Finding the Right Financing Mix: The Capital Structure Decision
Transcript of Finding the Right Financing Mix: The Capital Structure Decision
Asw
ath Dam
odaran2
Finding the R
ight Financing M
ix: The
Capital S
tructure Decision
Asw
ath Dam
odaran
Stern School of Business
Asw
ath Dam
odaran3
First P
rinciples
Invest in projects that yield a return greater than the minim
umacceptable hurdle rate.•
The hurdle rate should be higher for riskier projects and reflect the
financing mix used - ow
ners’ funds (equity) or borrowed m
oney (debt)
•R
eturns on projects should be measured based on cash flow
s generatedand the tim
ing of these cash flows; they should also consider both positive
and negative side effects of these projects.
Choose a financing m
ix that minim
izes the hurdle rate and matches the
assets being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.•
The form
of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
Objective: M
aximize the V
alue of the Firm
Asw
ath Dam
odaran4
The C
hoices in Financing
There are only tw
o ways in w
hich a business can make m
oney.•
The first is debt. T
he essence of debt is that you promise to m
ake fixedpaym
ents in the future (interest payments and repaying principal). If you
fail to make those paym
ents, you lose control of your business.
•T
he other is equity. With equity, you do get w
hatever cash flows are left
over after you have made debt paym
ents.
The equity can take different form
s:•
For very small businesses: it can be ow
ners investing their savings
•For slightly larger businesses: it can be venture capital
•For publicly traded firm
s: it is comm
on stock
The debt can also take different form
s•
For private businesses: it is usually bank loans
•For publicly traded firm
s: it can take the form of bonds
Asw
ath Dam
odaran5
The F
inancing Mix Q
uestion
In deciding to raise financing for a business, is there an optimal m
ix ofdebt and equity?•
If yes, what is the trade off that lets us determ
ine this optimal m
ix?
•If not, w
hy not?
Asw
ath Dam
odaran6
Measuring a firm
’s financing mix
The sim
plest measure of how
much debt and equity a firm
is usingcurrently is to look at the proportion of debt in the total financing. T
hisratio is called the debt to capital ratio:
Debt to C
apital Ratio =
Debt / (D
ebt + E
quity)
Debt includes all interest bearing liabilities, short term
as well as long
term.
Equity can be defined either in accounting term
s (as book value ofequity) or in m
arket value terms (based upon the current price). T
heresulting debt ratios can be very different.
Asw
ath Dam
odaran7
Costs and B
enefits of Debt
Benefits of D
ebt•
Tax B
enefits
•A
dds discipline to managem
ent
Costs of D
ebt•
Bankruptcy C
osts
•A
gency Costs
•L
oss of Future Flexibility
Asw
ath Dam
odaran8
Tax B
enefits of Debt
When you borrow
money, you are allow
ed to deduct interest expensesfrom
your income to arrive at taxable incom
e. This reduces your taxes.
When you use equity, you are not allow
ed to deduct payments to
equity (such as dividends) to arrive at taxable income.
The dollar tax benefit from
the interest payment in any year is a
function of your tax rate and the interest payment:
•T
ax benefit each year = T
ax Rate * Interest Paym
ent
Proposition 1: Other things being equal, the higher the m
arginal taxrate of a business, the m
ore debt it will have in its capital structure.
Asw
ath Dam
odaran9
The E
ffects of Taxes
You are com
paring the debt ratios of real estate corporations, which pay the
corporate tax rate, and real estate investment trusts, w
hich are not taxed, but
are required to pay 95% of their earnings as dividends to their stockholders.
Which of these tw
o groups would you expect to have the higher debt ratios?
The real estate corporations
The real estate investm
ent trusts
Cannot tell, w
ithout more inform
ation
Asw
ath Dam
odaran10
Debt adds discipline to m
anagement
If you are managers of a firm
with no debt, and you generate high
income and cash flow
s each year, you tend to become com
placent. The
complacency can lead to inefficiency and investing in poor projects.
There is little or no cost borne by the m
anagers
Forcing such a firm to borrow
money can be an antidote to the
complacency. T
he managers now
have to ensure that the investments
they make w
ill earn at least enough return to cover the interestexpenses. T
he cost of not doing so is bankruptcy and the loss of such ajob.
Asw
ath Dam
odaran11
Debt and D
iscipline
Assum
e that you buy into this argument that debt adds discipline to m
anagement.
Which of the follow
ing types of companies w
ill most benefit from
debt adding
this discipline?
Conservatively financed (very little debt), privately ow
ned businesses
Conservatively
financed, publicly
traded companies,
with
stocks held
by
millions of investors, none of w
hom hold a large percent of the stock.
Conservatively
financed, publicly
traded com
panies, w
ith an
activist and
primarily institutional holding.
Asw
ath Dam
odaran12
Bankruptcy C
ost
The expected bankruptcy cost is a function of tw
o variables--•
the cost of going bankrupt–
direct costs: Legal and other D
eadweight C
osts
–indirect costs: C
osts arising because people perceive you to be in financialtrouble
•the probability of bankruptcy, w
hich will depend upon how
uncertain youare about future cash flow
s
As you borrow
more, you increase the probability of bankruptcy and
hence the expected bankruptcy cost.
Asw
ath Dam
odaran13
The B
ankruptcy Cost P
roposition
Proposition 2: Other things being equal, the greater the indirect
bankruptcy cost and/or probability of bankruptcy in the operatingcashflow
s of the firm, the less debt the firm
can afford to use.
Asw
ath Dam
odaran14
Debt &
Bankruptcy C
ost
Rank the follow
ing companies on the m
agnitude of bankruptcy costs from m
ost to
least, taking into account both explicit and implicit costs:
A G
rocery Store
An A
irplane Manufacturer
High T
echnology company
Asw
ath Dam
odaran15
Agency C
ost
An agency cost arises w
henever you hire someone else to do som
ething foryou. It arises because your interests(as the principal) m
ay deviate from those
of the person you hired (as the agent).
When you lend m
oney to a business, you are allowing the stockholders to use
that money in the course of running that business. Stockholders interests are
different from your interests, because
•Y
ou (as lender) are interested in getting your money back
•Stockholders are interested in m
aximizing your w
ealth
In some cases, the clash of interests can lead to stockholders
•Investing in riskier projects than you w
ould want them
to
•Paying them
selves large dividends when you w
ould rather have them keep the cash
in the business.
Proposition 3: Other things being equal, the greater the agency problem
sassociated w
ith lending to a firm, the less debt the firm
can afford to use.
Asw
ath Dam
odaran16
Debt and A
gency Costs
Assum
e that you are a bank. Which of the follow
ing businesses would
you perceive the greatest agency costs?
A L
arge Pharm
aceutical company
A L
arge Regulated E
lectric Utility
Why?
Asw
ath Dam
odaran17
Loss of future financing flexibility
When a firm
borrows up to its capacity, it loses the flexibility of
financing future projects with debt.
Proposition 4: Other things rem
aining equal, the more uncertain a firm
is about its future financing requirements and projects, the less debt the
firm w
ill use for financing current projects.
Asw
ath Dam
odaran18
What m
anagers consider important in deciding
on how m
uch debt to carry...
