Aswath Damodaran 0

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

THE OBJECTIVE IN CORPORATE

FINANCE
“If you don’t know where you are going, it does not
matter how you get there”
The End Game in Business?

¨ Businesses have always struggled with mission statements.

Put simply, what should the end game of a business?
¤ The simplest and most pragmatic answer is that it is to sell products
and services that customers want, while generating the most you can
in profits for their owners, over the long term.
¤ The pushback, often from non-business critics, has been that
businesses should also serve society, not just minimizing social costs
but also providing social benefits.
¨ In recent years, that pushback has found backing within
business, with movements to expand business missions:
¤ To put business sustainability first
¤ To maximize the value to all stakeholders, not just owners
¤ To incorporate environmental, social and governance goals

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A business has many stakeholders…

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 In running a business, one of these stakeholders
has to be given primacy…
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¨ 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
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 Giving corporate finance its focus…
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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

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 Why traditional corporate financial theory
focuses on maximizing stockholder wealth.
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¨ You can have only one objective, i.e., one interest

group, whose interests get placed first.
¨ Corporate finance picks shareholders because they have a
residual claim, whereas every other claimholder has a
contractual claim that they can negotiate to protect their
interests.
¨ If the company is traded, the stock price gets chosen
as the optimizing metric because:
¤ Stock price is easily observable and constantly updated
¤ If investors are rational, stock prices reflect the wisdom of
decisions, short term and long term, instantaneously.

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 The Strawman Version: Cutthroat
Corporatism
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 Real Choices or False Ones?
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¨ 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.
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 The Classical Objective Function
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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

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 Utopian Corporatism
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 What can go wrong?
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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

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 I. Stockholder Interests vs. Management
Interests
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¨ 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 also
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.

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 The Annual Meeting as a disciplinary venue
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¨ 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 management’s liking.

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 And institutional investors go along with incumbent
managers…
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 Boards of directors are often rubber
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stamps…
¨ 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 don’t 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 other’s boards.

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 And lack the expertise (and the willingness) to
ask the necessary tough questions..
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¨ Robert’s 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.
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 The worst board ever? The Disney Experience -
1997
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 The Calpers Tests for Independent Boards
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¨ 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.
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 Business Week piles on… The Worst Boards in 1997..
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 Application Test: Who’s on board?
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¨ 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.
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 So, what next? When the cat is idle, the mice
will play ....
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¨ 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.

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 Managerial Self Interest or Stockholder
Wealth? Overpaying on takeovers!
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¨ 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.

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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
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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

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 Kodak Says Drug Unit Is Not for Sale … but…
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¨ 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 Kodak’s 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 later…Taking 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.

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 Application Test: Who owns/runs your firm?
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¨ 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
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Case 1: Splintering of Stockholders
Disney’s top stockholders in 2003

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

Valespar(ownership Brazilian(Govt.( Valespar(

4%( 1%(
Brazilian(retail(
5%(
Brazilian(
Litel&Participaço 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( Brazilian(Ins<tu<onal( Non.Brazilian(
54%(
(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.
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Case 3: Cross and Pyramid Holdings
Tata Motor’s top stockholders in 2013

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But it is a benevolent family!

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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: Baidu’s 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.

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 Things change.. Disney’s top stockholders in 2009
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 II. Stockholders' objectives vs. Bondholders'
objectives
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¨ 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

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 Examples of the conflict..
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¨ 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
firm’s 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.

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 An Extreme Example: Unprotected Lenders?
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 III. Firms and Financial Markets
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¨ 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.

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 Managers control the release of information to
the general public
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¨ 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.
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 Evidence that managers delay bad news?
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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)

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 Some critiques of market efficiency..
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¨ 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

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 Are markets short sighted and too focused
on the near term? What do you think?
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¨ 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

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 Are markets short term? Some counter (albeit
not conclusive) evidence that they are not..
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¨ 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.

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 If markets are so short term, why do they react to big
investments (that potentially lower short term earnings) so
positively?
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 But what about market crises?
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¨ 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 marketplace. 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)

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 IV. Firms and Society
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¨ In theory: All costs and benefits associated with a

firm’s 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

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 Social Costs and Benefits are difficult to quantify
because ..
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¨ 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.
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 A test of your social consciousness:
Put your money where you mouth is…
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¨ 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?

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 So this is what can go wrong...
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¨ M
1. Annual meetings
are too tightly
STOCKHOLDERS
Businesses create side
scripted & Managers put costs and side benefits to
Have little control their interests society that cannot be
controlled over managers
2. Boards are rubber above stockholders traced back to the firm.
stamps for CEOs

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
Covenant and lender news or Markets make Markets are sometimes
protections provide only provide mistakes and short term & oftentimes
partial defense against misleading can overreact irrational.
shareholder overreach. information

FINANCIAL MARKETS

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 Traditional corporate financial theory breaks
down when ...
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¨ 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.

