pay on the stock buyback. (The current price is $ 26.91)

Assuming that firm value will grow by 4% a year, estimate the maximum price. What would happen to the stock price after the buyback if you were able to buy stock back at $ 26.91? 157 The Downside Risk Doing What-if analysis on Operating Income A. Standard Deviation Approach Standard Deviation In Past Operating Income Standard Deviation In Earnings (If Operating Income Is Unavailable) Reduce Base Case By One Standard Deviation (Or More) B. Past Recession Approach Look At What Happened To Operating Income During The Last Recession. (How Much Did It Drop In % Terms?) Reduce Current Operating Income By Same Magnitude Constraint on Bond Ratings

158 Disneys Operating Income: History Year EBIT 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 756 848 1177 1368 1124 1287 1560 1804 2262

3024 3945 3843 3580 2525 2832 2384 2713 % Change in EBIT 12.17% 38.80% 16.23% -17.84% 14.50% 21.21% 15.64% 25.39% 33.69% 30.46% -2.59% -6.84% -29.47% 12.16% -15.82% 13.80% 159 Disney: Effects of Past Downturns Recession 2002 1991 1981-82

Worst Year Decline in Operating Income Drop of 15.82% Drop of 22.00% Increased Drop of 29.47% The standard deviation in past operating income is about 20%. 160 Disney: The Downside Scenario % Drop in EBITDA EBIT Optimal Debt Ratio 0% $ 2,805 30% 5% $ 2,665 20% 10% $ 2,524

20% 15% $ 2385 20% 20% $ 2,245 20% 161 Constraints on Ratings Management often specifies a 'desired Rating' below which they do not want to fall. The rating constraint is driven by three factors it is one way of protecting against downside risk in operating income (so do not do both) a drop in ratings might affect operating income there is an ego factor associated with high ratings Caveat: Every Rating Constraint Has A Cost. Provide Management With A Clear Estimate Of How Much The Rating Constraint Costs By Calculating The Value Of The Firm Without The

Rating Constraint And Comparing To The Value Of The Firm With The Rating Constraint. 162 Ratings Constraints for Disney At its optimal debt ratio of 30%, Disney has an estimated rating of BB+. Assume that Disney imposes a rating constraint of A or greater. The optimal debt ratio for Disney is then 20% (see next page) The cost of imposing this rating constraint can then be calculated as follows: Value at 30% Debt = $ 71,239 million - Value at 20% Debt = $ 69,837 million Cost of Rating Constraint = $ 1,376 million 163 Effect of Ratings Constraints: Disney Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Rating AAA AAA ABB+ CCC C C C C C Firm Value $62,279 $66,397 $69,837 $71,239 $51,661 $34,969 $30,920 $27,711 $25,105 $22,948 164 What if you do not buy back stock.. The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate. Will the optimal be different if you invested in projects instead of buying back stock? No. As long as the projects financed are in the same business mix that the

company has always been in and your tax rate does not change significantly. Yes, if the projects are in entirely different types of businesses or if the tax rate is significantly different. 165 Analyzing Financial Service Firms The interest coverage ratios/ratings relationship is likely to be different for financial service firms. The definition of debt is messy for financial service firms. In general, using all debt for a financial service firm will lead to high debt ratios. Use only interest-bearing long term debt in calculating debt ratios. The effect of ratings drops will be much more negative for financial service firms. There are likely to regulatory constraints on capital 166 Interest Coverage ratios, ratings and Operating income Long Term Interest Coverage Ratio Rating is Spread is Operating Income Decline < 0.05 D 16.00% -50.00% 0.05 0.10

C 14.00% -40.00% 0.10 0.20 CC 12.50% -40.00% 0.20 - 0.30 CCC 10.50% -40.00% 0.30 0.40 B6.25% -25.00% 0.40 0.50 B 6.00% -20.00% 0.50 0.60 B+ 5.75% -20.00% 0.60 0.75 BB 4.75% -20.00% 0.75 0.90 BB+ 4.25% -20.00% 0.90 1.20 BBB 2.00% -20.00% 1.20 1.50

A1.50% -17.50% 1.50 2.00 A 1.40% -15.00% 2.00 2.50 A+ 1.25% -10.00% 2.50 3.00 AA 0.90% -5.00% > 3.00 AAA 0.70% 0.00% 167 Deutsche Bank: Optimal Capital Structure Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Beta 0.44 0.47 0.50 0.55 0.62 0.71 0.84 1.07 1.61 3.29 Cost of Equity 6.15% 6.29% 6.48% 6.71% 7.02% 7.45% 8.10% 9.19% 11.83% 19.91% Bond Interest Tax Cost of Debt Rating rate on debt Rate (after-tax) AAA 4.75% 38.00% 2.95% AAA

4.75% 38.00% 2.95% AAA 4.75% 38.00% 2.95% AAA 4.75% 38.00% 2.95% AAA 4.75% 38.00% 2.95% A+ 5.30% 38.00% 3.29% A 5.45% 38.00% 3.38% A 5.45% 38.00% 3.38% BB+ 8.30% 32.43% 5.61% BB 8.80% 27.19% 6.41% WACC 6.15% 5.96% 5.77% 5.58% 5.39% 5.37% 5.27%

5.12% 6.85% 7.76% Firm Value (G) $111,034 $115,498 $120,336 $125,597 $131,339 $118,770 $114,958 $119,293 $77,750 $66,966 168 Determinants of Optimal Debt Ratios Firm Specific Factors

1. Tax Rate Higher tax rates - - > Higher Optimal Debt Ratio Lower tax rates - - > Lower Optimal Debt Ratio 2. Pre-Tax CF on Firm = EBITDA / MV of Firm Higher Pre-tax CF - - > Higher Optimal Debt Ratio Lower Pre-tax CF - - > Lower Optimal Debt Ratio 3. Variance in Earnings [ Shows up when you do 'what if' analysis] Higher Variance - - > Lower Optimal Debt Ratio Lower Variance - - > Higher Optimal Debt Ratio Macro-Economic Factors 1. Default Spreads Higher Lower - - > Lower Optimal Debt Ratio - - > Higher Optimal Debt Ratio 169 Application Test: Your firms optimal financing mix Using the optimal capital structure spreadsheet provided:

Estimate the optimal debt ratio for your firm Estimate the new cost of capital at the optimal Estimate the effect of the change in the cost of capital on firm value Estimate the effect on the stock price In terms of the mechanics, what would you need to do to get to the optimal immediately? 170 II. Relative Analysis I. Industry Average with Subjective Adjustments The safest place for any firm to be is close to the industry average Subjective adjustments can be made to these averages to arrive at the right debt ratio. Higher tax rates -> Higher debt ratios (Tax benefits) Lower insider ownership -> Higher debt ratios (Greater discipline) More stable income -> Higher debt ratios (Lower bankruptcy costs) More intangible assets -> Lower debt ratios (More agency problems) 171 Comparing to industry averages Disney Entertainment Aracruz Market Debt Ratio 21.02% 19.56% 30.82%

Book Debt Ratio 35.10% 28.86% 43.12% Paper and Pulp (Emerging Market) 27.71% 49.00% 172 A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Yes Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes

No Take good projects with 1. Pay off debt with retained new equity or with retained earnings. earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt. Is the firm a takeover target? Yes Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends No

Buy back stock 173 Disney: Applying the Framework Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Yes Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes No Take good projects with 1. Pay off debt with retained new equity or with retained earnings. earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off

debt. Is the firm a takeover target? Yes Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends No Buy back stock 174 Application Test: Getting to the Optimal

Based upon your analysis of both the firms capital structure and investment record, what path would you map out for the firm? Immediate change in leverage Gradual change in leverage No change in leverage Would you recommend that the firm change its financing mix by Paying off debt/Buying back equity Take projects with equity/debt 175 Designing Debt: The Fundamental Principle The objective in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets. By doing so, we reduce our risk of default, increase debt capacity and increase firm value. 176 Design the perfect financing instrument The perfect financing instrument will

Have all of the tax advantages of debt While preserving the flexibility offered by equity Design Effect Duration Growth Cyclicality Define Duration/ Currency Fixed Straight Special Start Commodity with vs. of Debt debt Features Patterns versus Inflation Floating the &Bonds to haveRate cash flows that match up to cash flows on the assets financed Uncertainty Other Characteristics Maturity *Mix

Convertible on Cash Catastrophe More Debt Flows Effects floating about Notes rate Future - Options on if Assets/ Convertible CF move to make with if inflation cash Projects flows on lowdebt - withbut now match greater cash high flows uncertainty exp.assets

on future growth 177 Ensuring that you have not crossed the line drawn by the tax code All of this design work is lost, however, if the security that you have designed does not deliver the tax benefits. In addition, there may be a trade off between mismatching debt and getting greater tax benefits. Zero Overlay Deductibility Differences If tax Coupons advantages tax inoftax cash are rates flows large enough, you might override results of previous step preferences for across tax different purposeslocales

178 While keeping equity research analysts, ratings agencies and regulators applauding Ratings agencies want companies to issue equity, since it makes them safer. Equity research analysts want them not to issue equity because it dilutes earnings per share. Regulatory authorities want to ensure that you meet their requirements in terms of capital ratios (usually book value). Financing that leaves all three groups happy is nirvana. Operating Consider Analyst Ratings Regulatory Can securities Agency Concerns Leases Concerns be designed that can make these different entities happy? -ratings MIPs Effect agency Measures on Ratios EPS used -&Value Surplus Ratios

analyst relative Notes relative concerns totocomparables comparables 179 Debt or Equity: The Strange Case of Trust Preferred Trust preferred stock has A fixed dividend payment, specified at the time of the issue That is tax deductible And failing to make the payment can cause ? (Can it cause default?) When trust preferred was first created, ratings agencies treated it as equity. As they have become more savvy, ratings agencies have started giving firms only partial equity credit for trust preferred. 180 Debt, Equity and Quasi Equity Assuming that trust preferred stock gets treated as equity by ratings

agencies, which of the following firms is the most appropriate firm to be issuing it? A firm that is under levered, but has a rating constraint that would be violated if it moved to its optimal A firm that is over levered that is unable to issue debt because of the rating agency concerns. 181 Soothe bondholder fears There are some firms that face skepticism from bondholders when they go out to raise debt, because Of their past history of defaults or other actions They are small firms without any borrowing history Bondholders tend to demand much higher interest rates from these firms to reflect these concerns. Convertibiles Factor Observability Type Existing If agency ofinAssets Debt problems agency of covenants

financed Cash areFlows substantial, consider issuing convertible bonds conflicts -by Puttable Tangible Restrictions Lenders Bonds between andon liquid Financing stock assets -and create Rating Less bond less observable Sensitive holders agency cash problems flows lead to more Notes conflicts LYONs 182

And do not lock in market mistakes that work against you Ratings agencies can sometimes under rate a firm, and markets can under price a firms stock or bonds. If this occurs, firms should not lock in these mistakes by issuing securities for the long term. In particular, Issuing equity or equity based products (including convertibles), when equity is under priced transfers wealth from existing stockholders to the new stockholders Issuing long term debt when a firm is under rated locks in rates at levels that are far too high, given the firms default risk. What is the solution If you need to use equity? If you need to use debt? 183 Designing Debt: Bringing it all together Start with the Cash Flows on Assets/ Projects Define Debt Characteristics Duration Currency

Effect of Inflation Uncertainty about Future Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Cyclicality & Other Effects Growth Patterns Straight versus Convertible - Convertible if cash flows low now but high exp. growth Special Features on Debt - Options to make cash flows on debt match cash flows on assets

Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Overlay tax preferences Consider ratings agency & analyst concerns Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough, you might override results of previous step Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Operating Leases MIPs Surplus Notes

Can securities be designed that can make these different entities happy? Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing If agency problems are substantial, consider issuing convertible bonds Consider Information Asymmetries Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt Convertibiles Puttable Bonds Rating Sensitive

Notes LYONs 184 The Right Debt for Disney Business Movies Broadcasting Project Cash Flow Characteristics Projects are likely to 1. Be short term 2. Have cash outflows primaril y in dollars (sinceDisneymakesmost of its movies in theU.S.) but cashinflows could havea substantial foreign currency component (becausef overseas o sales) 3. Have net cash flows thatear heavily driven by whether the movie is a hit, which is often difficul t to predict. Projects are likel y to be 1. Short term 2. Primarily in dollars, though foreign componentis growing 3. Driven by advertising revenuesandshowsuccess Type of Financing Debt should be 1. Short term 2. Primarily dollar debt. 3. If possible,tied to the success of movies.(Lion King or