A survey of C
hief Financial Officers of large U
.S. companies provided
the following ranking (from
most im
portant to least important) for the
factors that they considered important in the financing decisions
Factor
Ranking (0-5)
1. Maintain financial flexibility
4.55
2. Ensure long-term
survival4.55
3. Maintain Predictable Source of Funds
4.05
4. Maxim
ize Stock Price3.99
5. Maintain financial independence
3.88
6. Maintain high debt rating
3.56
7. Maintain com
parability with peer group
2.47
Asw
ath Dam
odaran19
Debt: S
umm
arizing the Trade O
ff
Advantages of B
orrowing
Disadvantages of B
orrowing
1. Tax B
enefit:
Higher tax rates -->
Higher tax benefit
1. Bankruptcy C
ost:
Higher business risk -->
Higher C
ost
2. Added D
iscipline:
Greater the separation betw
een managers
and stockholders --> G
reater the benefit
2. Agency C
ost:
Greater the separation betw
een stock-
holders & lenders -->
Higher C
ost
3. Loss of F
uture Financing F
lexibility:
Greater the uncertainty about future
financing needs --> H
igher Cost
Asw
ath Dam
odaran20
Application T
est: Would you expect your firm
to gain or lose from using a lot of debt?
Considering, for your firm
,•
The potential tax benefits of borrow
ing
•T
he benefits of using debt as a disciplinary mechanism
•T
he potential for expected bankruptcy costs
•T
he potential for agency costs
•T
he need for financial flexibility
Would you expect your firm
to have a high debt ratio or a low debt
ratio?
Does the firm
’s current debt ratio meet your expectations?
Asw
ath Dam
odaran21
A H
ypothetical Scenario
Assum
e you operate in an environment, w
here(a) there are no taxes
(b) there is no separation between stockholders and m
anagers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know
their future financing needs
Asw
ath Dam
odaran22
The M
iller-Modigliani T
heorem
In an environment, w
here there are no taxes, default risk or agencycosts, capital structure is irrelevant.
The value of a firm
is independent of its debt ratio.
Asw
ath Dam
odaran23
Implications of M
M T
heorem
Leverage is irrelevant. A
firm's value w
ill be determined by its project
cash flows.
The cost of capital of the firm
will not change w
ith leverage. As a firm
increases its leverage, the cost of equity will increase just enough to
offset any gains to the leverage
Asw
ath Dam
odaran24
What do firm
s look at in financing?
Is there a financing hierarchy?
Argum
ent:•
There are som
e who argue that firm
s follow a financing hierarchy, w
ithretained earnings being the m
ost preferred choice for financing, followed
by debt and that new equity is the least preferred choice.
Asw
ath Dam
odaran25
Rationale for F
inancing Hierarchy
Managers value flexibility. E
xternal financing reduces flexibility more
than internal financing.
Managers value control. Issuing new
equity weakens control and new
debt creates bond covenants.
Asw
ath Dam
odaran26
Preference rankings long-term
finance: Results
of a survey
Ranking
SourceScore
1R
etained Earnings
5.61
2Straight D
ebt4.88
3C
onvertible Debt
3.02
4E
xternal Com
mon E
quity2.42
5Straight Preferred Stock
2.22
6C
onvertible Preferred1.72
Asw
ath Dam
odaran27
Financing C
hoices
You are reading the W
all Street Journal and notice a tombstone ad for a com
pany,
offering to sell convertible preferred stock. What w
ould you hypothesize about
the health of the company issuing these securities?
Nothing
Healthier than the average firm
In much m
ore financial trouble than the average firm
Asw
ath Dam
odaran28
Measuring C
ost of Capital
It will depend upon:
•(a) the com
ponents of financing: Debt, E
quity or Preferred stock
•(b) the cost of each com
ponent
In summ
ary, the cost of capital is the cost of each component w
eightedby its relative m
arket value.W
AC
C =
ke (E
/(D+
E)) +
kd (D
/(D+
E))
Asw
ath Dam
odaran29
Recapping the M
easurement of cost of capital
The cost of debt is the m
arket interest rate that the firm has to pay on
its borrowing. It w
ill depend upon three components
(a) The general level of interest rates
(b) The default prem
ium
(c) The firm
's tax rate
The cost of equity is1. the required rate of return given the risk
2. inclusive of both dividend yield and price appreciation
The w
eights attached to debt and equity have to be market value
weights, not book value w
eights.
Asw
ath Dam
odaran30
Costs of D
ebt & E
quity
A recent article in an A
sian business magazine argued that equity w
as cheaper
than debt, because dividend yields are much low
er than interest rates on debt.
Do you agree w
ith this statement
Yes
No
Can equity ever be cheaper than debt?
Yes
No
Asw
ath Dam
odaran31
Fallacies about B
ook Value
1. People will not lend on the basis of m
arket value.
2. Book V
alue is more reliable than M
arket Value because it does not
change as much.
3. Using book value is m
ore conservative than using market value.
Asw
ath Dam
odaran32
Issue: Use of B
ook Value
Many C
FO
s argue that using book value is more conservative than using
market value, because the m
arket value of equity is usually much
higher than book value. Is this statement true, from
a cost of capitalperspective? (W
ill you get a more conservative estim
ate of cost ofcapital using book value rather than m
arket value?)Y
esN
o
Asw
ath Dam
odaran33
Why does the cost of capital m
atter?
Value of a Firm
= Present V
alue of Cash Flow
s to the Firm,
discounted back at the cost of capital.
If the cash flows to the firm
are held constant, and the cost of capital ism
inimized, the value of the firm
will be m
aximized.
Asw
ath Dam
odaran34
Applying A
pproach: The T
extbook Exam
ple
D/(D
+E
)ke
kdA
fter-tax Cost of D
ebtW
AC
C
010.50%
8%4.80%
10.50%
10%11%
8.50%5.10%
10.41%
20%11.60%
9.00%5.40%
10.36%
30%12.30%
9.00%5.40%
10.23%
40%13.10%
9.50%5.70%
10.14%
50%14%
10.50%6.30%
10.15%
60%15%
12%7.20%
10.32%
70%16.10%
13.50%8.10%
10.50%
80%17.20%
15%9.00%
10.64%
90%18.40%
17%10.20%
11.02%
100%19.70%
19%11.40%
11.40%
Asw
ath Dam
odaran35
WA
CC
and Debt R
atios
Weighted A
verage Cost of C
apital and Debt R
atios
Debt R
atio
WACC
9.40%9.60%9.80%
10.00%10.20%10.40%10.60%10.80%11.00%11.20%11.40%
0
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Asw
ath Dam
odaran36
Current C
ost of Capital: D
isney
Equity•
Cost of E
quity = R
iskfree rate + B
eta * Risk Prem
ium=
7% +
1.25 (5.5%) =
13.85%
•M
arket Value of E
quity =
$50.88 Billion
•E
quity/(Debt+
Equity ) =
82%
Debt
•A
fter-tax Cost of debt =
(Riskfree rate +
Default Spread) (1-t)
= (7%
+0.50) (1-.36) =
4.80%
•M
arket Value of D
ebt =$ 11.18 B
illion
•D
ebt/(Debt +
Equity) =
18%
Cost of C
apital = 13.85%
(.82)+4.80%
(.18) = 12.22%
50.88/(50.88+
11.18)
Asw
ath Dam
odaran37
Mechanics of C
ost of Capital E
stimation
1. Estim
ate the Cost of E
quity at different levels of debt:E
quity will becom
e riskier -> B
eta will increase ->
Cost of E
quity will
increase.
