DCF

 Choices:  Equity  Valua4on  versus  Firm  

Valua4on  
5

Firm Valuation: Value the entire business

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

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran
5
 Equity  Valua4on  
6

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

Aswath Damodaran
6
 Firm  Valua4on  
7

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth use
assets Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

Aswath Damodaran
7
 Firm  Value  and  Equity  Value  
8

¨ To  get  from  firm  value  to  equity  value,  which  of  the  following  
would  you  need  to  do?  
a. Subtract  out  the  value  of  long  term  debt  
b. Subtract  out  the  value  of  all  debt  
c. Subtract  the  value  of  any  debt  that  was  included  in  the  cost  of  
capital  calcula4on  
d. Subtract  out  the  value  of  all  liabili4es  in  the  firm  
¨ Doing  so,  will  give  you  a  value  for  the  equity  which  is  
a. greater  than  the  value  you  would  have  got  in  an  equity  valua4on  
b. lesser  than  the  value  you  would  have  got  in  an  equity  valua4on  
c. equal  to  the  value  you  would  have  got  in  an  equity  valua4on  

Aswath Damodaran
8
 Cash  Flows  and  Discount  Rates  
9

¨ Assume  that  you  are  analyzing  a    company  with  the  following  

cashflows  for  the  next  five  years.    
Year  CF  to  Equity  Interest  Exp  (1-­‐tax  rate)  CF  to  Firm  
1    $  50    $  40    $  90  
2    $  60    $  40    $  100  
3    $  68    $  40    $  108  
4    $  76.2    $  40    $  116.2  
5    $  83.49    $  40    $  123.49  
Terminal  Value  $  1603.0        $  2363.008  
¨ Assume  also  that  the  cost  of  equity  is  13.625%  and  the  firm  can  
borrow  long  term  at  10%.  (The  tax  rate  for  the  firm  is  50%.)    
¨ The  current  market  value  of  equity  is  $1,073  and  the  value  of  debt  
outstanding  is  $800.  

Aswath Damodaran
9
 Equity  versus  Firm  Valua4on  
10

¨ Method  1:  Discount  CF  to  Equity  at  Cost  of  Equity  to  get  value  
of  equity  
¤ Cost  of  Equity  =  13.625%  
¤ Value  of  Equity  =  50/1.13625  +  60/1.136252  +  68/1.136253  +  
76.2/1.136254  +  (83.49+1603)/1.136255    =  $1073  
¨ Method  2:  Discount  CF  to  Firm  at  Cost  of  Capital  to  get  value  
of  firm  
¤ Cost  of  Debt  =  Pre-­‐tax  rate  (1-­‐  tax  rate)  =  10%  (1-­‐.5)  =  5%  
Cost  of  Capital  =  13.625%  (1073/1873)  +  5%  (800/1873)  =  9.94%    
¤ PV  of  Firm  =  90/1.0994  +  100/1.09942  +  108/1.09943  +  116.2/1.09944  +  
(123.49+2363)/1.09945  =  $1873    
¤ Value  of  Equity  =  Value  of  Firm  -­‐  Market  Value  of  Debt    
     =  $  1873  -­‐  $  800  =  $1073    

Aswath Damodaran
10
 First  Principle  of  Valua4on  
11

¨ Discoun4ng  Consistency  Principle:  Never  mix  and  

match  cash  flows  and  discount  rates.      
¨ Mismatching    cash  flows  to  discount  rates  is  deadly.  
¤ Discoun4ng  cashflows  aber  debt  cash  flows  (equity  cash  
flows)  at  the  weighted  average  cost  of  capital  will  lead  to  
an  upwardly  biased  es4mate  of  the  value  of  equity  
¤ Discoun4ng  pre-­‐debt  cashflows  (cash  flows  to  the  firm)  at  
the  cost  of  equity  will  yield  a  downward  biased  es4mate  of  
the  value  of  the  firm.  