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 When traditional corporate financial theory
breaks down, the solution is:
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¨ 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, either by shifting to a
different metric or stakeholder group(s).
¨ 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
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 I. An Alternative Corporate Governance System
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¨ 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.

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 One End game: Managerial Corporatism
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 A Skewed Version: Crony Corporatism
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 IIa. Choose a Different Metric to Maximize
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¨ 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

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 IIb. Maximize stakeholder wealth
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¨ A fairness argument: To the extent that shareholder

wealth maximization seems to, at least at first sight, put
all other stakeholders in the back seat, it seems unfair.
¨ An Easy Fix? The logical response seems to be
stakeholder wealth maximization, where the collective
wealth of all stakeholders is maximized. That is the
promise of stakeholder wealth maximization.
¨ Protective response: As corporations have found
themselves losing the battle for public opinions, many
CEOs and even some institutional investors seem to have
bought into this idea.

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The Business Roundtable’s Message..

¨ While each of our individual companies serves its own corporate purpose,
we share a fundamental commitment to all of our stakeholders. We
commit to:
¤ Delivering value to our customers. We will further the tradition of American
companies leading the way in meeting or exceeding customer expectations.
¤ Investing in our employees. This starts with compensating them fairly and
providing important benefits. It also includes supporting them through training and
education that help develop new skills for a rapidly changing world. We foster
diversity and inclusion, dignity and respect.
¤ Dealing fairly and ethically with our suppliers. We are dedicated to serving as
good partners to the other companies, large and small, that help us meet our
missions.
¤ Supporting the communities in which we work. We respect the people in our
communities and protect the environment by embracing sustainable practices
across our businesses.
¤ Generating long-term value for shareholders, who provide the capital that allows
companies to invest, grow and innovate. We are committed to transparency and
effective engagement with shareholders

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 Confused Corporatism
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If confused corporatism sounds like a good
deal, some cautionary notes..
¨ Government-owned companies: The managers of these
companies were given a laundry list of objectives, resembling
in large part the listing of stakeholder objectives, and told to
deliver on them all. The end results were some of the most
inefficient companies on the face of the earth, with every
stakeholder group feeling ill-served in the process.
¨ US research universities: These entities lack a central focus,
where whose interests dominate and why shifts, depending
on who you talk to and when. The end result is not just
economically inefficient operations, capable of running a
deficit no matter how much tuition is collection, but one
where every stakeholder group feels aggrieved.

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The ESG Promises: Cake for all, with no calories!

¨ Good for companies: For companies, the promise is that

being "good" will generate higher profits for the
company, at least in the long term, with lower risk, and
thus make them more valuable.
¨ Good for investors: For investors in these companies, the
promise is that investing in "good" companies
will generate higher returns than investing in "bad" or
middling companies.
¨ Good for society: For society, the promise is that not
only would good companies help fight problems directly
related to ESG, like climate change and low wages, but
also counter more general problems like income
inequality and healthcare crises.

58
But what comprises goodness? The
services disagree..

59
1. ESG and Value: Where’s the beef?

¨ A Weak Link to Profitability: There is a small positive link between ESG and
profitability, but one that is very sensitive to how profits are measured
and over what period. Breaking down ESG into its component
parts, environment (E) offered the strongest positive link to performance
and social (S) the weakest, with governance (G) falling in the middle.
¨ A Stronger Link to Funding Costs: Studies of “sin” stocks, i.e., companies
involved in businesses such as producing alcohol, tobacco, and gaming,
find that these stocks are less commonly held by institutions and that
they face higher costs for funding, from equity and debt). While these
companies face higher costs, and have lower value, investors in these
companies generate higher returns.
¨ And to Failure/Disaster Risk: “Bad” companies are exposed to disaster
risks, where a combination of missteps by the company, luck, and a failure
to build in enough protective controls (because they cost too much) can
cause a disaster, either in human or financial terms.

60
2. ESG and Returns: Mixed findings

¨ Invest in bad companies: A comparison of two Vanguard Index funds, the Vice fund
(invested in tobacco, gambling, and defense companies) and the FTSE Social Index fund
(invested in companies screened for good corporate behavior on multiple dimensions)
and note that a dollar invested in the former in August 2002 would have been worth
almost 20% more by 2015 than a dollar invested in the latter.
¨ Invest in good companies: There are some studies that find that good companies earn
higher returns, but the outperformance is more due to factor and industry tilts than to
social responsiveness. Some of the strongest links between returns and ESG come from
the governance portion, which, as we noted earlier, is ironic, because the essence of
governance, at least as measured in most of these studies, is fealty to shareholder
rights, which is at odds with the current ESG framework that pushes for a stakeholder
perspective.
¨ ESG has no effect: Splitting the difference, there are other studies that find little or no
differences in returns between good and bad companies. In fact, studies that more
broadly look at factors that have driven stock returns for the last few decades find that
much of the positive payoff attributed to ESG comes from its correlation with
momentum and growth.