Nemo Bonds) Debt should be 1. Short term 2. Primarily dollar debt 3. If possible,linked to network ratings. Theme Parks Projects are likel y to be Debt should be 1. Very long term 1. Long term 2. Primarily in dollars, but a significant proportion of revenues come 2. Mix of currencies,basedupon from foreign tourists, who are likely to stay away if the dollar tourist make up. strengthens 3. Affected by success of movie and broadcast ing divisions. Consumer Products Projectsare likely to be shor t to mediumterm and linked to the success ofDebt should be the movie division. Most of Disneys product offerings are derived from a. Medium term their movieproductions. b. Dollar debt. 185 Analyzing Disneys Current Debt

Disney has $13.1 billion in debt with an average maturity of 11.53 years. Even allowing for the fact that the maturity of debt is higher than the duration, this would indicate that Disneys debt is far too long term for its existing business mix. Of the debt, about 12% is Euro debt and no yen denominated debt. Based upon our analysis, a larger portion of Disneys debt should be in foreign currencies. Disney has about $1.3 billion in convertible debt and some floating rate debt, though no information is provided on its magnitude. If floating rate debt is a relatively small portion of existing debt, our analysis would indicate that Disney should be using more of it. 186 Adjusting Debt at Disney It can swap some of its existing long term, fixed rate, dollar debt with shorter term, floating rate, foreign currency debt. Given Disneys standing in financial markets and its large market capitalization, this should not be difficult to do. If Disney is planning new debt issues, either to get to a higher debt ratio or to fund new investments, it can use primarily short term, floating rate, foreign currency debt to fund these new investments. While it may be mismatching the funding on these investments, its debt matching will become better at the company level. 187 Returning Cash to the Owners: Dividend Policy 188

First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm 189 Steps to the Dividend Decision Cashflow Cashflows Reinvestment Cash Stock Dividends

How What much good is do available held Paid Buybacks ayour reasonable are back out to from didDebt back your you borrow? investment cash balance? choices? from (Principal Operations into for by stockholders the return thecompany business

to repaid, toprefer? Operations Interest Equity stockholders Investors Expenses) 190 I. Dividends are sticky 191 II. Dividends tend to follow earnings Dividends and Earnings on U.S. companies - 1960 - 2004 60.00 50.00 40.00 Earnings 30.00 Dividends Dividends & Earnings 20.00 10.00

0.00 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

1995 1996 1997 1998 1999 2000 2001 2002 2003 Year 192 III. More and more firms are buying back stock, rather than pay dividends... Stock Buybacks and Dividends: Aggregate for US Firms - 1989-2002 $300,000.00 $250,000.00 $200,000.00 $150,000.00 $ Dividends & Buybacks $100,000.00 $50,000.00 $1988 1989 1990

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year Stock Buybacks Dividends 193 IV. But the change in dividend tax law in 2003 may cause a shift back to dividends 194

Measures of Dividend Policy Dividend Payout: measures the percentage of earnings that the company pays in dividends = Dividends / Earnings Dividend Yield : measures the return that an investor can make from dividends alone = Dividends / Stock Price 195 Dividend Payout Ratios: January 2005 Payout Ratio: US companies in January 2005 300 250 200 150 100 50 0 0-10%

10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% 90-100% >100% 196 Dividend Yields in the United States: January 2005 Dividend Yields: US companies in January 2005 140 5362 companies paid no dividends in 2004 1729 companies paid dividends 120 100 80

60 40 20 0 002- 0.4- 0.60.2% 0.4% 0.6% 0.8% 0.81% 11.2- 1.4- 1.61.2% 1.4% 1.6% 1.8% 1.82% 22.2- 2.4- 2.62.2% 2.4% 2.6% 2.8% 2.83% 33.5% 3.54% 44.5% 4.55% >5% 197 Three Schools Of Thought On Dividends 1. If

(a) there are no tax disadvantages associated with dividends (b) companies can issue stock, at no cost, to raise equity, whenever needed Dividends do not matter, and dividend policy does not affect value. 2. If dividends have a tax disadvantage, Dividends are bad, and increasing dividends will reduce value 3. If stockholders like dividends, or dividends operate as a signal of future prospects, Dividends are good, and increasing dividends will increase value 198 The balanced viewpoint If a company has excess cash, and few good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is good. If a company does not have excess cash, and/or has several good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is bad. 199 Assessing Dividend Policy

Approach 1: The Cash/Trust Nexus Assess how much cash a firm has available to pay in dividends, relative what it returns to stockholders. Evaluate whether you can trust the managers of the company as custodians of your cash. Approach 2: Peer Group Analysis Pick a dividend policy for your company that makes it comparable to other firms in its peer group. 200 I. The Cash/Trust Assessment Step 1: How much could the company have paid out during the period under question? Step 2: How much did the the company actually pay out during the period in question? Step 3: How much do I trust the management of this company with excess cash? How well did they make investments during the period in question? How well has my stock performed during the period in question? 201 A Measure of How Much a Company Could have Afforded to Pay out: FCFE

The Free Cashflow to Equity (FCFE) is a measure of how much cash is left in the business after non-equity claimholders (debt and preferred stock) have been paid, and after any reinvestment needed to sustain the firms assets and future growth. Net Income + Depreciation & Amortization = Cash flows from Operations to Equity Investors - Preferred Dividends - Capital Expenditures - Working Capital Needs - Principal Repayments + Proceeds from New Debt Issues = Free Cash flow to Equity 202 Estimating FCFE when Leverage is Stable Net Income - (1- ) (Capital Expenditures - Depreciation) - (1- ) Working Capital Needs = Free Cash flow to Equity = Debt/Capital Ratio For this firm, Proceeds from new debt issues = Principal Repayments + (Capital Expenditures - Depreciation + Working Capital Needs) 203 An Example: FCFE Calculation Consider the following inputs for Microsoft in 1996. In 1996, Microsofts FCFE was:

Net Income = $2,176 Million Capital Expenditures = $494 Million Depreciation = $ 480 Million Change in Non-Cash Working Capital = $ 35 Million Debt Ratio = 0% FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (!-DR) = $ 2,176 - (494 - 480) (1-0) = $ 2,127 Million - $ 35 (1-0) 204 Microsoft: Dividends? By this estimation, Microsoft could have paid $ 2,127 Million in dividends/stock buybacks in 1996. They paid no dividends and bought back no stock. Where will the $2,127 million show up in Microsofts balance sheet? 205 Dividends versus FCFE: U.S. Figure 11.2: Dividends paid as % of FCFE 300

250 200 150 Number of firms 100 50 0 0 -5% 5-10% >100% 10-15% 15-20% 20-25% 25-30% 30-35% 35-40% 40-45% 45-50% 50-55% 55-60% 60-65% 65-70% 70-75% 75-80% 80-85% 85-90% 90-95% 95-100% Dividends/FCFE

Dividends with negative FCFE 206 The Consequences of Failing to pay FCFE Chrysler: FCFE, Dividends and Cash Balance $3,000 $9,000 $8,000 $2,500 $7,000 $2,000 $6,000 $1,500 $5,000 $4,000 $1,000 Cash Flow Cash Balance $3,000 $500 $2,000 $0 1985 1986

1987 1988 1989 1990 1991 1992 1993 1994 ($500) $1,000 $0 Year = Free CF to Equity = Cash to Stockholders Cumulated Cash 207 Application Test: Estimating your firms FCFE In General, Net Income

+ Depreciation & Amortization - Capital Expenditures - Change in Non-Cash Working Capital - Preferred Dividend - Principal Repaid + New Debt Issued = FCFE Compare to Dividends (Common) + Stock Buybacks If cash flow statement used Net Income + Depreciation & Amortization + Capital Expenditures + Changes in Non-cash WC + Preferred Dividend + Increase in LT Borrowing + Decrease in LT Borrowing + Change in ST Borrowing = FCFE -Common Dividend - Decrease in Capital Stock + Increase in Capital Stock 208 A Practical Framework for Analyzing Dividend Policy How much did the firm pay out? How much could it have afforded to pay out? What it could have paid out What it actually paid out Net Income

Dividends - (Cap Ex - Deprn) (1-DR) + Equity Repurchase - Chg Working Capital (1-DR) = FCFE Firm pays out too little FCFE > Dividends Firm pays out too much FCFE < Dividends Do you trust managers in the company with your cash? Look at past project choice: Compare ROE to Cost of Equity ROC to WACC What investment opportunities does the firm have? Look at past project choice: Compare ROE to Cost of Equity ROC to WACC Firm has history of good project choice and good projects in the future Firm has history of poor project choice Firm has good projects

Give managers the flexibility to keep cash and set dividends Force managers to justify holding cash or return cash to stockholders Firm should cut dividends and reinvest more Firm has poor projects Firm should deal with its investment problem first and then cut dividends 209 A Dividend Matrix Quality Poor Good Cash projects Surplus Deficit projects

of projects + +Poor Good Good Poor taken: ROE versus Cost of Equity Projects Maximum Significant Reduce Cut out dividends cash flexibility pressure payout, but intoif setting pay any, real out problem to stockholders dividend moreistoinpolicy stockholderspolicy. investment as dividends or stock buybacks 210

Disney: An analysis of FCFE from 1994-2003 Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Net Capital Income Depreciation Expend itures $1,110.40 $1,608.30 $1,026.11 $1,380.10 $1,853.00 $896.50 $1,214.00 $3,944.00 $13,464.00 $1,966.00 $4,958.00 $1,922.00 $1,850.00 $3,323.00 $2,314.00 $1,300.00 $3,779.00 $2,134.00 $920.00 $2,195.00 $2,013.00 ($158.00) $1,754.00 $1,795.00 $1,236.00 $1,042.00 $1,086.00 $1,267.00 $1,077.00 $1,049.00 Average $1,208.55 $2,553.33 $2,769.96 Changein FCFE

FCFE non-cash (befor e Net CF (after WC debtCF) fromDebt DebtCF) $654.10 $1,038.49 $551.10 $1,589.59 ($270.70 ) $2,607.30 $14.20 $2,621.50 $617.00 ($8,923.00) $8,688.00 ($235.00) ($174.00) $5,176.00 ($1,641.00)$3,535.00 $939.00 $1,920.00 $618.00 $2,538.00 ($363.00) $3,308.00 ($176.00) $3,132.00 ($1,184.00) $2,286.00 ($2,118.00) $168.00 $244.00 ($443.00) $77.00 ($366.00) $27.00 $1,165.00 $1,892.00 $3,057.00 ($264.00) $1,559.00 ($1,145.00) $414.00 $22.54 $969.38 $676.03 $1,645.41 211 Disneys Dividends and Buybacks from 1994 to 2003 Disney Year

Dividends (in $) Equity Repurchases (in $) Cash to Equity 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 $153 $180 $271 $342 $412 $0 $434 $438 $428 $429 $571 $349 $462 $633 $30

$19 $166 $1,073 $0 $0 $724 $529 $733 $975 $442 $19 $600 $1,511 $428 $429 Average $ 308.70 $ 330.30 $ 639 212 Disney: Dividends versus FCFE Disney paid out $ 330 million less in dividends (and stock buybacks) than it could afford to pay out (Dividends and stock buybacks were $639 million; FCFE before net debt issues was $969 million). How much cash do you think Disney accumulated during the period?

213 Disneys track record on projects and stockholder wealth Figure 11.3: ROE, Return on Stock and Cost of Equity: Disney Disney acquired Cap Cities in 1996 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -10.00% -20.00% -30.00% 1994 1995 1996 1997 1998

1999 2000 2001 2002 2003 Year ROE Return on Stock Cost of Equity 214 Can you trust Disneys management? Given Disneys track record over the last 10 years, if you were a Disney stockholder, would you be comfortable with Disneys dividend policy? Yes No 215 The Bottom Line on Disney Dividends

Disney could have afforded to pay more in dividends during the period of the analysis. It chose not to, and used the cash for acquisitions (Capital Cities/ABC) and ill fated expansion plans (Go.com). While the company may have flexibility to set its dividend policy a decade ago, its actions over that decade have frittered away this flexibility. Bottom line: Large cash balances will not be tolerated in this company. Expect to face relentless pressure to pay out more dividends. 216 Aracruz: Dividends and FCFE: 1998-2003 Year 1998 1999 2000 2001 2002 2003 Net Income $3.45 $90.77 $201.71