Aswath Damodaran
11
 The  Effects  of  Mismatching  Cash  Flows  and  
Discount  Rates  
12

¨ Error  1:  Discount  CF  to  Equity  at  Cost  of  Capital  to  get  equity  
value  
¤ PV  of  Equity  =  50/1.0994  +  60/1.09942  +  68/1.09943  +  76.2/1.09944  +  
(83.49+1603)/1.09945    =  $1248  
¤ Value  of  equity  is  overstated  by  $175.  
¨ Error  2:  Discount  CF  to  Firm  at  Cost  of  Equity  to  get  firm  value  
¤ PV  of  Firm  =  90/1.13625  +  100/1.136252  +  108/1.136253  +  
116.2/1.136254  +  (123.49+2363)/1.136255  =  $1613    
¤ PV  of  Equity  =  $1612.86  -­‐  $800  =  $813  
¤ Value  of  Equity  is  understated  by  $  260.  
¨ Error  3:  Discount  CF  to  Firm  at  Cost  of  Equity,  forget  to  
subtract  out  debt,  and  get  too  high  a  value  for  equity  
¤ Value  of  Equity  =  $  1613  
¤ Value  of  Equity  is  overstated  by  $  540  

Aswath Damodaran
12
 Discounted  Cash  Flow  Valua4on:  The  Steps  
13

1. Es4mate  the  discount  rate  or  rates  to  use  in  the  valua4on  
1. Discount  rate  can  be  either  a  cost  of  equity  (if  doing  equity  valua4on)  or  a  cost  of  
capital  (if  valuing  the  firm)  
2. Discount  rate  can  be  in  nominal  terms  or  real  terms,  depending  upon  whether  
the  cash  flows  are  nominal  or  real  
3. Discount  rate  can  vary  across  4me.    
2. Es4mate  the  current  earnings  and  cash  flows  on  the  asset,  to  either  
equity  investors  (CF  to  Equity)  or  to  all  claimholders  (CF  to  Firm)  
3. Es4mate  the  future  earnings  and  cash  flows  on  the  firm  being  valued,  
generally  by  es4ma4ng  an  expected  growth  rate  in  earnings.  
4. Es4mate  when  the  firm  will  reach  “stable  growth”  and  what  
characteris4cs  (risk  &  cash  flow)  it  will  have  when  it  does.  
5. Choose  the  right  DCF  model  for  this  asset  and  value  it.  

Aswath Damodaran
13
 Generic  DCF  Valua4on  Model  
14

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

Aswath Damodaran
14
 Same  ingredients,  different  approaches…  
15

Input   Dividend  Discount   FCFE  (Poten;al   FCFF  (firm)  

Model   dividend)  discount   valua;on  model  
model  
Cash  flow     Dividend   Poten4al  dividends   FCFF  =  Cash  flows  
=  FCFE  =  Cash  flows   before  debt  
aber  taxes,   payments  but  aber  
reinvestment  needs   reinvestment  needs  
and  debt  cash  flows   and  taxes.  

Expected  growth   In  equity  income   In  equity  income   In  opera4ng  

and    dividends   and  FCFE   income  and  FCFF  
Discount  rate   Cost  of  equity   Cost  of  equity   Cost  of  capital  
Steady  state   When  dividends   When  FCFE  grow  at   When  FCFF  grow  at  
grow  at  constant   constant  rate   constant  rate  
rate  forever   forever   forever  
Aswath Damodaran
15
 Start  easy:  The  Dividend  Discount  Model  
16

Expected Retention ratio

growth in net needed to
income sustain growth

Net Income Expected dividends = Expected net

* Payout ratio income * (1- Retention ratio)
= Dividends

Length of high growth period: PV of dividends during

high growth Stable Growth
Value of equity When net income and
dividends grow at constant
rate forever.
Cost of Equity
Rate of return
demanded by equity
investors

Aswath Damodaran
16
 Moving  on  up:  The  “poten4al  dividends”  or  
FCFE  model  
17

Equity reinvestment
Expected growth in needed to sustain
net income growth
Free Cashflow to Equity
Non-cash Net Income
- (Cap Ex - Depreciation) Expected FCFE = Expected net income *
- Change in non-cash WC (1- Equity Reinvestment rate)
- (Debt repaid - Debt issued)
= Free Cashflow to equity

Length of high growth period: PV of FCFE during high

Value of Equity in non-cash Assets growth Stable Growth
+ Cash When net income and FCFE
= Value of equity grow at constant rate forever.