Estim
ation will use levered beta calculation
2. Estim
ate the Cost of D
ebt at different levels of debt:D
efault risk will go up and bond ratings w
ill go down as debt goes up ->
Cost
of Debt w
ill increase.
To estim
ating bond ratings, we w
ill use the interest coverage ratio(E
BIT
/Interest expense)
3. Estim
ate the Cost of C
apital at different levels of debt
4. Calculate the effect on Firm
Value and Stock Price.
Asw
ath Dam
odaran38
Medians of K
ey Ratios : 1993-1995
AA
AA
AA
BB
BB
BB
CC
CPretax Interest C
overage13.50
9.675.76
3.942.14
1.510.96
EB
ITD
A Interest C
overage17.08
12.808.18
6.003.49
2.451.51
Funds from O
perations / Total D
ebt(%
)98.2%
69.1%45.5%
33.3%17.7%
11.2%6.7%
Free Operating C
ashflow/ T
otalD
ebt (%)
60.0%26.8%
20.9%7.2%
1.4%1.2%
0.96%
Pretax Return on Perm
anent Capital
(%)
29.3%21.4%
19.1%13.9%
12.0%7.6%
5.2%
Operating Incom
e/Sales (%)
22.6%17.8%
15.7%13.5%
13.5%12.5%
12.2%L
ong Term
Debt/ C
apital13.3%
21.1%31.6%
42.7%55.6%
62.2%69.5%
Total D
ebt/Capitalization
25.9%33.6%
39.7%47.8%
59.4%67.4%
69.1%
Asw
ath Dam
odaran39
Process of R
atings and Rate E
stimation
We use the m
edian interest coverage ratios for large manufacturing
firms to develop “interest coverage ratio” ranges for each rating class.
We then estim
ate a spread over the long term bond rate for each
ratings class, based upon yields at which these bonds trade in the
market place.
Asw
ath Dam
odaran40
Interest Coverage R
atios and Bond R
atings
If Interest Coverage R
atio isE
stimated B
ond Rating
> 8.50
AA
A6.50 - 8.50
AA
5.50 - 6.50A
+4.25 - 5.50
A3.00 - 4.25
A–
2.50 - 3.00B
BB
2.00 - 2.50B
B1.75 - 2.00
B+
1.50 - 1.75B
1.25 - 1.50B
–0.80 - 1.25
CC
C0.65 - 0.80
CC
0.20 - 0.65C
< 0.20
DFor m
ore detailed interest coverage ratios and bond ratings, try the ratings. xlsspreadsheet on m
y web site.
Asw
ath Dam
odaran41
Spreads over long bond rate for ratings
classes: 1996
Rating
SpreadA
AA
0.20%A
A0.50%
A+
0.80%A
1.00%A
-1.25%
BB
B1.50%
BB
2.00%B
+2.50%
B3.25%
B-
4.25%C
CC
5.00%C
C6.00%
C7.50%
D10.00%
See http://ww
w.bondsonline.com
for latest spreads
Asw
ath Dam
odaran42
Current Incom
e Statem
ent for Disney: 1996
Revenues
18,739
-Operating E
xpenses12,046
EB
ITD
A
6,693
-Depreciation
1,134
EB
IT
5,559
-Interest Expense
479
Income before taxes
5,080
-Taxes
847
Income after taxes
4,233
Interest coverage ratio= 5,559/479 =
11.61
(Am
ortization from C
apital Cities acquisition not considered)
Asw
ath Dam
odaran43
Estim
ating Cost of E
quity
Current B
eta = 1.25
Unlevered B
eta = 1.09
Market prem
ium =
5.5%T
.Bond R
ate = 7.00%
t=36%
Debt R
atioD
/E R
atioB
etaC
ost of Equity
0%0%
1.0913.00%
10%11%
1.1713.43%
20%25%
1.2713.96%
30%43%
1.3914.65%
40%67%
1.5615.56%
50%100%
1.7916.85%
60%150%
2.1418.77%
70%233%
2.7221.97%
80%400%
3.9928.95%
90%900%
8.2152.14%
Asw
ath Dam
odaran44
Disney: B
eta, Cost of E
quity and D/E
Ratio
0.0
0
1.0
0
2.0
0
3.0
0
4.0
0
5.0
0
6.0
0
7.0
0
8.0
0
9.0
0
0%
10
%2
0%
30
%4
0%
50
%6
0%
70
%8
0%
90
%
De
bt
Ra
tio
Beta
0.0
0%
10
.00
%
20
.00
%
30
.00
%
40
.00
%
50
.00
%
60
.00
%
Cost of Equity
Beta
Cost of E
quity
Asw
ath Dam
odaran45
Estim
ating Cost of D
ebt
D/(D
+E)
0.00%10.00%
Calculation D
etailsStep
D/E
0.00%11.11%
= [D
/(D+
E)]/( 1 -[D
/(D+
E)])
$ Debt
$0 $6,207
= [D
/(D+
E)]* Firm
Value
1
EB
ITD
A$6,693
$6,693 K
ept constant as debt changes.D
epreciation$1,134
$1,134 "
EB
IT$5,559
$5,559Interest
$0 $447
= Interest R
ate * $ Debt
2T
axable Income
$5,559 $5,112
= E
BIT
- InterestT
ax$2,001
$1,840 =
Tax R
ate * Taxable Incom
eN
et Income
$3,558$3,272
= T
axable Income - T
ax
Pre-tax Int. cov∞
12.44= E
BIT
/Int. Exp
3L
ikely Rating
AA
AA
AA
Based upon interest coverage
4Interest R
ate7.20%
7.20%Interest rate for given rating
5E
ff. Tax R
ate36.00%
36.00%See notes on effective tax rate
After-tax k
d4.61%
4.61%=
Interest Rate * (1 - T
ax Rate)
Firm
Value = 50,888+11,180= $62,068
Asw
ath Dam
odaran46
The R
atings Table
If Interest Coverage R
atio isE
stimated B
ond Rating
Default spread
> 8.50A
AA
0.20%6.50 - 8.50
AA
0.50%5.50 - 6.50
A+
0.80%4.25 - 5.50
A1.00%
3.00 - 4.25A
–1.25%
2.50 - 3.00B
BB
1.50%2.00 - 2.50
BB
2.00%1.75 - 2.00
B+
2.50%1.50 - 1.75
B3.25%
1.25 - 1.50B
–4.25%
0.80 - 1.25C
CC
5.00%0.65 - 0.80
CC
6.00%0.20 - 0.65
C7.50%
< 0.20D
10.00%
Asw
ath Dam
odaran47
A T
est: Can you do the 20%
level?
