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    The document discusses corporate finance and the objectives of decision making. It states that traditional corporate finance theory holds that the objective should be to maximize firm value. A narrower objective is to maximize shareholder wealth by maximizing the stock price. However, in practice it can be difficult to align manager interests with shareholder interests to achieve this objective for a few reasons: - Shareholders have limited control over managers through annual meetings and the board of directors. Annual meetings are tightly controlled by management, and most small shareholders do not attend. - The board of directors is not entirely effective at representing shareholders and keeping managers in check, as theory suggests. Managers can exert influence over board decisions and priorities. - Large

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    Aswath Lecture Notes 1

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    The document discusses corporate finance and the objectives of decision making. It states that traditional corporate finance theory holds that the objective should be to maximize firm value. A narrower objective is to maximize shareholder wealth by maximizing the stock price. However, in practice it can be difficult to align manager interests with shareholder interests to achieve this objective for a few reasons: - Shareholders have limited control over managers through annual meetings and the board of directors. Annual meetings are tightly controlled by management, and most small shareholders do not attend. - The board of directors is not entirely effective at representing shareholders and keeping managers in check, as theory suggests. Managers can exert influence over board decisions and priorities. - Large

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    Corporate Finance Lecture

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    The document discusses corporate finance and the objectives of decision making. It states that traditional corporate finance theory holds that the objective should be to maximize firm value. A narrower objective is to maximize shareholder wealth by maximizing the stock price. However, in practice it can be difficult to align manager interests with shareholder interests to achieve this objective for a few reasons: - Shareholders have limited control over managers through annual meetings and the board of directors. Annual meetings are tightly controlled by management, and most small shareholders do not attend. - The board of directors is not entirely effective at representing shareholders and keeping managers in check, as theory suggests. Managers can exert influence over board decisions and priorities. - Large

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    © All Rights Reserved
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    164 views322 pages

    Aswath Lecture Notes 1

    Uploaded by

    jbedi91
    The document discusses corporate finance and the objectives of decision making. It states that traditional corporate finance theory holds that the objective should be to maximize firm value. A narrower objective is to maximize shareholder wealth by maximizing the stock price. However, in practice it can be difficult to align manager interests with shareholder interests to achieve this objective for a few reasons: - Shareholders have limited control over managers through annual meetings and the board of directors. Annual meetings are tightly controlled by management, and most small shareholders do not attend. - The board of directors is not entirely effective at representing shareholders and keeping managers in check, as theory suggests. Managers can exert influence over board decisions and priorities. - Large

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    of 322

    Aswath

    Damodaran 0

    CORPORATE FINANCE
    B40.2302
    LECTURE NOTES: PACKET 1
    Aswath Damodaran
    Aswath Damodaran 1

    THE OBJECTIVE IN CORPORATE


    FINANCE
    If you dont know where you are going, it doesnt
    matter how you get there
    First Principles
    2

    Maximize the value of the business (firm)

    The Investment Decision The Financing Decision The Dividend Decision


    Invest in assets that earn a Find the right kind of debt If you cannot find investments
    return greater than the for your firm and the right that make your minimum
    minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
    rate fund your operations to owners of your business

    The hurdle rate The return How much How you choose
    should reflect the The optimal The right kind
    should reflect the cash you can to return cash to
    riskiness of the mix of debt of debt
    magnitude and return the owners will
    investment and and equity matches the
    the timing of the depends upon depend on
    the mix of debt maximizes firm tenor of your
    cashflows as well current & whether they
    and equity used value assets
    as all side effects. potential prefer dividends
    to fund it. investment or buybacks
    opportunities

    Aswath Damodaran
    2
    The Objective in Decision Making
    3

    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.
    Maximize equity Maximize market
    Maximize value estimate of equity
    firm value
    value
    Assets Liabilities
    Existing Investments Fixed Claim on cash flows
    Generate cashflows today Assets in Place Debt Little or No role in management
    Includes long lived (fixed) and Fixed Maturity
    short-lived(working Tax Deductible
    capital) assets

    Expected Value that will be Growth Assets Equity Residual Claim on cash flows
    created by future investments Significant Role in management
    Perpetual Lives
    Aswath Damodaran
    3
    Maximizing Stock Prices is too narrow an
    objective: A preliminary response
    4

    Maximizing stock price is not incompatible with


    meeting employee needs/objectives. In particular:
    Employees are often stockholders in many firms
    Firms that maximize stock price generally are profitable
    firms that can afford to treat employees well.
    Maximizing stock price does not mean that
    customers are not critical to success. In most
    businesses, keeping customers happy is the route to
    stock price maximization.
    Maximizing stock price does not imply that a
    company has to be a social outlaw.
    Aswath Damodaran
    4
    Why traditional corporate financial theory
    focuses on maximizing stockholder wealth.
    5

    Stock price is easily observable and constantly updated


    (unlike other measures of performance, which may not
    be as easily observable, and certainly not updated as
    frequently).
    If investors are rational (are they?), stock prices reflect
    the wisdom of decisions, short term and long term,
    instantaneously.
    The objective of stock price performance provides some
    very elegant theory on:
    Allocating resources across scarce uses (which investments to
    take and which ones to reject)
    how to finance these investments
    how much to pay in dividends

    Aswath Damodaran
    5
    The Classical Objective Function
    6

    STOCKHOLDERS

    Hire & fire Maximize


    managers stockholder
    - Board wealth
    - Annual Meeting

    Lend Money No Social Costs


    BONDHOLDERS/ Managers SOCIETY
    LENDERS Protect All costs can be
    bondholder traced to firm
    Interests
    Reveal Markets are
    information efficient and
    honestly and assess effect on
    on time value

    FINANCIAL MARKETS

    Aswath Damodaran
    6
    What can go wrong?
    7

    STOCKHOLDERS

    Have little control Managers put


    over managers their interests
    above stockholders

    Lend Money Significant Social Costs


    BONDHOLDERS Managers SOCIETY
    Bondholders can Some costs cannot be
    get ripped off traced to firm
    Delay bad
    news or Markets make
    provide mistakes and
    misleading can over react
    information

    FINANCIAL MARKETS

    Aswath Damodaran
    7
    I. Stockholder Interests vs. Management
    Interests
    8

    In theory: The stockholders have significant control over


    management. The two mechanisms for disciplining
    management are the annual meeting and the board of
    directors. Specifically, we assume that
    Stockholders who are dissatisfied with managers can not only
    express their disapproval at the annual meeting, but can use
    their voting power at the meeting to keep managers in check.
    The board of directors plays its true role of representing
    stockholders and acting as a check on management.
    In Practice: Neither mechanism is as effective in
    disciplining management as theory posits.
    Aswath Damodaran
    8
    The Annual Meeting as a disciplinary venue
    9

    The power of stockholders to act at annual meetings is


    diluted by three factors
    Most small stockholders do not go to meetings because the cost
    of going to the meeting exceeds the value of their holdings.
    Incumbent management starts off with a clear advantage when
    it comes to the exercise of proxies. Proxies that are not voted
    becomes votes for incumbent management.
    For large stockholders, the path of least resistance, when
    confronted by managers that they do not like, is to vote with
    their feet.
    Annual meetings are also tightly scripted and controlled
    events, making it difficult for outsiders and rebels to
    bring up issues that are not to the managements liking.

    Aswath Damodaran
    9
    And institutional investors go along with incumbent
    managers
    10

    Aswath Damodaran
    10
    Board of Directors as a disciplinary mechanism
    11

    Directors are paid well: In 2010, the median board member at a Fortune
    500 company was paid $212,512, with 54% coming in stock and the
    remaining 46% in cash. If a board member was a non-executive chair, he
    or she received about $150,000 more in compensation.
    Spend more time on their directorial duties than they used to: A board
    member worked, on average, about 227.5 hours a year (and that is being
    generous), or 4.4 hours a week, according to the National Associate of
    Corporate Directors. Of this, about 24 hours a year are for board
    meetings. Those numbers are up from what they were a decade ago.
    Even those hours are not very productive: While the time spent on being
    a director has gone up, a significant portion of that time was spent on
    making sure that they are legally protected (regulations & lawsuits).
    And they have many loyalties: Many directors serve on three or more
    boards, and some are full time chief executives of other companies.

    Aswath Damodaran
    11
    The CEO often hand-picks directors..
    12

    CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of


    companies relied on recommendations from the CEO to come up with
    new directors and only 16% used an outside search firm. While that
    number has changed in recent years, CEOs still determine who sits on
    their boards. While more companies have outsiders involved in picking
    directors now, CEOs exercise significant influence over the process.
    Directors dont have big equity stakes: Directors often hold only token
    stakes in their companies. Most directors in companies today still receive
    more compensation as directors than they gain from their stockholdings.
    While share ownership is up among directors today, they usually get these
    shares from the firm (rather than buy them).
    And some directors are CEOs of other firms: Many directors are
    themselves CEOs of other firms. Worse still, there are cases where CEOs
    sit on each others boards.

    Aswath Damodaran
    12
    Directors lack the expertise (and the willingness)
    to ask the necessary tough questions..
    13

    Roberts Rules of Order? In most boards, the CEO


    continues to be the chair. Not surprisingly, the CEO sets
    the agenda, chairs the meeting and controls the
    information provided to directors.
    Be a team player? The search for consensus overwhelms
    any attempts at confrontation.
    The CEO as authority figure: Studies of social psychology
    have noted that loyalty is hardwired into human
    behavior. While this loyalty is an important tool in
    building up organizations, it can also lead people to
    suppress internal ethical standards if they conflict with
    loyalty to an authority figure. In a board meeting, the
    CEO generally becomes the authority figure.
    Aswath Damodaran
    13
    The worst board ever? The Disney Experience -
    1997
    14

    Aswath Damodaran
    14
    The Calpers Tests for Independent Boards
    15

    Calpers, the California Employees Pension fund,


    suggested three tests in 1997 of an independent
    board:
    Are a majority of the directors outside directors?
    Is the chairman of the board independent of the company
    (and not the CEO of the company)?
    Are the compensation and audit committees composed
    entirely of outsiders?
    Disney was the only S&P 500 company to fail all
    three tests.
    Aswath Damodaran
    15
    Business Week piles on The Worst Boards in 1997..
    16

    Aswath Damodaran
    16
    Application Test: Whos on board?
    17

    Look at the board of directors for your firm.


    How many of the directors are inside directors (Employees of the firm,
    ex-managers)?
    Is there any information on how independent the directors in the firm
    are from the managers?
    Are there any external measures of the quality of corporate
    governance of your firm?
    Yahoo! Finance now reports on a corporate governance score for firms,
    where it ranks firms against the rest of the market and against their
    sectors.
    Is there tangible evidence that your board acts independently
    of management?
    Check news stories to see if there are actions that the CEO has wanted
    to take that the board has stopped him or her from taking or at least
    slowed him or her down.

    Aswath Damodaran
    17
    So, what next? When the cat is idle, the mice
    will play ....
    18

    When managers do not fear stockholders, they will often put


    their interests over stockholder interests
    No stockholder approval needed.. Stockholder Approval needed

    Greenmail: The (managers of ) target of a hostile takeover buy out the


    potential acquirer's existing stake, at a price much greater than the
    price paid by the raider, in return for the signing of a 'standstill'
    agreement.
    Golden Parachutes: Provisions in employment contracts, that allows
    for the payment of a lump-sum or cash flows over a period, if
    managers covered by these contracts lose their jobs in a takeover.
    Poison Pills: A security, the rights or cashflows on which are triggered
    by an outside event, generally a hostile takeover, is called a poison pill.
    Shark Repellents: Anti-takeover amendments are also aimed at
    dissuading hostile takeovers, but differ on one very important count.
    They require the assent of stockholders to be instituted.
    Overpaying on takeovers: Acquisitions often are driven by
    management interests rather than stockholder interests.

    Aswath Damodaran
    18
    Overpaying on takeovers
    19

    The quickest and perhaps the most decisive way to


    impoverish stockholders is to overpay on a takeover.
    The stockholders in acquiring firms do not seem to share
    the enthusiasm of the managers in these firms. Stock
    prices of bidding firms decline on the takeover
    announcements a significant proportion of the time.
    Many mergers do not work, as evidenced by a number of
    measures.
    The profitability of merged firms relative to their peer groups,
    does not increase significantly after mergers.
    An even more damning indictment is that a large number of
    mergers are reversed within a few years, which is a clear
    admission that the acquisitions did not work.

    Aswath Damodaran
    19
    A case study in value destruction:
    Eastman Kodak & Sterling Drugs

    Kodak enters bidding war Kodak wins!!!!


    In late 1987, Eastman Kodak
    entered into a bidding war with
    Hoffman La Roche for Sterling
    Drugs, a pharmaceutical
    company.
    The bidding war started with
    Sterling Drugs trading at about
    $40/share.
    At $72/share, Hoffman dropped
    out of the bidding war, but Kodak
    kept bidding.
    At $89.50/share, Kodak won and
    claimed potential synergies !
    explained the premium.
    Earnings and Revenues at Sterling Drugs
    21

    Sterling Drug under Eastman Kodak: Where is the synergy?

    5,000
    4,500
    4,000
    3,500
    3,000
    2,500
    2,000
    1,500
    1,000
    500
    0
    1988 1989 1990 1991 1992

    Revenue Operating Earnings

    Aswath Damodaran
    21
    Kodak Says Drug Unit Is Not for Sale but
    22

    An article in the NY Times in August of 1993 suggested that Kodak was eager to
    shed its drug unit.
    In response, Eastman Kodak officials say they have no plans to sell Kodaks Sterling Winthrop
    drug unit.
    Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as massive speculation,
    which flies in the face of the stated intent of Kodak that it is committed to be in the health
    business.
    A few months laterTaking a stride out of the drug business, Eastman Kodak said
    that the Sanofi Group, a French pharmaceutical company, agreed to buy the
    prescription drug business of Sterling Winthrop for $1.68 billion.
    Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock
    Exchange.
    Samuel D. Isaly an analyst , said the announcement was very good for Sanofi and very good
    for Kodak.
    When the divestitures are complete, Kodak will be entirely focused on imaging, said George
    M. C. Fisher, the company's chief executive.
    The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.

    Aswath Damodaran
    22
    The connection to corporate governance: HP buys
    Autonomy and explains the premium
    23

    Aswath Damodaran
    23
    A year later HP admits a mistakeand explains it
    24

    Aswath Damodaran
    24
    Application Test: Who owns/runs your firm?
    25

    Look at: Bloomberg printout HDS for your firm


    Who are the top stockholders in your firm?
    What are the potential conflicts of interests that you see
    emerging from this stockholding structure?
    Government
    Outside stockholders Managers
    - Size of holding - Length of tenure
    - Active or Passive? - Links to insiders
    - Short or Long term? Control of the firm

    Employees Lenders

    Inside stockholders
    % of stock held
    Voting and non-voting shares
    Control structure
    Aswath Damodaran
    25
    Case 1: Splintering of Stockholders
    Disneys top stockholders in 2003

    Aswath Damodaran
    26
    Case 2: Voting versus Non-voting Shares &
    Golden Shares: Vale

    Valespar(ownership Brazilian(Govt.( Valespar(


    4%( 1%(
    Brazilian(retail(
    5%(
    Brazilian(
    Litel&Participao 49.00%
    Brazilian(Ins=tu=onal(
    6%(
    Govt.(
    6%(
    Eletron&S.A. 0.03%
    Bradespar&S.A. 21.21%
    Mitsui&&&Co. 18.24% Brazilian(retail(
    18%(
    BNDESPAR 11.51%

    Valespar( Golden (veto)


    Non/Brazilian( 54%( Brazilian(Ins<tu<onal( Non.Brazilian(
    (ADR&Bovespa)( shares owned 18%( (ADR&Bovespa)(
    29%( 59%(
    by Brazilian govt

    Common (voting) shares Preferred (non-voting)


    3,172 million 1,933 million
    Vale Equity

    Vale has eleven members on its board of directors, ten of


    whom were nominated by Valepar and the board was
    chaired by Don Conrado, the CEO of Valepar.
    Aswath Damodaran
    27
    Case 3: Cross and Pyramid Holdings
    Tata Motors top stockholders in 2013

    Aswath Damodaran
    28
    Case 4: Legal rights and Corporate
    Structures: Baidu
    The Board: The company has six directors, one of whom is Robin Li,
    who is the founder/CEO of Baidu. Mr. Li also owns a majority stake
    of Class B shares, which have ten times the voting rights of Class A
    shares, granting him effective control of the company.
    The structure: Baidu is a Chinese company, but it is incorporated in
    the Cayman Islands, its primary stock listing is on the NASDAQ and
    the listed company is structured as a shell company, to get around
    Chinese government restrictions of foreign investors holding shares
    in Chinese corporations.
    The legal system: Baidus operating counterpart in China is
    structured as a Variable Interest Entity (VIE), and it is unclear how
    much legal power the shareholders in the shell company have to
    enforce changes at the VIE.

    Aswath Damodaran
    29
    Things change.. Disneys top stockholders in 2009
    30

    Aswath Damodaran
    30
    II. Stockholders' objectives vs. Bondholders'
    objectives
    31

    In theory: there is no conflict of interests between


    stockholders and bondholders.
    In practice: Stockholder and bondholders have
    different objectives. Bondholders are concerned
    most about safety and ensuring that they get paid
    their claims. Stockholders are more likely to think
    about upside potential

    Aswath Damodaran
    31
    Examples of the conflict..
    32

    A dividend/buyback surge: When firms pay cash out as


    dividends, lenders to the firm are hurt and stockholders
    may be helped. This is because the firm becomes riskier
    without the cash.
    Risk shifting: When a firm takes riskier projects than
    those agreed to at the outset, lenders are hurt. Lenders
    base interest rates on their perceptions of how risky a
    firms investments are. If stockholders then take on
    riskier investments, lenders will be hurt.
    Borrowing more on the same assets: If lenders do not
    protect themselves, a firm can borrow more money and
    make all existing lenders worse off.

    Aswath Damodaran
    32
    An Extreme Example: Unprotected Lenders?
    33

    Aswath Damodaran
    33
    III. Firms and Financial Markets
    34

    In theory: Financial markets are efficient. Managers


    convey information honestly and and in a timely manner
    to financial markets, and financial markets make
    reasoned judgments of the effects of this information on
    'true value'. As a consequence-
    A company that invests in good long term projects will be
    rewarded.
    Short term accounting gimmicks will not lead to increases in
    market value.
    Stock price performance is a good measure of company
    performance.
    In practice: There are some holes in the 'Efficient
    Markets' assumption.

    Aswath Damodaran
    34
    Managers control the release of information to
    the general public
    35

    Information management (timing and spin):


    Information (especially negative) is sometimes
    suppressed or delayed by managers seeking a better
    time to release it. When the information is released,
    firms find ways to spin or frame it to put
    themselves in the best possible light.
    Outright fraud: In some cases, firms release
    intentionally misleading information about their
    current conditions and future prospects to financial
    markets.
    Aswath Damodaran
    35
    Evidence that managers delay bad news?
    36

    DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by


    Weekday

    8.00%

    6.00%

    4.00%

    2.00%

    0.00%

    -2.00%

    -4.00%

    -6.00%
    Monday Tuesday Wednesday Thursday Friday

    % Chg(EPS) % Chg(DPS)

    Aswath Damodaran
    36
    Some critiques of market efficiency..
    37

    Investor irrationality: The base argument is that investors


    are irrational and prices often move for no reason at all.
    As a consequence, prices are much more volatile than
    justified by the underlying fundamentals. Earnings and
    dividends are much less volatile than stock prices.
    Manifestations of irrationality
    Reaction to news: Some believe that investors overreact to
    news, both good and bad. Others believe that investors
    sometimes under react to big news stories.
    An insider conspiracy: Financial markets are manipulated by
    insiders; Prices do not have any relationship to value.
    Short termism: Investors are short-sighted, and do not consider
    the long-term implications of actions taken by the firm

    Aswath Damodaran
    37
    Are markets short sighted and too focused
    on the near term? What do you think?
    38

    Focusing on market prices will lead companies towards short term


    decisions at the expense of long term value.
    a. I agree with the statement
    b. I do not agree with this statement
    Allowing managers to make decisions without having to worry
    about the effect on market prices will lead to better long term
    decisions.
    a. I agree with this statement
    b. I do not agree with this statement
    Neither managers nor markets are trustworthy. Regulations/laws
    should be written that force firms to make long term decisions.
    a. I agree with this statement
    b. I do not agree with this statement

    Aswath Damodaran
    38
    Are markets short term? Some evidence that
    they are not..
    39

    Value of young firms: There are hundreds of start-up and


    small firms, with no earnings expected in the near future,
    that raise money on financial markets. Why would a myopic
    market that cares only about short term earnings attach high
    prices to these firms?
    Current earnings vs Future growth: If the evidence suggests
    anything, it is that markets do not value current earnings and
    cashflows enough and value future earnings and cashflows
    too much. After all, studies suggest that low PE stocks are
    under priced relative to high PE stocks
    Market reaction to investments: The market response to
    research and development and investment expenditures is
    generally positive.