Cost of equity
Rate of return
demanded by equity
investors

Aswath Damodaran
17
 To  valuing  the  en4re  business:  The  FCFF  model  
18

Reinvestment
Expected growth in needed to sustain
operating ncome growth

Free Cashflow to Firm

After-tax Operating Income
- (Cap Ex - Depreciation) Expected FCFF= Expected operating
- Change in non-cash WC income * (1- Reinvestment rate)
= Free Cashflow to firm

Value of Operatng Assets Length of high growth period: PV of FCFF during high
+ Cash & non-operating assets growth Stable Growth
- Debt When operating income and
= Value of equity FCFF grow at constant rate
forever.
Cost of capital
Weighted average of
costs of equity and
debt

Aswath Damodaran
18
 Aswath Damodaran 19

DISCOUNTED  CASH  FLOW  

VALUATION:  THE  INPUTS  
Aswath  Damodaran  
 Aswath Damodaran 20

I.  ESTIMATING  DISCOUNT  RATES  

Discount  rates  maner,  but  not  as  much  as  you  think  
they  do!  
 Es4ma4ng  Inputs:  Discount  Rates  
21

¨ While  discount  rates  obviously  maner  in  DCF  valua4on,  they  

don’t  maner  as  much  as  most  analysts  think  they  do.  
¨ At  an  intui4ve  level,  the  discount  rate  used  should  be  
consistent  with  both  the  riskiness  and  the  type  of  cashflow  
being  discounted.  
¤ Equity  versus  Firm:  If  the  cash  flows  being  discounted  are  cash  flows  to  
equity,  the  appropriate  discount  rate  is  a  cost  of  equity.  If  the  cash  
flows  are  cash  flows  to  the  firm,  the  appropriate  discount  rate  is  the  
cost  of  capital.  
¤ Currency:  The  currency  in  which  the  cash  flows  are  es4mated  should  
also  be  the  currency  in  which  the  discount  rate  is  es4mated.  
¤ Nominal  versus  Real:  If  the  cash  flows  being  discounted  are  nominal  
cash  flows  (i.e.,  reflect  expected  infla4on),  the  discount  rate  should  be  
nominal  

Aswath Damodaran
21
 Risk  in  the  DCF  Model  
22

Relative risk of Equity Risk Premium

Risk Adjusted Risk free rate in the company/equity in X
Cost of equity
=
currency of analysis + questiion
required for average risk
equity

Aswath Damodaran
22
 Not  all  risk  is  created  equal…  
23

¨ Es4ma4on  versus  Economic  uncertainty  

¤ Es4ma4on  uncertainty  reflects  the  possibility  that  you  could  have  the  “wrong  
model”  or  es4mated  inputs  incorrectly  within  this  model.  
¤ Economic  uncertainty  comes  the  fact  that  markets  and  economies  can  change  over  
4me  and  that  even  the  best  models  will  fail  to  capture  these  unexpected  changes.  
¨ Micro  uncertainty  versus  Macro  uncertainty  
¤ Micro  uncertainty  refers  to  uncertainty  about  the  poten4al  market  for  a  firm’s  
products,  the  compe44on  it  will  face  and  the  quality  of  its  management  team.  
¤ Macro  uncertainty  reflects  the  reality  that  your  firm’s  fortunes  can  be  affected  by  
changes  in  the  macro  economic  environment.  
¨ Discrete  versus  con4nuous  uncertainty  
¤ Discrete  risk:  Risks  that  lie  dormant  for  periods  but  show  up  at  points  in  4me.    
(Examples:  A  drug  working  its  way  through  the  FDA  pipeline  may  fail  at  some  stage  
of  the  approval  process  or  a  company  in  Venezuela  may  be  na4onalized)  
¤ Con4nuous  risk:  Risks  changes  in  interest  rates  or  economic  growth  occur  
con4nuously  and  affect  value  as  they  happen.    