$18.11 $111.91 $148.09 Average $95.67 Change in FCFE Capital non-cash (before net Net Debt DepreciationExpenditures WC Debt CF) Cashflow $152.80 $88.31 $76.06 ($8.11) $174.27 $158.83 $56.47 $2.18 $190.95 ($604.48) $167.96 $219.37 $12.30 $138.00 ($292.07) $162.57 $421.49 ($56.76) ($184.06) $318.24 $171.50 $260.70 ($5.63) $28.34 $36.35 $162.57 $421.49 ($7.47)

($103.37) $531.20 $162.70 $244.64 $3.45 $10.29 $27.25 FCFE (after net Debt CF) $166.16 ($413.53) ($154.07) $134.19 $64.69 $427.83 $37.54 217 Aracruz: Cash Returned to Stockholders Year 1998 1999 2000 2001 2002 2003 1998 2003

Net IncomeDividendsPayout Ra tio $3.45 $90.77 $201.71 $18.11 $111.91 $148.09 $574.04 $24.39 $18.20 $57.96 $63.17 $73.80 $109.31 $346.83 FCFE Cash retur nedto Cash Returned/FCFE Stockholders 707.51% $166.16 $50.79 30.57% 20.05% ($413.53) $18.20 NA 28.74% ($154.07) $80.68 NA 348.87% $134.19 $63.17

47.08% 65.94% $64.69 $75.98 117.45% 73.81% $427.83 $112.31 26.25% 60.42% $225.27 $401.12 178.07% 218 Aracruz: Stock and Project Returns Figure 11.4: ROE, Return on Stock and Cost of Equity: Aracruz 40.00% 30.00% 20.00% 10.00% 0.00% -10.00% -20.00% 1998 1999

2000 ROE 2001 Return on stock 2002 2003 1998-2003 Cost of Equity 219 Aracruz: Its your call.. Assume that you are a large stockholder in Aracruz. They have been paying more in dividends than they have available in FCFE. Their project choice has been acceptable and your stock has performed well over the period. Would you accept a cut in dividends? Yes No 220 Mandated Dividend Payouts

There are many countries where companies are mandated to pay out a certain portion of their earnings as dividends. Given our discussion of FCFE, what types of companies will be hurt the most by these laws? Large companies making huge profits Small companies losing money High growth companies that are losing money High growth companies that are making money 221 BP: Dividends- 1983-92 1 Net Income 2 3 4 5 6 7 8 10 $712.00

$947.00 $1,256.00 $1,626.00 $2,309.00 $1,098.00 $2,076.00 - (Cap. Exp - Depr)*(1-DR) $1,499.00 $1,281.00 $1,737.50 $1,600.00 $580.00 Working Capital*(1-DR) $369.50 ($286.50) $678.50 = Free CF to Equity ($612.50) $631.50 ($107.00) ($584.00) $3,764.00 $1,940.50 $1,022.00 $831.00

$949.00 $1,079.00 $1,314.00 $1,391.00 $1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00 $831.00 $949.00 $1,079.00 $1,314.00 $1,391.00 $1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00 66.16% 58.36% Dividends $82.00 $2,140.00 $2,542.00 $2,946.00 9 $1,184.00 $1,090.50 $1,975.50 $1,545.50 $1,100.00 ($2,268.00) ($984.50) $429.50

$1,047.50 ($77.00) ($305.00) ($415.00) ($528.50) $262.00 + Equity Repurchases = Cash to Stockholders Dividend Ratios Payout Ratio Cash Paid as % of FCFE -135.67% 46.73% 119.67% 67.00% 91.64% 68.69% 64.32% 296.63% 177.93% 150.28% -1008.41% -225.00%

36.96% 101.06% 170.84% -2461.04% -399.62% 643.13% Performance Ratios 1. Accounting Measure ROE 9.58% 12.14% 19.82% 9.25% 12.43% 15.60% 21.47% 19.93% 4.27% 7.66% Required rate of return 19.77%

6.99% 27.27% 16.01% 5.28% 14.72% 26.87% -0.97% 25.86% 7.12% -10.18% 5.16% -7.45% -6.76% 7.15% 0.88% -5.39% 20.90%

-21.59% 0.54% Difference 222 BP: Summary of Dividend Policy Summary of calculations Average Standard Deviation $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 11.49% 20.90% -21.59% Free CF to Equity Dividend Payout Ratio 84.77% Cash Paid as % of FCFE 262.00% ROE - Required return -1.67% Maximum Minimum 223 BP: Just Desserts! 224

The Limited: Summary of Dividend Policy: 1983-1992 Summary of calculations Average Standard Deviation Maximum Minimum Free CF to Equity ($34.20) $109.74 $96.89 ($242.17) Dividends $40.87 $32.79 $101.36 $5.97 Dividends+Repurchases $40.87 $32.79

$101.36 $5.97 Dividend Payout Ratio 18.59% 19.07% 29.26% -19.84% Cash Paid as % of FCFE -119.52% ROE - Required return 1.69% 225 Growth Firms and Dividends High growth firms are sometimes advised to initiate dividends because its increases the potential stockholder base for the company (since there are some investors - like pension funds - that cannot buy stocks that do not pay dividends) and, by extension, the stock price. Do you agree with this argument? Yes No Why? 226

Summing up Figure 11.5: Analyzing Dividend Policy Poor Projects Good Projects Increase payout Flexibility to Reduce Investment accumulate cash Disney Cash Returned < FCFE Microsoft Aracruz Cash Returned > FCFE Cut payout Cut payout Reduce Investment Invest in Projects ROE - Cost of Equity 227 Valuation

Aswath Damodaran 228 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm 229 Discounted Cashflow Valuation: Basis for Approach t = n CF t Value =

t t = 1 (1 + r) where, n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows 230 Equity Valuation The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. Value of Equity = t=n CF to Equity t (1+ k e )t t=1 where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity

The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. 231 Firm Valuation The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. Value of Firm = t=n CF to Firm t (1+ WACC )t t=1 where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital 232 Generic DCF Valuation Model Length Cash Expected Firm Forever

Terminal CF Discount ......... Value inofValue stable Rate Growth Period growth: of High Growth 1 isflows 2 3 4 5 n DISCOUNTED CASHFLOW GrowsValue Firm:Cost Firm: Pre-debt Growth at constant ofofCapital inFirm cashrate flow Operating forever Earnings Equity: After