D/(D
+E
)0.00%
10.00%20.00%
Second Iteration
D/E
0.00%11.11%
$ Debt
$0 $6,207
EB
ITD
A$6,693
$6,693
Depreciation
$1,134 $1,134
EB
IT$5,559
$5,559
Interest Expense
$0 $447
Pre-tax Int. cov
∞∞ ∞∞12.44
Likely R
atingA
AA
AA
A
Interest Rate
7.20%7.20%
Eff. T
ax Rate
36.00%36.00%
Cost of D
ebt4.61%
4.61%
Asw
ath Dam
odaran48
Bond R
atings, Cost of D
ebt and Debt R
atios
WO
RK
SHE
ET
FO
R E
STIM
AT
ING
RA
TIN
GS/IN
TE
RE
ST R
AT
ES
D/(D
+E)
0.00%10.00%
20.00%30.00%
40.00%50.00%
60.00%70.00%
80.00%90.00%
D/E
0.00%11.11%
25.00%42.86%
66.67%100.00%
150.00%233.33%
400.00%900.00%
$ Debt
$0$6,207
$12,414$18,621
$24,827$31,034
$37,241$43,448
$49,655$55,862
EB
ITD
A$6,693
$6,693$6,693
$6,693$6,693
$6,693$6,693
$6,693$6,693
$6,693D
epreciation$1,134
$1,134$1,134
$1,134$1,134
$1,134$1,134
$1,134$1,134
$1,134E
BIT
$5,559$5,559
$5,559$5,559
$5,559$5,559
$5,559$5,559
$5,559$5,559
Interest$0
$447$968
$1,536$2,234
$3,181$4,469
$5,214$5,959
$7,262T
axable Income
$5,559$5,112
$4,591$4,023
$3,325$2,378
$1,090$345
($400)($1,703)
Tax
$2,001$1,840
$1,653$1,448
$1,197$856
$392$124
($144)($613)
Pre-tax Int. co v∞
12.445.74
3.622.49
1.751.24
1.070.93
0.77L
ikely Rating
AA
AA
AA
A+
A-
BB
BC
CC
CC
CC
CC
CC
Interest Rate
7.20%7.20%
7.80%8.25%
9.00%10.25%
12.00%12.00%
12.00%13.00%
Eff. T
ax Rate
36.00%36.00%
36.00%36.00%
36.00%36.00%
36.00%36.00%
33.59%27.56%
Cost of debt
4.61%4.61%
4.99%5.28%
5.76%6.56%
7.68%7.68%
7.97%9.42%
Asw
ath Dam
odaran49
Stated versus E
ffective Tax R
ates
You need taxable incom
e for interest to provide a tax savings
In the Disney case, consider the interest expense at 70%
and 80%70%
Debt R
atio80%
Debt R
atio
EB
IT$ 5,559 m
$ 5,559 m
Interest Expense
$ 5,214 m$ 5,959 m
Tax Savings
$ 1,866 m5559*.36 =
$ 2,001m
Effective T
ax Rate
36.00%2001/5959 =
33.59%
Pre-tax interest rate12.00%
12.00%
After-tax Interest R
ate7.68%
7.97%
You can deduct only $5,559m
illion of the $5,959 million of the
interest expense at 80%. T
herefore, only 36% of $ 5,559 is considered
as the tax savings.
Asw
ath Dam
odaran50
Cost of D
ebt
0.0
0%
2.0
0%
4.0
0%
6.0
0%
8.0
0%
10
.00
%
12
.00
%
14
.00
%
0%
10
%2
0%
30
%4
0%
50
%6
0%
70
%8
0%
90
%
Debt R
atio
Cost of Debt
Inte
rest R
ate
AT
Cost of D
ebt
Asw
ath Dam
odaran51
Disney’s C
ost of Capital S
chedule
Debt R
atioC
ost of Equity
AT
Cost of D
ebtC
ost of Capital
0.00%13.00%
4.61%13.00%
10.00%13.43%
4.61%12.55%
20.00%13.96%
4.99%12.17%
30.00%14.65%
5.28%11.84%
40.00%15.56%
5.76%11.64%
50.00%16.85%
6.56%11.70%
60.00%18.77%
7.68%12.11%
70.00%21.97%
7.68%11.97%
80.00%28.95%
7.97%12.17%
90.00%52.14%
9.42%13.69%
Asw
ath Dam
odaran52
Disney: C
ost of Capital C
hart
10
.50
%
11
.00
%
11
.50
%
12
.00
%
12
.50
%
13
.00
%
13
.50
%
14
.00
%
0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%
Debt R
atio
Cost of Capital
Cost of C
apital
Asw
ath Dam
odaran53
Effect on F
irm V
alue
Firm V
alue before the change = 50,888+
11,180= $ 62,068
WA
CC
b = 12.22%
Annual C
ost = $62,068 *12.22%
= $7,583 m
illionW
AC
Ca =
11.64%A
nnual Cost =
$62,068 *11.64% =
$7,226 million
∆ W
AC
C =
0.58%C
hange in Annual C
ost =
$ 357 million
If there is no growth in the firm
value, (Conservative E
stimate)
•Increase in firm
value = $357 / .1164 =
$3,065 million
•C
hange in Stock Price = $3,065/675.13=
$4.54 per share
If there is growth (of 7.13%
) in firm value over tim
e,•
Increase in firm value =
$357 * 1.0713 /(.1164-.0713) = $ 8,474
•C
hange in Stock Price = $8,474/675.13 =
$12.55 per share
Implied G
rowth R
ate obtained byFirm
value Today =
FCFF(1+
g)/(WA
CC
-g): Perpetual growth form
ula$62,068 =
$2,947(1+g)/(.1222-g): Solve for g
Asw
ath Dam
odaran54
A T
est: The R
epurchase Price
Let us suppose that the C
FO of D
isney approached you about buyingback stock. H
e wants to know
the maxim
um price that he should be
willing to pay on the stock buyback. (T
he current price is $ 75.38)A
ssuming that firm
value will grow
by 7.13% a year, estim
ate them
aximum
price.
What w
ould happen to the stock price after the buyback if you were
able to buy stock back at $ 75.38?
Asw
ath Dam
odaran55
The D
ownside R
isk
Doing W
hat-if analysis on Operating Incom
e•
A. Standard D
eviation Approach
–Standard D
eviation In Past Operating Incom
e
–Standard D
eviation In Earnings (If O
perating Income Is U
navailable)
–R
educe Base C
ase By O
ne Standard Deviation (O
r More)
•B
. Past Recession A
pproach–
Look A
t What H
appened To O
perating Income D
uring The L
ast Recession.
(How
Much D
id It Drop In %
Term
s?)
–R
educe Current O
perating Income B
y Same M
agnitude
Constraint on B
ond Ratings
Asw
ath Dam
odaran56
Disney’s O
perating Income: H
istory
Year
Operating Incom
e C
hange in Operating Incom
e
1981 $
119.35
1982 $
141.3918.46%
1983 $
133.87-5.32%
1984 $
142.606.5%
1985 $
205.6044.2%
1986 $
280.5836.5%
1987 $
707.00152.0%
1988 $
789.0011.6%
1989 $
1,109.0040.6%
1990 $
1,287.0016.1%
1991 $
1,004.00-22.0%
1992 $
1,287.0028.2%
1993 $
1,560.0021.2%
1994 $
1,804.0015.6%
1995 $
2,262.0025.4%
1996 $
3,024.0033.7%
Asw
ath Dam
odaran57
Disney: E
ffects of Past D
ownturns
Recession
Decline in O
perating Income
1991D
rop of 22.00%
1981-82Increased
Worst Y
earD
rop of 26%
The standard deviation in past operating incom
e is about 39%.
Asw
ath Dam
odaran58
Disney: T
he Dow
nside Scenario
Disney: C
ost of Capital w
ith 40% low
er EB
IT
10
.00
%
11
.00
%
12
.00
%
13
.00
%
14
.00
%
15
.00
%
16
.00
%
17
.00
%
18
.00
%
0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%
Debt R
atio
Cost
Cost of C
apital
Asw
ath Dam
odaran59
Constraints on R
atings
Managem
ent often specifies a 'desired Rating' below
which they do
not want to fall.