Aswath Damodaran
23
 Risk  and  Cost  of  Equity:  The  role  of  the  marginal  
investor  
24

¨ Not  all  risk  counts:  While  the  no4on  that  the  cost  of  equity  should  
be  higher  for  riskier  investments  and  lower  for  safer  investments  is  
intui4ve,  what  risk  should  be  built  into  the  cost  of  equity  is  the  
ques4on.  
¨ Risk  through  whose  eyes?  While  risk  is  usually  defined  in  terms  of  
the  variance  of  actual  returns  around  an  expected  return,  risk  and  
return  models  in  finance  assume  that  the  risk  that  should  be  
rewarded  (and  thus  built  into  the  discount  rate)  in  valua4on  should  
be  the  risk  perceived  by  the  marginal  investor  in  the  investment  
¨ The  diversifica4on  effect:  Most  risk  and  return  models  in  finance  
also  assume  that  the  marginal  investor  is  well  diversified,  and  that  
the  only  risk  that  he  or  she  perceives  in  an  investment  is  risk  that  
cannot  be  diversified  away  (i.e,  market  or  non-­‐diversifiable  risk).  In  
effect,  it  is  primarily  economic,  macro,  con4nuous  risk  that  should  
be  incorporated  into  the  cost  of  equity.    

Aswath Damodaran
24
 The  Cost  of  Equity:  Compe4ng  “  Market  Risk”  
Models  
25

Model  Expected  Return  Inputs  Needed  

CAPM  E(R)  =  Rf  +  β  (Rm-­‐  Rf)  Riskfree  Rate  
       Beta  rela4ve  to  market  porrolio  
       Market  Risk  Premium  
APM  E(R)  =  Rf  +  Σ βj  (Rj-­‐  Rf)  Riskfree  Rate;  #  of  Factors;  
       Betas  rela4ve  to  each  factor  
       Factor  risk  premiums  
Mul4    E(R)  =  Rf  +  Σ βj  (Rj-­‐  Rf)  Riskfree  Rate;  Macro  factors  
factor        Betas  rela4ve  to  macro  factors  
       Macro  economic  risk  premiums  
Proxy  E(R)  =  a  +  Σ    bj  Yj  Proxies  
       Regression  coefficients  

Aswath Damodaran
25
 The  CAPM:  Cost  of  Equity  
26

¨ Consider  the  standard  approach  to  es4ma4ng  cost  

of  equity:  
Cost  of  Equity  =  Riskfree  Rate  +  Equity  Beta  *  (Equity  Risk  
Premium)  
¨ In  prac4ce,  
¤ Government  security  rates  are  used  as  risk  free  rates  
¤ Historical  risk  premiums  are  used  for  the  risk  premium  

¤ Betas  are  es4mated  by  regressing  stock  returns  against  

market  returns  

Aswath Damodaran
26
 I.  A  Riskfree  Rate  
27

¨ 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,  then,  it  has  to  have  
¤ No  default  risk  
¤ No  reinvestment  risk  
1. Time  horizon  maners:  Thus,  the  riskfree  rates  in  
valua4on  will  depend  upon  when  the  cash  flow  is  
expected  to  occur  and  will  vary  across  4me.    
2. Not  all  government  securi4es  are  riskfree:  Some  
governments  face  default  risk  and  the  rates  on  bonds  
issued  by  them  will  not  be  riskfree.  