Growth Cost Value debt ofofEquity inEquity cashIncome/EPS Net flows VALUATION 233 Estimating Inputs: I. Discount Rates Critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. The cost of equity is the rate at which we discount cash flows to equity (dividends or free cash flows to equity). The cost of capital is the rate at which we discount free cash flows to the firm. 234 Reviewing Disneys Costs of Equity & Debt

Business Medi a Networks Parks an d Resorts Studio Entertainment Consumer Products Disn e y D/E Unlevered Beta Ratio 1.08 5 0 26.6 2 % Lever e d Beta 1.26 6 1 Cost of Equit y 10.1 0 % 0.91 0 5 26.6 2 % 1.06 2 5 9.12% 1.14 3 5

26.6 2 % 1.33 4 4 10.4 3 % 1.13 5 3 1.06 7 4 26.6 2 % 26.6 2 % 1.32 4 8 1.24 5 6 10.3 9 % 10.0 0 % Disneys Cost of Debt (based upon rating) = 5.25% Disneys tax rate = 37.3% 235 Current Cost of Capital: Disney Equity Cost of Equity = Riskfree rate + Beta * Risk Premium = 4% + 1.25 (4.82%) = 10.00% Market Value of Equity = $55.101 Billion Equity/(Debt+Equity ) = 79%

Debt After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t) = (4%+1.25%) (1-.373) = 3.29% Market Value of Debt = $ 14.668 Billion Debt/(Debt +Equity) = 21% Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59% 55.101/ (55.101+14.668) 236 II. Estimating Cash Flows EBIT To The Equity Firm Strict Broader (1-t) View View Cash Flows Dividends -Net ( Cap Income Ex +- Depreciation)

-Stock Net Cap Change Buybacks in ExWorking (1-Debt Capital Ratio) - Chg = FreeWC Cashflow (1 - Debt to Firm Ratio) = Free Cashflow to Equity 237 Estimating FCFF in 2003: Disney EBIT = $ 2,805 Million Tax rate = 37.30% Capital spending = $ 1,735 Million Depreciation = $ 1,254 Million Increase in Non-cash Working capital = $ 454 Million Estimating FCFF EBIT * (1 - tax rate) - Net Capital Expenditures -Change in Working Capital

Free Cashflow to Firm $1,759 $481 $454 $824 : 2805 (1-.373) : (1735 - 1254) Total Reinvestment = Net Cap Ex + Change in WC = 481 + 454 = 935 Reinvestment Rate =935/1759 = 53.18% 238 III. Expected Growth Net Operating Retention R X Return einvestment Income on Ratio= Income Equity Capital = Expected Growth 1 - Dividends/Net

Net Rate EBIT(1-t)/Book Income/Book = (Net CapValue Value of of Income Equity Ex Capital + Chg in WC/EBIT(1-t) 239 Estimating Growth in EBIT: Disney We begin by estimating the reinvestment rate and return on capital for Disney in 2003, using the numbers from the latest financial statements. We did convert operating leases into debt and adjusted the operating income and capital expenditure accordingly. Reinvestment Rate2003 = (Cap Ex Depreciation + Chg in non-cash WC)/ EBIT (1-t) = (1735 1253 + 454)/(2805(1-.373)) = 53.18% Return on capital2003 = EBIT (1-t)2003/ (BV of Debt2002 + BV of Equity2002) = 2805 (1-.373)/ (15,883+23,879) = 4.42% Expected Growth Rate from existing fundamentals = 53.18% * 4.42% = 2.35% We will assume that Disney will be able to earn a return on capital of 12% on its new investments and that the reinvestment rate will be 53.18% for the immediate future.

Expected Growth Rate in operating income = Return on capital * Reinvestment Rate = 12% * .5318 = 6.38% 240 IV. Getting Closure in Valuation A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. t = CFt Value = t t = 1 (1+ r) Since we cannot estimate cash flows forever, we estimate cash flows for a growth period and then estimate a terminal value, to capture the value at the end of the period: Value = t=N CF t + Terminal Value N t (1 + r) t =1 (1 + r) 241 Stable Growth and Terminal Value

When a firms cash flows grow at a constant rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. While companies can maintain high growth rates for extended periods, they will all approach stable growth at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the terminal value of all cash flows beyond. 242 Growth Patterns A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions: there is no high growth, in which case the firm is already in stable growth there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage) there will be high growth for a period, at the end of which the growth rate will decline gradually to a stable growth rate(3-stage)

The assumption of how long high growth will continue will depend upon several factors including: the size of the firm (larger firm -> shorter high growth periods) current growth rate (if high -> longer high growth period) barriers to entry and differential advantages (if high -> longer growth period) 243 Firm Characteristics as Growth Changes Variable Risk Dividend Payout Net Cap Ex Return on Capital Leverage High Growth Firms tend to be above-average risk pay little or no dividends have high net cap ex earn high ROC (excess return) have little or no debt Stable Growth Firms tend to be average risk pay high dividends have low net cap ex earn ROC closer to WACC higher leverage 244

Estimating Stable Growth Inputs Start with the fundamentals: Profitability measures such as return on equity and capital, in stable growth, can be estimated by looking at industry averages for these measure, in which case we assume that this firm in stable growth will look like the average firm in the industry cost of equity and capital, in which case we assume that the firm will stop earning excess returns on its projects as a result of competition. Leverage is a tougher call. While industry averages can be used here as well, it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are, use current leverage; if they are not; use industry averages) Use the relationship between growth and fundamentals to estimate payout and net capital expenditures. 245 Estimating Stable Period Inputs: Disney The beta for the stock will drop to one, reflecting Disneys status as a mature company. This will lower the cost of equity for the firm to 8.82%. Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4% + 4.82% = 8.82%

The debt ratio for Disney will rise to 30%. This is the optimal we computed for Disney earlier and we are assuming that investor pressure will be the impetus for this change. Since we assume that the cost of debt remains unchanged at 5.25%, this will result in a cost of capital of 7.16% Cost of capital = 8.82% (.70) + 5.25% (1-.373) (.30) = 7.16% The return on capital for Disney will drop from its high growth period level of 12% to a stable growth return of 10%. This is still higher than the cost of capital of 7.16% but the competitive advantages that Disney has are unlikely to dissipate completely by the end of the 10th year. The expected growth rate in stable growth will be 4%. In conjunction with the return on capital of 10%, this yields a stable period reinvestment rate of 40%: Reinvestment Rate = Growth Rate / Return on Capital = 4% /10% = 40% 246 Disney: Inputs to Valuation High Growth Phase Transition Phase 5 years 5 years Length of Period Tax Rate 37.3% Return on Capital 12% (last years return o