61
3. ESG and Society

¨ There are some who argue that even if ESG is bad for
companies and investors, it is good for society, because
companies will treat their customers and employees
better, while catering to their local communities.
¨ There are three fundamental flaws:
¤ Greenwashing: ESG allows companies to sound good, while not
doing good, and that it will allow for posturing and public
relation ploys that do little to advance public good.
¤ Outsourcing goodness: It makes the CEOs the arbiters of
goodness and badness.
¤ Behind the curtain: Pressuring companies to invest in the good
and divest themselves or avoid the bad may only push bad
behavior to less observable and monitored parts of the
economy.

62
 III. Maximize Stock Price, subject to ..
63

¨ 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
63
 The Stockholder Backlash
64

¨ 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 firms 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
64
 The Hostile Acquisition Threat
65

¨ 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
65
 In response, boards are becoming more
independent…
66

¨ 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
66
Disney: Eisner’s 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 Eisner’s 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 Eisner’s 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
67
 Eisner’s concession: Disney’s Board in 2003
68

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 O’Donovan 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
68
 Changes in corporate governance at Disney
69

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
69
 Eisner’s exit… and a new age dawns? Disney’s board
in 2008
70

Aswath Damodaran
70
But as a CEO’s tenure lengthens, does
corporate governance suffer?
¨ In 2011, Iger announced his intent to step down as
CEO in 2015 to allow a successor to be groomed.
¨ 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.
¨ There were signs of restiveness among Disney’s
stockholders, especially those interested in
corporate governance. Activist investors (CalSTRS)
started 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
71
 Iger’s non-exit, the domino effect and a
resolution?
72

¨ In 2015 but Disney’s board convinced Iger to stay on as

CEO for an extra year, for the “the good of the company”.
¤ In 2016, Thomas Staggs who was considered heir apparent to
Iger left Disney. Others who were considered potential CEOs also
left.
¤ In 2017, Disney acquired Fox and announced that Iger’s term
would be extended to 2019 (and perhaps beyond) because his
stewardship was essential for the merger to work.
¨ In February 2020, Iger stepped down as CEO (but stayed
on as Exec Chair until Dec 2021), and Bob Chapek, head
of Disney Theme Parks, took his place. Disney’s stock
price dropped about 8% in the immediate aftermath.

Aswath Damodaran
72
A Life Cycle View of CEOs

73
 The Compressed Tech Life Cycle
74

Aswath Damodaran
74
 The Bondholders’ Defense Against
Stockholder Excesses
75

¨ 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
75
 The Financial Market Response
76

¨ 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
76
 The Societal Response
77

¨ 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
77
 The Self-Correction?
78

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
78
 Constrained Corporatism
79

Aswath Damodaran
79
 The Modified Objective Function
80

¨ 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
80
 Aswath Damodaran 81

THE INVESTMENT PRINCIPLE:

RISK AND RETURN MODELS
“You cannot swing upon a rope that is attached only
to your own belt.”
 First Principles
82

Aswath Damodaran
82
 The notion of a benchmark
83

¨ 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
83
 What is Risk?
84

¨ Risk, in traditional terms, is viewed as a ‘negative’.

Webster’s 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
危机
¨ 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
84
 A good risk and return model should…
85

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
85
 The Capital Asset Pricing Model
86

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
86
 1. The Mean-Variance Framework
87

¨ The variance on any investment measures the disparity

between actual and expected returns.
Low Variance Investment

High Variance Investment

Expected Return

Aswath Damodaran
87
 How risky is Disney? A look at the past…
88

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
88
 Do you live in a mean-variance world?
89

¨ 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 B’s 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
89
 2. The Importance of Diversification: Risk Types
90

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,
Entire Sector Inflation &
worse than
expected may be affected news about
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
90
 Why diversification reduces/eliminates
firm specific risk
91

¨ 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
91
 The Role of the Marginal Investor
92

¨ 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
92
 Identifying the Marginal Investor in your firm…
93

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
93
Gauging the marginal investor: Disney in
2013

Aswath Damodaran
94
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
company’s stock.

Aswath Damodaran
95
 3. The Limiting Case: The Market Portfolio
96

¨ 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
96
 4. The Risk & Expected Return of an
Individual Asset
97

¨ 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
97
 Limitations of the CAPM
98

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
98
 Alternatives to the CAPM
99
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
99
 Why the CAPM persists…
100

¨ 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
100
 Application Test: Who is the marginal investor in
your firm?
101

¨ You can get information on insider and institutional

holdings in your firm from:
¤ http://finance.yahoo.com/
¤ Enter your company’s 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
101
 Aswath Damodaran 102

From Risk Models to Hurdle Rates:

Estimation Challenges
“The price of purity is purists…”
Anonymous
 Inputs required to use the CAPM -
103

¨ 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
103
 The Riskfree Rate and Time Horizon
104

¨ 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
104
 Riskfree Rate in Practice
105

¨ Definition: The riskfree rate is the rate on a zero coupon

default-free bond matching the time horizon of the cash flow
being analyzed.
¨ Implication: 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 ...
¨ A Practical Solution: 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.
¨ In corporate finance, almost everything we do is long term.
So, using a long term default free rate as the risk free rate
makes sense.
Aswath Damodaran
105
The Bottom Line on Riskfree Rates

¨ Currency Matching: 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.
¨ Just use the government bond 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.
¨ 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.