Aswath Damodaran
27
 Test  1:  A  riskfree  rate  in  US  dollars!  
28

¨ In  valua4on,  we  es4mate  cash  flows  forever  (or  at  

least  for  very  long  4me  periods).  The  right  risk  free  
rate  to  use  in  valuing  a  company  in  US  dollars  would  
be  
a. A  three-­‐month  Treasury  bill  rate  (0.2%)  
b. A  ten-­‐year  Treasury  bond  rate  (2%)  
c. A  thirty-­‐year  Treasury  bond  rate  (3%)  
d. A  TIPs  (infla4on-­‐indexed  treasury)  rate  (1%)  
e. None  of  the  above  

Aswath Damodaran
28
 Test  2:  A  Riskfree  Rate  in  Euros  
29

Euro  Government  Bond  Rates  -­‐  January  1,  2015  

10.00%  

9.00%  

8.00%  

7.00%  

6.00%  

5.00%  

4.00%  

3.00%  

2.00%  

1.00%  

0.00%  

Aswath Damodaran
29
 Test  3:  A  Riskfree  Rate  in  Indian  Rupees  
30

¨ The  Indian  government  had  10-­‐year  Rupee  bonds  

outstanding,  with  a  yield  to  maturity  of  about  7.87%  on  
January  1,  2015.    
¨ In  January  2015,  the  Indian  government  had  a  local  currency  
sovereign  ra4ng  of  Baa3.  The  typical  default  spread  (over  a  
default  free  rate)  for  Baa3  rated  country  bonds  in  early  2015  
was  2.2%.  The  riskfree  rate  in  Indian  Rupees  is  
a. The  yield  to  maturity  on  the  10-­‐year  bond  (7.87%)  
b. The  yield  to  maturity  on  the  10-­‐year  bond  +  Default  spread  (10.07%)  
c. The  yield  to  maturity  on  the  10-­‐year  bond  –  Default  spread  (5.67%)  
d. None  of  the  above  

Aswath Damodaran
30
 Sovereign  Default  Spread:  Three  paths  to  the  
same  des4na4on…  
31

¨ Sovereign  dollar  or  euro  denominated  bonds:  Find  

sovereign  bonds  denominated  in  US  dollars,  issued  
by  emerging  markets.  The  difference  between  the  
interest  rate  on  the  bond  and  the  US  treasury  bond  
rate  should  be  the  default  spread.    
¨ CDS  spreads:  Obtain  the  default  spreads  for  
sovereigns  in  the  CDS  market.    
¨ Average  spread:  For  countries  which  don’t  issue  
dollar  denominated  bonds  or  have  a  CDS  spread,  
you  have  to  use  the  average  spread  for  other  
countries  in  the  same  ra4ng  class.  
Aswath Damodaran
31
 Local  Currency  Government  Bond  Rates  –  
January  2015  
32

Currency   Govt  Bond  Rate  (1/1/15   Currency   Govt  Bond  Rate  (1/1/15)  
Australian  $   2.81%   Mexican  Peso   5.83%  
Bri4sh  Pound   1.73%   Naira   15.13%  
Bulgarian  Lev   3.15%   Norwegian  Krone   1.51%  
Canadian  $   1.79%   NZ  $   3.67%  
Chilean  Peso   4.30%   Pakistani  Rupee   10.00%  
Chinese  Yuan   3.65%   Peruvian  Sol   5.43%  
Colombian  Peso   7.17%   Phillipine  Peso   4.37%  
Czech  Koruna   0.47%   Polish  Zloty   2.53%  
Danish  Krone   0.79%   Reai  (Brazil)   12.42%  
Euro   0.54%   Romanian  Leu   3.68%  
HK  $   1.97%   Russian  Ruble   14.09%  
Hungarian  Forint   3.69%   Singapore  $   2.33%  
Iceland  Krona   6.15%   South  African  Rand   7.80%  
Indian  Rupee   7.87%   Swedish  Krona   0.90%  
Indonesian  Rupiah   7.81%   Swiss  Franc   0.31%  
Israeli  Shekel   2.30%   Taiwanese  $   1.61%  
Japanese  Yen   0.33%   Thai  Baht   2.91%  
Kenyan  Shilling   12.35%   Turkish  Lira   8.09%  
Korean  Won   2.60%   US  $   2.12%  
Kuna   3.78%   Venezuelan  Bolivar   10.05%  
Malyasian  Ringgit   4.13%   Vietnamese  Dong   7.15%  