    Aswath Damodaran
    39
    If markets are so short term, why do they react to big
    investments (that potentially lower short term earnings) so
    positively?
    40

    Aswath Damodaran
    40
    But what about market crises?
    41

    Markets are the problem: Many critics of markets point to market


    bubbles and crises as evidence that markets do not work. For
    instance, the market turmoil between September and December
    2008 is pointed to as backing for the statement that free markets
    are the source of the problem and not the solution.
    The counter: There are two counter arguments that can be offered:
    The events of the last quarter of 2008 illustrate that we are more
    dependent on functioning, liquid markets, with risk taking investors, than
    ever before in history. As we saw, no government or other entity (bank,
    Buffett) is big enough to step in and save the day.
    The firms that caused the market collapse (banks, investment banks) were
    among the most regulated businesses in the market place. If anything,
    their failures can be traced to their attempts to take advantage of
    regulatory loopholes (badly designed insurance programs capital
    measurements that miss risky assets, especially derivatives)

    Aswath Damodaran
    41
    IV. Firms and Society
    42

    In theory: All costs and benefits associated with a


    firms decisions can be traced back to the firm.
    In practice: Financial decisions can create social costs
    and benefits.
    A social cost or benefit is a cost or benefit that accrues to society
    as a whole and not to the firm making the decision.
    n Environmental costs (pollution, health costs, etc..)
    n Quality of Life' costs (traffic, housing, safety, etc.)
    Examples of social benefits include:
    n creating employment in areas with high unemployment
    n supporting development in inner cities
    n creating access to goods in areas where such access does not
    exist

    Aswath Damodaran
    42
    Social Costs and Benefits are difficult to quantify
    because ..
    43

    Cannot know the unknown: They might not be known at


    the time of the decision. In other words, a firm may
    think that it is delivering a product that enhances
    society, at the time it delivers the product but discover
    afterwards that there are very large costs. (Asbestos was
    a wonderful product, when it was devised, light and easy
    to work with It is only after decades that the health
    consequences came to light)
    Eyes of the beholder: They are person-specific, since
    different decision makers can look at the same social
    cost and weight them very differently.
    Decision paralysis: They can be paralyzing if carried to
    extremes.
    Aswath Damodaran
    43
    A test of your social consciousness:
    Put your money where you mouth is
    44

    Assume that you work for Disney and that you have an opportunity
    to open a store in an inner-city neighborhood. The store is
    expected to lose about a million dollars a year, but it will create
    much-needed employment in the area, and may help revitalize it.
    Would you open the store?
    Yes
    No
    If yes, would you tell your stockholders and let them vote on the
    issue?
    Yes
    No
    If no, how would you respond to a stockholder query on why you
    were not living up to your social responsibilities?

    Aswath Damodaran
    44
    So this is what can go wrong...
    45

    STOCKHOLDERS

    Managers put
    Have little control their interests
    over managers above stockholders

    Lend Money Significant Social Costs


    BONDHOLDERS Managers SOCIETY
    Bondholders can Some costs cannot be
    get ripped off traced to firm
    Delay bad
    news or Markets make
    provide mistakes and
    misleading can over react
    information

    FINANCIAL MARKETS

    Aswath Damodaran
    45
    Traditional corporate financial theory breaks
    down when ...
    46

    Managerial self-interest: The interests/objectives of the


    decision makers in the firm conflict with the interests of
    stockholders.
    Unprotected debt holders: Bondholders (Lenders) are
    not protected against expropriation by stockholders.
    Inefficient markets: Financial markets do not operate
    efficiently, and stock prices do not reflect the underlying
    value of the firm.
    Large social side costs: Significant social costs can be
    created as a by-product of stock price maximization.

    Aswath Damodaran
    46
    When traditional corporate financial theory
    breaks down, the solution is:
    47

    A non-stockholder based governance system: To choose a


    different mechanism for corporate governance, i.e, assign the
    responsibility for monitoring managers to someone other
    than stockholders.
    A better objective than maximizing stock prices? To choose a
    different objective for the firm.
    Maximize stock prices but minimize side costs: To maximize
    stock price, but reduce the potential for conflict and
    breakdown:
    Making managers (decision makers) and employees into stockholders
    Protect lenders from expropriation
    By providing information honestly and promptly to financial markets
    Minimize social costs

    Aswath Damodaran
    47
    I. An Alternative Corporate Governance System
    48

    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.

    Aswath Damodaran
    48
    II. Choose a Different Objective Function
    49

    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

    Aswath Damodaran
    49
    III. Maximize Stock Price, subject to ..
    50

    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 led to a much more
    active market for corporate control.
    stockholders taking advantage of bondholders has led to bondholders
    protecting themselves at the time of the issue.
    firms revealing incorrect or delayed information to markets has led to
    markets becoming more skeptical and punitive
    firms creating social costs has led to more regulations, as well as
    investor and customer backlashes.

    Aswath Damodaran
    50
    The Stockholder Backlash
    51

    Activist Institutional investors have become much more


    active in monitoring companies that they invest in and
    demanding changes in the way in which business is done.
    They have been joined by private equity funds like KKR and
    Blackstone.
    Activist individuals like Carl Icahn specialize in taking large
    positions in companies which they feel need to change their
    ways (Blockbuster, Time Warner, Motorola & Apple) and push
    for change.
    Vocal stockholders, armed with more information and new
    powers: At annual meetings, stockholders have taken to
    expressing their displeasure with incumbent management by
    voting against their compensation contracts or their board of
    directors

    Aswath Damodaran
    51
    The Hostile Acquisition Threat
    52

    The typical target firm in a hostile takeover has


    a return on equity almost 5% lower than its peer group
    had a stock that has significantly under performed the peer
    group over the previous 2 years
    has managers who hold little or no stock in the firm
    In other words, the best defense against a hostile
    takeover is to run your firm well and earn good returns
    for your stockholders
    Conversely, when you do not allow hostile takeovers, this
    is the firm that you are most likely protecting (and not a
    well run or well managed firm)

    Aswath Damodaran
    52
    In response, boards are becoming more
    independent
    53

    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%.

    Aswath Damodaran
    53
    Disney: Eisners rise & fall from grace

    In his early years at Disney, Michael Eisner brought about long-delayed changes in
    the company and put it on the path to being an entertainment giant that it is
    today. His success allowed him to consolidate power and the boards that he
    created were increasingly captive ones (see the 1997 board).
    In 1996, Eisner spearheaded the push to buy ABC and the board rubberstamped
    his decision, as they had with other major decisions. In the years following, the
    company ran into problems both on its ABC acquisition and on its other
    operations and stockholders started to get restive, especially as the stock price
    halved between 1998 and 2002.
    In 2003, Roy Disney and Stanley Gold resigned from the Disney board, arguing
    against Eisners autocratic style.
    In early 2004, Comcast made a hostile bid for Disney and later in the year, 43% of
    Disney shareholders withheld their votes for Eisners reelection to the board of
    directors. Following that vote, the board of directors at Disney voted unanimously
    to elect George Mitchell as the Chair of the board, replacing Eisner, who vowed to
    stay on as CEO.

    Aswath Damodaran
    54
    Eisners concession: Disneys Board in 2003
    55

    Board Members Occupation


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

    Aswath Damodaran
    55
    Changes in corporate governance at Disney
    56

    1. Required at least two executive sessions of the board, without the CEO
    or other members of management present, each year.
    2. Created the position of non-management presiding director, and
    appointed Senator George Mitchell to lead those executive sessions and
    assist in setting the work agenda of the board.
    3. Adopted a new and more rigorous definition of director independence.
    4. Required that a substantial majority of the board be comprised of
    directors meeting the new independence standards.
    5. Provided for a reduction in committee size and the rotation of
    committee and chairmanship assignments among independent
    directors.
    6. Added new provisions for management succession planning and
    evaluations of both management and board performance
    7. Provided for enhanced continuing education and training for board
    members.

    Aswath Damodaran
    56
    Eisners exit and a new age dawns? Disneys board
    in 2008
    57

    Aswath Damodaran
    57
    But as a CEOs tenure lengthens, does
    corporate governance suffer?
    1. While the board size has stayed compact (at twelve members),
    there has been only one change since 2008, with Sheryl
    Sandberg, COO of Facebook, replacing the deceased Steve Jobs.
    2. The board voted reinstate Iger as chair of the board in 2011,
    reversing a decision made to separate the CEO and Chair
    positions after the Eisner years.
    3. In 2011, Iger announced his intent to step down as CEO in 2015
    but Disneys board convinced Iger to stay on as CEO for an extra
    year, for the the good of the company.
    4. There were signs of restiveness among Disneys stockholders,
    especially those interested in corporate governance. Activist
    investors (CalSTRS) starting making noise and Institutional
    Shareholder Services (ISS), which gauges corporate governance at
    companies, raised red flags about compensation and board
    monitoring at Disney.

    Aswath Damodaran
    58
    Igers non-exit and the Domino effect
    59

    When Iger stayed on as CEO, the ranks below him


    thinned out, as executives who were waiting to
    move up moved on instead.
    Igers rumored successor, Tom Staggs, resigned (in a
    surprise) in April 2016, leaving a vacuum in the
    leadership ranks.
    The board considered asking Iger to postpone his
    retirement again.

    Aswath Damodaran
    59
    What about legislation?
    60

    Every corporate scandal creates impetus for a


    legislative response. The scandals at Enron and
    WorldCom laid the groundwork for Sarbanes-Oxley.
    You cannot legislate good corporate governance.
    The costs of meeting legal requirements often exceed the
    benefits
    Laws always have unintended consequences

    In general, laws tend to be blunderbusses that penalize


    good companies more than they punish the bad
    companies.

    Aswath Damodaran
    60
    Is there a payoff to better corporate
    governance?
    61

    In the most comprehensive study of the effect of corporate governance


    on value, a governance index was created for each of 1500 firms based
    upon 24 distinct corporate governance provisions.
    Buying stocks that had the strongest investor protections while simultaneously
    selling shares with the weakest protections generated an annual excess return of
    8.5%.
    Every one point increase in the index towards fewer investor protections decreased
    market value by 8.9% in 1999
    Firms that scored high in investor protections also had higher profits, higher sales
    growth and made fewer acquisitions.
    The link between the composition of the board of directors and firm value
    is weak. Smaller boards do tend to be more effective.
    On a purely anecdotal basis, a common theme at problem companies and
    is an ineffective board that fails to ask tough questions of an imperial CEO.

    Aswath Damodaran
    61
    The Bondholders Defense Against Stockholder
    Excesses
    62

    More restrictive covenants on investment, financing and dividend


    policy have been incorporated into both private lending
    agreements and into bond issues, to prevent future Nabiscos.
    New types of bonds have been created to explicitly protect
    bondholders against sudden increases in leverage or other actions
    that increase lender risk substantially. Two examples of such bonds
    Puttable Bonds, where the bondholder can put the bond back to the firm
    and get face value, if the firm takes actions that hurt bondholders
    Ratings Sensitive Notes, where the interest rate on the notes adjusts to
    that appropriate for the rating of the firm
    More hybrid bonds (with an equity component, usually in the form
    of a conversion option or warrant) have been used. This allows
    bondholders to become equity investors, if they feel it is in their
    best interests to do so.

    Aswath Damodaran
    62
    The Financial Market Response
    63

    While analysts are more likely still to issue buy rather


    than sell recommendations, the payoff to uncovering
    negative news about a firm is large enough that such
    news is eagerly sought and quickly revealed (at least to a
    limited group of investors).
    As investor access to information improves, it is
    becoming much more difficult for firms to control when
    and how information gets out to markets.
    As option trading has become more common, it has
    become much easier to trade on bad news. In the
    process, it is revealed to the rest of the market.
    When firms mislead markets, the punishment is not only
    quick but it is savage.
    Aswath Damodaran
    63
    The Societal Response
    64

    If firms consistently flout societal norms and create


    large social costs, the governmental response
    (especially in a democracy) is for laws and
    regulations to be passed against such behavior.
    For firms catering to a more socially conscious
    clientele, the failure to meet societal norms (even if
    it is legal) can lead to loss of business and value.
    Finally, investors may choose not to invest in stocks
    of firms that they view as socially irresponsible.

    Aswath Damodaran
    64
    The Counter Reaction
    65

    STOCKHOLDERS

    1. More activist Managers of poorly


    investors run firms are put
    2. Hostile takeovers on notice.

    Protect themselves Corporate Good Citizen Constraints


    BONDHOLDERS Managers SOCIETY
    1. Covenants 1. More laws
    2. New Types 2. Investor/Customer Backlash
    Firms are
    punished Investors and
    for misleading analysts become
    markets more skeptical

    FINANCIAL MARKETS

    Aswath Damodaran
    65
    So what do you think?
    66

    At this point in time, the following statement best describes


    where I stand in terms of the right objective function for
    decision making in a business
    a. Maximize stock price, with no constraints
    b. Maximize stock price, with constraints on being a good social citizen.
    c. Maximize stockholder wealth, with good citizen constraints, and
    hope/pray that the market catches up with you.
    d. Maximize profits or profitability
    e. Maximize earnings growth
    f. Maximize market share
    g. Maximize revenues
    h. Maximize social good
    i. None of the above

    Aswath Damodaran
    66
    The Modified Objective Function
    67

    For publicly traded firms in reasonably efficient markets,


    where bondholders (lenders) are protected:
    Maximize Stock Price: This will also maximize firm value
    For publicly traded firms in inefficient markets, where
    bondholders are protected:
    Maximize stockholder wealth: This will also maximize firm value,
    but might not maximize the stock price
    For publicly traded firms in inefficient markets, where
    bondholders are not fully protected
    Maximize firm value, though stockholder wealth and stock
    prices may not be maximized at the same point.
    For private firms, maximize stockholder wealth (if
    lenders are protected) or firm value (if they are not)
    Aswath Damodaran
    67
    Aswath Damodaran 68

    THE INVESTMENT PRINCIPLE: RISK


    AND RETURN MODELS

    You cannot swing upon a rope that is attached only


    to your own belt.
    First Principles
    69

    Aswath Damodaran
    69
    The notion of a benchmark
    70

    Since financial resources are finite, there is a hurdle that


    projects have to cross before being deemed acceptable.
    This hurdle should 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?

    Aswath Damodaran
    70
    What is Risk?
    71

    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. You cannot have one, without the other.
    Risk is therefore neither good nor bad. It is just a fact of life.
    The question that businesses have to address is therefore not
    whether to avoid risk but how best to incorporate it into their
    decision making.
    Aswath Damodaran
    71
    A good risk and return model should
    72

    1. It should come up with a measure of risk that applies to all assets


    and not be asset-specific.
    2. It should clearly delineate what types of risk are rewarded and
    what are not, and provide a rationale for the delineation.
    3. It should come up with standardized risk measures, i.e., an
    investor presented with a risk measure for an individual asset
    should be able to draw conclusions about whether the asset is
    above-average or below-average risk.
    4. It should translate the measure of risk into a rate of return that
    the investor should demand as compensation for bearing the risk.
    5. It should work well not only at explaining past returns, but also in
    predicting future expected returns.

    Aswath Damodaran
    72
    The Capital Asset Pricing Model
    73

    1. Uses variance of actual returns around an expected


    return as a measure of risk.
    2. Specifies that a portion of variance can be diversified
    away, and that is only the non-diversifiable portion that
    is rewarded.
    3. Measures the non-diversifiable risk with beta, which is
    standardized around one.
    4. Translates beta into expected return -
    Expected Return = Riskfree rate + Beta * Risk Premium
    5. Works as well as the next best alternative in most
    cases.
    Aswath Damodaran
    73
    1. The Mean-Variance Framework
    74

    The variance on any investment measures the disparity


    between actual and expected returns.
    Low Variance Investment

    High Variance Investment

    Expected Return

    Aswath Damodaran
    74
    How risky is Disney? A look at the past
    75

    Returns on Disney - 2008-2013


    25.00% Average monthly return = 1.65%
    Average monthly standard deviation = 7.64%
    20.00% Average annual return = 21.70%
    Average annual standard deviation = 26.47%
    15.00%

    10.00%

    5.00%

    0.00%

    -5.00%

    -10.00%

    -15.00%

    -20.00%

    -25.00%
    Oct-08
    Dec-08
    Feb-09
    Apr-09
    Jun-09
    Aug-09
    Oct-09
    Dec-09
    Feb-10
    Apr-10
    Jun-10
    Aug-10
    Oct-10
    Dec-10
    Feb-11
    Apr-11
    Jun-11
    Aug-11
    Oct-11
    Dec-11
    Feb-12
    Apr-12
    Jun-12
    Aug-12
    Oct-12
    Dec-12
    Feb-13
    Apr-13
    Jun-13
    Aug-13
    Aswath Damodaran
    75
    Do you live in a mean-variance world?
    76

    Assume that you had to pick between two investments. They


    have the same expected return of 15% and the same
    standard deviation of 25%; however, investment A offers a
    very small possibility that you could quadruple your money,
    while investment Bs highest possible payoff is a 60% return.
    Would you
    a. be indifferent between the two investments, since they have the
    same expected return and standard deviation?
    b. prefer investment A, because of the possibility of a high payoff?
    b. prefer investment B, because it is safer?
    Would your answer change if you were not told that there is a
    small possibility that you could lose 100% of your money on
    investment A but that your worst case scenario with
    investment B is -50%?

    Aswath Damodaran
    76
    The Importance of Diversification: Risk Types
    77

    Figure 3.5: A Break Down of Risk

    Competition
    may be stronger
    or weaker than Exchange rate
    anticipated and Political
    risk
    Projects may
    do better or Interest rate,
    worse than Entire Sector Inflation &
    may be affected news about
    expected by action economy

    Firm-specific Market

    Actions/Risk that Actions/Risk that


    affect only one Affects few Affects many affect all investments
    firm firms firms
    Firm can Investing in lots Acquiring Diversifying Diversifying Cannot affect
    reduce by of projects competitors across sectors across countries

    Investors Diversifying across domestic stocks Diversifying globally Diversifying across


    can asset classes
    mitigate by

    Aswath Damodaran
    77
    Why diversification reduces/eliminates
    firm specific risk
    78

    Firm-specific risk can be reduced, if not eliminated, by


    increasing the number of investments in your portfolio
    (i.e., by being diversified). Market-wide risk cannot. This
    can be justified on either economic or statistical
    grounds.
    On economic grounds, diversifying and holding a larger
    portfolio eliminates firm-specific risk for two reasons-
    a. Each investment is a much smaller percentage of the portfolio,
    muting the effect (positive or negative) on the overall
    portfolio.
    b. Firm-specific actions can be either positive or negative. In a
    large portfolio, it is argued, these effects will average out to
    zero. (For every firm, where something bad happens, there will
    be some other firm, where something good happens.)

    Aswath Damodaran
    78
    The Role of the Marginal Investor
    79

    The marginal investor in a firm is the investor who is


    most likely to be the buyer or seller on the next trade
    and to influence the stock price.
    Generally speaking, the marginal investor in a stock has
    to own a lot of stock and also trade that stock on a
    regular basis.
    Since trading is required, the largest investor may not be
    the marginal investor, especially if he or she is a
    founder/manager of the firm (Larry Ellison at Oracle,
    Mark Zuckerberg at Facebook)
    In all risk and return models in finance, we assume that
    the marginal investor is well diversified.

    Aswath Damodaran
    79
    Identifying the Marginal Investor in your firm
    80

    Percent of Stock held Percent of Stock held by Marginal Investor


    by Institutions Insiders
    High Low Institutional Investor
    High High Institutional Investor, with insider influence
    Low High (held by Tough to tell; Could be insiders but only if they
    founder/manager of firm) trade. If not, it could be individual investors.
    Low High (held by wealthy Wealthy individual investor, fairly diversified
    individual investor)
    Low Low Small individual investor with restricted
    diversification

    Aswath Damodaran
    80
    Gauging the marginal investor: Disney in
    2013

    Aswath Damodaran
    81
    Extending the assessment of the investor
    base
    In all five of the publicly traded companies that we
    are looking at, institutions are big holders of the
    companys stock.