Aswath Damodaran
106
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
107
When the government is default free: Risk
free rates – in November 2013

Aswath Damodaran
108
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 Moody’s 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 choose 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
109
 Three paths to estimating sovereign
default spreads
110

¤ 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, Brazil’s rating was Baa2, yielding a
default spread of 2%.
Aswath Damodaran
110
 111
Ta
iw

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
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Aswath Damodaran
K o P ou
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with default risk in November 2013

$R
Figure 4.2: Risk free rates in Currencies where Governments not Aaa
Risk free rates in currencies: Sovereigns

Risk free rate

Default Spread

111
 112

0.00%
5.00%

-5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
Euro
Swiss Franc
Japanese Yen
Danish Krone
Swedish Krona
Croatian Kuna
Taiwanese $

Aswath Damodaran
Bulgarian Lev
British Pound
Indonesian Rupiah
Israeli Shekel
Canadian $
HK $
US $
Singapore $
Australian $
Norwegian Krone

Riskfree Rate
Thai Baht
Qatari Dinar
Vietnamese Dong
Korean Won
NZ $
Chinese Yuan
Czech Koruna
Malyasian Ringgit
Polish Zloty
Iceland Krona
Default Spread based on rating Hungarian Forint
Phillipine Peso
Romanian Lev
Risk free Rates in January 2022

Chilean Peso
Riskfree Rates in January 2022 : Government Bond Rate

Peruvian Sol
Indian Rupee
Mexican Peso
Colombian Peso
Russian Ruble
South African Rand
Brazilian Reai
Pakistani Rupee
Kenyan Shilling
Nigerian Naira
Turkish Lira
Zambian kwacha
112
 Measurement of the equity risk premium
113

¨ The equity 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
113
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
114
 Risk Aversion and Risk Premiums
115

¨ 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
Buffett’s 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
115
 Risk Premiums do change..
116

¨ 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
116
 Estimating Risk Premiums in Practice
117

¨ 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 today’s asset
prices.

Aswath Damodaran
117
 1. The Survey Approach
118

¨ 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
118
 2. The Historical Premium Approach
119

¨ 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
119
Historical ERP: A Historical Snapshot

Historical
premium for
the US

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

¤ Long term (because of the standard error)
¤ Consistent with your choice of 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.

120
 3. A Forward Looking ERP
121

¨ For a start: If you know the price paid for an asset and
have estimates of the expected cash flows on the asset,
you can estimate the IRR of these cash flows. If you paid
the price, this is your expected return.
¨ Stock Price & Risk: If you assume that stocks are
correctly priced in the aggregate and you can estimate
the expected cashflows from buying stocks, you can
estimate the expected rate of return on stocks by finding
that discount rate that makes the present value equal to
the price paid.
¨ Implied ERP: Subtracting out the riskfree rate should
yield an implied equity risk premium. This implied
equity premium is a forward-looking number and can be
updated as often as you want.

Aswath Damodaran
121
 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%
122
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%. ! $ σ Equity
Emerging Market ERP = 5.5% + Country Default Spread*## &&
" σ Country Bond %

Aswath Damodaran
123
 What about equity risk premiums for other
markets?
124

¨ 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.
¨ You could try to compute implied equity risk
premiums but getting the inputs, especially for long
term growth are difficult to do.
Aswath Damodaran
124
One solution: Bond default spreads as CRP
– November 2013
¨ In November 2013, the equity risk premium for the US was 5.50% 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% 5.50% 7.75%
China Aa3 0.80% 5.50% 6.30%
Brazil Baa2 2.00% 5.50% 7.50%

¨ If you prefer CDS spreads:

Country Sovereign CDS Spread US ERP Total ERP for country
India 4.20% 5.50% 9.70%
China 1.20% 5.50% 6.70%
Brazil 2.59% 5.50% 8.09%

Aswath Damodaran
125
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.
Brazil’s Equity Risk Premium = 5.50% + 2.00% (21%/14%) = 8.50%
¨ Using the same approach for China and India:
¨ China’s Equity Risk Premium = 5.50% + 0.80% (18%/10%) = 6.94%
¨ India’s Equity Risk Premium = 5.50% + 2.25% (24%/17%) = 9.10%

Aswath Damodaran
126
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
127
 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%
Czech Republic 6.93% 1.43%
Germany 5.50% 0.00% Sweden 5.50% 0.00% 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%
Cameroon 13.75% 8.25% Russia 8.05% 2.55%
Brazil 8.50% 3.00% 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%
Slovakia 7.15% 1.65%
Colombia 8.88% 3.38% Egypt 17.50% 12.00% 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 Disney’s
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
129
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
130
 The Anatomy of a Crisis: Implied ERP from
September 12, 2008 to January 1, 2009
131