Aswath Damodaran
32
Approach  1:  Default  spread  from  Government  
Bonds  

The Brazil Default Spread

Brazil 2020 Bond: 3.20%
US 2020 T.Bond: 1.65%
Spread: 1.55%

33
 Approach  2:  CDS  Spreads  –  January  2015  
34
Moody's   CDS  Spread   Moody's   CDS  Spread   Moody's   CDS  Spread  
Country   CDS  Spread   Country   CDS  Spread   Country   CDS  Spread  
ra;ng   adj  for  US   ra;ng   adj  for  US   ra;ng   adj  for  US  
Abu  Dhabi   Aa2   1.43%   1.12%   Hungary   Ba1   2.64%   2.33%   Poland   A2   1.46%   1.15%  
Argen4na   Caa1   83.48%   83.17%   Iceland   Baa3   2.27%   1.96%   Portugal   Ba1   3.09%   2.78%  
Australia   Aaa   0.97%   0.66%   India   Baa3   2.64%   2.33%   Qatar   Aa2   1.57%   1.26%  
Austria   Aaa   0.81%   0.50%   Indonesia   Baa3   2.82%   2.51%   Romania   Baa3   2.23%   1.92%  
Bahrain   Baa2   3.18%   2.87%   Ireland   Baa1   1.26%   0.95%   Russia   Baa2   5.63%   5.32%  
Belgium   Aa3   1.20%   0.89%   Israel   A1   0.42%   0.11%   Saudi  Arabia   Aa3   1.39%   1.08%  
Brazil   Baa2   3.17%   2.86%   Italy   Baa2   2.34%   2.03%   Slovakia   A2   1.32%   1.01%  
Bulgaria   Baa2   2.99%   2.68%   Japan   A1   1.55%   1.24%   Slovenia   Ba1   2.14%   1.83%  
Chile   Aa3   1.77%   1.46%   Kazakhstan   Baa2   4.16%   3.85%   South  Africa   Baa2   2.96%   2.65%  
China   Aa3   1.78%   1.47%   Korea   Aa3   1.17%   0.86%   Spain   Baa2   1.79%   1.48%  
Colombia   Baa2   2.57%   2.26%   Latvia   Baa1   1.92%   1.61%   Sweden   Aaa   0.65%   0.34%  
Costa  Rica   Ba1   3.58%   3.27%   Lebanon   B2   4.69%   4.38%   Switzerland   Aaa   0.72%   0.41%  
Croa4a   Ba1   3.65%   3.34%   Lithuania   Baa1   1.88%   1.57%   Thailand   Baa1   1.91%   1.60%  
Cyprus   B3   6.35%   6.04%   Malaysia   A3   2.15%   1.84%   Tunisia   Ba3   3.38%   3.07%  
Czech  Republic   A1   1.25%   0.94%   Mexico   A3   2.05%   1.74%   Turkey   Baa3   2.77%   2.46%  
Egypt   Caa1   3.56%   3.25%   Netherlands   Aaa   0.78%   0.47%   Ukraine   Caa3   15.74%   15.43%  
Estonia   A1   1.20%   0.89%   New  Zealand   Aaa   1.01%   0.70%   United  Arab  Emirates   Aa2   1.54%   1.23%  
Finland   Aaa   0.81%   0.50%   Norway   Aaa   0.61%   0.30%   United  Kingdom   Aa1   0.77%   0.46%  
France   Aa1   1.22%   0.91%   Pakistan   Caa1   10.41%   10.10%   United  States  of  America   Aaa   0.31%   0.00%  
Germany   Aaa   0.74%   0.43%   Panama   Baa2   2.09%   1.78%   Venezuela   Caa1   18.06%   17.75%  
Greece   Caa1   10.76%   10.45%   Peru   A3   2.23%   1.92%   Vietnam   B1   3.15%   2.84%  
Hong  Kong   Aa1   1.12%   0.81%   Philippines   Baa2   1.98%   1.67%  

Aswath Damodaran
34
 Approach  3:  Typical  Default  Spreads:  January  
2014  
35