    Aswath Damodaran
    82
    The Limiting Case: The Market Portfolio
    83

    The big assumptions & the follow up: Assuming diversification costs
    nothing (in terms of transactions costs), and that all assets can be
    traded, the limit of diversification is to hold a portfolio of every
    single asset in the economy (in proportion to market value). This
    portfolio is called the market portfolio.
    The consequence: Individual investors will adjust for risk, by
    adjusting their allocations to this market portfolio and a riskless
    asset (such as a T-Bill):
    Preferred risk level Allocation decision
    No risk 100% in T-Bills
    Some risk 50% in T-Bills; 50% in Market Portfolio;
    A little more risk 25% in T-Bills; 75% in Market Portfolio
    Even more risk 100% in Market Portfolio
    A risk hog.. Borrow money; Invest in market portfolio

    Aswath Damodaran
    83
    The Risk of an Individual Asset
    84

    The essence: The risk of any asset is the risk that it adds to
    the market portfolio Statistically, this risk can be measured by
    how much an asset moves with the market (called the
    covariance)
    The measure: Beta is a standardized measure of this
    covariance, obtained by dividing the covariance of any asset
    with the market by the variance of the market. It is a measure
    of the non-diversifiable risk for any asset can be measured by
    the covariance of its returns with returns on a market index,
    which is defined to be the asset's beta.
    The result: The required return on an investment will be a
    linear function of its beta:
    Expected Return = Riskfree Rate+ Beta * (Expected Return on the
    Market Portfolio - Riskfree Rate)

    Aswath Damodaran
    84
    Limitations of the CAPM
    85

    1. The model makes unrealistic assumptions


    2. The parameters of the model cannot be estimated precisely
    The market index used can be wrong.
    The firm may have changed during the 'estimation' period'
    3. The model does not work well
    - If the model is right, there should be:
    n A linear relationship between returns and betas
    n The only variable that should explain returns is betas
    - The reality is that
    n The relationship between betas and returns is weak
    n Other variables (size, price/book value) seem to explain differences
    in returns better.

    Aswath Damodaran
    85
    Alternatives to the CAPM
    86
    Step 1: Defining Risk
    The risk in an investment can be measured by the variance in actual returns around an
    expected return
    Riskless Investment Low Risk Investment High Risk Investment

    E(R) E(R) E(R)


    Step 2: Differentiating between Rewarded and Unrewarded Risk
    Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
    Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
    1. each investment is a small proportion of portfolio are affected by it.
    2. risk averages out across investments in portfolio
    The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
    be rewarded and priced.
    Step 3: Measuring Market Risk
    The CAPM The APM Multi-Factor Models Proxy Models
    If there is If there are no Since market risk affects In an efficient market,
    1. no private information arbitrage opportunities most or all investments, differences in returns
    2. no transactions cost then the market risk of it must come from across long periods must
    the optimal diversified any asset must be macro economic factors. be due to market risk
    portfolio includes every captured by betas Market Risk = Risk differences. Looking for
    traded asset. Everyone relative to factors that exposures of any variables correlated with
    will hold thismarket portfolio affect all investments. asset to macro returns should then give
    Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
    added by any investment exposures of any Market Risk =
    to the market portfolio: asset to market Captured by the
    factors Proxy Variable(s)
    Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
    Market portfolio (from to unspecified market to specified macro returns to proxy
    a regression) factors (from a factor economic factors (from variables (from a
    analysis) a regression) regression)

    Aswath Damodaran
    86
    Why the CAPM persists
    87

    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.

    Aswath Damodaran
    87
    Application Test: Who is the marginal investor in
    your firm?
    88

    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
    An individual investor

    An insider

    Aswath Damodaran
    88
    Aswath Damodaran 89

    From Risk & Return Models to Hurdle


    Rates:
    Estimation Challenges

    The price of purity is purists


    Anonymous
    Inputs required to use the CAPM -
    90

    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, i.e. the market
    portfolio, over the riskless asset.
    c. The beta of the asset being analyzed.

    Aswath Damodaran
    90
    The Riskfree Rate and Time Horizon
    91

    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.

    Aswath Damodaran
    91
    Riskfree Rate in Practice
    92

    The riskfree rate is the rate on a zero coupon default-


    free 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.
    Aswath Damodaran
    92
    The Bottom Line on Riskfree Rates

    If the government is default-free, using a long term government rate


    (even on a coupon bond) as the risk free 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.
    If your cash flows are in Euros, your riskfree rate should be a Euro riskfree rate.
    The conventional practice of estimating riskfree rates is to use the
    government bond rate, with the government being the one that is in
    control of issuing that currency. In November 2013, for instance, the rate
    on a ten-year US treasury bond (2.75%) is used as the risk free rate in US
    dollars.

    Aswath Damodaran
    93
    What is the Euro riskfree rate? An exercise
    in November 2013
    Rate on 10-year Euro Government Bonds: November 2013

    9.00% 8.30%

    8.00%

    7.00% 6.42%
    5.90%
    6.00%

    5.00%
    3.90% 3.95%
    4.00% 3.30%

    3.00% 2.35%
    2.10% 2.15%
    1.75%
    2.00%

    1.00%

    0.00%
    Germany Austria France Belgium Ireland Italy Spain Portugal Slovenia Greece

    Aswath Damodaran
    94
    When the government is default free: Risk
    free rates in November 2013

    Aswath Damodaran
    95
    What if there is no default-free entity?
    Risk free rates in November 2013
    Adjust the local currency government borrowing rate for default risk to
    get a riskless local currency rate.
    In November 2013, the Indian government rupee bond rate was 8.82%. the local
    currency rating from Moodys was Baa3 and the default spread for a Baa3 rated
    country bond was 2.25%.
    Riskfree rate in Rupees = 8.82% - 2.25% = 6.57%
    In November 2013, the Chinese Renmimbi government bond rate was 4.30% and
    the local currency rating was Aa3, with a default spread of 0.8%.
    Riskfree rate in Chinese Renmimbi = 4.30% - 0.8% = 3.5%
    Do the analysis in an alternate currency, where getting the riskfree rate is
    easier. With Vale in 2013, we could chose to do the analysis in US dollars
    (rather than estimate a riskfree rate in R$). The riskfree rate is then the
    US treasury bond rate.
    Do your analysis in real terms, in which case the riskfree rate has to be a
    real riskfree rate. The inflation-indexed treasury rate is a measure of a real
    riskfree rate.

    Aswath Damodaran
    96
    Three paths to estimating sovereign
    default spreads
    97

    Sovereign dollar or euro denominated bonds: The difference


    between the interest rate on a sovereign US $ bond, issued
    by the country, and the US treasury bond rate can be used as
    the default spread. For example, in November 2013, the 10-
    year Brazil US $ bond, denominated in US dollars had a yield
    of 4.25% and the US 10-year T.Bond rate traded at 2.75%.
    Default spread = 4.25% - 2.75% = 1.50%
    CDS spreads: Obtain the default spreads for sovereigns in the
    CDS market. The CDS spread for Brazil in November 2013 was
    2.50%.
    Average spread: If you know the sovereign rating for a
    country, you can estimate the default spread based on the
    rating. In November 2013, Brazils rating was Baa2, yielding a
    default spread of 2%.
    Aswath Damodaran
    97
    Risk free rates in currencies: Sovereigns
    with default risk in November 2013
    98

    Figure 4.2: Risk free rates in Currencies where Governments not Aaa
    rated
    16.00%

    14.00%

    12.00%

    10.00%

    8.00%
    Default Spread
    6.00%
    Risk free rate
    4.00%

    2.00%

    0.00%

    Aswath Damodaran
    98
    99

    -5.00%
    0.00%
    5.00%
    10.00%
    15.00%
    20.00%
    25.00%
    Japanese Yen
    Czech Koruna
    Croatian Kuna
    Bulgarian Lev
    Swiss Franc
    Euro

    Aswath Damodaran
    Danish Krone
    Taiwanese $
    Pakistani Rupee
    Swedish Krona
    Hungarian Forint
    British Pound
    Thai Baht
    Vietnamese Dong
    Romanian Leu
    Israeli Shekel
    HK $

    Risk free Rate


    Korean Won
    Norwegian Krone
    Canadian $
    Chinese Yuan
    Phillipine Peso
    US $
    Singapore $
    Polish Zloty
    Risk free Rates - January 2017

    Australian $
    Default Spread based on rating Malyasian Ringgit
    NZ $
    Chilean Peso
    Risk free Rates in January 2017

    Iceland Krona
    Indian Rupee
    Colombian Peso
    Peruvian Sol
    Indonesian Rupiah
    Russian Ruble
    Mexican Peso
    South African Rand
    Venezuelan Bolivar
    Brazilian Reai
    Turkish Lira
    Kenyan Shilling
    Nigerian Naira
    99
    Measurement of the risk premium
    100

    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

    Aswath Damodaran
    100
    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 3%
    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 3%
    b. Between 3% - 5%
    c. Between 5% - 7%
    d. Between 7% -9%
    e. Between 9%- 11%
    f. More than 11%

    Aswath Damodaran
    101
    Risk Aversion and Risk Premiums
    102

    If this were the entire market, 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 wealth that
    each investor brings to the market. Thus, Warren
    Buffetts 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.

    Aswath Damodaran
    102
    Risk Premiums do change..
    103

    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

    Aswath Damodaran
    103
    Estimating Risk Premiums in Practice
    104

    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.

    Aswath Damodaran
    104
    The Survey Approach
    105

    Surveying all investors in a market place is impractical.


    However, you can survey a few individuals and use these results. In
    practice, this translates into surveys of the following:

    The limitations of this approach are:


    There are no constraints on reasonability (the survey could produce negative risk
    premiums or risk premiums of 50%)
    The survey results are more reflective of the past than the future.
    They tend to be short term; even the longest surveys do not go beyond one year.

    Aswath Damodaran
    105
    The Historical Premium Approach
    106

    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
    Defines a time period for the estimation (1928-Present, last 50 years...)
    Calculates average returns on a stock index during the period
    Calculates average returns on a riskless security over the period
    Calculates the difference between the two averages 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.

    Aswath Damodaran
    106
    ERP: A Historical Snapshot

    Arithmetic Average Geometric Average


    Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
    1928-2016 7.96% 6.24% 6.11% 4.62% Historical
    Std Error 2.13% 2.28% premium for
    1967-2016 6.57% 4.37% 5.26% 3.42% the US
    Std Error 2.42% 2.74%
    2007-2016 7.91% 3.62% 6.15% 2.30%
    Std Error 6.06% 8.66%

    If you are going to use a historical risk premium, make it


    Long term (because of the standard error)
    Consistent with your risk free rate
    A compounded average
    No matter which estimate you use, recognize that it is
    backward looking, is noisy and may reflect selection bias.

    107
    What about historical premiums for other
    markets?
    108

    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 data problem and there is much greater
    error associated with the estimates of the
    premiums.

    Aswath Damodaran
    108
    One solution: Bond default spreads as CRP
    November 2013
    In November 2013, the historical risk premium for the US was 4.20%
    (geometric average, stocks over T.Bonds, 1928-2012)
    Arithmetic Average Geometric Average
    Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
    1928-2012 7.65% 5.88% 5.74% 4.20%
    2.20% 2.33%
    Using the default spread on the sovereign bond or based upon the
    sovereign rating and adding that spread to the mature market premium
    (4.20% for the US) gives you a total ERP for a country.
    Country Rating Default Spread (Country Risk Premium) US ERP Total ERP for country
    India Baa3 2.25% 4.20% 6.45%
    China Aa3 0.80% 4.20% 5.00%
    Brazil Baa2 2.00% 4.20% 6.20%

    If you prefer CDS spreads:


    Country Sovereign CDS Spread US ERP Total ERP for country
    India 4.20% 4.20% 8.40%
    China 1.20% 4.20% 5.40%
    Brazil 2.59% 4.20% 6.79%

    Aswath Damodaran
    109
    Beyond the default spread? Equities are
    riskier than bonds
    While default risk spreads and equity risk premiums are highly correlated,
    one would expect equity spreads to be higher than debt spreads. One
    approach to scaling up the premium is to look at the relative volatility of
    equities to bonds and to scale up the default spread to reflect this:

    Brazil: The annualized standard deviation in the Brazilian equity index


    over the previous year is 21 percent, whereas the annualized standard
    deviation in the Brazilian C-bond is 14 percent.
    ! 21% $
    Brazil's Total Risk Premium = 4.20% + 2.00%# & = 7.20%
    " 14% %

    Using the same approach for China and India:


    ! 24% $
    Equity Risk PremiumIndia = 4.20% + 2.25%# & = 7.80%
    " 17% %
    ! 18% $
    Equity Risk PremiumChina = 4.20% + 0.80%# & = 5.64%
    " 10% %
    Aswath Damodaran
    110
    Implied ERP in November 2013: Watch
    what I pay, not what I say..
    If you can observe what investors are willing to pay
    for stocks, you can back out an expected return from
    that price and an implied equity risk premium.
    Base year cash flow (last 12 mths)
    Dividends (TTM): 33.22 Expected growth in next 5 years
    + Buybacks (TTM): 49.02 Top down analyst estimate of
    = Cash to investors (TTM): 82.35 earnings growth for S&P 500 with
    Earnings in TTM: stable payout: 5.59%
    Beyond year 5
    E(Cash to investors) 86.96 91.82 96.95 102.38 108.10 Expected growth rate =
    Riskfree rate = 2.55%
    S&P 500 on 11/1/13= Expected CF in year 6 =
    1756.54 86.96 91.82 96.95 102.38 108.10 110.86 108.1(1.0255)
    1756.54 = + + + + +
    (1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r .0255)(1+ r)5
    2 3 4 5

    r = Implied Expected Return on Stocks = 8.04%


    Minus

    Risk free rate = T.Bond rate on 1/1/14=2.55%

    Equals
    Aswath Damodaran Implied Equity Risk Premium (1/1/14) = 8.04% - 2.55% = 5.49%
    111
    The bottom line on Equity Risk Premiums
    in November 2013
    Mature Markets: In November 2013, the number that we chose to use as the
    equity risk premium for all mature markets was 5.5%. This was set equal to the
    implied premium at that point in time and it was much higher than the historical
    risk premium of 4.20% prevailing then (1928-2012 period).
    Arithmetic Average Geometric Average
    Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
    1928-2012 7.65% 5.88% 5.74% 4.20%
    2.20% 2.33%
    1962-2012 5.93% 3.91% 4.60% 2.93%
    2.38% 2.66%
    2002-2012 7.06% 3.08% 5.38% 1.71%
    5.82% 8.11%
    For emerging markets, we will use the melded default spread approach (where
    default spreads are scaled up to reflect additional equity risk) to come up with the
    additional risk premium that we will add to the mature market premium. Thus,
    markets in countries with lower sovereign ratings will have higher risk premiums
    that 5.5%.
    ! $
    Emerging Market ERP = 5.5% + Country Default Spread*## Equity
    && !
    " Country Bond %

    Aswath Damodaran
    112
    A Composite way of estimating ERP for
    countries
    Step 1: Estimate an equity risk premium for a mature market. If your
    preference is for a forward looking, updated number, you can
    estimate an implied equity risk premium for the US (assuming that
    you buy into the contention that it is a mature market)
    My estimate: In November 2013, my estimate for the implied premium in
    the US was 5.5%. That will also be my estimate for a mature market ERP.
    Step 2: Come up with a generic and measurable definition of a mature
    market.
    My estimate: Any AAA rated country is mature.
    Step 3: Estimate the additional risk premium that you will charge for
    markets that are not mature. You have two choices:
    The default spread for the country, estimated based either on sovereign
    ratings or the CDS market.
    A scaled up default spread, where you adjust the default spread upwards
    for the additional risk in equity markets.

    Aswath Damodaran
    113
    Andorra 7.45% 1.95% Liechtenstein 5.50% 0.00%Albania 12.25% 6.75%
    ERP : Nov 2013 Austria 5.50% 0.00% Luxembourg 5.50% 0.00%Armenia 10.23% 4.73% Bangladesh 10.90% 5.40%
    Belgium 6.70% 1.20% Malta 7.45% 1.95%Azerbaijan 8.88% 3.38% Cambodia 13.75% 8.25%
    Cyprus 22.00% 16.50% Netherlands 5.50% 0.00%Belarus 15.63% 10.13% China 6.94% 1.44%
    Denmark 5.50% 0.00% Norway 5.50% 0.00%Bosnia 15.63% 10.13% Fiji 12.25% 6.75%
    Finland 5.50% 0.00% Portugal 10.90% 5.40%Bulgaria 8.50% 3.00%
    Hong Kong 5.95% 0.45%
    France 5.95% 0.45% Spain 8.88% 3.38%Croatia 9.63% 4.13%
    India 9.10% 3.60%
    Germany 5.50% 0.00% Sweden 5.50% 0.00%Czech Republic 6.93% 1.43%
    Indonesia 8.88% 3.38%
    Estonia 6.93% 1.43%
    Greece 15.63% 10.13% Switzerland 5.50% 0.00% Japan 6.70% 1.20%
    Georgia 10.90% 5.40%
    Iceland 8.88% 3.38% Turkey 8.88% 3.38%Hungary 9.63% 4.13% Korea 6.70% 1.20%
    Ireland 9.63% 4.13% United Kingdom 5.95% 0.45%Kazakhstan 8.50% 3.00% Macao 6.70% 1.20%
    Italy 8.50% 3.00% Western Europe 6.72% 1.22%Latvia 8.50% 3.00% Malaysia 7.45% 1.95%
    Canada 5.50% 0.00% Lithuania 8.05% 2.55% Mauritius 8.05% 2.55%
    United States of America 5.50% 0.00% Country TRP CRP Macedonia 10.90% 5.40% Mongolia 12.25% 6.75%
    North America 5.50% 0.00% Angola 10.90% 5.40% Moldova 15.63% 10.13% Pakistan 17.50% 12.00%
    Argentina 15.63% 10.13% Benin 13.75% 8.25% Montenegro 10.90% 5.40% Papua NG 12.25% 6.75%
    Belize 19.75% 14.25% Botswana 7.15% 1.65% Poland 7.15% 1.65% Philippines 9.63% 4.13%
    Bolivia 10.90% 5.40% Burkina Faso 13.75% 8.25% Romania 8.88% 3.38%
    Singapore 5.50% 0.00%
    Brazil 8.50% 3.00% Cameroon 13.75% 8.25% Russia 8.05% 2.55%
    Sri Lanka 12.25% 6.75%
    Cape Verde 12.25% 6.75% Serbia 10.90% 5.40%
    Chile 6.70% 1.20% Taiwan 6.70% 1.20%
    Egypt 17.50% 12.00% Slovakia 7.15% 1.65%
    Colombia 8.88% 3.38% Thailand 8.05% 2.55%
    Slovenia 9.63% 4.13%
    Costa Rica 8.88% 3.38% Gabon 10.90% 5.40% Vietnam 13.75% 8.25%
    Ukraine 15.63% 10.13%
    Ecuador 17.50% 12.00% Ghana 12.25% 6.75% Asia 7.27% 1.77%
    E. Europe & Russia 8.60% 3.10%
    El Salvador 10.90% 5.40% Kenya 12.25% 6.75%
    Guatemala 9.63% 4.13% Morocco 9.63% 4.13% Bahrain 8.05% 2.55%
    Mozambique 12.25% 6.75% Israel 6.93% 1.43% Australia 5.50% 0.00%
    Honduras 13.75% 8.25%
    Namibia 8.88% 3.38% Jordan 12.25% 6.75% Cook Islands 12.25% 6.75%
    Mexico 8.05% 2.55%
    Nigeria 10.90% 5.40% Kuwait 6.40% 0.90% New Zealand 5.50% 0.00%
    Nicaragua 15.63% 10.13%
    Rwanda 13.75% 8.25% Lebanon 12.25% 6.75% Australia & NZ 5.50% 0.00%
    Panama 8.50% 3.00%
    Paraguay 10.90% 5.40% Senegal 12.25% 6.75% Oman 6.93% 1.43%
    Peru 8.50% 3.00% South Africa 8.05% 2.55% Qatar 6.40% 0.90%
    Suriname 10.90% 5.40% Tunisia 10.23% 4.73% Saudi Arabia 6.70% 1.20%
    UruguayAswath Damodaran
    8.88% 3.38% Uganda 12.25% 6.75% United Arab Emirates 6.40% 0.90% Black #: Total ERP
    Venezuela 12.25% 6.75% Zambia 12.25% 6.75% Middle East 6.88% 1.38% Red #: Country risk premium
    Latin America 9.44% 3.94% Africa 11.22% 5.82% AVG: GDP weighted average
    Estimating ERP for Disney: November 2013

    Incorporation: The conventional practice on equity risk premiums is to


    estimate an ERP based upon where a company is incorporated. Thus, the
    cost of equity for Disney would be computed based on the US equity risk
    premium, because it is a US company, and the Brazilian ERP would be
    used for Vale, because it is a Brazilian company.
    Operations: The more sensible practice on equity risk premium is to
    estimate an ERP based upon where a company operates. For Disney in
    2013:
    Proportion of Disneys
    Region/ Country ERP
    Revenues
    US& Canada 82.01% 5.50%
    Europe 11.64% 6.72%
    Asia-Pacific 6.02% 7.27%
    Latin America 0.33% 9.44%
    Disney 100.00% 5.76%

    Aswath Damodaran
    115
    ERP for Companies: November 2013
    Company Region/ Country Weight ERP
    Bookscape United States 100% 5.50%
    US & Canada 4.90% 5.50%
    Brazil 16.90% 8.50%
    Rest of Latin
    1.70% 10.09%
    America
    China 37.00% 6.94%
    Vale
    Japan 10.30% 6.70%
    In November 2013, Rest of Asia 8.50% 8.61%
    the mature market Europe 17.20% 6.72%
    Rest of World 3.50% 10.06%
    premium used was Company 100.00% 7.38%
    5.5% India 23.90% 9.10%
    China 23.60% 6.94%
    UK 11.90% 5.95%
    Tata Motors United States 10.00% 5.50%
    Mainland Europe 11.70% 6.85%
    Rest of World 18.90% 6.98%
    Company 100.00% 7.19%
    Baidu China 100% 6.94%
    Germany 35.93% 5.50%
    North America 24.72% 5.50%
    Rest of Europe 28.67% 7.02%
    Deutsche Bank
    Asia-Pacific 10.68% 7.27%
    South America 0.00% 9.44%
    Company 100.00% 6.12%

    Aswath Damodaran
    116
    The Anatomy of a Crisis: Implied ERP from
    September 12, 2008 to January 1, 2009
    117

    Aswath Damodaran
    117
    An Implied ERP

    Aswath Damodaran
    118
    119

    2016
    2015
    2014
    2013
    2012
    Implied Premiums in the US: 1960-2016

    2011
    2010
    2009
    2008
    2007
    2006
    2005
    Implied Premium for US Equity Market: 1960-2016

    2004
    2003
    2002
    2001
    2000
    1999
    1998
    1997
    1996
    1995
    1994
    1993
    1992
    1991
    1990
    1989
    1988
    1987
    1986
    1985
    1984
    1983
    1982
    1981
    1980
    1979
    1978
    1977
    1976
    1975
    1974
    1973
    1972
    1971
    1970
    1969
    1968
    1967
    1966

    Aswath Damodaran
    1965
    1964
    1963
    1962
    1961
    1960

    7.00%

    6.00%

    5.00%

    4.00%

    3.00%

    2.00%

    1.00%

    0.00%
    Implied Premium
    ERP : Jan 2017

    Black #: Total ERP


    Red #: Country risk premium
    AVG: GDP weighted average
    Application Test: Estimating a Market Risk
    Premium
    121

    For your company, get the geographical breakdown of revenues in


    the most recent year. Based upon this revenue breakdown and the
    most recent country risk premiums, estimate the equity risk
    premium that you would use for your company.