Stable Growth Phase Forever after 10 years 37.3% 37.3% n Declines linearly to 10% Stable ROC of 10% capital was 4.42%) Reinvestment Rate 53.18% (Last years Declines to 40% as ROC an d 40% of afte r-tax operating (Net Cap Ex + Working Capita l reinvestment rate) growth rates drop: income, estimated from stabl e Investments/EBIT) Reinvestment Rate = g/ROC growth rate of 4% and return

on capital of 10%. Reinvestment rate = 4/10 =40% Expected Growth Rate in EBIT ROC * Reinvestment Rate = Linear decline t o Stable 4%: Set to riskfree rate 12%*0.5318 = 6.38% Growth Rate of 4% Debt/Capital Ratio 21% (Existing debt ratio) Increases linearly to 30% Stable debt ratio of 30% Risk Parameters Beta = 1.25, ke = 10% Beta decreases linearly to 1.00; Beta = 1.00; k e = 8.82%

Cost of Debt = 5.25% Cost of debt stays at 5.25% Cost of debt stays at 5.25% Cost of capital = 8.59% Cost of capital drops to 7.16% Cost of capital = 7.16% 247 Disney: FCFF Estimates Year Current 1 2 3 4 5 6 7 8 9 10 Expected Growth 6.38 % 6.38 % 6.38 % 6.38 %

6.38 % 5.90 % 5.43 % 4.95 % 4.48 % 4.00 % EBIT $2,805 $2,984 $3,174 $3,377 $3,592 $3,822 $4,047 $4,267 $4,478 $4,679 $4,866 EBIT (1t) $1,871 $1,990 $2,117 $2,252 $2,396 $2,538 $2,675 $2,808 $2,934 $3,051 Reinvestment Rate

Reinvestment 53.18 % 53.18 % 53.18 % 53.18 % 53.18 % 50.54 % 47.91 % 45.27 % 42.64 % 40.00 % $994.92 $1,058.41 $1,125.94 $1,197.79 $1,274.23 $1,282.59 $1,281.71 $1,271.19 $1,250.78 $1,220.41 FCFF $876.06 $931.96 $991.43 $1,054.70 $1,122.00 $1,255.13 $1,393.77 $1,536.80 $1,682.90 $1,830.62

248 Disney: Costs of Capital and Present Value Year Cost of c apital FCFF 1 8.59 % $876.06 2 8.59 % $931.96 3 8.59 % $991.43 4 8.59 % $1,054.70 5 8.59 % $1,122.00 6 8.31 % $1,255.13 7 8.02 % $1,393.77 8 7.73 % $1,536.80 9 7.45 %

$1,682.90 10 7.16 % $1,830.62 PV of cashflows during high growth = PV of FCFF $806.74 $790.31 $774.21 $758.45 $743.00 $767.42 $788.91 $807.42 $822.90 $835.31 $7,894.66 249 Disney: Terminal Value and Firm Value Terminal Value FCFF11 = EBIT11 (1-t) (1- Reinvestment RateStable Growth)/ = 4866 (1.04) (1-.40) = $1,903.84 million Terminal Value = FCFF11/ (Cost of capitalStable Growth g) = 1903.84/ (.0716 - .04) = $60,219.11 million Value of firm PV of cashflows during the high growth phase =$ 7,894.66

PV of terminal value =$ 27,477.81 + Cash and Marketable Securities =$ 1,583.00 + Non-operating Assets (Holdings in other companies) =$ 1,849.00 Value of the firm =$ 38,804.48 250 From Firm to Equity Value: What do you subtract out? The first thing you have to subtract out is the debt that you computed (and used in estimating the cost of capital). If you have capitalized operating leases, you should continue to treat operating leases as debt in this stage in the process. This is also your last chance to consider other potential liabilities that may be faced by the firm including Expected liabilities on lawsuits: You could be analyzing a firm that is the defendant in a lawsuit, where it potentially could have to pay tens of millions of dollars in damages. You should estimate the probability that this will occur and use this probability to estimate the expected liability. Unfunded Pension and Health Care Obligations: If a firm has significantly under funded a pension or a health plan, it will need to set aside cash in future years to meet these obligations. While it would not be considered debt for cost of capital purposes, it should be subtracted from firm value to arrive at equity value. Deferred Tax Liability: The deferred tax liability that shows up on the financial statements of many firms reflects the fact that firms often use strategies that reduce their taxes in the current year while increasing their taxes in the future years. 251

From Equity Value to Equity Value per share: The Effect of Options When there are warrants and employee options outstanding, the estimated value of these options has to be subtracted from the value of the equity, before we divide by the number of shares outstanding. There are two alternative approaches that are used in practice: One is to divide the value of equity by the fully diluted number of shares outstanding rather than by the actual number. This approach will underestimate the value of the equity, because it fails to consider the cash proceeds from option exercise. The other shortcut, which is called the treasury stock approach, adds the expected proceeds from the exercise of the options (exercise price multiplied by the number of options outstanding) to the numerator before dividing by the number of shares outstanding. While this approach will yield a more reasonable estimate than the first one, it does not include the time value of the options outstanding. 252 Valuing Disneys options At the end of 2003, Disney had 219 million options outstanding, with a weighted average exercise price of $26.44 and weighted average life

of 6 years. Using the current stock price of $26.91, an estimated standard deviation of 40, a dividend yield of 1.21%. a riskfree rate of 4% and the Black-Scholes option pricing model we arrived at a value of $2,129 million. Since options expenses are tax-deductible, we used the tax rate of 37.30% to estimate the value of the employee options: Value of employee options = 2129 (1- .373) = $1334.67 million 253 Disney: Value of Equity per Share Subtracting out the market value of debt (including operating leases) of $14,668.22 million and the value of the equity options (estimated to be worth $1,334.67 million in illustration 12.10) yields the value of the common stock: Value of equity in common stock = Value of firm Debt Equity Options = $38,804.48 - $14,668.22 - $1334.67 = $ 22,801.59 Dividing by the number of shares outstanding (2047.60 million), we arrive at a value per share o $11.14, well below the market price of $ 26.91 at the time of this valuation. 254 Growth Current Expected Stable Terminal