The rating constraint is driven by three factors•
it is one way of protecting against dow
nside risk in operating income (so
do not do both)
•a drop in ratings m
ight affect operating income
•there is an ego factor associated w
ith high ratings
Caveat: E
very Rating C
onstraint Has A
Cost.
•Provide M
anagement W
ith A C
lear Estim
ate Of H
ow M
uch The R
atingC
onstraint Costs B
y Calculating T
he Value O
f The Firm
Without T
heR
ating Constraint A
nd Com
paring To T
he Value O
f The Firm
With T
heR
ating Constraint.
Asw
ath Dam
odaran60
Ratings C
onstraints for Disney
Assum
e that Disney im
poses a rating constraint of BB
B or greater.
The optim
al debt ratio for Disney is then 30%
(see next page)
The cost of im
posing this rating constraint can then be calculated asfollow
s:
Value at 40%
Debt
= $ 70,542 m
illion
- Value at 30%
Debt
= $ 67,419 m
illion
Cost of R
ating Constraint
= $ 3,123 m
illion
Asw
ath Dam
odaran61
Effect of A
Ratings C
onstraint: Disney
Debt R
atioR
atingF
irm V
alue0%
AA
A$
53
,17
210%
AA
A$
58
,01
420%
A+
$6
2,7
05
30%A
-$
67
,41
940%
BB$
70
,54
250%
B$
69
,56
060%
CC
C$
63
,44
570%
CC
C$
65
,52
480%
CC
C$
62
,75
190%
CC$
47
,14
0
Asw
ath Dam
odaran62
What if you do not buy back stock..
The optim
al debt ratio is ultimately a function of the underlying
riskiness of the business in which you operate and your tax rate
Will the optim
al be different if you invested in projects instead ofbuying back stock?•
NO
. As long as the projects financed are in the sam
e business mix that
the company has alw
ays been in and your tax rate does not changesignificantly.
•Y
ES, if the projects are in entirely different types of businesses or if the
tax rate is significantly different.
Asw
ath Dam
odaran63
Analyzing F
inancial Service F
irms
The interest coverage ratios/ratings relationship is likely to be different
for financial service firms.
The definition of debt is m
essy for financial service firms. In general,
using all debt for a financial service firm w
ill lead to high debt ratios.U
se only interest-bearing long term debt in calculating debt ratios.
The effect of ratings drops w
ill be much m
ore negative for financialservice firm
s.
There are likely to regulatory constraints on capital
Asw
ath Dam
odaran64
Interest Coverage ratios, ratings and O
peratingincom
e
Interest Coverage R
atioR
ating isS
pread isO
perating Income D
ecline
< 0.05
D10.00%
-50.00%
0.05 - 0.10C
7.50%-40.00%
0.10 - 0.20C
C6.00%
-40.00%
0.20 - 0.30C
CC
5.00%-40.00%
0.30 - 0.40B
-4.25%
-25.00%
0.40 - 0.50B
3.25%-20.00%
0.50 - 0.60B
+2.50%
-20.00%
0.60 - 0.80B
B2.00%
-20.00%
0.80 - 1.00B
BB
1.50%-20.00%
1.00 - 1.50A
-1.25%
-17.50%
1.50 - 2.00A
1.00%-15.00%
2.00 - 2.50A
+0.80%
-10.00%
2.50 - 3.00A
A0.50%
-5.00%
> 3.00
AA
A0.20%
0.00%
Asw
ath Dam
odaran65
Deutsche B
ank: Optim
al Capital S
tructure
Debt
Ratio
Cost of
Equity
Cost of D
ebtW
AC
CF
irm V
alue
0%10.13%
4.24%10.13%
DM
124,288.85
10%10.29%
4.24%9.69%
DM
132,558.74
20%10.49%
4.24%9.24%
DM
142,007.59
30%10.75%
4.24%8.80%
DM
152,906.88
40%11.10%
4.24%8.35%
DM
165,618.31
50%11.58%
4.24%7.91%
DM
165,750.19
60%12.30%
4.40%7.56%
DM
162,307.44
70%13.51%
4.57%7.25%
DM
157,070.00
80%15.92%
4.68%6.92%
DM
151,422.87
90%25.69%
6.24%8.19%
DM
30,083.27
Asw
ath Dam
odaran66
Analyzing C
ompanies after A
bnormal Y
ears
The operating incom
e that should be used to arrive at an optimal debt
ratio is a “normalized” operating incom
e
A norm
alized operating income is the incom
e that this firm w
ouldm
ake in a normal year.
•For a cyclical firm
, this may m
ean using the average operating income
over an economic cycle rather than the latest year’s incom
e
•For a firm
which has had an exceptionally bad or good year (due to som
efirm
-specific event), this may m
ean using industry average returns oncapital to arrive at an optim
al or looking at past years
•For any firm
, this will m
ean not counting one time charges or profits
Asw
ath Dam
odaran67
Analyzing A
racruz Cellulose’s O
ptimal D
ebtR
atio
In 1996, Aracruz had earnings before interest and taxes of only 15
million B
R, and claim
ed depreciation of 190 million B
r. Capital
expenditures amounted to 250 m
illion BR
.
Aracruz had debt outstanding of 1520 m
illion BR
. While the nom
inalrate on this debt, especially the portion that is in B
razilian Real, is
high, we w
ill continue to do the analysis in real terms, and use a
current real cost of debt of 5.5%, w
hich is based upon a real riskfreerate of 5%
and a default spread of 0.5%.
The corporate tax rate in B
razil is estimated to be 32%
.
Aracruz had 976.10 m
illion shares outstanding, trading 2.05 BR
pershare. T
he beta of the stock is estimated, using com
parable firms, to be
0.71.
Asw
ath Dam
odaran68
Setting up for the A
nalysis
Current C
ost of Capital
Current C
ost of Equity =
5% +
0.71 (7.5%) =
10.33%
Market V
alue of Equity =
2.05 BR
* 976.1 = 2,001 m
illion BR
Current C
ost of Capital
= 10.33%
(2001/(2001+1520)) +
5.5% (1-.32) (1520/(2001+
1520) = 7.48%
1996 was a poor year for A
racruz, both in terms of revenues and
operating income. In 1995, A
racruz had earnings before interest andtaxes of 271 m
illion BR
. We w
ill use this as our normalized E
BIT
.
Asw
ath Dam
odaran69
Aracruz’s O
ptimal D
ebt Ratio
Debt
Beta
Cost of
Rating
Cost of
AT
Cost
Cost of
Firm
Value
Ratio
Equity
Debt
of Debt
Capital
0.00%0.47
8.51%A
AA
5.20%3.54%
8.51%2,720 B
R
10.00%0.50
8.78%A
AA
5.20%3.54%
8.25%2,886 B
R
20.00%0.55
9.11%A
A5.50%
3.74%8.03%
3,042 BR
30.00%0.60
9.53%A
6.00%4.08%
7.90%3,148 B
R
40.00%0.68
10.10%A
-6.25%
4.25%7.76%
3,262 BR
50.00%0.79
10.90%B
B7.00%
4.76%7.83%
3,205 BR
60.00%0.95
12.09%B
-9.25%
6.29%8.61%
2,660 BR
70.00%1.21
14.08%C
CC
10.00%6.80%
8.98%2,458 B
R
80.00%1.76
18.23%C
CC
10.00%6.92%
9.18%2,362 B
R
90.00%3.53
31.46%C
CC
10.00%7.26%
9.68%2,149 B
R
Asw
ath Dam
odaran70
Analyzing a P
rivate Firm
The approach rem
ains the same w
ith important caveats
•It is far m
ore difficult estimating firm
value, since the equity and the debtof private firm
s do not trade
•M
ost private firms are not rated.