    This computation was based entirely on revenues. With your


    company, what concerns would you have about your estimate
    being too high or too low?

    Aswath Damodaran
    121
    Estimating Beta
    122

    The standard procedure for estimating betas is to regress


    stock returns (Rj) against market returns (Rm):
    Rj = a + b R m
    where a is the intercept and b is the slope of the regression.
    The slope of the regression corresponds to the beta of
    the stock, and measures the riskiness of the stock.
    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.

    Aswath Damodaran
    122
    Estimating Performance
    123

    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 ........... Capital Asset Pricing Model
    Rj = a + b Rm ........... 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.

    Aswath Damodaran
    123
    Setting up for the Estimation
    124

    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
    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.

    Aswath Damodaran
    124
    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 2009,
    Price for Disney at end of November 2009 = $ 30.22
    Price for Disney at end of December 2009 = $ 32.25
    Dividends during month = $0.35 (It was an ex-dividend month)
    Return =($32.25 - $30.22 + $ 0.35)/$30.22= 7.88%
    To estimate returns on the index in the same month
    Index level at end of November 2009 = 1095.63
    Index level at end of December 2009 = 1115.10
    Dividends on index in December 2009 = 1.683
    Return =(1115.1 1095.63+1.683)/ 1095.63 = 1.78%

    Aswath Damodaran
    125
    Disneys Historical Beta

    !
    Return on Disney = .0071 + 1.2517 Return on Market R = 0.73386
    (0.10)
    Analyzing Disneys Performance

    Intercept = 0.712%
    This is an intercept based on monthly returns. Thus, it has to be
    compared to a monthly riskfree rate.
    Between 2008 and 2013
    n Average Annualized T.Bill rate = 0.50%
    n Monthly Riskfree Rate = 0.5%/12 = 0.042%
    n Riskfree Rate (1-Beta) = 0.042% (1-1.252) = -.0105%
    The Comparison is then between
    Intercept versus Riskfree Rate (1 - Beta)
    0.712% versus 0.0105%
    Jensens Alpha = 0.712% - (-0.0105)% = 0.723%
    Disney did 0.723% better than expected, per month, between
    October 2008 and September 2013
    Annualized, Disneys annual excess return = (1.00723)12 -1= 9.02%

    Aswath Damodaran
    127
    More on Jensens Alpha
    128

    If you did this analysis on every stock listed on an exchange, what would the
    average Jensens alpha be across all stocks?
    a. Depend upon whether the market went up or down during the period
    b. Should be zero
    c. Should be greater than zero, because stocks tend to go up more often than down.
    Disney has a positive Jensens alpha of 9.02% a year between 2008 and 2013.
    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
    Disney has had a positive Jensens alpha between 2008 and 2013. If you were an
    investor in early 2014, looking at the stock, you would view this as a sign that the
    stock will be a:
    a. Good investment for the future
    b. Bad investment for the future
    c. No information about the future

    Aswath Damodaran
    128
    Estimating Disneys Beta

    Slope of the Regression of 1.25 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 0.10.
    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?

    Aswath Damodaran
    129
    The Dirty Secret of Standard Error

    Distribution of Standard Errors: Beta Estimates for U.S. stocks

    1600

    1400

    1200

    1000
    Number of Firms

    800

    600

    400

    200

    0
    <.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75

    Standard Error in Beta Estimate

    Aswath Damodaran
    130
    Breaking down Disneys Risk

    R Squared = 73%
    This implies that
    73% of the risk at Disney comes from market sources
    27%, therefore, comes from firm-specific sources
    The firm-specific risk is diversifiable and will not be
    rewarded.
    The R-squared for companies, globally, has increased
    significantly since 2008. Why might this be happening?

    What are the implications for investors?

    Aswath Damodaran
    131
    The Relevance of R Squared
    132

    You are a diversified investor trying to decide


    whether you should invest in Disney or Amgen. They
    both have betas of 1.25, but Disney has an R
    Squared of 73% while Amgens R squared is only
    25%. Which one would you invest in?
    Amgen, because it has the lower R squared
    Disney, because it has the higher R squared

    You would be indifferent

    Would your answer be different if you were an


    undiversified investor?
    Aswath Damodaran
    132
    Beta Estimation: Using a Service
    (Bloomberg)

    Aswath Damodaran
    133
    Estimating Expected Returns for Disney in
    November 2013
    Inputs to the expected return calculation
    Disneys Beta = 1.25
    Riskfree Rate = 2.75% (U.S. ten-year T.Bond rate in
    November 2013)
    Risk Premium = 5.76% (Based on Disneys operating
    exposure)
    Expected Return = Riskfree Rate + Beta (Risk Premium)
    = 2.75% + 1.25 (5.76%) = 9.95%

    Aswath Damodaran
    134
    Use to a Potential Investor in Disney

    As a potential investor in Disney, what does this expected


    return of 9.95% tell you?
    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,
    This is the return that I need to make on Disney in the long term to
    break even on my investment in the stock
    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 9.95%, you would
    Buy the stock
    Sell the stock

    Aswath Damodaran
    135
    How managers use this expected return

    Managers at Disney
    need to make at least 9.95% 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 9.95%.
    What is the cost of not delivering this cost of equity?

    Aswath Damodaran
    136
    Application Test: Analyzing the Risk Regression
    137

    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?
    Intercept - (Riskfree Rate/n) (1- Beta) = Jensens Alpha
    n 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

    Aswath Damodaran
    137
    A Quick Test
    138

    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 20%. 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?


    Yes
    No

    Aswath Damodaran
    138
    Regression Diagnostics for Tata Motors

    Beta = 1.83
    67% range
    1.67-1.99

    69% market risk


    31% firm specific

    Jensens a
    = 2.28% - 4%/12 (1-1.83) = 2.56% Expected Return (in Rupees)
    Annualized = (1+.0256)12-1= 35.42% = Riskfree Rate+ Beta*Risk premium
    Average monthly riskfree rate (2008-13) = 4% = 6.57%+ 1.83 (7.19%) = 19.73%
    Aswath Damodaran
    139
    A better beta? Vale

    Aswath Damodaran
    140
    Deutsche Bank and Baidu: Index Effects on
    Risk Parameters
    For Deutsche Bank, a widely held European stock,
    we tried both the DAX (German index) and the FTSE
    European index.

    For Baidu, a NASDAQ listed stock, we ran regressions


    against both the S&P 500 and the NASDAQ.

    Aswath Damodaran
    141
    Beta: Exploring Fundamentals
    142

    Beta > 2 Bulgari: 2.45

    Qwest Communications: 1.85

    Beta
    between 1 Microsoft: 1.25
    and 2
    GE: 1.15

    Beta <1 Exxon Mobil: 0.70

    Altria (Philip Morris): 0.60

    Harmony Gold Mining: -0.15


    Beta <0

    Aswath Damodaran
    142
    Determinant 1: Product Type
    143

    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

    Aswath Damodaran
    143
    A Simple Test
    144

    Phone service is close to being non-discretionary in the


    United States and Western Europe. However, in much of
    Asia and Latin America, there are large segments of the
    population for which phone service is a luxury.
    Given our discussion of discretionary and non-
    discretionary products, which of the following
    conclusions would you be willing to draw:
    Emerging market telecom companies should have higher betas
    than developed market telecom companies.
    Developed market telecom companies should have higher betas
    than emerging market telecom companies
    The two groups of companies should have similar betas

    Aswath Damodaran
    144
    Determinant 2: Operating Leverage Effects
    145

    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.

    Aswath Damodaran
    145
    Measures of Operating Leverage
    146

    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.

    Aswath Damodaran
    146
    Disneys Operating Leverage: 1987- 2013

    Year Net Sales % Change in EBIT % Change in


    Sales EBIT
    1987 $2,877 $756
    1988 $3,438 19.50% $848 12.17%
    1989 $4,594 33.62% $1,177 38.80%
    1990 $5,844 27.21% $1,368 16.23%
    1991 $6,182 5.78% $1,124 -17.84%
    1992 $7,504 21.38% $1,287 14.50%
    1993 $8,529 13.66% $1,560 21.21% Average across entertainment companies = 1.35
    1994 $10,055 17.89% $1,804 15.64%
    1995 $12,112 20.46% $2,262 25.39%
    1996 $18,739 54.71% $3,024 33.69%
    1997 $22,473 19.93% $3,945 30.46%
    Given Disneys operating leverage measures (1.01
    1998 $22,976 2.24% $3,843 -2.59% or 1.25), would you expect Disney to have a higher
    1999 $23,435 2.00% $3,580 -6.84%
    2000 $25,418 8.46% $2,525 -29.47% or a lower beta than other entertainment
    2001 $25,172 -0.97% $2,832 12.16%
    2002 $25,329 0.62% $2,384 -15.82%
    companies?
    2003 $27,061 6.84% $2,713 13.80% a.Higher
    2004 $30,752 13.64% $4,048 49.21%
    2005 $31,944 3.88% $4,107 1.46% b.Lower
    2006 $33,747 5.64% $5,355 30.39%
    2007 $35,510 5.22% $6,829 27.53%
    c.No effect
    2008 $37,843 6.57% $7,404 8.42%
    2009 $36,149 -4.48% $5,697 -23.06%
    2010 $38,063 5.29% $6,726 18.06%
    2011 $40,893 7.44% $7,781 15.69%
    2012 $42,278 3.39% $8,863 13.91%
    2013 $45,041 6.54% $9,450 6.62% Operating Leverage
    Average:
    87-13 11.79% 11.91% 11.91/11.79 =1.01
    Average:
    96-13 8.16% 10.20% 10.20/8.16 =1.25
    Aswath Damodaran
    147
    Determinant 3: Financial Leverage
    148

    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.
    The beta of equity alone can be written as a function of the
    unlevered beta and the debt-equity ratio
    bL = bu (1+ ((1-t)D/E))
    where
    bL = Levered or Equity Beta D/E = Market value Debt to equity ratio
    bu = Unlevered or Asset Beta t = Marginal tax rate

    Earlier, we estimated the beta for Disney from a regression. Was


    that beta a levered or unlevered beta?
    a. Levered
    b. Unlevered

    Aswath Damodaran
    148
    Effects of leverage on betas: Disney

    The regression beta for Disney is 1.25. 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 (2008 to 2013)
    The average debt equity ratio during this period was
    19.44%.
    The unlevered beta for Disney can then be estimated
    (using a marginal tax rate of 36.1%)
    = Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
    = 1.25 / (1 + (1 - 0.361)(0.1944))= 1.1119

    Aswath Damodaran
    149
    Disney : Beta and Financial Leverage

    Debt to Capital Debt/Equity Ratio Beta Effect of Leverage


    0.00% 0.00% 1.11 0.00
    10.00% 11.11% 1.1908 0.08
    20.00% 25.00% 1.29 0.18
    30.00% 42.86% 1.42 0.30
    40.00% 66.67% 1.59 0.47
    50.00% 100.00% 1.82 0.71
    60.00% 150.00% 2.18 1.07
    70.00% 233.33% 2.77 1.66
    80.00% 400.00% 3.95 2.84
    90.00% 900.00% 7.51 6.39

    Aswath Damodaran
    150
    Betas are weighted Averages
    151

    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.

    Aswath Damodaran
    151
    The Disney/Cap Cities Merger (1996): Pre-
    Merger
    152

    Disney: The Acquirer

    Debt = $3,186 million


    Equity Beta Market value of equity = $31,100 million
    1.15 Debt + Equity = Firm value = $31,100
    + $3186 = $34,286 million
    D/E Ratio = 3186/31100 = 0.10

    +
    Capital Cities: The Target
    Debt = $ 615 million
    Equity Beta Market value of equity = $18, 500 million
    0.95 Debt + Equity = Firm value = $18,500 +
    $615 = $19,115 million
    D/E Ratio = 615/18500 = 0.03

    Aswath Damodaran
    152
    Disney Cap Cities Beta Estimation: Step 1
    153

    Calculate the unlevered betas for both firms


    Disneys unlevered beta = 1.15/(1+0.64*0.10) = 1.08
    Cap Cities unlevered beta = 0.95/(1+0.64*0.03) = 0.93

    Calculate the unlevered beta for the combined firm


    Unlevered Beta for combined firm
    = 1.08 (34286/53401) + 0.93 (19115/53401)
    = 1.026
    The weights used are the firm values (and not just the
    equity values) of the two firms, since these are unlevered
    betas and thus reflects the risks of the entire businesses
    and not just the equity]

    Aswath Damodaran
    153
    Disney Cap Cities Beta Estimation: Step 2
    154

    If Disney had used all equity to buy Cap Cities equity, while assuming Cap
    Cities debt, the consolidated numbers would have looked as follows:
    Debt = $ 3,186+ $615 = $ 3,801 million
    Equity = $ 31,100 + $18,500 = $ 49,600 m (Disney issues $18.5 billion in equity)
    D/E Ratio = 3,801/49600 = 7.66%
    New Beta = 1.026 (1 + 0.64 (.0766)) = 1.08
    Since Disney borrowed $ 10 billion to buy Cap Cities/ABC, funded the rest
    with new equity and assumed Cap Cities debt:
    The market value of Cap Cities equity is $18.5 billion. If $ 10 billion comes from
    debt, the balance ($8.5 billion) has to come from new equity.
    Debt = $ 3,186 + $615 million + $ 10,000 = $ 13,801 million
    Equity = $ 31,100 + $8,500 = $39,600 million
    D/E Ratio = 13,801/39600 = 34.82%
    New Beta = 1.026 (1 + 0.64 (.3482)) = 1.25

    Aswath Damodaran
    154
    Firm Betas versus divisional Betas
    155

    Firm Betas as weighted averages: The beta of a firm


    is the weighted average of the betas of its individual
    projects.
    Firm Betas and Business betas: At a broader level of
    aggregation, the beta of a firm is the weighted
    average of the betas of its individual division.

    Aswath Damodaran
    155
    Bottom-up versus Top-down Beta
    156

    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 is a better estimate than the top down
    beta for the following reasons
    The standard error of the beta estimate will be much lower
    The betas can reflect the current (and even expected future) mix of
    businesses that the firm is in rather than the historical mix

    Aswath Damodaran
    156
    Disneys businesses: The financial
    breakdown (from 2013 annual report)

    Aswath Damodaran
    157
    Unlevered Betas for businesses Unlevered Beta
    (1 - Cash/ Firm Value)

    Median
    Company Cash/ Business
    Sample Median Median Median Unlevered Firm Unlevered
    Business Comparable firms size Beta D/E Tax rate Beta Value Beta
    US firms in
    broadcasting
    Media Networks business 26 1.43 71.09% 40.00% 1.0024 2.80% 1.0313
    Global firms in
    amusement park
    Parks & Resorts business 20 0.87 46.76% 35.67% 0.6677 4.95% 0.7024
    Studio
    Entertainment US movie firms 10 1.24 27.06% 40.00% 1.0668 2.96% 1.0993

    Global firms in
    Consumer toys/games
    Products production & retail 44 0.74 29.53% 25.00% 0.6034 10.64% 0.6752
    Global computer
    Interactive gaming firms 33 1.03 3.26% 34.55% 1.0085 17.25% 1.2187

    Aswath Damodaran
    158
    A closer look at the process
    Studio Entertainment Betas
    Enterprise Value (EV) = Market Cap + Debt - Cash
    Firm value = Market Cap + Total Debt Gross D/E = Total Debt/ Market
    Cap

    Aswath Damodaran
    159
    Backing into a pure play beta: Studio
    Entertainment
    160

    The Median Movie Company


    Movie Business 97.04 Beta (movies) = 1.0993 Debt 21.30 Beta (debt) = 0

    Equity 78.70 Beta (equity) = 1.24


    Cash Businesss 2.96 Beta (cash) = 0.0000

    Movie Company 100.0 Beta (company) = 1.0668

    1. Start with the median regression beta (equity beta) of 1.24


    2. Unlever the beta, using the median gross D/E ratio of 27.06%
    Gross D/E ratio = 21.30/78.70 = 27.06%
    Unlevered beta = 1.24/ (1+ (1-.4) (.2706)) = 1.0668
    3. Take out the cash effect, using the median cash/value of 2.96%
    (.0296) (0) + (1-.0296) (Beta of movie business) = 1.0668
    Beta of movie business = 1.0668/(1-.0296) = 1.0993
    Alternatively, you could have used the net debt to equity ratio
    Net D/E ratio = (21.30-2.96)/78.70 = 23.30%
    Aswath DamodaranUnlevered beta for movies = 1.24/ (1+(1-.4)(.233)) = 1.0879
    160
    Disneys unlevered beta: Operations &
    Entire Company

    Value of Proportion of Unlevered


    Business Revenues EV/Sales Business Disney beta Value Proportion
    Media Networks $20,356 3.27 $66,580 49.27% 1.03 $66,579.81 49.27%
    Parks & Resorts $14,087 3.24 $45,683 33.81% 0.70 $45,682.80 33.81%
    Studio Entertainment $5,979 3.05 $18,234 13.49% 1.10 $18,234.27 13.49%
    Consumer Products $3,555 0.83 $2,952 2.18% 0.68 $2,951.50 2.18%
    Interactive $1,064 1.58 $1,684 1.25% 1.22 $1,683.72 1.25%
    Disney Operations $45,041 $135,132 100.00% 0.9239 $135,132.11

    Disney has $3.93 billion in cash, invested in close to riskless assets (with a beta of zero).
    You can compute an unlevered beta for Disney as a company (inclusive of cash):

    Aswath Damodaran
    161
    The levered beta: Disney and its divisions

    To estimate the debt ratios for division, we allocate Disneys total debt
    ($15,961 million) to its divisions based on identifiable assets.