Cost Weights Discount Op. Riskfree Beta M X Unlevered Firms Reinvestment Return Term Disney EBIT Cashflows In ature transition Assets (1-t) Yr of D/E on was Growth drops market Equity Debt Rate Cashflow Value at

Capital Beta Growth trading phase, Cost Rate to 35,373 $1,871 for : 4% = ofat1,904/(.0716-.04) to Capital about $1,990 Firm$2,117 (WACC) $2,252 ==10.00% 60,219 $2,396 (.79) $2,538+ 3.29% $2,675 (0.21) $2,808 =$2,934 8.59 $3,051 10 + Disney: Valuation EBIT(1-t) in g

(4.00%+1.25%)(1-.373) E + Riskfree 1.2456 premium Sectors: Ratio: $12% debt -53.18%% 10% Reinvestment 3089 26 Cash: ==EBIT 4%; 79% ratio at24.77% the 1.0674 Rate= (1-t) Beta increases D:time = $995 21% 4% =of 3,432 1.00; this

to 30% $1,058 1,759 and $1,126 cost $1,198 $1,274 $1,283 $1,282 $1,271 $1,251 $1,220 - -Nt .5318*.12=.0638 Cost = +Other 4% valuation. of FCFF 3.29% capital 864 CpX ofInv capital decreases $876 = 7.16% to $932 7.16% 481$991 $1,055 $1,122 $1,255 $1,394 $1,537 $1,683 $1,831 6.38 -ROC= = Debt Chg 2225 %WC 10% 14,668

454 = FCFF Reinvestment =Equity 24,136 Rate=g/ROC $ 824 -Reinvestment Options =4/ 10=Rate=(481+454)/1759 1,335 40% =Equity CS 22,802 = 53.18% Value/Sh $11.14 255 Current The Investment Return Reinvestment Expected Existing New Financing Cost Investment Dividend Financing Investments of on capital EBIT

Growth Mix Choices Capital decision (1-t) Rate Decision =Decision 10% Decision Rate affects (.79) = Financing 12% +risk 3.29% * 53.18% of assets (.21) = being 8.59% finance and financing decision affects hurdle rate Disney: Corporate Decisiions and Firm Value Fxed

$ Invest If Choose 12% 53.18% = Investments D=21%; you 1,759 6.38% rate cannot inaE= projects US financing 79% find $ that investments mix earn thata that earn returnwith more minimizes ROC debt = than greater 4.22% duration

the than hurdle a minimum rate rate,and return match the acceptable cash your of 11.5 financing to years the hurdle owners to your rate of the assets. businesss. Year Expected EBIT EBIT Reinvestment Growth (1-t) Reinvestment FCFF Cost Rate PVofofca

Current $2,805 1 6.38% $2,984 $1,871 53.18% $994.92 $876.06 8.59% $806. 2 6.38% $3,174 $1,990 53.18% $1,058.41 $931.96 8.59% $790. 3 6.38% $3,377 $2,117 53.18% $1,125.94 $991.43 8.59% $774. 4 6.38% $3,592 $2,252 53.18% $1,197.79

$1,054.70 8.59% $758. 5 6.38% $3,822 $2,396 53.18% $1,274.23 $1,122.00 8.59% $743. 6 5.90% $4,047 $2,538 50.54% $1,282.59 $1,255.13 8.31% $767. 7 5.43% $4,267 $2,675 47.91% $1,281.71 $1,393.77 8.02% $788. 8 4.95% $4,478 $2,808 45.27%

$1,271.19 $1,536.80 7.73% $807. 9 4.48% $4,679 $2,934 42.64% $1,250.78 $1,682.90 7.45% $822. 10 4.00% $4,866 $3,051 40.00% $1,220.41 $1,830.62 7.16% $835. Terminal Value Value $60,219.11 $27,47 of & $35,3 Opera + Cash Non $3,43 Value of $38,8

firm -- Debt $14,6 Options $1,33 Value of $22,8 equity Value per $11.1 shar 256 Current The Investment Return Reinvestment Expected Existing New Financing Cost Investment Dividend Financing Investments of on capital EBIT Growth Mix Choices Capital decision

(1-t) Rate Decision =Decision 10.53% Decision Rate affects (.70) 15% risk+ * 53.18% of 3.45%(.30) assets being = 8.40% finance and financing decision affects hurdle rate Disney: The Value of= Control Debt $ Invest If Choose 15% 53.18% = Investments D=30%; you 3,417 7.98% incannot

indifferent aE= projects financing 70% find that investments mix earn thata that earn return= more minimizes ROC currencies than greater 8.59% the withthan hurdle a minimum rate rate,and return match the acceptable cash your duration financing to the of 4hurdle owners

years to your rate of the assets. businesss. Year Expected EBIT E BIT Reinvestment Growth (1-t) Reinvestment FCFF Cost PV of Rate of cap FC Current$5,327 1 7.98% $5,752 $3,606 53.18% $1,918 $1,688 8.40% $1,558 2

7.98% $6,211 $3,894 53.18% $2,071 $1,823 8.40% $1,551 3 7.98% $6,706 $4,205 53.18% $2,236 $1,969 8.40% $1,545 4 7.98% $7,241 $4,540 53.18% $2,414 $2,126 8.40% $1,539 5 7.98% $7,819 $4,902 53.18% $2,607 $2,295 8.40% $1,533

6 7.18% $8,380 $5,254 50.54% $2,656 $2,599 8.16% $1,605 7 6.39% $8,915 $5,590 47.91% $2,678 $2,912 7.91% $1,667 8 5.59% $9,414 $5,902 45.27% $2,672 $3,230 7.66% $1,717 9 4.80% $9,865 $6,185 42.64% $2,637 $3,548 7.41%

$1,756 104.00% $10,260 $6,433 40.00% $2,573 $3,860 7.16% $1,783 Terminal Value $126,967 $58,64 Value of $74,90 Oper + Cash $3,432 & No Value of $78,33 firm Debt $14,64 Options $1,335 Value of $62,34 equit Value per sha

$30.45 257 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm 258

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