•If the cost of equity is based upon the m
arket beta, it is possible that we
might be overstating the optim
al debt ratio, since private firm ow
nersoften consider all risk.
Asw
ath Dam
odaran71
Estim
ating the Optim
al Debt R
atio for a Private
Bookstore
Adjusted E
BIT
=
EB
IT +
Imputed Interest on O
p. Lease E
xp.
= $ 2,000,000 +
$ 252,000 = $ 2,252,000
While B
ookscape has no debt outstanding, the present value of theoperating lease expenses of $ 3.36 m
illion is considered as debt.
To estim
ate the market value of equity, w
e use a multiple of 22.41
times of net incom
e. This m
ultiple is the average multiple at w
hichcom
parable firms w
hich are publicly traded are valued.
Estim
ated Market V
alue of Equity =
Net Incom
e * Average PE
=
1,160,000* 22.41 = 26,000,000
The interest rates at different levels of debt w
ill be estimated based
upon a “synthetic” bond rating. This rating w
ill be assessed usinginterest coverage ratios for sm
all firms w
hich are rated by S&P.
Asw
ath Dam
odaran72
Interest Coverage R
atios, Spreads and
Ratings: S
mall F
irms
Interest Coverage R
atioR
atingSpread over T
Bond R
ate
> 12.5A
AA
0.20%
9.50-12.50A
A0.50%
7.5 - 9.5A
+0.80%
6.0 - 7.5A
1.00%
4.5 - 6.0A
-1.25%
3.5 - 4.5B
BB
1.50%
3.0 - 3.5B
B2.00%
2.5 - 3.0B
+2.50%
2.0 - 2.5B
3.25%
1.5 - 2.0B
-4.25%
1.25 - 1.5C
CC
5.00%
0.8 - 1.25C
C6.00%
0.5 - 0.8C
7.50%
< 0.5D
10.00%
Asw
ath Dam
odaran73
Optim
al Debt R
atio for Bookscape
Debt R
atioB
etaC
ost of Equity
Bond R
atingInterest R
ateA
T C
ost of Debt
Cost of C
apitalFirm
Value
0%1.03
12.65%A
A7.50%
4.35%12.65%
$26,78110%
1.0913.01%
AA
7.50%4.35%
12.15%$29,112
20%1.18
13.47%B
BB
8.50%4.93%
11.76%$31,182
30%1.28
14.05%B
+9.50%
5.51%11.49%
$32,80340%
1.4214.83%
B-
11.25%6.53%
11.51%$32,679
50%1.62
15.93%C
C13.00%
7.54%11.73%
$31,34160%
1.9717.84%
CC
13.00%7.96%
11.91%$30,333
70%2.71
21.91%C
14.50%10.18%
13.70%$22,891
80%4.07
29.36%C
14.50%10.72%
14.45%$20,703
90%8.13
51.72%C
14.50%11.14%
15.20%$18,872
Asw
ath Dam
odaran74
Determ
inants of Optim
al Debt R
atios
Firm Specific Factors
•1. T
ax Rate
•H
igher tax rates- - >
Higher O
ptimal D
ebt Ratio
•L
ower tax rates
- - > L
ower O
ptimal D
ebt Ratio
•2. Pre-T
ax Returns on Firm
= (O
perating Income) / M
V of Firm
•H
igher Pre-tax Returns
- - > H
igher Optim
al Debt R
atio
•L
ower Pre-tax R
eturns- - >
Low
er Optim
al Debt R
atio
•3. V
ariance in Earnings [ Show
s up when you do 'w
hat if' analysis]
•H
igher Variance
- - > L
ower O
ptimal D
ebt Ratio
•L
ower V
ariance- - >
Higher O
ptimal D
ebt Ratio
Macro-E
conomic Factors
•1. D
efault SpreadsH
igher- - >
Low
er Optim
al Debt R
atio
Low
er- - >
Higher O
ptimal D
ebt Ratio
Asw
ath Dam
odaran75
Application T
est: Your firm
’s optimal
financing mix
Using the optim
al capital structure spreadsheet provided:•
Estim
ate the optimal debt ratio for your firm
•E
stimate the new
cost of capital at the optimal
•E
stimate the effect of the change in the cost of capital on firm
value
•E
stimate the effect on the stock price
In terms of the m
echanics, what w
ould you need to do to get to theoptim
al imm
ediately?
Asw
ath Dam
odaran76
The A
PV
Approach to O
ptimal C
apitalS
tructure
In the adjusted present value approach, the value of the firm is w
rittenas the sum
of the value of the firm w
ithout debt (the unlevered firm)
and the effect of debt on firm value
Firm V
alue = U
nlevered Firm V
alue + (T
ax Benefits of D
ebt -E
xpected Bankruptcy C
ost from the D
ebt)
The optim
al dollar debt level is the one that maxim
izes firm value
Asw
ath Dam
odaran77
Implem
enting the AP
V A
pproach
Step 1: Estim
ate the unlevered firm value. T
his can be done in one oftw
o ways:
•E
stimating the unlevered beta, a cost of equity based upon the unlevered
beta and valuing the firm using this cost of equity (w
hich will also be the
cost of capital, with an unlevered firm
)
•A
lternatively, Unlevered Firm
Value =
Current M
arket Value of Firm
-T
ax Benefits of D
ebt (Current) +
Expected B
ankruptcy cost from D
ebt
Step 2: Estim
ate the tax benefits at different levels of debt. The
simplest assum
ption to make is that the savings are perpetual, in w
hichcase•
Tax benefits =
Dollar D
ebt * Tax R
ate
Step 3: Estim
ate a probability of bankruptcy at each debt level, andm
ultiply by the cost of bankruptcy (including both direct and indirectcosts) to estim
ate the expected bankruptcy cost.
Asw
ath Dam
odaran78
Estim
ating Expected B
ankruptcy Cost
Probability of Bankruptcy
•E
stimate the synthetic rating that the firm
will have at each level of debt
•E
stimate the probability that the firm
will go bankrupt over tim
e, at thatlevel of debt (U
se studies that have estimated the em
pirical probabilitiesof this occurring over tim
e - Altm
an does an update every year)
Cost of B
ankruptcy•
The direct bankruptcy cost is the easier com
ponent. It is generallybetw
een 5-10% of firm
value, based upon empirical studies
•T
he indirect bankruptcy cost is much tougher. It should be higher for
sectors where operating incom
e is affected significantly by default risk(like airlines) and low
er for sectors where it is not (like groceries)
Asw
ath Dam
odaran79
Ratings and D
efault Probabilities
Rating
Default R
iskA
AA
0.01%
AA
0.28%
A+
0.40%
A0.53%
A-
1.41%
BB
B2.30%
BB
12.20%
B+
19.28%
B26.36%
B-
32.50%
CC
C46.61%
CC
52.50%
C60%
D75%
Asw
ath Dam
odaran80
Disney: E
stimating U
nlevered Firm
Value
Current V
alue of the Firm =
50,888 + 11,180
=$62,068
- Tax B
enefit on Current D
ebt = 11,180 * .36
=$4,025
+ E
xpected Bankruptcy C
ost = 0.28%
of .25*(62,068-4025) =$41
Unlevered V
alue of Firm =
$58,084
Cost of B
ankruptcy for Disney =
25% of firm
value
Probability of Bankruptcy =
0.28%, based on firm
’s current rating
Tax R
ate = 36%
Market V
alue of Equity =
$ 50,888
Market V
alue of Debt =
$ 11,180
Asw
ath Dam
odaran81
Disney: A
PV
at Debt R
atios
D/
$ Debt
Tax R
ateU
nlevered T
ax R
atingProb.