    We use the allocated debt to compute D/E ratios and levered betas.
    Business Unlevered beta Value of business D/E ratio Levered beta Cost of Equity
    Media Networks 1.0313 $66,580 10.03% 1.0975 9.07%
    Parks & Resorts 0.7024 $45,683 11.41% 0.7537 7.09%
    Studio Entertainment 1.0993 $18,234 20.71% 1.2448 9.92%
    Consumer Products 0.6752 $2,952 117.11% 1.1805 9.55%
    Interactive 1.2187 $1,684 41.07% 1.5385 11.61%
    Disney Operations 0.9239 $135,132 13.10% 1.0012 8.52%
    Aswath Damodaran
    162
    Discussion Issue
    163

    Assume now that you are the CFO of Disney. The


    head of the movie business has come to you with a
    new big budget movie that he would like you to
    fund. He claims that his analysis of the movie
    indicates that it will generate a return on equity of
    9.5%. Would you fund it?
    Yes. It is higher than the cost of equity for Disney as a
    company
    No. It is lower than the cost of equity for the movie
    business.
    What are the broader implications of your choice?

    Aswath Damodaran
    163
    Estimating Bottom Up Betas & Costs of
    Equity: Vale
    Sample' Unlevered'beta' Peer'Group' Value'of' Proportion'of'
    Business' Sample' size' of'business' Revenues' EV/Sales' Business' Vale'

    Global'firms'in'metals'&'
    Metals'&' mining,'Market'cap>$1'
    Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'

    Iron'Ore' Global'firms'in'iron'ore' 78' 0.83' $32,717' 2.48' $81,188' 76.20%'

    Global'specialty'
    Fertilizers' chemical'firms' 693' 0.99' $3,777' 1.52' $5,741' 5.39%'

    Global'transportation'
    Logistics' firms' 223' 0.75' $1,644' 1.14' $1,874' 1.76%'
    Vale'
    Operations' '' '' 0.8440' $47,151' '' $106,543' 100.00%'

    Aswath Damodaran
    164
    Vale: Cost of Equity Calculation in
    nominal $R
    To convert a discount rate in one currency to another, all you need are
    expected inflation rates in the two currencies.
    (1+ Inflation Rate Brazil )
    (1+ $ Cost of Equity) 1
    (1+ Inflation Rate US )

    From US $ to R$: If we use 2% as the inflation rate in US dollars and 9% as


    the inflation ratio in Brazil, we can convert Vales US dollar cost of equity

    of 11.23% to a $R cost of equity:

    Alternatively, you can compute a cost of equity, starting with the $R


    riskfree rate of 10.18%.
    Cost of Equity in $R = = 10.18% + 1.15 (7.38%) = 18.67%

    Aswath Damodaran
    165
    Bottom up betas & Costs of Equity: Tata
    Motors & Baidu
    Tata Motors: We estimated an unlevered beta of 0.8601
    across 76 publicly traded automotive companies (globally)
    and estimated a levered beta based on Tata Motors D/E ratio
    of 41.41% and a marginal tax rate of 32.45% for India:
    Levered Beta for Tata Motors = 0.8601 (1 + (1-.3245) (.4141)) = 1.1007
    Cost of equity for Tata Motors (Rs) = 6.57% + 1.1007 (7.19%) = 14.49%
    Baidu: To estimate its beta, we looked at 42 global companies
    that derive all or most of their revenues from online
    advertising and estimated an unlevered beta of 1.30 for the
    business. Incorporating Baidus current market debt to equity
    ratio of 5.23% and the marginal tax rate for China of 25%, we
    estimate Baidus current levered beta to be 1.3560.
    Levered Beta for Baidu = 1.30 (1 + (1-.25) (.0523)) = 1.356
    Cost of Equity for Baidu (Renmimbi) = 3.50% + 1.356 (6.94%) = 12.91%

    Aswath Damodaran
    166
    Bottom up Betas and Costs of Equity:
    Deutsche Bank
    We break Deutsche Bank down into two businesses commercial and
    investment banking.

    We do not unlever or relever betas, because estimating debt and equity


    for banks is an exercise in futility. Using a riskfree rate of 1.75% (Euro risk
    free rate) and Deutsches ERP of 6.12%:

    Aswath Damodaran
    167
    Estimating Betas for Non-Traded Assets
    168

    The conventional approaches of estimating betas


    from regressions do not work for assets that are not
    traded. There are no stock prices or historical
    returns that can be used to compute regression
    betas.
    There are two ways in which betas can be estimated
    for non-traded assets
    Using comparable firms
    Using accounting earnings

    Aswath Damodaran
    168
    Using comparable firms to estimate beta
    for Bookscape

    Unlevered beta for book company = 0.8130/ (1+ (1-.4) (.2141)) = 0.7205
    Aswath Damodaran Unlevered beta for book business = 0.7205/(1-.05) = 0.7584 169
    Estimating Bookscape Levered Beta and
    Cost of Equity
    Because the debt/equity ratios used in computing
    levered betas 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 book industry median market
    debt to equity ratio of 21.41 percent.
    Using a marginal tax rate of 40 percent for Bookscape,
    we get a levered beta of 0.8558.
    Levered beta for Bookscape = 0.7584[1 + (1 0.40) (0.2141)] = 0.8558
    Using a riskfree rate of 2.75% (US treasury bond rate)
    and an equity risk premium of 5.5%:
    Cost of Equity = 2.75%+ 0.8558 (5.5%) = 7.46%

    Aswath Damodaran
    170
    Is Beta an Adequate Measure of Risk for a
    Private Firm?
    Beta measures the risk added on to a diversified
    portfolio. The owners of most private firms are not
    diversified. 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

    Aswath Damodaran
    171
    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 0.8558
    and the median R-squared of the comparable publicly traded
    firms is 26.00%; the correlation with the market is 50.99%.
    Market Beta 0.8558
    = = 1.6783
    R squared .5099

    Total Cost of Equity = 2.75 + 1.6783 (5.5%) = 11.98%

    Aswath Damodaran
    172
    Application Test: Estimating a Bottom-up Beta
    173

    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.

    Aswath Damodaran
    173
    From Cost of Equity to Cost of Capital
    174

    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

    Aswath Damodaran
    174
    What is debt?
    175

    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.

    Aswath Damodaran
    175
    Estimating the Cost of Debt
    176

    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.

    Aswath Damodaran
    176
    The easy route: Outsourcing the
    measurement of default risk
    For those firms that have bond ratings from global
    ratings agencies, I used those ratings:
    Company S&P Rating Risk-Free Rate Default Spread Cost of Debt
    Disney A 2.75% (US $) 1.00% 3.75%
    Deutsche Bank A 1.75% (Euros) 1.00% 2.75%
    Vale A- 2.75% (US $) 1.30% 4.05%

    If you want to estimate Vales cost of debt in $R


    terms, we can again use the differential inflation
    approach we used for the cost of equity:

    Aswath Damodaran
    177
    A more general route: Estimating Synthetic
    Ratings
    The rating for a firm can be estimated using the
    financial characteristics of the firm. In its simplest
    form, we can use just the interest coverage ratio:
    Interest Coverage Ratio = EBIT / Interest Expenses
    For the non-financial service companies, we obtain
    the following:
    Company Operating income Interest Expense Interest coverage ratio
    Disney $10.023 $444 22.57
    Vale $15,667 $1,342 11.67
    Tata Motors Rs 166,605 Rs 36,972 4.51
    Baidu CY 11,193 CY 472 23.72
    Bookscape $2,536 $492 5.16

    Aswath Damodaran
    178
    Interest Coverage Ratios, Ratings and
    Default Spreads- November 2013

    Disney: Large cap, developed 22.57 AAA


    Vale: Large cap, emerging 11.67 AA
    Tata Motors: Large cap, Emerging 4.51 A-
    Baidu: Small cap, Emerging 23.72 AAA
    Bookscape: Small cap, private 5.16 A-
    Aswath Damodaran
    179
    Synthetic versus Actual Ratings: Rated
    Firms
    Disneys synthetic rating is AAA, whereas its actual rating is A.
    The difference can be attributed to any of the following:
    Synthetic ratings reflect only the interest coverage ratio whereas
    actual ratings incorporate all of the other ratios and qualitative factors
    Synthetic ratings do not allow for sector-wide biases in ratings
    Synthetic rating was based on 2013 operating income whereas actual
    rating reflects normalized earnings
    Vales synthetic rating is AA, but the actual rating for dollar
    debt is A-. The biggest factor behind the difference is the
    presence of country risk, since Vale is probably being rated
    lower for being a Brazil-based corporation.
    Deutsche Bank had an A rating. We will not try to estimate a
    synthetic rating for the bank. Defining interest expenses on
    debt for a bank is difficult

    Aswath Damodaran
    180
    Estimating Cost of Debt

    For Bookscape, we will use the synthetic rating (A-) to estimate the cost of
    debt:
    Default Spread based upon A- rating = 1.30%
    Pre-tax cost of debt = Riskfree Rate + Default Spread = 2.75% + 1.30% = 4.05%
    After-tax cost of debt = Pre-tax cost of debt (1- tax rate) = 4.05% (1-.40) = 2.43%
    For the three publicly traded firms that are rated in our sample, we will
    use the actual bond ratings to estimate the costs of debt.
    Company S&P Rating Risk-Free Rate Default Spread Cost of Debt Tax Rate After-Tax Cost of Debt
    Disney A 2.75% (US $) 1.00% 3.75% 36.1% 2.40%
    Deutsche Bank A 1.75% (Euros) 1.00% 2.75% 29.48% 1.94%
    Vale A- 2.75% (US $) 1.30% 4.05% 34% 2.67%

    For Tata Motors, we have a rating of AA- from CRISIL, an Indian bond-
    rating firm, that measures only company risk. Using that rating:
    Cost of debtTMT = Risk free rateRupees + Default spreadIndia + Default spreadTMT
    = 6.57% + 2.25% + 0.70% = 9.62%
    After-tax cost of debt = 9.62% (1-.3245) = 6.50%

    Aswath Damodaran
    181
    Default Spreads January 2017

    Default Spreads for 10-year Corporate Bonds: 2015 thru 2017


    25.00%

    20.00%

    15.00%
    Axis Title

    10.00%

    5.00%

    0.00%
    Aaa/AA Baa2/BB
    Aa2/AA A1/A+ A2/A A3/A- Ba1/BB+ Ba2/BB B1/B+ B2/B B3/B- Caa/CCC Ca2/CC C2/C D2/D
    A B
    Spread: 2017 0.60% 0.80% 1.00% 1.10% 1.25% 1.60% 2.50% 3.00% 3.75% 4.50% 5.50% 6.50% 8.00% 10.50% 14.00%
    Spread: 2016 0.75% 1.00% 1.10% 1.25% 1.75% 2.25% 3.25% 4.25% 5.50% 6.50% 7.50% 9.00% 12.00% 16.00% 20.00%
    Spread: 2015 0.40% 0.70% 0.90% 1.00% 1.20% 1.75% 2.75% 3.25% 4.00% 5.00% 6.00% 7.00% 8.00% 10.00% 12.00%

    Aswath Damodaran
    182
    Application Test: Estimating a Cost of Debt
    183

    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 tables from prior
    pages)
    A pre-tax cost of debt for your firm

    An after-tax cost of debt for your firm

    Aswath Damodaran
    183
    Costs of Hybrids
    184

    Preferred stock shares some of the characteristics of


    debt - the preferred dividend is pre-specified at the time
    of the issue and is paid out before common dividend --
    and some of the characteristics of equity - the payments
    of preferred dividend are not tax deductible. If preferred
    stock is viewed as perpetual, the cost of preferred stock
    can be written as follows:
    kps = Preferred Dividend per share/ Market Price per
    preferred share
    Convertible debt is part debt (the bond part) and part
    equity (the conversion option). It is best to break it up
    into its component parts and eliminate it from the mix
    altogether.

    Aswath Damodaran
    184
    Weights for Cost of Capital Calculation
    185

    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.

    Aswath Damodaran
    185
    Disney: From book value to market value
    for interest bearing debt
    In Disneys 2013 financial statements, the debt due over time was footnoted.
    Weight
    Time due Amount due Weight
    *Maturity
    0.5 $1,452 11.96% 0.06 The debt in this table does
    2 $1,300 10.71% 0.21
    not add up to the book value
    3 $1,500 12.36% 0.37
    of debt, because Disney
    4 $2,650 21.83% 0.87
    6 $500 4.12% 0.25
    does not break down the
    8 $1,362 11.22% 0.9 maturity of all of its debt.
    9 $1,400 11.53% 1.04
    19 $500 4.12% 0.78
    26 $25 0.21% 0.05
    28 $950 7.83% 2.19
    29 $500 4.12% 1.19
    $12,139 7.92
    Disneys total debt due, in book value terms, on the balance sheet is $14,288
    million and the total interest expense for the year was $349 million. Using 3.75%
    as the pre-tax cost of debt: " 1 %
    $ (1 (1.0375) '
    Estimated MV of Disney Debt = 349 $ '+
    7.92
    14, 288
    = $13, 028 million
    7.92
    $ .0375 ' (1.0375)
    $# '&

    Aswath Damodaran
    186
    Operating Leases at Disney

    The debt value of operating leases is the present


    value of the lease payments, at a rate that reflects
    their risk, usually the pre-tax cost of debt.
    The pre-tax cost of debt at Disney is 3.75%.
    Year Commitment Present Value @3.75%
    1 $507.00 $488.67 Disney reported $1,784 million
    2 $422.00 $392.05 in commitments after year 5.
    3 $342.00 $306.24 Given that their average
    4 $272.00 $234.76 commitment over the first 5
    5 $217.00 $180.52 years, we assumed 5 years @
    6-10 $356.80 $1,330.69 $356.8 million each.
    Debt value of leases $2,932.93

    Debt outstanding at Disney = $13,028 + $ 2,933= $15,961 million

    Aswath Damodaran
    187
    Application Test: Estimating Market Value
    188

    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

    Aswath Damodaran
    188
    Current Cost of Capital: Disney

    Equity
    Cost of Equity = Riskfree rate + Beta * Risk Premium
    = 2.75% + 1.0013 (5.76%) = 8.52%
    Market Value of Equity = $121,878 million
    Equity/(Debt+Equity ) = 88.42%
    Debt
    After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
    = (2.75%+1%) (1-.361) = 2.40%
    Market Value of Debt = $13,028+ $2933 = $ 15,961 million
    Debt/(Debt +Equity) = 11.58%
    Cost of Capital = 8.52%(.8842)+ 2.40%(.1158) = 7.81%
    Aswath Damodaran
    121,878/ (121,878+15,961)
    189
    Divisional Costs of Capital: Disney and Vale

    Disney
    Cost!of! Cost!of! Marginal!tax! After6tax!cost!of! Debt! Cost!of!
    !! equity! debt! rate! debt! ratio! capital!
    Media!Networks! 9.07%! 3.75%! 36.10%! 2.40%! 9.12%! 8.46%!
    Parks!&!Resorts! 7.09%! 3.75%! 36.10%! 2.40%! 10.24%! 6.61%!
    Studio!
    Entertainment! 9.92%! 3.75%! 36.10%! 2.40%! 17.16%! 8.63%!
    Consumer!Products! 9.55%! 3.75%! 36.10%! 2.40%! 53.94%! 5.69%!
    Interactive! 11.65%! 3.75%! 36.10%! 2.40%! 29.11%! 8.96%!
    Disney!Operations! 8.52%! 3.75%! 36.10%! 2.40%! 11.58%! 7.81%!

    Vale
    Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
    Business equity debt ratio US$) $R)
    Metals &
    Mining 11.35% 2.67% 35.48% 8.27% 15.70%
    Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
    Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
    Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
    Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%
    Aswath Damodaran
    190
    Costs of Capital: Tata Motors, Baidu and
    Bookscape
    To estimate the costs of capital for Tata Motors in Indian
    rupees:
    Cost of capital= 14.49% (1-.2928) + 6.50% (.2928) = 12.15%
    For Baidu, we follow the same path to estimate a cost of
    equity in Chinese RMB:
    Cost of capital = 12.91% (1-.0523) + 3.45% (.0523) = 12.42%
    For Bookscape, the cost of capital is different depending on
    whether you look at market or total beta:
    Cost of After-tax cost of
    equity Pre-tax Cost of debt debt D/(D+E) Cost of capital
    Market Beta 7.46% 4.05% 2.43% 17.63% 6.57%
    Total Beta 11.98% 4.05% 2.43% 17.63% 10.30%

    Aswath Damodaran
    191
    Application Test: Estimating Cost of Capital
    192

    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?
    Aswath Damodaran
    192
    Choosing a Hurdle Rate
    193

    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.

    Aswath Damodaran
    193
    Back to First Principles
    194

    Aswath Damodaran
    194
    Aswath Damodaran 195

    MEASURING INVESTMENT RETURNS


    I: THE MECHANICS OF INVESTMENT
    ANALYSIS

    Show me the money


    from Jerry Maguire
    First Principles
    196

    Aswath Damodaran
    196
    Measures of return: earnings versus cash flows
    197

    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).

    Aswath Damodaran
    197
    Measuring Returns Right: The Basic Principles
    198

    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

    Aswath Damodaran
    198
    Setting the table: What is an
    investment/project?
    199

    An investment/project can range the spectrum from big to


    small, money making to cost saving:
    Major strategic decisions to enter new areas of business or new
    markets.
    Acquisitions of other firms are projects as well, notwithstanding
    attempts to create separate sets of rules for them.
    Decisions on new ventures within existing businesses or markets.
    Decisions that may change the way existing ventures and projects are
    run.
    Decisions on how best to deliver a service that is necessary for the
    business to run smoothly.
    Put in broader terms, every choice made by a firm can be
    framed as an investment.

    Aswath Damodaran
    199
    Here are four examples
    200

    Rio Disney: We will consider whether Disney should invest in its first
    theme parks in South America. These parks, while similar to those that
    Disney has in other parts of the world, will require us to consider the
    effects of country risk and currency issues in project analysis.
    New iron ore mine for Vale: This is an iron ore mine that Vale is
    considering in Western Labrador, Canada.
    An Online Store for Bookscape: Bookscape is evaluating whether it should
    create an online store to sell books. While it is an extension of their basis
    business, it will require different investments (and potentially expose
    them to different types of risk).
    Acquisition of Harman by Tata Motors: A cross-border bid by Tata for
    Harman International, a publicly traded US firm that manufactures high-
    end audio equipment, with the intent of upgrading the audio upgrades on
    Tata Motors automobiles. This investment will allow us to examine
    currency and risk issues in such a transaction.

    Aswath Damodaran
    200
    Earnings versus Cash Flows: A Disney Theme
    Park
    201

    The theme parks to be built near Rio, modeled on


    Euro Disney in Paris and Disney World in Orlando.
    The complex 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 fourth year.
    The earnings and cash flows are estimated in
    nominal U.S. Dollars.
    Aswath Damodaran
    201
    Key Assumptions on Start Up and Construction
    202

    Disney has already spent $0.5 Billion researching the proposal and
    getting the necessary licenses for the park; none of this investment
    can be recovered if the park is not built. This expenditure has been
    capitalized and will be depreciated straight line over ten years to a
    salvage value of zero.
    Disney will face substantial construction costs, if it chooses to build
    the theme parks.
    The cost of constructing Magic Kingdom will be $3 billion, with $ 2 billion
    to be spent right now, and $1 Billion to be spent one year from now.
    The cost of constructing Epcot II will be $ 1.5 billion, with $ 1 billion to be
    spent at the end of the second year and $0.5 billion at the end of the third
    year.
    These investments will be depreciated based upon a depreciation
    schedule in the tax code, where depreciation will be different each year.

    Aswath Damodaran
    202
    Key Revenue Assumptions
    203

    Revenue estimates for the parks and resort properties (in millions)
    Year Magic Kingdom Epcot II Resort Properties Total
    1 $0 $0 $0 $0
    2 $1,000 $0 $250 $1,250
    3 $1,400 $0 $350 $1.750
    4 $1,700 $300 $500 $2.500
    5 $2,000 $500 $625 $3.125
    6 $2,200 $550 $688 $3,438
    7 $2,420 $605 $756 $3,781
    8 $2,662 $666 $832 $4,159
    9 $2,928 $732 $915 $4,575
    10 $2,987 $747 $933 $4,667

    Aswath Damodaran
    203
    Key Expense Assumptions
    204

    The operating expenses are assumed to be 60% of


    the revenues at the parks, and 75% of revenues at
    the resort properties.
    Disney will also allocate corporate general and
    administrative costs to this project, based upon
    revenues; the G&A allocation will be 15% of the
    revenues each year. It is worth noting that a recent
    analysis of these expenses found that only one-third
    of these expenses are variable (and a function of
    total revenue) and that two-thirds are fixed.
    Aswath Damodaran
    204
    Depreciation and Capital Maintenance
    205

    The capital maintenance expenditures are low in the


    early years, when the parks are still new but increase as
    the parks age.