Aswath Damodaran
131
 And in 2020.. COVID effects
132

Aswath Damodaran
132
An Updated Implied ERP

Aswath Damodaran
133
 134

2021
2020
2019
2018
2017
2016
Implied Premiums in the US: 1960-2021

2015
2014
2013
2012
2011
2010
2009
Implied Premium for US Equity Market: 1960-2021

2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992

Year
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
A Composite way of estimating ERP for
countries

Aswath Damodaran
135
ERP : Jan 2022

Blue: Moody’s Rating

Aswath Damodaran
Red: Added Country Risk
Green #: Total ERP
 Application Test: Estimating a Market Risk
Premium
137

¨ 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
137
 Estimating Beta
138

¨ 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
138
 Estimating Performance
139

¨ 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
139
 Setting up for the Estimation
140

¨ 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
140
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
141
Disney’s Historical Beta

!
Return on Disney = .0071 + 1.2517 Return on Market R² = 0.73386
(.0053) (0.10)
Analyzing Disney’s 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%
¤ Jensen’s Alpha = 0.712% - (-0.0105)% = 0.723%
¨ Disney did 0.723% better than expected, per month, between
October 2008 and September 2013
¤ Annualized, Disney’s annual excess return = (1.00723)12 -1= 9.02%

Aswath Damodaran
143
 More on Jensen’s Alpha
144

¨ If you did this analysis on every stock listed on an exchange, what would the
average Jensen’s 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 Jensen’s 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 Jensen’s 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
144
Estimating Disney’s 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 Disney’s 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
145
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
146
Breaking down Disney’s 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
147
 The Relevance of R Squared
148

¨ 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 Amgen’s 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
148
Beta Estimation: Using a Service
(Bloomberg)

Aswath Damodaran
149
Estimating Expected Returns for Disney in
November 2013
¨ Inputs to the expected return calculation
¤Disney’s Beta = 1.25
¤ Riskfree Rate = 2.75% (U.S. ten-year T.Bond rate in
November 2013)
¤ Risk Premium = 5.76% (Based on Disney’s operating
exposure)
Expected Return = Riskfree Rate + Beta (Risk Premium)
= 2.75% + 1.25 (5.76%) = 9.95%

Aswath Damodaran
150
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
151
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, Disney’s cost of equity is 9.95%.
¨ What is the cost of not delivering this cost of equity?

Aswath Damodaran
152
 Application Test: Analyzing the Risk Regression
153

¨ 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) = Jensen’s 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
153
 A Quick Test
154

¨ 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
154
Regression Diagnostics for Tata Motors

Beta = 1.83
67% range
1.67-1.99

69% market risk

31% firm specific

Jensen’s 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
155
A better beta? For Vale..

Aswath Damodaran
156
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
157
 Beta: Exploring Fundamentals
158

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
158
 Determinant 1: Product Type
159

¨ 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
159
 A Simple Test
160

¨ 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
160
 Determinant 2: Operating Leverage Effects
161

¨ 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
161
 Measures of Operating Leverage
162

¨ 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
162
 Disney’s 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 Disney’s 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
163
 Determinant 3: Financial Leverage
164

¨ 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
164
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
165
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
166
 Betas are weighted Averages
167

¨ 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
167
 The Disney/Cap Cities Merger (1996): Pre-
Merger
168

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
168
 Disney Cap Cities Beta Estimation: Step 1
169

¨ Calculate the unlevered betas for both firms

¤ Disney’s 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
169
 Disney Cap Cities Beta Estimation: Step 2
170

¨ 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
170
 Firm Betas versus divisional Betas
171

¨ 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
171
 Bottom-up versus Top-down Beta
172

¨ 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 firm’s 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
172
Disney’s businesses: The financial
breakdown (from 2013 annual report)