Sovereign Default Spread

Rating over riskfree
Aaa   0.00%  
Aa1   0.40%  
Aa2   0.50%  
Aa3   0.60%  
A1   0.70%  
A2   0.85%  
A3   1.20%  
Baa1   1.60%  
Baa2   1.90%  
Baa3   2.20%  
Ba1   2.50%  
Ba2   3.00%  
Ba3   3.60%  
B1   4.50%  
B2   5.50%  
B3   6.50%  
Caa1   7.50%  
Caa2   9.00%  
Caa3   10.00%  
Aswath Damodaran
35
 Ge}ng  to  a  risk  free  rate  in  a  currency:  Example  
36

¨ The  Brazilian  government  bond  rate  in  nominal  reais  in  

January  2015  was  12.42%.  To  get  to  a  riskfree  rate  in  nominal  
reais,  we  can  use  one  of  three  approaches.  
¨ Approach  1:  Government  Bond  spread  
¤ The  2020  Brazil  bond,  denominated  in  US  dollars,  has  a  spread  of  
1.55%  over  the  US  treasury  bond  rate.  
¤ Riskfree  rate  in  $R  =  12.42%  -­‐  1.55%%  =  10.87%  
¨ Approach  2:  The  CDS  Spread  
¤ The  CDS  spread  for  Brazil,  adjusted  for  the  US  CDS  spread,  on  
January  1,  2015  was  2.86%.    
¤ Riskfree  rate  in  $R  =  12.42%  -­‐  2.86%  =  9.56%  
¨ Approach  3:  The  Ra4ng  based  spread  
¤ Brazil  has  a  Baa2  local  currency  ra4ng  from  Moody’s.  The  default  
spread  for  that  ra4ng  is  1.90%  
¤ Riskfree  rate  in  $R  =  12.42%  -­‐  1.90%  =  10.52%  

Aswath Damodaran
36
 Test  4:  A  Real  Riskfree  Rate  
37

¨ In  some  cases,  you  may  want  a  riskfree  rate  in  real  terms  
(in  real  terms)  rather  than  nominal  terms.    
¨ To  get  a  real  riskfree  rate,  you  would  like  a  security  with  
no  default  risk  and  a  guaranteed  real  return.  Treasury  
indexed  securi4es  offer  this  combina4on.  
¨  In  January  2015,  the  yield  on  a  10-­‐year  indexed  treasury  
bond  was  1.00%.  Which  of  the  following  statements  
would  you  subscribe  to?  
a. This  (1.00%)  is  the  real  riskfree  rate  to  use,  if  you  are  valuing  
US  companies  in  real  terms.  
b. This  (1.00%)  is  the  real  riskfree  rate  to  use,  anywhere  in  the  
world  
Explain.  

Aswath Damodaran
37
 No  default  free  en4ty:  Choices  with  riskfree  
rates….  
38

¨ Es4mate  a  range  for  the  riskfree  rate  in  local  terms:  

¤ Approach  1:  Subtract  default  spread  from  local  government  bond  rate:  
Government  bond  rate  in  local  currency  terms  -­‐  Default  spread  for  
Government  in  local  currency  
¤ Approach  2:  Use  forward  rates  and  the  riskless  rate  in  an  index  currency  
(say  Euros  or  dollars)  to  es4mate  the  riskless  rate  in  the  local  currency.  
¨ Do  the  analysis  in  real  terms  (rather  than  nominal  terms)  using  a  
real  riskfree  rate,  which  can  be  obtained  in  one  of  two  ways  –  
¤ from  an  infla4on-­‐indexed  government  bond,  if  one  exists  
¤ set  equal,  approximately,  to  the  long  term  real  growth  rate  of  the  
economy  in  which  the  valua4on  is  being  done.  
¨ Do  the  analysis  in  a  currency  where  you  can  get  a  riskfree  rate,  say  
US  dollars  or  Euros.  