    Aswath Damodaran
    205
    Other Assumptions
    206

    Disney will have to maintain non-cash working


    capital (primarily consisting of inventory at the
    theme parks and the resort properties, netted
    against accounts payable) of 5% of revenues, with
    the investments being made at the end of each year.
    The income from the investment will be taxed at
    Disneys marginal tax rate of 36.1%.

    Aswath Damodaran
    206
    Laying the groundwork:
    Book Capital, Working Capital and Depreciation
    207

    12.5% of book
    value at end of
    prior year
    ($3,000)

    Aswath Damodaran
    207
    Step 1: Estimate Accounting Earnings on Project
    208

    Aswath Damodaran
    208
    And the Accounting View of Return
    209

    After-tax BV of pre- BV of BV of Average


    Operating project fixed Working BV of BV of
    Year Income investment assets capital Capital Capital ROC(a) ROC(b)
    0 500 2000 0 $2,500
    1 -$32 $450 $3,000 $0 $3,450 $2,975 -1.07% -1.28%
    2 -$96 $400 $3,813 $63 $4,275 $3,863 -2.48% -2.78%
    3 -$54 $350 $4,145 $88 $4,582 $4,429 -1.22% -1.26%
    4 $68 $300 $4,027 $125 $4,452 $4,517 1.50% 1.48%
    5 $202 $250 $3,962 $156 $4,368 $4,410 4.57% 4.53%
    6 $249 $200 $3,931 $172 $4,302 $4,335 5.74% 5.69%
    7 $299 $150 $3,931 $189 $4,270 $4,286 6.97% 6.94%
    8 $352 $100 $3,946 $208 $4,254 $4,262 8.26% 8.24%
    9 $410 $50 $3,978 $229 $4,257 $4,255 9.62% 9.63%
    10 $421 $0 $4,010 $233 $4,243 $4,250 9.90% 9.89%
    Average 4.18% 4.11%

    (a) Based upon average book capital over the year


    (b) Based upon book capital at the start of each year
    Aswath Damodaran
    209
    What should this return be compared to?

    The computed return on capital on this investment is


    about 4.18%. To make a judgment on whether this is
    a sufficient return, we need to compare this return
    to a hurdle rate. Which of the following is the right
    hurdle rate? Why or why not?
    a. The riskfree rate of 2.75% (T. Bond rate)
    b. The cost of equity for Disney as a company (8.52%)
    c. The cost of equity for Disney theme parks (7.09%)
    d. The cost of capital for Disney as a company (7.81%)
    e. The cost of capital for Disney theme parks (6.61%)
    f. None of the above
    Aswath Damodaran
    210
    Should there be a risk premium for foreign
    projects?
    211

    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
    some political risk, which would mean that it too should not affect
    the discount rate. However, there are aspects of political risk
    especially in emerging markets that will be difficult to diversify and
    may 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 Brazil (or any other emerging market)

    Aswath Damodaran
    211
    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
    some political risk, which would mean that it too should not affect
    the discount rate. However, there are aspects of political risk
    especially in emerging markets that will be difficult to diversify and
    may 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 Brazil (or any other emerging market)

    Aswath Damodaran
    212
    Estimating a hurdle rate for Rio Disney

    We did estimate a cost of capital of 6.61% for the Disney theme park
    business, using a bottom-up levered beta of 0.7537 for the business.
    This cost of equity may not adequately reflect the additional risk
    associated with the theme park being in an emerging market.
    The only concern we would have with using this cost of equity for this
    project is that it may not adequately reflect the additional risk associated
    with the theme park being in an emerging market (Brazil). We first
    computed the Brazil country risk premium (by multiplying the default
    spread for Brazil by the relative equity market volatility) and then re-
    estimated the cost of equity:
    Country risk premium for Brazil = 5.5%+ 3% = 8.5%
    Cost of Equity in US$= 2.75% + 0.7537 (8.5%) = 9.16%
    Using this estimate of the cost of equity, Disneys theme park debt ratio
    of 10.24% and its after-tax cost of debt of 2.40% (see chapter 4), we can
    estimate the cost of capital for the project:
    Cost of Capital in US$ = 9.16% (0.8976) + 2.40% (0.1024) = 8.46%

    Aswath Damodaran
    213
    Would lead us to conclude that...

    Do not invest in this park. The return on capital of


    4.18% is lower than the cost of capital for theme
    parks of 8.46%; This would suggest that the project
    should not be taken.
    Given that we have computed the average over an
    arbitrary period of 10 years, while the theme park
    itself would have a life greater than 10 years, would
    you feel comfortable with this conclusion?
    Yes
    No

    Aswath Damodaran
    214
    A Tangent: From New to Existing
    Investments: ROC for the entire firm
    Assets Liabilities
    Existing Investments Fixed Claim on cash flows
    Generate cashflows today Assets in Place Debt Little or No role in management
    How good are the Includes long lived (fixed) and Fixed Maturity
    short-lived(working Tax Deductible
    existing investments capital) assets
    of the firm?
    Expected Value that will be Growth Assets Equity Residual Claim on cash flows
    created by future investments Significant Role in management
    Perpetual Lives

    Measuring ROC for existing investments..

    Aswath Damodaran
    215
    The return on capital is an accounting number,
    though, and that should scare you.

    Aswath Damodaran
    216
    Return Spreads Globally.
    217

    217
    6 Application Test: Assessing Investment
    Quality
    For the most recent period for which you have data,
    compute the after-tax return on capital earned by your
    firm, where after-tax return on capital is computed to be
    After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of
    Equity-Cash)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-
    Cash)previous year

    Aswath Damodaran
    218
    The cash flow view of this project..

    0 1 2 3 4 5 6 7 8 9 10
    After-tax Operating Income -$32 -$96 -$54 $68 $202 $249 $299 $352 $410 $421
    + Depreciation & Amortization $0 $50 $425 $469 $444 $372 $367 $364 $364 $366 $368
    - Capital Expenditures $2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
    - Change in non-cash Work Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
    Cashflow to firm ($2,500) ($982) ($921) ($361) $198 $285 $314 $332 $367 $407 $434

    To get from income to cash flow, we


    I. added back all non-cash charges such as depreciation. Tax
    benefits:
    II. subtracted out the capital expenditures
    III. subtracted out the change in non-cash working capital

    Aswath Damodaran
    219
    The Depreciation Tax Benefit
    220

    While depreciation reduces taxable income and taxes, it does not reduce
    the cash flows.
    The benefit of depreciation is therefore the tax benefit. In general, the tax
    benefit from depreciation can be written as:
    Tax Benefit = Depreciation * Tax Rate
    Disney Theme Park: Depreciation tax savings (Tax rate = 36.1%)

    1 2 3 4 5 6 7 8 9 10
    Depreciation $50 $425 $469 $444 $372 $367 $364 $364 $366 $368
    Tax Bendfits from Depreciation $18 $153 $169 $160 $134 $132 $132 $132 $132 $133

    Proposition 1: The tax benefit from depreciation and other non-cash


    charges is greater, the higher your tax rate.
    Proposition 2: Non-cash charges that are not tax deductible (such as
    amortization of goodwill) and thus provide no tax benefits have no effect
    on cash flows.

    Aswath Damodaran
    220
    Depreciation Methods
    221

    Broadly categorizing, depreciation methods can be classified


    as straight line or accelerated methods. In straight line
    depreciation, the capital expense is spread evenly over time,
    In accelerated depreciation, the capital expense is
    depreciated more in earlier years and less in later years.
    Assume that you made a large investment this year, and that
    you are choosing between straight line and accelerated
    depreciation methods. Which will result in higher net income
    this year?
    Straight Line Depreciation
    Accelerated Depreciation
    Which will result in higher cash flows this year?
    Straight Line Depreciation
    Accelerated Depreciation

    Aswath Damodaran
    221
    The Capital Expenditures Effect
    222

    Capital expenditures are not treated as accounting expenses


    but they do cause cash outflows.
    Capital expenditures can generally be categorized into two
    groups
    New (or Growth) capital expenditures are capital expenditures
    designed to create new assets and future growth
    Maintenance capital expenditures refer to capital expenditures
    designed to keep existing assets.
    Both initial and maintenance capital expenditures reduce
    cash flows
    The need for maintenance capital expenditures will increase
    with the life of the project. In other words, a 25-year project
    will require more maintenance capital expenditures than a 2-
    year project.
    Aswath Damodaran
    222
    To cap ex or not to cap ex?
    223

    Assume that you run your own software business, and


    that you have an expense this year of $ 100 million from
    producing and distribution promotional CDs in software
    magazines. Your accountant tells you that you can
    expense this item or capitalize and depreciate it over
    three years. Which will have a more positive effect on
    income?
    Expense it
    Capitalize and Depreciate it
    Which will have a more positive effect on cash flows?
    Expense it
    Capitalize and Depreciate it

    Aswath Damodaran
    223
    The Working Capital Effect
    224

    Intuitively, money invested in inventory or in accounts receivable cannot


    be used elsewhere. It, thus, represents a drain on cash flows
    To the degree that some of these investments can be financed using
    supplier credit (accounts payable), the cash flow drain is reduced.
    Investments in working capital are thus cash outflows
    Any increase in working capital reduces cash flows in that year
    Any decrease in working capital increases cash flows in that year
    To provide closure, working capital investments need to be salvaged at
    the end of the project life.
    Proposition 1: The failure to consider working capital in a capital
    budgeting project will overstate cash flows on that project and make it
    look more attractive than it really is.
    Proposition 2: Other things held equal, a reduction in working capital
    requirements will increase the cash flows on all projects for a firm.

    Aswath Damodaran
    224
    The incremental cash flows on the project

    $ 500 million has


    already been spent & $
    50 million in
    2/3rd of allocated G&A is fixed.
    depreciation will exist Add back this amount (1-t)
    anyway Tax rate = 36.1%

    Aswath Damodaran
    225
    A more direct way of getting to
    incremental cash flows
    226

    0 1 2 3 4 5 6 7 8 9 10
    Revenues $0 $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,159 $4,575 $4,667
    Direct Expenses $0 $788 $1,103 $1,575 $1,969 $2,166 $2,382 $2,620 $2,882 $2,940
    Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
    Incremental G&A $0 $63 $88 $125 $156 $172 $189 $208 $229 $233
    Incremental Operating Income $0 $25 $141 $406 $678 $783 $896 $1,017 $1,148 $1,175
    - Taxes $0 $9 $51 $147 $245 $283 $323 $367 $415 $424
    Incremental after-tax Operating income $0 $16 $90 $260 $433 $500 $572 $650 $734 $751
    + Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
    - Capital Expenditures $2,000 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
    - Change in non-cash Working Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
    Cashflow to firm ($2,000) ($1,000) ($859) ($267) $340 $466 $516 $555 $615 $681 $715

    Aswath Damodaran
    226
    Sunk Costs
    227

    What is a sunk cost? Any expenditure that has already


    been incurred, and cannot be recovered (even if a
    project is rejected) is called a sunk cost. A test market for
    a consumer product and R&D expenses for a drug (for a
    pharmaceutical company) would be good examples.
    The sunk cost rule: When analyzing a project, sunk costs
    should not be considered since they are not incremental.
    A Behavioral Aside: It is a well established finding in
    psychological and behavioral research that managers
    find it almost impossible to ignore sunk costs.

    Aswath Damodaran
    227
    Test Marketing and R&D: The Quandary of Sunk
    Costs
    228

    A consumer product company has spent $ 100 million on


    test marketing. Looking at only the incremental cash
    flows (and ignoring the test marketing), the project looks
    like it will create $25 million in value for the company.
    Should it take the investment?
    Yes
    No
    Now assume that every investment that this company
    has shares the same characteristics (Sunk costs > Value
    Added). The firm will clearly not be able to survive. What
    is the solution to this problem?

    Aswath Damodaran
    228
    Allocated Costs
    229

    Firms allocate costs to individual projects from a


    centralized pool (such as general and administrative
    expenses) based upon some characteristic of the
    project (sales is a common choice, as is earnings)
    For large firms, these allocated costs can be
    significant and result in the rejection of projects
    To the degree that these costs are not incremental
    (and would exist anyway), this makes the firm worse
    off. Thus, it is only the incremental component of
    allocated costs that should show up in project
    analysis.
    Aswath Damodaran
    229
    Breaking out G&A Costs into fixed and variable
    components: A simple example
    230

    Assume that you have a time series of revenues and


    G&A costs for a company.

    What percentage of the G&A cost is variable?

    Aswath Damodaran
    230
    To Time-Weighted Cash Flows
    231

    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
    Aswath Damodaran
    231
    Present Value Mechanics
    232

    Cash Flow Type Discounting Formula Compounding Formula


    1. Simple CF CFn / (1+r)n CF0 (1+r)n

    2. Annuity ! 1 $
    # 1 -
    (1+r)n & " (1 + r) n - 1 %
    A$
    A# & # r
    '
    &
    # r &
    #" &%
    !
    3. Growing Annuity (1+g)n $
    #1 - n &
    (1+r)
    A(1+g) # &
    # r-g &
    #" &%

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

    Aswath Damodaran
    232
    Discounted cash flow measures of return
    233

    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

    Aswath Damodaran
    233
    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
    10 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)
    =715 (1.02) /(.0846-.02) = $ 11,275 million

    Aswath Damodaran
    234
    Which yields a NPV of..

    Discounted at Rio Disney cost


    Aswath Damodaran of capital of 8.46% 235
    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 $3,296 million.

    Aswath Damodaran
    236
    The IRR of this project

    $5,000.00

    $4,000.00

    $3,000.00

    $2,000.00
    Internal Rate of Return=12.60%
    NPV

    $1,000.00

    $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

    Aswath Damodaran
    237
    The IRR suggests..

    The project is a good one. Using time-weighted, incremental cash


    flows, this project provides a return of 12.60%. This is greater than
    the cost of capital of 8.46%.
    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. They can yield different results, especially why comparing
    across projects because
    A project can have only one NPV, whereas it can have more than one IRR.
    The NPV is a dollar surplus value, whereas the IRR is a percentage measure
    of return. The NPV is therefore likely to be larger for large scale projects,
    while the IRR is higher for small-scale projects.
    The NPV assumes that intermediate cash flows get reinvested at the
    hurdle rate, which is based upon what you can make on investments of
    comparable risk, while the IRR assumes that intermediate cash flows get
    reinvested at the IRR.

    Aswath Damodaran
    238
    Does the currency matter?

    The analysis was done in dollars. Would the


    conclusions have been any different if we had done
    the analysis in Brazilian Reais?
    a. Yes
    b. No

    Aswath Damodaran
    239
    The Consistency Rule for Cash Flows
    240

    The cash flows on a project and the discount rate


    used should be defined in the same terms.
    If cash flows are in dollars ($R), the discount rate has to be
    a dollar ($R) discount rate
    If the cash flows are nominal (real), the discount rate has
    to be nominal (real).
    If consistency is maintained, the project conclusions
    should be identical, no matter what cash flows are
    used.

    Aswath Damodaran
    240
    Disney Theme Park: Project Analysis in $R
    241

    The inflation rates were assumed to be 9% in Brazil and 2% in the


    United States. The $R/dollar rate at the time of the analysis was
    2.35 $R/dollar.
    The expected exchange rate was derived assuming purchasing
    power parity.
    Expected Exchange Ratet = Exchange Rate today * (1.09/1.02)t
    The expected growth rate after year 10 is still expected to be the
    inflation rate, but it is the 9% $R inflation rate.
    The cost of capital in $R was derived from the cost of capital in
    dollars and the differences in inflation rates:
    $R Cost of Capital = (1+ Exp InflationBrazil )
    (1+ US $ Cost of Capital) 1
    (1+ Exp InflationUS )

    = (1.0846) (1.09/1.02) 1 = 15.91%



    Aswath Damodaran
    241
    Disney Theme Park: $R NPV
    Expected Exchange Ratet Discount at $R cost of capital
    = Exchange Rate today * (1.09/1.02)t = (1.0846) (1.09/1.02) 1 = 15.91%

    NPV = R$ 7,745/2.35= $ 3,296 Million


    Aswath Damodaran
    NPV is equal to NPV in dollar terms 242
    Uncertainty in Project Analysis: What can we
    do?
    243

    Based on our expected cash flows and the estimated cost of capital, the
    proposed theme park looks like a very good investment for Disney. Which
    of the following may affect your assessment of value?
    Revenues may be over estimated (crowds may be smaller and spend less)
    Actual costs may be higher than estimated costs
    Tax rates may go up
    Interest rates may rise
    Risk premiums and default spreads may increase
    All of the above
    How would you respond to this uncertainty?
    Will wait for the uncertainty to be resolved
    Will not take the investment
    Ask someone else (consultant, boss, colleague) to make the decision
    Ignore it.
    Other

    Aswath Damodaran
    243
    One simplistic solution: See how quickly
    you can get your money back
    If your biggest fear is losing the billions that you invested in the project,
    one simple measure that you can compute is the number of years it will
    take you to get your money back.
    Year Cash Flow Cumulated CF PV of Cash Flow Cumulated DCF
    0 -$2,000 -$2,000 -$2,000 -$2,000
    1 -$1,000 -$3,000 -$922 -$2,922
    2 -$859 -$3,859 -$730 -$3,652
    3 -$267 -$4,126 -$210 -$3,862
    4 $340 -$3,786 $246 -$3,616
    5 $466 -$3,320 $311 -$3,305
    6 $516 -$2,803 $317 -$2,988
    7 $555 -$2,248 $314 -$2,674
    8 $615 -$1,633 $321 -$2,353
    9 $681 -$952 $328 -$2,025
    Payback = 10.3 years
    10 $715 -$237 $317 -$1,708
    11 $729 $491 $298 -$1,409
    12 $743 $1,235 $280 -$1,129
    13 $758 $1,993 $264 -$865
    14 $773 $2,766 $248 -$617 Discounted Payback
    15 $789 $3,555 $233 -$384 = 16.8 years
    16 $805 $4,360 $219 -$165
    Aswath Damodaran 17 $821 $5,181 $206 $41 244
    A slightly more sophisticated approach:
    Sensitivity Analysis & What-if Questions
    The NPV, IRR and accounting returns for an investment will change
    as we change the values that we use for different variables.
    One way of analyzing uncertainty is to check to see how sensitive
    the decision measure (NPV, IRR..) is to changes in key assumptions.
    While this has become easier and easier to do over time, there are
    caveats that we would offer.
    Caveat 1: When analyzing the effects of changing a variable, we
    often hold all else constant. In the real world, variables move
    together.
    Caveat 2: The objective in sensitivity analysis is that we make
    better decisions, not churn out more tables and numbers.
    Corollary 1: Less is more. Not everything is worth varying
    Corollary 2: A picture is worth a thousand numbers (and tables).

    Aswath Damodaran
    245
    And here is a really good picture

    Aswath Damodaran
    246
    The final step up: Incorporate probabilistic
    estimates.. Rather than expected values..
    Actual Revenues as % of Forecasted Revenues (Base case = 100%)

    Country Risk Premium (Base Case = 3%


    (Brazil))

    !
    Operating Expenses at Parks as % of
    Revenues (Base Case = 60%)

    Aswath Damodaran
    247
    The resulting simulation
    Average = $3.40 billion
    Median = $3.28 billion

    !
    NPV ranges from -$1 billion to +$8.5 billion. NPV is negative 12% of the
    time.

    Aswath Damodaran
    248
    You are the decision maker
    249

    Assume that you are the person at Disney who is given


    the results of the simulation. The average and median
    NPV are close to your base case values of $3.29 billion.
    However, there is a 10% probability that the project
    could have a negative NPV and that the NPV could be a
    large negative value? How would you use this
    information?
    I would accept the investment and print the results of this
    simulation and file them away to show that I exercised due
    diligence.
    I would reject the investment, because it is too risky (there is a
    10% chance that it could be a bad project)
    Other

    Aswath Damodaran
    249
    Equity Analysis: The Parallels
    250

    The investment analysis can be done entirely in equity


    terms, as well. The returns, cashflows and hurdle rates
    will all be defined from the perspective of equity
    investors.
    If using accounting returns,
    Return will be Return on Equity (ROE) = Net Income/BV of Equity
    ROE has to be greater than cost of equity
    If using discounted cashflow models,
    Cashflows will be cashflows after debt payments to equity
    investors
    Hurdle rate will be cost of equity

    Aswath Damodaran
    250
    A Vale Iron Ore Mine in Canada Investment
    Operating Assumptions
    251

    1. The mine will require an initial investment of $1.25 billion and is expected to have a production
    capacity of 8 million tons of iron ore, once established. The initial investment of $1.25 billion will
    be depreciated over ten years, using double declining balance depreciation, down to a salvage
    value of $250 million at the end of ten years.
    2. The mine will start production midway through the next year, producing 4 million tons of iron
    ore for year 1, with production increasing to 6 million tons in year 2 and leveling off at 8 million
    tons thereafter (until year 10). The price, in US dollars per ton of iron ore is currently $100 and is
    expected to keep pace with inflation for the life of the plant.
    3. The variable cost of production, including labor, material and operating expenses, is expected to
    be $45/ton of iron ore produced and there is a fixed cost of $125 million in year 1. Both costs,
    which will grow at the inflation rate of 2% thereafter. The costs will be in Canadian dollars, but
    the expected values are converted into US dollars, assuming that the current parity between the
    currencies (1 Canadian $ = 1 US dollar) will continue, since interest and inflation rates are similar
    in the two currencies.
    4. The working capital requirements are estimated to be 20% of total revenues, and the
    investments have to be made at the beginning of each year. At the end of the tenth year, it is
    anticipated that the entire working capital will be salvaged.
    5. Vales corporate tax rate of 34% will apply to this project as well.