Aswath Damodaran
173
 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
174
 A closer look at the process…
Studio Entertainment Betas
+ Total Debt
Market including = Enterprise Cash/Firm Pre-tax cost Marginal tax Gross D/E Revenue
Company Name Levered Beta Capitalization Leases =Firm Value -Cash Value Value of debt rate ratio (Sales) EV/Sales
SFX Entertainment Inc. (NasdaqGS:SFXE) 1.12 $738.8 $98.9 $837.7 $143.6 $694.1 17.14% 8.46% 40.00% 13.39% 62.0 11.20
Mass Hysteria Entertainment Company, 1.19 $0.2 $1.1 $1.4 $- $1.4 0.00% 10.00% 40.00% 477.94% 0 12.45
Inc. (OTCPK:MHYS)
Medient Studios, Inc. (OTCPK:MDNT) 0.93 $3.2 $3.2 $6.4 $0.1 $6.3 0.81% 4.84% 40.00% 99.07% 5.22 1.21
POW! Entertainment, Inc. 0.94 $4.0 $0.3 $4.3 $0.4 $3.9 9.85% 4.00% 40.00% 8.65% 2.03 1.92
(OTCPK:POWN)
MGM Holdings Inc. (OTCPK:MGMB) 1.29 $3,631.7 $142.2 $3,773.9 $140.7 $3,633.2 3.73% 10.00% 40.00% 3.91% 1,892.6 1.92
Lions Gate Entertainment Corp. 1.20 $4,719.6 $1,283.2 $6,002.8 $67.2 $5,935.6 1.12% 6.34% 40.00% 27.19% 2,597.8 2.28
(NYSE:LGF)
DreamWorks Animation SKG Inc. 1.32 $2,730.0 $348.3 $3,078.3 $156.4 $2,921.9 5.08% 3.00% 40.00% 12.76% 767.3 3.81
(NasdaqGS:DWA)
Twenty-First Century Fox, Inc. 1.28 $77,743.5 $20,943.0 $98,686.5 $6,681.0 $92,005.5 6.77% 6.15% 40.00% 26.94% 28,733.0 3.20
(NasdaqGS:FOXA)
Independent Film Development 1.61 $1.3 $1.0 $2.3 $- $2.2 2.20% 10.00% 40.00% 72.35% 1 3.37
Corporation (OTCPK:IFLM)
Odyssey Pictures Corp. (OTCPK:OPIX) 2.60 $0.3 $1.6 $1.9 $0.0 $1.9 0.10% 3.00% 40.00% 551.12% 0.669 2.90
Average 1.35 4.68% 6.58% 40.00% 129.33% 4.43
Aggregate 1.35 $22,822.82 $112,395.45 $7,189.43 $105,206.02 6.40% 6.58% 40.00% 25.48% 34,061.4 3.09
Median 1.24 2.96% 6.24% 40.00% 27.06% 3.05

Aswath Damodaran
175
 Backing into a pure play beta: Studio
Entertainment
176

Value Beta Value Beta

Movie Business 97.04 1.0993 Debt 21.3 0
Cash Business 2.96 0 Equity 78.7 1.24
Movie Company 100 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%
Unlevered beta for movies = 1.24/ (1+(1-.4)(.233)) = 1.0879
Aswath Damodaran
176
 Disney’s 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
177
 The levered beta: Disney and its divisions

¨ To estimate the debt ratios for division, we allocate Disney’s 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
178
 Discussion Issue
179

¨ 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
179
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
180
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 Vale’s 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
181
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 Motor’s 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 Baidu’s current market debt to equity
ratio of 5.23% and the marginal tax rate for China of 25%, we
estimate Baidu’s 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
182
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 Deutsche’s ERP of 6.12%:

Aswath Damodaran
183
 Estimating Betas for Non-Traded Assets
184

¨ 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
184
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 185
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%

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186
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

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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%

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188
 Application Test: Estimating a Bottom-up Beta
189

¨ 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.

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189
 From Cost of Equity to Cost of Capital
190

¨ 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

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190
 What is debt?
191

¨ 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.

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191
 Estimating the Cost of Debt
192

¨ 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.

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192
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 Vale’s cost of debt in $R

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

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193
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

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194
Interest Coverage Ratios, Ratings and
Default Spreads- November 2013

Disney: Large cap, developed 22.57 à AAA

Vale: Large cap, emerging 11.67 à AA
Tata Motors: Large cap, Emerging 4.51 à A-
Baidu: Small cap, Emerging 23.72 à AAA
Bookscape: Small cap, private 5.16 à A-
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195
Synthetic versus Actual Ratings: Rated
Firms
¨ Disney’s 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
¨ Vale’s 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…

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196
 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%

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197
Default Spreads – January 2022

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198
 But some years are volatile: 2020 as a case
in point…
199

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199
 Application Test: Estimating a Cost of Debt
200

¨ Based upon your firm’s 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

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200
 Costs of Hybrids
201

¨ 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.

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201
 Weights for Cost of Capital Calculation
202

¨ 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.

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202
Disney: From book value to market value
for interest bearing debt…
¨ In Disney’s 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
4 $2,650 21.83% 0.87
of debt, because Disney
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

¨ Disney’s 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)
$# '&

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203
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

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204
 Accounting comes to its senses on
operating leases
205

¨ In 2019, both IFRS and GAAP made a major shift on

operating leases, requiring companies to capitalize
leases and show the resulting debt (and counter
asset) on the balance sheets.
¨ That said, the accounting rules for capitalizing leases
are far more complex than the simple calculations
that I have used, for two reasons:
¤ Accounting has to balance its desire to do the right thing
with maintaining some connection to its legacy rules.
¤ Companies have lobbied to modify rules in their sectors to
cushion the impact.

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205
 Application Test: Estimating Market Value
206

¨ 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

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206
 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)
207
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%
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208
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%

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209
 Application Test: Estimating Cost of Capital
210

¨ 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?
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210
 Choosing a Hurdle Rate
211

¨ 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.

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211
 Back to First Principles
212

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212
 Aswath Damodaran 213

MEASURING INVESTMENT RETURNS

I: THE MECHANICS OF INVESTMENT
ANALYSIS
“Show me the money”
from Jerry Maguire
 First Principles
214

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214
 Measures of return: earnings versus cash flows
215

¨ 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).