Exp
Value of
(D+
E)
Firm V
alueB
enefitD
efaultB
k Cst
Firm
0%$0
36.00%$58,084
$0 A
AA
0.01%$2
$58,083
10%$6,207
36.00%$58,084
$2,234 A
AA
0.01%$2
$60,317
20%$12,414
36.00%$58,084
$4,469 A
+0.40%
$62 $62,491
30%$18,621
36.00%$58,084
$6,703 A
-1.41%
$219 $64,569
40%$24,827
36.00%$58,084
$8,938 B
B12.20%
$1,893 $65,129
50%$31,034
36.00%$58,084
$11,172 B26.36%
$4,090 $65,166
60%$37,241
36.00%$58,084
$13,407 CC
C50.00%
$7,759 $63,732
70%$43,448
36.00%$58,084
$15,641 CC
C50.00%
$7,759 $65,967
80%$49,655
33.59%$58,084
$16,677 CC
C50.00%
$7,759 $67,003
90%$55,862
27.56%$58,084
$15,394 CC
65.00%$10,086 $63,392
Exp. B
k. Cst: E
xpected Bankruptcy cost
Asw
ath Dam
odaran82
Relative A
nalysis
I. Industry Average w
ith Subjective Adjustm
ents
The “safest” place for any firm
to be is close to the industry average
Subjective adjustments can be m
ade to these averages to arrive at theright debt ratio.•
Higher tax rates ->
Higher debt ratios (T
ax benefits)
•L
ower insider ow
nership -> H
igher debt ratios (Greater discipline)
•M
ore stable income ->
Higher debt ratios (L
ower bankruptcy costs)
•M
ore intangible assets -> L
ower debt ratios (M
ore agency problems)
Asw
ath Dam
odaran83
Disney’s C
omparables
Com
pany N
am
eM
arke
t De
bt R
atio
Bo
ok D
eb
t Ra
tioD
isne
y (Wa
lt)1
8.1
9%
43
.41
%T
ime
Wa
rne
r2
9.3
9%
68
.34
%W
estin
gh
ou
se E
lectric
26
.98
%5
1.9
7%
Via
com
Inc. 'A
'4
8.1
4%
46
.54
%G
aylo
rd E
nte
rtain
m. 'A
'1
3.9
2%
41
.47
%B
elo
(A.H
.) 'A' C
orp
.2
3.3
4%
63
.04
%E
verg
ree
n M
ed
ia 'A
'1
6.7
7%
39
.45
%T
ele
-Co
mm
un
icatio
ns In
tl Inc
23
.28
%3
4.6
0%
Kin
g W
orld
Pro
du
ction
s0
.00
%0
.00
%Ja
cor C
om
mu
nica
tion
s3
0.9
1%
57
.91
%L
IN T
ele
vision
19
.48
%7
1.6
6%
Regal C
inemas
4.5
3%
15
.24
%W
estw
oo
d O
ne
11
.40
%6
0.0
3%
Un
ited
Te
levisio
n4
.51
%1
5.1
1%
Av
era
ge
o
f L
arg
e
Firm
s1
9.3
4%
43
.48
%
Asw
ath Dam
odaran84
II. Regression M
ethodology
Step 1: Run a regression of debt ratios on proxies for benefits and
costs. For example,
DE
BT
RA
TIO
= a +
b (TA
X R
AT
E) +
c (EA
RN
ING
SV
AR
IAB
ILIT
Y) +
d (EB
ITD
A/Firm
Value)
Step 2: Estim
ate the proxies for the firm under consideration. Plugging
into the crosssectional regression, we can obtain an estim
ate ofpredicted debt ratio.
Step 3: Com
pare the actual debt ratio to the predicted debt ratio.
Asw
ath Dam
odaran85
Applying the R
egression Methodology:
Entertainm
ent Firm
s
Using a sam
ple of 50 entertainment firm
s, we arrived at the follow
ingregression:
Debt R
atio = - 0.1067 +
0.69 Tax R
ate+ 0.61 E
BIT
DA
/Value- 0.07 σ
OI
(0.90)(2.58)
(2.21)(0.60)
The R
squared of the regression is 27.16%. T
his regression can beused to arrive at a predicted value for D
isney of:
Predicted Debt R
atio = - 0.1067 +
0.69 (.4358) + 0.61 (.0837) - 0.07
(.2257) = .2314
Based upon the capital structure of other firm
s in the entertainment
industry, Disney should have a m
arket value debt ratio of 23.14%.
Asw
ath Dam
odaran86
Cross S
ectional Regression: 1996 D
ata
Using 1996 data for 2929 firm
s listed on the NY
SE, A
ME
X and
NA
SDA
Q data bases. T
he regression provides the following results –
DFR
=
0.1906- 0.0552 PRV
AR
-.1340 CL
SH - 0.3105 C
PXFR
+ 0.1447 FC
P
(37.97a) (2.20a) (6.58a)
(8.52a) (12.53a)
where,
DFR
=
Debt / ( D
ebt + M
arket Value of E
quity)
PRV
AR
=
Variance in Firm
Value
CL
SH
= C
losely held shares as a percent of outstanding shares
CPX
FR
= C
apital Expenditures / B
ook Value of C
apital
FCP
= Free C
ash Flow to Firm
/ Market V
alue of Equity
While the coefficients all have the right sign and are statistically
significant, the regression itself has an R-squared of only 13.57%
.
Asw
ath Dam
odaran87
An A
ggregated Regression
One w
ay to improve the predictive pow
er of the regression is toaggregate the data first and then do the regression. T
o illustrate with
the 1994 data, the firms are aggregated into tw
o-digit SIC codes, and
the same regression is re-run.
DFR
=0.2370- 0.1854 PR
VA
R +
.1407 CL
SH +
1.3959 CPX
F -.6483 FCP
(6.06a) (1.96b) (1.05a)
(5.73a)(3.89a)
The R
squared of this regression is 42.47%.
Data Source: For the latest regression, go to updated data on m
y web site
and click on the debt regression.
Asw
ath Dam
odaran88
Applying the R
egression
Lets check w
hether we can use this regression. D
isney had the following values
for these inputs in 1996. Estim
ate the optimal debt ratio using the debt
regression.V
ariance in Firm V
alue = .04
Closely held shares as percent of shares outstanding =
4% (.04)
Capital E
xpenditures as fraction of firm value =
6.00%(.06)
Free Cash Flow
as percent of Equity V
alue = 3%
(.03)
Optim
al Debt R
atio=
0.2370- 0.1854 ( ) +.1407 ( ) +
1.3959( ) -.6483 ( )W
hat does this optimal debt ratio tell you?
Why m
ight it be different from the optim
al calculated using the weighted average
cost of capital?