    Aswath Damodaran
    251
    Financing Assumptions
    252

    Vale plans to borrow $0.5 billion at its current cost of debt of 4.05% (based
    upon its rating of A-), using a ten-year term loan (where the loan will be paid
    off in equal annual increments). The breakdown of the payments each year
    into interest and principal are provided below:

    Aswath Damodaran
    252
    The Hurdle Rate
    253

    The analysis is done US dollar terms and to equity


    investors. Thus, the hurdle rate has to be a US $ cost
    of equity.
    In the earlier section, we estimated costs of equity,
    debt and capital in US dollars and $R for Vales iron
    ore business.
    Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
    Business equity debt ratio US$) $R)
    Metals &
    Mining 11.35% 2.67% 35.48% 8.27% 15.70%
    Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
    Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
    Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
    Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%

    Aswath Damodaran
    253
    Net Income: Vale Iron Ore Mine
    254

    1 2 3 4 5 6 7 8 9 10
    Production (millions of tons) 4.00 6.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
    * Price per ton 102 104.04 106.12 108.24 110.41 112.62 114.87 117.17 119.51 121.9
    = Revenues (millions US$) $408.00 $624.24 $848.97 $865.95 $883.26 $900.93 $918.95 $937.33 $956.07 $975.20
    - Variable Costs $180.00 $275.40 $374.54 $382.03 $389.68 $397.47 $405.42 $413.53 $421.80 $430.23
    - Fixed Costs $125.00 $127.50 $130.05 $132.65 $135.30 $138.01 $140.77 $143.59 $146.46 $149.39
    - Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
    EBIT -$97.00 $61.34 $216.37 $248.86 $276.37 $299.91 $307.22 $314.68 $322.28 $330.04
    - Interest Expenses $20.25 $18.57 $16.82 $14.99 $13.10 $11.13 $9.07 $6.94 $4.72 $2.41
    Taxable Income -$117.25 $42.77 $199.56 $233.87 $263.27 $288.79 $298.15 $307.74 $317.57 $327.63
    - Taxes ($39.87) $14.54 $67.85 $79.51 $89.51 $98.19 $101.37 $104.63 $107.97 $111.40
    = Net Income (millions US$) -$77.39 $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
    Book Value and Depreciation
    Beg. Book Value $1,250.00 $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54
    - Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
    + Capital Exp. $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
    End Book Value $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54 $250.00
    - Debt Outstanding $458.45 $415.22 $370.24 $323.43 $274.73 $224.06 $171.34 $116.48 $59.39 $0.00
    End Book Value of Equity $591.55 $474.78 $391.76 $336.17 $302.95 $288.08 $275.27 $264.60 $256.14 $250.00

    Aswath Damodaran
    254
    A ROE Analysis
    255

    BV of
    Beg. BV: Capital Ending BV: Average
    Year Net Income Depreciation Working Debt BV: Equity ROE
    Assets Expense Assets BV: Equity
    Capital
    0 $0.00 $0.00 $1,250.00 $1,250.00 $81.60 $500.00 $831.60
    1 ($77.39) $1,250.00 $200.00 $0.00 $1,050.00 $124.85 $458.45 $716.40 $774.00 -10.00%
    2 $28.23 $1,050.00 $160.00 $0.00 $890.00 $169.79 $415.22 $644.57 $680.49 4.15%
    3 $131.71 $890.00 $128.00 $0.00 $762.00 $173.19 $370.24 $564.95 $604.76 21.78%
    4 $154.35 $762.00 $102.40 $0.00 $659.60 $176.65 $323.43 $512.82 $538.89 28.64%
    5 $173.76 $659.60 $81.92 $0.00 $577.68 $180.19 $274.73 $483.13 $497.98 34.89%
    6 $190.60 $577.68 $65.54 $0.00 $512.14 $183.79 $224.06 $471.87 $477.50 39.92%
    7 $196.78 $512.14 $65.54 $0.00 $446.61 $187.47 $171.34 $462.74 $467.31 42.11%
    8 $203.11 $446.61 $65.54 $0.00 $381.07 $191.21 $116.48 $455.81 $459.27 44.22%
    9 $209.59 $381.07 $65.54 $0.00 $315.54 $195.04 $59.39 $451.18 $453.50 46.22%
    10 $216.24 $315.54 $65.54 $0.00 $250.00 $0.00 $0.00 $250.00 $350.59 61.68%
    Average ROE over the ten-year period = 31.36%

    US $ ROE of 31.36% is greater than


    Vale Iron Ore US$ Cost of Equity of 11.13%

    Aswath Damodaran
    255
    From Project ROE to Firm ROE
    256

    As with the earlier analysis, where we used return on capital and cost of
    capital to measure the overall quality of projects at firms, we can
    compute return on equity and cost of equity to pass judgment on
    whether firms are creating value to its equity investors.
    Specifically, we can compute the return on equity (net income as a
    percentage of book equity) and compare to the cost of equity. The return
    spread is then:
    Equity Return Spread = Return on Equity Cost of equity
    This measure is particularly useful for financial service firms, where
    capital, return on capital and cost of capital are difficult measures to nail
    down.
    For non-financial service firms, it provides a secondary (albeit a more
    volatile measure of performance). While it usually provides the same
    general result that the excess return computed from return on capital,
    there can be cases where the two measures diverge.

    Aswath Damodaran
    256
    An Incremental CF Analysis
    257

    0 1 2 3 4 5 6 7 8 9 10
    Net Income ($77.39) $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
    + Depreciation & Amortization $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
    - Capital Expenditures $750.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
    - Change in Working Capital $81.60 $43.25 $44.95 $3.40 $3.46 $3.53 $3.60 $3.68 $3.75 $3.82 ($195.04)
    - Principal Repayments $41.55 $43.23 $44.98 $46.80 $48.70 $50.67 $52.72 $54.86 $57.08 $59.39
    + Salvage Value of mine $250.00
    Cashflow to Equity ($831.60) $37.82 $100.05 $211.33 $206.48 $203.44 $201.86 $205.91 $210.04 $214.22 $667.42

    Aswath Damodaran
    257
    An Equity NPV
    Discounted at US$ cost of
    equity of 11.13% for Vales
    iron ore business
    258

    Aswath Damodaran
    258
    An Equity IRR
    259

    Aswath Damodaran
    259
    Real versus Nominal Analysis
    260

    In computing the NPV of the plant, we estimated US $


    cash flows and discounted them at the US $ cost of
    equity. We could have estimated the cash flows in real
    terms (with no inflation) and discounted them at a real
    cost of equity. Would the answer be different?
    Yes

    No

    Explain

    Aswath Damodaran
    260
    Dealing with Macro Uncertainty: The Effect of
    Iron Ore Price
    261

    Like the Disney Theme Park, the Vale Iron Ore Mines actual value will be
    buffeted as the variables change. The biggest source of variability is an
    external factor the price of iron ore.
    Vale Paper Plant: Effect of Changing Iron Ore Prices

    $1,500 40.00%

    30.00%
    $1,000
    20.00%
    $500
    10.00%
    NPV

    N
    $0 0.00%
    $50 $60 $70 $80 $90 $100 $110 $120 $130
    -10.00%
    -$500
    -20.00%
    -$1,000
    -30.00%

    -$1,500 Price per ton of iron ore -40.00%


    Aswath Damodaran
    261
    And Exchange Rates
    262

    Exchange Rate effects on Iron Ore Plant


    $700 25.00%

    $600

    20.00%
    $500

    Internal Rate of Return


    $400
    Net Present Value

    15.00%

    $300
    NPV

    10.00% IRR
    $200

    $100
    5.00%
    $0

    -$100 0.00%

    Canadian $ versus US $

    Aswath Damodaran
    262
    Should you hedge?
    263

    The value of this mine is very much a function iron ore prices. There are futures,
    forward and option markets iron ore that Vale can use to hedge against price
    movements. Should it?
    Yes
    No
    Explain.
    The value of the mine is also a function of exchange rates. There are forward,
    futures and options markets on currency. Should Vale hedge against exchange rate
    risk?
    Yes
    No
    Explain.
    On the last question, would your answer have been different if the mine were in
    Brazil.
    Yes
    No

    Aswath Damodaran
    263
    Value Trade Off

    What is the cost to the firm of hedging this risk? Cash flow benefits
    - Tax benefits
    - Better project choices
    Negligible High

    Survival benefits (truncation risk)


    Is there a significant benefit in Is there a significant benefit in - Protect against catastrophic risk
    terms of higher cash flows or terms of higher expected cash - Reduce default risk
    a lower discount rate? flows or a lower discount rate?
    Discount rate benefits
    - Hedge "macro" risks (cost of equity)
    Yes No Yes No - Reduce default risk (cost of debt or debt ratio)

    Hedge this risk. The Indifferent to Can marginal investors Do not hedge this risk.
    benefits to the firm will hedging risk hedge this risk cheaper The benefits are small
    exceed the costs than the firm can? relative to costs
    Pricing Trade
    Earnings Multiple Earnings
    - Effect on multiple X - Level
    Yes No
    - Volatility

    Will the benefits persist if investors hedge Hedge this risk. The
    the risk instead of the firm? benefits to the firm will
    exceed the costs
    Yes No

    Let the risk pass Hedge this risk. The


    through to investors benefits to the firm will
    and let them hedge exceed the costs
    the risk.

    264 Aswath Damodaran


    Acquisitions and Projects
    265

    An acquisition is an investment/project like any other and all


    of the rules that apply to traditional investments should apply
    to acquisitions as well. In other words, for an acquisition to
    make sense:
    It should have positive NPV. The present value of the expected cash
    flows from the acquisition should exceed the price paid on the
    acquisition.
    The IRR of the cash flows to the firm (equity) from the acquisition >
    Cost of capital (equity) on the acquisition
    In estimating the cash flows on the acquisition, we should
    count in any possible cash flows from synergy.
    The discount rate to assess the present value should be based
    upon the risk of the investment (target company) and not the
    entity considering the investment (acquiring company).

    Aswath Damodaran
    265
    Tata Motors and Harman International
    266

    Harman International is a publicly traded US firm


    that manufactures high end audio equipment. Tata
    Motors is an automobile company, based in India.
    Tata Motors is considering an acquisition of Harman,
    with an eye on using its audio equipment in its
    Indian automobiles, as optional upgrades on new
    cars.

    Aswath Damodaran
    266
    Estimating the Cost of Capital for the
    Acquisition (no synergy)
    267

    1. Currency: Estimated in US $, since cash flows will be estimated in US $.


    2. Beta: Harman International is an electronic company and we use the unlevered beta
    (1.17) of electronics companies in the US.
    3. Equity Risk Premium: Computed based on Harmans operating exposure:

    4. Debt ratio & cost of debt: Tata Motors plans to assume the existing debt of Harman
    International and to preserve Harmans existing debt ratio. Harman currently has a debt
    (including lease commitments) to capital ratio of 7.39% (translating into a debt to equity
    ratio of 7.98%) and faces a pre-tax cost of debt of 4.75% (based on its BBB- rating).
    Levered Beta = 1.17 (1+ (1-.40) (.0798)) = 1.226
    Cost of Equity= 2.75% + 1.226 (6.13%) = 10.26%
    Cost of Capital = 10.26% (1-.0739) + 4.75% (1-.40) (.0739) = 9.67%

    Aswath Damodaran
    267
    Estimating Cashflows- First Steps
    268

    Operating Income: The firm reported operating income of


    $201.25 million on revenues of $4.30 billion for the year.
    Adding back non-recurring expenses (restructuring charge of
    $83.2 million in 2013) and adjusting income for the
    conversion of operating lease commitments to debt, we
    estimated an adjusted operating income of $313.2 million.
    The firm paid 18.21% of its income as taxes in 2013 and we
    will use this as the effective tax rate for the cash flows.
    Reinvestment: Depreciation in 2013 amounted to $128.2
    million, whereas capital expenditures and acquisitions for the
    year were $206.4 million. Non-cash working capital increased
    by $272.6 million during 2013 but was 13.54% of revenues in
    2013.
    Aswath Damodaran
    268
    Bringing in growth
    269

    We will assume that Harman International is a mature firm, growing


    2.75% in perpetuity.
    We assume that revenues, operating income, capital expenditures and
    depreciation will all grow 2.75% for the year and that the non-cash
    working capital remain 13.54% of revenues in future periods.

    Aswath Damodaran
    269
    Value of Harman International: Before Synergy
    270

    Earlier, we estimated the cost of capital of 9.67% as the right discount rate to apply in
    valuing Harman International and the cash flow to the firm of $166.85 million for 2014 (next
    year), assuming a 2.75% growth rate in revenues, operating income, depreciation, capital
    expenditures and total non-cash working capital. We also assumed that these cash flows
    would continue to grow 2.75% a year in perpetuity.

    Adding the cash balance of the firm ($515 million) and subtracting out the existing debt
    ($313 million, including the debt value of leases) yields the value of equity in the firm:
    Value of Equity = Value of Operating Assets + Cash Debt
    = $2,476 + $ 515 - $313 million = $2,678 million
    The market value of equity in Harman in November 2013 was $5,428 million.
    To the extent that Tata Motors pays the market price, it will have to generate benefits from
    synergy that exceed $2750 million.

    Aswath Damodaran
    270
    Aswath Damodaran 271

    Measuring Investment Returns


    II. Investment Interactions, Options
    and Remorse
    Life is too short for regrets, right?
    Independent investments are the exception
    272

    In all of the examples we have used so far, the


    investments that we have analyzed have stood alone.
    Thus, our job was a simple one. Assess the expected cash
    flows on the investment and discount them at the right
    discount rate.
    In the real world, most investments are not
    independent. Taking an investment can often mean
    rejecting another investment at one extreme (mutually
    exclusive) to being locked in to take an investment in the
    future (pre-requisite).
    More generally, accepting an investment can create side
    costs for a firms existing investments in some cases and
    benefits for others.
    Aswath Damodaran
    272
    I. Mutually Exclusive Investments
    273

    We have looked at how best to assess a stand-alone


    investment and concluded that a good investment will have
    positive NPV and generate accounting returns (ROC and ROE)
    and IRR that exceed your costs (capital and equity).
    In some cases, though, firms may have to choose between
    investments because
    They are mutually exclusive: Taking one investment makes the other
    one redundant because they both serve the same purpose
    The firm has limited capital and cannot take every good investment
    (i.e., investments with positive NPV or high IRR).
    Using the two standard discounted cash flow measures, NPV
    and IRR, can yield different choices when choosing between
    investments.
    Aswath Damodaran
    273
    Comparing Projects with the same (or similar)
    lives..
    274

    When comparing and choosing between investments


    with the same lives, we can
    Compute the accounting returns (ROC, ROE) of the investments
    and pick the one with the higher returns
    Compute the NPV of the investments and pick the one with the
    higher NPV
    Compute the IRR of the investments and pick the one with the
    higher IRR
    While it is easy to see why accounting return measures
    can give different rankings (and choices) than the
    discounted cash flow approaches, you would expect NPV
    and IRR to yield consistent results since they are both
    time-weighted, incremental cash flow return measures.

    Aswath Damodaran
    274
    Case 1: IRR versus NPV
    275

    Consider two projects with the following cash flows:


    Year Project 1 CF Project 2 CF
    0 -1000 -1000
    1 800 200
    2 1000 300
    3 1300 400
    4 -2200 500

    Aswath Damodaran
    275
    Projects NPV Profile
    276

    Aswath Damodaran
    276
    What do we do now?
    277

    Project 1 has two internal rates of return. The first is


    6.60%, whereas the second is 36.55%. Project 2 has one
    internal rate of return, about 12.8%.
    Why are there two internal rates of return on project 1?

    If your cost of capital is 12%, which investment would


    you accept?
    a. Project 1
    b. Project 2
    Explain.

    Aswath Damodaran
    277
    Case 2: NPV versus IRR
    278

    Project A

    Cash Flow $ 350,000 $ 450,000 $ 600,000 $ 750,000

    Investment $ 1,000,000

    NPV = $467,937
    IRR= 33.66%

    Project B

    Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

    Investment $ 10,000,000
    NPV = $1,358,664
    IRR=20.88%

    Aswath Damodaran
    278
    Which one would you pick?
    279

    Assume that you can pick only one of these two projects.
    Your choice will clearly vary depending upon whether
    you look at NPV or IRR. You have enough money
    currently on hand to take either. Which one would you
    pick?
    a. Project A. It gives me the bigger bang for the buck and more
    margin for error.
    b. Project B. It creates more dollar value in my business.
    If you pick A, what would your biggest concern be?

    If you pick B, what would your biggest concern be?

    Aswath Damodaran
    279
    Capital Rationing, Uncertainty and Choosing a
    Rule
    280

    If a business has limited access to capital, has a stream of


    surplus value projects and faces more uncertainty in its
    project cash flows, it is much more likely to use IRR as its
    decision rule.
    Small, high-growth companies and private businesses are much
    more likely to use IRR.
    If a business has substantial funds on hand, access to
    capital, limited surplus value projects, and more
    certainty on its project cash flows, it is much more likely
    to use NPV as its decision rule.
    As firms go public and grow, they are much more likely
    to gain from using NPV.

    Aswath Damodaran
    280
    The sources of capital rationing
    281

    Cause Number of firms Percent of total


    Debt limit imposed by outside agreement 10 10.7
    Debt limit placed by management external 3 3.2
    to firm
    Limit placed on borrowing by internal 65 69.1
    management
    Restrictive policy imposed on retained 2 2.1
    earnings
    Maintenance of target EPS or PE ratio 14 14.9

    Aswath Damodaran
    281
    An Alternative to IRR with Capital Rationing
    282

    The problem with the NPV rule, when there is capital


    rationing, is that it is a dollar value. It measures success
    in absolute terms.
    The NPV can be converted into a relative measure by
    dividing by the initial investment. This is called the
    profitability index.
    Profitability Index (PI) = NPV/Initial Investment
    In the example described, the PI of the two projects
    would have been:
    PI of Project A = $467,937/1,000,000 = 46.79%
    PI of Project B = $1,358,664/10,000,000 = 13.59%
    Project A would have scored higher.

    Aswath Damodaran
    282
    Case 3: NPV versus IRR
    283

    Project A

    Cash Flow $ 5,000,000 $ 4,000,000 $ 3,200,000 $ 3,000,000

    Investment $ 10,000,000

    NPV = $1,191,712
    IRR=21.41%

    Project B

    Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

    Investment $ 10,000,000
    NPV = $1,358,664
    IRR=20.88%

    Aswath Damodaran
    283
    Why the difference?
    284

    These projects are of the same scale. Both the NPV


    and IRR use time-weighted cash flows. Yet, the
    rankings are different. Why?

    Which one would you pick?


    a. Project A. It gives me the bigger bang for the buck and
    more margin for error.
    b. Project B. It creates more dollar value in my business.

    Aswath Damodaran
    284
    NPV, IRR and the Reinvestment Rate
    Assumption
    285

    The NPV rule assumes that intermediate cash flows on


    the project get reinvested at the hurdle rate (which is
    based upon what projects of comparable risk should
    earn).
    The IRR rule assumes that intermediate cash flows on
    the project get reinvested at the IRR. Implicit is the
    assumption that the firm has an infinite stream of
    projects yielding similar IRRs.
    Conclusion: When the IRR is high (the project is creating
    significant surplus value) and the project life is long, the
    IRR will overstate the true return on the project.