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215
 Measuring Returns Right: The Basic Principles
216

¨ Use cash flows rather than earnings. You cannot spend

earnings.
¨ Use “incremental” cash flows relating to the investment
decision, i.e., cashflows that occur as a consequence of
the decision, rather than total cash flows.
¨ Use “time weighted” returns, i.e., value cash flows that
occur earlier more than cash flows that occur later.
The Return Mantra: “Time-weighted, Incremental Cash
Flow Return”

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216
 Setting the table: What is an
investment/project?
217

¨ 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.

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217
 Here are four examples…
218

¨ 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.

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218
 Earnings versus Cash Flows: A Disney Theme
Park
219

¨ 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.
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219
 Key Assumptions on Start Up and Construction
220

¨ 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.

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220
 Key Revenue Assumptions
221

¨ 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
¨

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221
 Key Expense Assumptions
222

¨ 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.

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222
 Depreciation and Capital Maintenance
223

¨ The capital maintenance expenditures are low in the

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

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223
 Other Assumptions
224

¨ 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
Disney’s marginal tax rate of 36.1%.

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 Laying the groundwork:
Book Capital, Working Capital and Depreciation
225

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

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225
 Step 1: Estimate Accounting Earnings on Project
226

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226
 And the Accounting View of Return
227

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
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227
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
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228
 Should there be a risk premium for foreign
projects?
229

¨ 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 Disney’s
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)

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229
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 Disney’s
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)

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230
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$= 2.75% + 0.7537 (8.5%) = 9.16%
¨ Using this estimate of the cost of equity, Disney’s theme park debt ratio
of 10.24% and its after-tax cost of debt of 2.40% (see chapter 4), we can
estimate the cost of capital for the project:
¤ Cost of Capital in US$ = 9.16% (0.8976) + 2.40% (0.1024) = 8.46%

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231
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

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232
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
233
The return on capital is an accounting number,
though, and that should scare you.

Aswath Damodaran
234
 Return Spreads Globally….
235

235
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
236
 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
237
 The Depreciation Tax Benefit
238

¨ 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
238
 Depreciation Methods
239

¨ 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
239
 The Capital Expenditures Effect
240

¨ 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
240
 To cap ex or not to cap ex?
241

¨ 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
241
 The Working Capital Effect
242

¨ 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
242
 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
243
 A more direct way of getting to
incremental cash flows
244

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
244
 Sunk Costs
245

¨ 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
245
 Test Marketing and R&D: The Quandary of Sunk
Costs
246

¨ 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
246
 Allocated Costs
247

¨ 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
247
 Breaking out G&A Costs into fixed and variable
components: A simple example
248

¨ 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
248
 To Time-Weighted Cash Flows
249

¨ 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
249
 Present Value Mechanics
250

¨ 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
250
 Discounted cash flow measures of return
251

¨ 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
251
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
252
Which yields a NPV of..

Discounted at Rio Disney cost

Aswath Damodaran of capital of 8.46% 253
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
254
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
255
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
256
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
257
 The ‘‘Consistency Rule” for Cash Flows
258

¨ 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
258
 Disney Theme Park: Project Analysis in $R
259

¨ 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
259
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

NPV is equal to NPV in dollar terms
Aswath Damodaran
260
 Uncertainty in Project Analysis: What can we
do?
261

¨ 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
261
 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 $41 262
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
263
And here is a really good picture…

Aswath Damodaran
264
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
265
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
266
 You are the decision maker…
267

¨ 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
267
 Equity Analysis: The Parallels
268

¨ 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
268
 A Vale Iron Ore Mine in Canada Investment
Operating Assumptions
269

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. Vale’s corporate tax rate of 34% will apply to this project as well.

Aswath Damodaran
269
 Financing Assumptions
270

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
270
 The Hurdle Rate
271

¨ 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 $R for Vale’s iron
ore business.
Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
Business equity debt ratio US$) $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
271
 Net Income: Vale Iron Ore Mine
272

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
272
 A ROE Analysis
273

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
273
 From Project ROE to Firm ROE
274

¨ 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.
¨ Applied to Disney in 2013, for example, here is what we get:
¤ ROE in 2013 = Net Income in 2013 / Book Value of Equity in 2013 = 14.62%
¤ Cost of Equity for Disney = 8.52%

Aswath Damodaran
274
 An Incremental CF Analysis
275

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
275
 An Equity NPV
Discounted at US$ cost of
equity of 11.13% for Vale’s
iron ore business
276

Aswath Damodaran
276
 An Equity IRR
277

Aswath Damodaran
277
 Real versus Nominal Analysis
278

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
278
 Dealing with Macro Uncertainty: The Effect of
Iron Ore Price
279

¨ Like the Disney Theme Park, the Vale Iron Ore Mine’s 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%
N…
NPV

$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
279
 And Exchange Rates…
280

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
IRR
10.00%
$200

$100
5.00%

$0
18% 15% 12% 9% 6% 3% Parity 3% 6% 9% 12% 15% 18%
weaker weaker weaker weaker weaker weaker stronger stronger stronger stronger stronger stronger
-$100 0.00%
Canadian $ versus US $

Aswath Damodaran
280
 Should you hedge?
281

¨ 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
281
 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.