Aswath Damodaran
38
Risk  free  Rate:  Don’t  have  or  trust  the  
government  bond  rate?    
1. Build  up  approach:  The  risk  free  rate  in  any  currency  can  be  
wrinen  as  the  sum  of  two  variables:  
Risk  free  rate  =  Expected  Infla4on  in  currency  +  Expected  real  interest  rate  
The  expected  real  interest  rate  can  be  computed  in  one  of  two  ways:  from  
the  US  TIPs  rate  or  set  equal  to  real  growth  in  the  economy.  Thus,  if  the  
expected  infla4on  rate  in  a  country  is  expected  to  be  15%  and  the  TIPs  rate  
is  1%,  the  risk  free  rate  is  16%.  
2. US  $  rate  &  Differen4al  Infla4on:  Alterna4vely,  you  can  scale  up  
the  US  $  risk  free  rate  by  the  differen4al  infla4on  between  the  US  
$  and  the  currency  in  ques4on:  
Risk  free  rateCurrency=  
 
Thus,  if  the  US  $  risk  free  rate  is  3.04%,  the  infla4on  rate  in  the  foreign  
currency  is  15%  and  the  infla4on  rate  in  US  $  is  2%,  the  foreign  currency  risk  
free  rate  is  as  follows:  
Risk  free  rate  =     1.0304 !.!"
!.!"
− 1!=!16.17%!

39
 40

0.00%  
2.00%  
4.00%  
6.00%  
8.00%  

-­‐2.00%  
10.00%  
12.00%  
14.00%  
Japanese  Yen  
Czech  Koruna  
Swiss  Franc  
Euro  
Danish  Krone  

Aswath Damodaran
Swedish  Krona  
Taiwanese  $  
Hungarian  Forint  
Bulgarian  Lev  
Kuna  
Thai  Baht  
Bri4sh  Pound  
Romanian  Leu  
Norwegian  Krone  
HK  $  
Israeli  Shekel  
Polish  Zloty  
Canadian  $  
Korean  Won  
US  $  
Singapore  $  
Phillipine  Peso  

Risk  free  Rate  

Pakistani  Rupee  
January  2015  Risk  free  rates  

Venezuelan  Bolivar  
Vietnamese  Dong  
Australian  $  
Malyasian  Ringgit  
Riskfree  Rates:  January  2015  

Chinese  Yuan  
NZ  $  
Chilean  Peso  
Iceland  Krona  
Peruvian  Sol  
Mexican  Peso  
Colombian  Peso  
Indonesian  Rupiah  
Indian  Rupee  
Turkish  Lira  
South  African  Rand  
Kenyan  Shilling  
Reai  
Why  do  risk  free  rates  vary  across  currencies?  

Naira  
Russian  Ruble  
40
 One  more  test  on  riskfree  rates…  
41

¨ In  January  2015,  the  10-­‐year  treasury  bond  rate  in  the  

United  States  was  2.17%,  a  historic  low.  Assume  that  you  
were  valuing  a  company  in  US  dollars  then,  but  were  
wary  about  the  risk  free  rate  being  too  low.  Which  of  the  
following  should  you  do?  
a. Replace  the  current  10-­‐year  bond  rate  with  a  more  reasonable  
normalized  riskfree  rate  (the  average  10-­‐year  bond  rate  over  
the  last  30  years  has  been  about  5-­‐6%)  
b. Use  the  current  10-­‐year  bond  rate  as  your  riskfree  rate  but  
make  sure  that  your  other  assump4ons  (about  growth  and  
infla4on)  are  consistent  with  the  riskfree  rate  
c. Something  else…  

Aswath Damodaran
41
 Some  perspec4ve  on  risk  free  rates  
42

Interest  rate  fundamentals:  T.  Bond  rates,  Real  growth  and  inflaDon  
20.00%  

15.00%  

10.00%  
Real  GDP  growth  

Infla4on  rate  

Ten-­‐year  T.Bond  rate  

5.00%  

0.00%  
1954  
1956  
1958  
1960  
1962  
1964  
1966  
1968  
1970  
1972  
1974  
1976  
1978  
1980  
1982  
1984  
1986  
1988  
1990  
1992  
1994  
1996  
1998  
2000  
2002  
2004  
2006  
2008  
2010  
2012  
-­‐5.00%  

Aswath Damodaran
42