    Aswath Damodaran
    285
    Solution to Reinvestment Rate Problem
    286

    Aswath Damodaran
    286
    Why NPV and IRR may differ.. Even if projects
    have the same lives
    287

    A project can have only one NPV, whereas it can have


    more than one IRR.
    The NPV is a dollar surplus value, whereas the IRR is a
    percentage measure of return. The NPV is therefore
    likely to be larger for large scale projects, while the IRR
    is higher for small-scale projects.
    The NPV assumes that intermediate cash flows get
    reinvested at the hurdle rate, which is based upon
    what you can make on investments of comparable risk,
    while the IRR assumes that intermediate cash flows get
    reinvested at the IRR.

    Aswath Damodaran
    287
    Comparing projects with different lives..
    288
    Project A

    $400 $400 $400 $400 $400

    -$1000
    NPV of Project A = $ 442
    IRR of Project A = 28.7%

    Project B
    $350 $350 $350 $350 $350 $350 $350 $350 $350 $350

    -$1500 NPV of Project B = $ 478


    IRR for Project B = 19.4%
    Hurdle Rate for Both Projects = 12%

    Aswath Damodaran
    288
    Why NPVs cannot be compared.. When projects
    have different lives.
    289

    The net present values of mutually exclusive projects


    with different lives cannot be compared, since there
    is a bias towards longer-life projects. To compare the
    NPV, we have to
    replicate the projects till they have the same life (or)
    convert the net present values into annuities

    The IRR is unaffected by project life. We can choose


    the project with the higher IRR.

    Aswath Damodaran
    289
    Solution 1: Project Replication
    290

    Project A: Replicated
    $400 $400 $400 $400 $400 $400 $400 $400 $400 $400

    -$1000 -$1000 (Replication)


    NPV of Project A replicated = $ 693

    Project B
    $350 $350 $350 $350 $350 $350 $350 $350 $350 $350

    -$1500
    NPV of Project B= $ 478

    Aswath Damodaran
    290
    Solution 2: Equivalent Annuities
    291

    Equivalent Annuity for 5-year project


    = $442 * PV(A,12%,5 years)
    = $ 122.62

    Equivalent Annuity for 10-year project


    = $478 * PV(A,12%,10 years)
    = $ 84.60

    Aswath Damodaran
    291
    What would you choose as your investment
    tool?
    292

    Given the advantages/disadvantages outlined for each of


    the different decision rules, which one would you choose
    to adopt?
    a. Return on Investment (ROE, ROC)
    b. Payback or Discounted Payback
    c. Net Present Value
    d. Internal Rate of Return
    e. Profitability Index
    Do you think your choice has been affected by the
    events of the last quarter of 2008? If so, why? If not, why
    not?

    Aswath Damodaran
    292
    What firms actually use ..
    293

    Decision Rule % of Firms using as primary decision rule in


    1976 1986 1998
    IRR 53.6% 49.0% 42.0%
    Accounting Return 25.0% 8.0% 7.0%
    NPV 9.8% 21.0% 34.0%
    Payback Period 8.9% 19.0% 14.0%
    Profitability Index 2.7% 3.0% 3.0%

    Aswath Damodaran
    293
    II. Side Costs and Benefits
    294

    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.

    Aswath Damodaran
    294
    A. Opportunity Cost
    295

    An opportunity cost arises when a project uses a


    resource that may already have been paid for by the
    firm.
    When a resource that is already owned by a firm is being
    considered for use in a project, this resource has to be
    priced on its next best alternative use, which may be
    a sale of the asset, in which case the opportunity cost is the
    expected proceeds from the sale, net of any capital gains taxes
    renting or leasing the asset out, in which case the opportunity
    cost is the expected present value of the after-tax rental or
    lease revenues.
    use elsewhere in the business, in which case the opportunity
    cost is the cost of replacing it.

    Aswath Damodaran
    295
    Case 1: Foregone Sale?
    296

    Assume that Disney owns land in Rio already. This land is


    undeveloped and was acquired several years ago for $ 5
    million for a hotel that was never built. It is anticipated,
    if this theme park is built, that this land will be used to
    build the offices for Disney Rio. The land currently can be
    sold for $ 40 million, though that would create a capital
    gain (which will be taxed at 20%). In assessing the theme
    park, which of the following would you do:
    Ignore the cost of the land, since Disney owns its already
    Use the book value of the land, which is $ 5 million
    Use the market value of the land, which is $ 40 million
    Other:

    Aswath Damodaran
    296
    Case 2: Incremental Cost?
    An Online Retailing Venture for Bookscape
    297

    The initial investment needed to start the service, including the


    installation of additional phone lines and computer equipment, will be $1
    million. These investments are expected to have a life of four years, at
    which point they will have no salvage value. The investments will be
    depreciated straight line over the four-year life.
    The revenues in the first year are expected to be $1.5 million, growing
    20% in year two, and 10% in the two years following. The cost of the
    books will be 60% of the revenues in each of the four years.
    The salaries and other benefits for the employees are estimated to be
    $150,000 in year one, and grow 10% a year for the following three years.
    The working capital, which includes the inventory of books needed for the
    service and the accounts receivable will be10% of the revenues; the
    investments in working capital have to be made at the beginning of each
    year. At the end of year 4, the entire working capital is assumed to be
    salvaged.
    The tax rate on income is expected to be 40%.

    Aswath Damodaran
    297
    Cost of capital for investment
    298

    We will re-estimate the beta for this online project by looking at


    publicly traded online retailers. The unlevered total beta of online
    retailers is 3.02, and we assume that this project will be funded
    with the same mix of debt and equity (D/E = 21.41%, Debt/Capital
    = 17.63%) that Bookscape uses in the rest of the business. We will
    assume that Bookscapes tax rate (40%) and pretax cost of debt
    (4.05%) apply to this project.
    Levered Beta Online Service = 3.02 [1 + (1 0.4) (0.2141)] = 3.41
    Cost of Equity Online Service = 2.75% + 3.41 (5.5%) = 21.48%
    Cost of CapitalOnline Service= 21.48% (0.8237) + 4.05% (1 0.4) (0.1763) =
    18.12%
    This is much higher than the cost of capital (10.30%) we computed
    for Bookscape earlier, but it reflects the higher risk of the online
    retail venture.

    Aswath Damodaran
    298
    Incremental Cash flows on Investment
    299

    0 1 2 3 4
    Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000

    Operating Expenses
    Labor $150,000 $165,000 $181,500 $199,650
    Materials $900,000 $1,080,000 $1,188,000 $1,306,800
    Depreciation $250,000 $250,000 $250,000 $250,000

    Operating Income $200,000 $305,000 $360,500 $421,550


    Taxes $80,000 $122,000 $144,200 $168,620
    After-tax Operating
    Income $120,000 $183,000 $216,300 $252,930
    + Depreciation $250,000 $250,000 $250,000 $250,000
    - Change in Working
    Capital $150,000 $30,000 $18,000 $19,800 -$217,800
    + Salvage Value of
    Investment $0
    Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730
    Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203

    NPV of investment = $76,375


    Aswath Damodaran
    299
    The side costs
    300

    It is estimated that the additional business associated with


    online ordering and the administration of the service itself
    will add to the workload for the current general manager of
    the bookstore. As a consequence, the salary of the general
    manager will be increased from $100,000 to $120,000 next
    year; it is expected to grow 5 percent a year after that for the
    remaining three years of the online venture. After the online
    venture is ended in the fourth year, the managers salary will
    revert back to its old levels.
    It is also estimated that Bookscape Online will utilize an office
    that is currently used to store financial records. The records
    will be moved to a bank vault, which will cost $1000 a year to
    rent.
    Aswath Damodaran
    300
    NPV with side costs
    301

    Additional salary costs = PV of $34,352

    Office Costs
    After-Tax Additional Storage Expenditure per Year = $1,000 (1 0.40) = $600
    PV of expenditures = $600 (PV of annuity, 18.12%,4 yrs) = $1,610
    NPV with Opportunity Costs = $76,375 $34,352 $1,610= $ 40,413
    Opportunity costs aggregated into cash flows
    Year Cashflows Opportunity costs Cashflow with opportunity costs Present Value
    0 ($1,150,000) ($1,150,000) ($1,150,000)
    1 $340,000 $12,600 $327,400 $277,170
    2 $415,000 $13,200 $401,800 $287,968
    3 $446,500 $13,830 $432,670 $262,517
    4 $720,730 $14,492 $706,238 $362,759
    Adjusted NPV $40,413
    Aswath Damodaran
    301
    Case 3: Excess Capacity
    302

    In the Vale example, assume that the firm will use its
    existing distribution system to service the
    production out of the new iron ore mine. The mine
    manager argues that there is no cost associated with
    using this system, since it has been paid for already
    and cannot be sold or leased to a competitor (and
    thus has no competing current use). Do you agree?
    a. Yes
    b. No

    Aswath Damodaran
    302
    A Framework for Assessing The Cost of Using
    Excess Capacity
    303

    If I do not add the new product, when will I run out


    of capacity?
    If I add the new product, when will I run out of
    capacity?
    When I run out of capacity, what will I do?
    Cut back on production: cost is PV of after-tax cash flows
    from lost sales
    Buy new capacity: cost is difference in PV between earlier
    & later investment

    Aswath Damodaran
    303
    Product and Project Cannibalization: A Real
    Cost?
    304

    Assume that in the Disney theme park example, 20% of the


    revenues at the Rio Disney park are expected to come from
    people who would have gone to Disney theme parks in the
    US. In doing the analysis of the park, you would
    a. Look at only incremental revenues (i.e. 80% of the total revenue)
    b. Look at total revenues at the park
    c. Choose an intermediate number
    Would your answer be different if you were analyzing
    whether to introduce a new show on the Disney cable
    channel on Saturday mornings that is expected to attract 20%
    of its viewers from ABC (which is also owned by Disney)?
    a. Yes
    b. No

    Aswath Damodaran
    304
    B. Project Synergies
    305

    A project may provide benefits for other projects within the firm.
    Consider, for instance, a typical Disney animated movie. Assume
    that it costs $ 50 million to produce and promote. This movie, in
    addition to theatrical revenues, also produces revenues from
    the sale of merchandise (stuffed toys, plastic figures, clothes ..)
    increased attendance at the theme parks
    stage shows (see Beauty and the Beast and the Lion King)
    television series based upon the movie
    In investment analysis, however, these synergies are either left
    unquantified and used to justify overriding the results of
    investment analysis, i.e,, used as justification for investing in
    negative NPV projects.
    If synergies exist and they often do, these benefits have to be
    valued and shown in the initial project analysis.

    Aswath Damodaran
    305
    Case 1: Adding a Caf to a bookstore: Bookscape
    306

    Assume that you are considering adding a caf to the bookstore. Assume
    also that based upon the expected revenues and expenses, the caf
    standing alone is expected to have a net present value of -$87,571.
    The cafe will increase revenues at the book store by $500,000 in year 1,
    growing at 10% a year for the following 4 years. In addition, assume that
    the pre-tax operating margin on these sales is 10%.

    1 2 3 4 5
    Increased Revenues $500,000 $550,000 $605,000 $665,500 $732,050
    Operating Margin 10.00% 10.00% 10.00% 10.00% 10.00%
    Operating Income $50,000 $55,000 $60,500 $66,550 $73,205
    Operating Income after Taxes $30,000 $33,000 $36,300 $39,930 $43,923
    PV of Additional Cash Flows $27,199 $27,126 $27,053 $26,981 $26,908
    PV of Synergy Benefits $135,268

    The net present value of the added benefits is $135,268. Added to the
    NPV of the standalone Caf of -$87,571 yields a net present value of
    $47,697.

    Aswath Damodaran
    306
    Case 2: Synergy in a merger..
    307

    We valued Harman International for an acquisition by Tata Motors and


    estimated a value of $ 2,476 million for the operating assets and $ 2,678
    million for the equity in the firm, concluding that it would not be a value-
    creating acquisition at its current market capitalization of $5,248 million.
    In estimating this value, though, we treated Harman International as a
    stand-alone firm.
    Assume that Tata Motors foresees potential synergies in the combination
    of the two firms, primarily from using its using Harmans high-end audio
    technology (speakers, tuners) as optional upgrades for customers buying
    new Tata Motors cars in India. To value this synergy, let us assume the
    following:
    It will take Tata Motors approximately 3 years to adapt Harmans products to Tata
    Motors cars.
    Tata Motors will be able to generate Rs 10 billion in after-tax operating income in
    year 4 from selling Harman audio upgrades to its Indian customers, growing at a
    rate of 4% a year after that in perpetuity (but only in India).

    Aswath Damodaran
    307
    Estimating the cost of capital to use in valuing
    synergy..
    308

    Business risk: The perceived synergies flow from optional add-ons


    in auto sales. We will begin with the levered beta of 1.10, that we
    estimated for Tata Motors in chapter 4, in estimating the cost of
    equity.
    Geographic risk: The second is that the synergies are expected to
    come from India; consequently, we will add the country risk
    premium of 3.60% for India, estimated in chapter 4 (for Tata
    Motors) to the mature market premium of 5.5%.
    Debt ratio: Finally, we will assume that the expansion will be
    entirely in India, with Tata Motors maintain its existing debt to
    capital ratio of 29.28% and its current rupee cost of debt of 9.6%
    and its marginal tax rate of 32.45%.
    Cost of equity in Rupees = 6.57% + 1.10 (5.5%+3.60%) = 16.59%
    Cost of debt in Rupees = 9.6% (1-.3245) = 6.50%
    Cost of capital in Rupees = 16.59% (1-.2928) + 6.50% (.2928) = 13.63%

    Aswath Damodaran
    308
    Estimating the value of synergy and what Tata can
    pay for Harman
    309

    Value of synergyYear 3 = Expected Cash Flow Year 4


    =
    10,000
    = Rs 103,814 million
    (Cost of Capital - g) (.1363-.04)
    Value of Synergy year 3 103,814
    Value of synergy today = =
    (1+Cost of Capital)3 (1.1363)3
    = Rs 70,753 million

    Converting the synergy value into dollar terms at the prevailing


    exchange rate of Rs 60/$, we can estimate a dollar value for the
    synergy from the potential acquisition:
    Value of synergy in US $ = Rs 70,753/60 = $ 1,179 million
    Adding this value to the intrinsic value of $2,678 million that we
    estimated for Harmans equity in chapter 5, we get a total value for
    the equity of $3,857 million.
    Value of Harman = $2,678 million + $1,179 million = $3,857 million
    Since Harmans equity trades at $5,248 million, the acquisition still
    does not make sense, even with the synergy incorporated into
    value.

    Aswath Damodaran
    309
    III. Project Options
    310

    One of the limitations of traditional investment analysis


    is that it is static and does not do a good job of capturing
    the options embedded in investment.
    The first of these options is the option to delay taking a project,
    when a firm has exclusive rights to it, until a later date.
    The second of these options is taking one project may allow us
    to take advantage of other opportunities (projects) in the future
    The last option that is embedded in projects is the option to
    abandon a project, if the cash flows do not measure up.
    These options all add value to projects and may make a
    bad project (from traditional analysis) into a good one.
    Aswath Damodaran
    310
    The Option to Delay
    311

    When a firm has exclusive rights to a project or product for a specific


    period, it can delay taking this project or product until a later date. A
    traditional investment analysis just answers the question of whether the
    project is a good one if taken today. The rights to a bad project can
    still have value.
    PV of Cash Flows

    Initial Investment in
    Project NPV is positive in this section

    Present Value of Expected


    Cash Flows on Product

    Aswath Damodaran
    311
    Insights for Investment Analyses
    312

    Having the exclusive rights to a product or project is


    valuable, even if the product or project is not viable
    today.
    The value of these rights increases with the volatility
    of the underlying business.
    The cost of acquiring these rights (by buying them or
    spending money on development - R&D, for
    instance) has to be weighed off against these
    benefits.

    Aswath Damodaran
    312
    The Option to Expand/Take Other Projects
    313

    Taking a project today may allow a firm to consider and take other
    valuable projects in the future. Thus, even though a project may have a
    negative NPV, it may be a project worth taking if the option it provides the
    firm (to take other projects in the future) has a more-than-compensating
    value.
    PV of Cash Flows
    from Expansion

    Additional Investment
    to Expand

    Cash Flows on Expansion


    Expansion becomes
    Firm will not expand in attractive in this section
    this section

    Aswath Damodaran
    313
    The Option to Abandon
    314

    A firm may sometimes have the option to abandon a project, if the cash
    flows do not measure up to expectations.
    If abandoning the project allows the firm to save itself from further
    losses, this option can make a project more valuable.

    PV of Cash Flows
    from Project

    Cost of Abandonment

    Present Value of Expected


    Cash Flows on Project

    Aswath Damodaran
    314
    IV. Assessing Existing or Past investments
    315

    While much of our discussion has been focused on


    analyzing new investments, the techniques and
    principles enunciated apply just as strongly to
    existing investments.
    With existing investments, we can try to address one
    of two questions:
    Post mortem: We can look back at existing investments
    and see if they have created value for the firm.
    What next? We can also use the tools of investment
    analysis to see whether we should keep, expand or
    abandon existing investments.

    Aswath Damodaran
    315
    Analyzing an Existing Investment
    316

    In a post-mortem, you look at the actual cash You can also reassess your expected cash
    flows, relative to forecasts. flows, based upon what you have learned,
    and decide whether you should expand,
    continue or divest (abandon) an investment

    Aswath Damodaran
    316
    a. Post Mortem Analysis
    317

    The actual cash flows from an investment can be greater than or less than
    originally forecast for a number of reasons but all these reasons can be
    categorized into two groups:
    Chance: The nature of risk is that actual outcomes can be different from
    expectations. Even when forecasts are based upon the best of information, they
    will invariably be wrong in hindsight because of unexpected shifts in both macro
    (inflation, interest rates, economic growth) and micro (competitors, company)
    variables.
    Bias: If the original forecasts were biased, the actual numbers will be different from
    expectations. The evidence on capital budgeting is that managers tend to be over-
    optimistic about cash flows and the bias is worse with over-confident managers.
    While it is impossible to tell on an individual project whether chance or
    bias is to blame, there is a way to tell across projects and across time. If
    chance is the culprit, there should be symmetry in the errors actuals
    should be about as likely to beat forecasts as they are to come under
    forecasts. If bias is the reason, the errors will tend to be in one direction.

    Aswath Damodaran
    317
    b. What should we do next?
    318

    t =n
    NFn ........ Liquidate the project

    t =0 (1 + r)
    n
    <0

    t =n
    NFn
    n
    < Salvage Value ........ Terminate the project
    t =0 (1 + r)


    t =n
    NFn ........ Divest the project

    t =0 (1 + r)
    n
    < Divestiture Value

    t =n
    NFn
    n
    > 0 > Divestiture Value ........ Continue the project
    t =0 (1 + r)

    Aswath Damodaran
    318

    Example: Disney California Adventure


    The 2008 judgment call
    319

    Disney opened the Disney California Adventure (DCA) Park in 2001, at a


    cost of $1.5 billion, with a mix of roller coaster rides and movie nostalgia.
    Disney expected about 60% of its visitors to Disneyland to come across to
    DCA and generate about $ 100 million in annual after-cash flows for the
    firm.
    By 2008, DCA had not performed up to expectations. Of the 15 million
    people who came to Disneyland in 2007, only 6 million visited California
    Adventure, and the cash flow averaged out to only $ 50 million between
    2001 and 2007.
    In early 2008, Disney faced three choices:
    Shut down California Adventure and try to recover whatever it can of its initial
    investment. It is estimated that the firm recover about $ 500 million of its investment.
    Continue with the status quo, recognizing that future cash flows will be closer to the
    actual values ($ 50 million) than the original projections.
    Invest about $ 600 million to expand and modify the park, with the intent of increasing
    the number of attractions for families with children, is expected to increase the
    percentage of Disneyland visitors who come to DCA from 40% to 60% and increase the
    annual after tax cash flow by 60% (from $ 50 million to $ 80 million) at the park.

    Aswath Damodaran
    319
    DCA: Evaluating the alternatives
    320

    Continuing Operation: Assuming the current after-tax cash flow of


    $ 50 million will continue in perpetuity, growing at the inflation rate
    of 2% and discounting back at the theme park cost of capital in
    2008 of 6.62% yields a value for continuing with the status quo
    Value of DCA = Expected Cash Flow next year
    (Cost of capital - g)
    =
    50(1.02)
    (.0662 .02)
    = $1.103 billion

    Abandonment: Abandoning this investment currently would allow


    Disney to recover only $ 500 million of its original investment.

    Abandonment value of DCA = $ 500 million
    Expansion: The up-front cost of $ 600 million will lead to more
    visitors in the park and an increase in the existing cash flows from $
    50 to $ 80 million.
    Value of CF from expansion = Increase in CF next year = 30(1.02) = $662 million
    (Cost of capital - g) (.0662 .02)


    Aswath Damodaran
    320
    First Principles
    321

    Aswath Damodaran
    321

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