282 Aswath Damodaran

 Acquisitions and Projects
283

¨ 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
283
 Tata Motors and Harman International
284

¨ 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
284
 Estimating the Cost of Capital for the
Acquisition (no synergy)
285

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 Harman’s operating exposure:

4. Debt ratio & cost of debt: Tata Motors plans to assume the existing debt of Harman
International and to preserve Harman’s 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
285
 Estimating Cashflows- First Steps
286

¨ 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
286
 Bringing in growth
287

¨ 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
287
 Value of Harman International: Before Synergy
288

¨ 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
288
 Aswath Damodaran 289

Measuring Investment Returns

II. Investment Interactions, Options
and Remorse…
Life is too short for regrets, right?
 Independent investments are the exception…
290

¨ 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 firm’s existing investments in some cases and
benefits for others.
Aswath Damodaran
290
 I. Mutually Exclusive Investments
291

¨ 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
291
 Comparing Projects with the same (or similar)
lives..
292

¨ 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
292
 Case 1: IRR versus NPV
293

¨ 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
293
 Project’s NPV Profile
294

Aswath Damodaran
294
 What do we do now?
295

¨ 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
295
 Case 2: NPV versus IRR
296

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
296
 Which one would you pick?
297

¨ 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
297
 Capital Rationing, Uncertainty and Choosing a
Rule
298

¨ 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
298
 The sources of capital rationing…
299

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
299
 An Alternative to IRR with Capital Rationing
300

¨ 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
300
 Case 3: NPV versus IRR
301

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
301
 Why the difference?
302

¨ 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
302
 NPV, IRR and the Reinvestment Rate
Assumption
303

¨ 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
303
 Solution to Reinvestment Rate Problem
304

Aswath Damodaran
304
 Why NPV and IRR may differ.. Even if projects
have the same lives
305

¨ 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
305
 Comparing projects with different lives..
306
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
306
 Why NPVs cannot be compared.. When projects
have different lives.
307

¨ 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
307
 Solution 1: Project Replication
308

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
308
 Solution 2: Equivalent Annuities
309

¨ 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
309
 What would you choose as your investment
tool?
310

¨ 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
310
 What firms actually use ..
311

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
311
 II. Side Costs and Benefits
312

¨ 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
312
 A. Opportunity Cost
313

¨ 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
313
 Case 1: Foregone Sale?
314

¨ 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
314
 Case 2: Incremental Cost?
An Online Retailing Venture for Bookscape
315

¨ 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 be 10% 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
315
 Cost of capital for Bookscape investment
316

¨ 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 Bookscape’s 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
316
 Incremental Cash flows on Investment
317

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
317
 The side costs…
318

¨ 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 manager’s
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
318
 NPV with side costs…
319

¨ 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
319
 Case 3: Excess Capacity
320

¨ 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
320
 A Framework for Assessing The Cost of Using
Excess Capacity
321

¨ 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
321
 Product and Project Cannibalization: A Real
Cost?
322

¨ 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
322
 B. Project Synergies
323

¨ 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
323
 Case 1: Adding a Café to a bookstore: Bookscape
324

¨ Assume that you are considering adding a café to the bookstore. Assume
also that based upon the expected revenues and expenses, the café
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 Café of -$87,571 yields a net present value of
$47,697.

Aswath Damodaran
324
 Case 2: Synergy in a merger..
325

¨ 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 Harman’s 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 Harman’s 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
325
 Estimating the cost of capital to use in valuing
synergy..
326

¨ 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
326
 Estimating the value of synergy… and what Tata can
pay for Harman
327

¨ 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 Harman’s 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 Harman’s equity trades at $5,248 million, the acquisition still
does not make sense, even with the synergy incorporated into
value.

Aswath Damodaran
327
 III. Project Options
328

¨ 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
328
 The Option to Delay
329

¨ 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
329
 Insights for Investment Analyses
330

¨ 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
330
 The Option to Expand/Take Other Projects
331

¨ 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
331
 The Option to Abandon
332

¨ 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
332
Bottom line: Investment Flexibility matters..

333
And especially during crisis… Performance
during 2020, across firm classes

334
 IV. Assessing Existing or Past investments…
335

¨ 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
335
 Analyzing an Existing Investment
336

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
336
 a. Post Mortem Analysis
337

¨ 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
337
 b. What should we do next?
338

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
< Divestiture Value ........ Divest the project
n
t =0 (1 + r)

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

Aswath Damodaran
338
€
 Example: Disney California Adventure –
The 2008 judgment call
339

¨ 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
339
 DCA: Evaluating the alternatives…
340

¨ 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
340
 First Principles
341

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341