Asw
ath Dam
odaran89
A F
ramew
ork for Getting to the O
ptimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual >
Optim
alO
verleveredA
ctual < O
ptimal
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes
No
Reduce D
ebt quickly1. E
quity for Debt sw
ap2. S
ell Assets; use cash
to pay off debt3. R
enegotiate with lenders
Does the firm
have good projects?R
OE
> C
ost of Equity
RO
C >
Cost of C
apital
Yes
Take good projects w
ithnew
equity or with retained
earnings.
No
1. Pay off debt w
ith retainedearnings.2. R
educe or eliminate dividends.
3. Issue new equity and pay off
debt.
Yes
No
Does the firm
have good projects?R
OE
> C
ost of Equity
RO
C >
Cost of C
apital
Yes
Take good projects w
ithdebt.
No
Do your stockholders like
dividends?
Yes
Pay D
ividendsN
oB
uy back stock
Increase leveragequickly1. D
ebt/Equity sw
aps2. B
orrow m
oney&buy shares.
Asw
ath Dam
odaran90
Disney: A
pplying the Fram
ework
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual >
Optim
alO
verleveredA
ctual < O
ptim
alU
nd
erlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes
No
Reduce D
ebt quickly1. E
quity for Debt sw
ap2. S
ell Assets; use cash
to pay off debt3. R
enegotiate with lenders
Does the firm
have good projects?R
OE
> C
ost of Equity
RO
C >
Cost of C
apital
Yes
Take good projects w
ithnew
equity or with retained
earnings.
No
1. Pay off debt w
ith retainedearnings.2. R
educe or eliminate dividends.
3. Issue new equity and pay off
debt.
Yes
No
Does the firm
have good projects?R
OE
> C
ost of Equity
RO
C >
Cost of C
apital
Yes
Take good projects w
ithdebt.
No
Do your stockholders like
dividends?
Yes
Pay D
ividendsN
oB
uy back stock
Increase leveragequickly1. D
ebt/Equity sw
aps2. B
orrow m
oney&buy shares.
Asw
ath Dam
odaran91
A
pplication Test: G
etting to the Optim
al
Based upon your analysis of both the firm
’s capital structure andinvestm
ent record, what path w
ould you map out for the firm
?
Imm
ediate change in leverage
Gradual change in leverage
No change in leverage
Would you recom
mend that the firm
change its financing mix by
Paying off debt/Buying back equity
Take projects w
ith equity/debt
Asw
ath Dam
odaran92
Designing D
ebt: The F
undamental P
rinciple
The objective in designing debt is to m
ake the cash flows on debt
match up as closely as possible w
ith the cash flows that the firm
makes
on its assets.
By doing so, w
e reduce our risk of default, increase debt capacity andincrease firm
value.
Asw
ath Dam
odaran95
Design the perfect financing instrum
ent
The perfect financing instrum
ent will
•H
ave all of the tax advantages of debt
•W
hile preserving the flexibility offered by equity
Duration
Currency
Effect of Inflation
Uncertainty about Future
Grow
th PatternsC
yclicality &O
ther Effects
Define D
ebtC
haracteristics
Duration/
Maturit y
Currency
Mix
Fixed vs. F
loating Rate
* More floating rate
- if CF m
ove with
inflation- w
ith greater uncertainty on future
Straight versusC
onvertible- C
onvertible ifcash flow
s low
now but high
exp. growth
Special Features
on Debt
- Options to m
ake cash flow
s on debt m
atch cash flows
on assets
Start with the
Cash F
lows
on Assets/
Projects
Com
modity B
ondsC
atastrophe Notes
Design debt to have cash flow
s that match up to cash flow
s on the assets financed
Asw
ath Dam
odaran96
Ensuring that you have not crossed the line
drawn by the tax code
All of this design w
ork is lost, however, if the security that you have
designed does not deliver the tax benefits.
In addition, there may be a trade off betw
een mism
atching debt andgetting greater tax benefits.
Overlay tax
preferences
Deductibility of cash flow
sfor tax purposes
Differences in tax rates
across different locales
If tax advantages are large enough, you might override results of previous step
Zero C
oupons
Asw
ath Dam
odaran97
While keeping equity research analysts, ratings
agencies and regulators applauding
Ratings agencies w
ant companies to issue equity, since it m
akes themsafer. E
quity research analysts want them
not to issue equity because itdilutes earnings per share. R
egulatory authorities want to ensure that
you meet their requirem
ents in terms of capital ratios (usually book
value). Financing that leaves all three groups happy is nirvana.
Consider
ratings agency&
analyst concerns
Analyst C
oncerns- E
ffect on EPS
- Value relative to com
parables
Ratings A
gency- E
ffect on Ratios
- Ratios relative to com
parables
Regulatory C
oncerns- M
easures used
Can securities be designed that can m
ake these different entities happy?
Operating L
easesM
IPsSurplus N
otes
Asw
ath Dam
odaran98
Debt or E
quity: The S
trange Case of T
rustP
referred
Trust preferred stock has•
A fixed dividend paym
ent, specified at the time of the issue
•T
hat is tax deductible
•A
nd failing to make the paym
ent can cause ? (Can it cause default?)
When trust preferred w
as first created, ratings agencies treated it asequity. A
s they have become m
ore savvy, ratings agencies have startedgiving firm
s only partial equity credit for trust preferred.
Asw
ath Dam
odaran99
Debt, E
quity and Quasi E
quity
Assum
ing that trust preferred stock gets treated as equity by ratingsagencies, w
hich of the following firm
s is the most appropriate firm
tobe issuing it?
A firm
that is under levered, but has a rating constraint that would be
violated if it moved to its optim
al
A firm
that is over levered that is unable to issue debt because of therating agency concerns.
Asw
ath Dam
odaran100
Soothe bondholder fears
There are som
e firms that face skepticism
from bondholders w
hen theygo out to raise debt, because•
Of their past history of defaults or other actions
•T
hey are small firm
s without any borrow
ing history
Bondholders tend to dem
and much higher interest rates from
thesefirm
s to reflect these concerns.
Factor in agency
conflicts between stock
and bond holders
Observability of C
ash Flows
by Lenders
- Less observable cash flow
s lead to m
ore conflicts
Type of A
ssets financed- T
angible and liquid assets create less agency problem
sE
xisting Debt covenants
- Restrictions on Financing
If agency problems are substantial, consider issuing convertible bonds
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LY
ON
s
Asw
ath Dam
odaran101
And do not lock in m
arket mistakes that w
orkagainst you
Ratings agencies can som
etimes under rate a firm
, and markets can
under price a firm’s stock or bonds. If this occurs, firm
s should notlock in these m
istakes by issuing securities for the long term. In
particular,•
Issuing equity or equity based products (including convertibles), when
equity is under priced transfers wealth from
existing stockholders to thenew
stockholders
•Issuing long term
debt when a firm
is under rated locks in rates at levelsthat are far too high, given the firm
’s default risk.
What is the solution
•If you need to use equity?
•If you need to use debt?
Asw
ath Dam
odaran102
Designing D
ebt: Bringing it all together
Duration
Currency
Effect of Inflation
Uncertainty about Future
Grow
th PatternsC
yclicality &O
ther Effects
Define D
ebtC
haracteristicsD
uration/M
aturityC
urrencyM
ix
Fixed vs. F
loating Rate
* More floating rate
- if CF m
ove with
inflation- w
ith greater uncertainty on future
Straight versusC
onvertible- C
onvertible ifcash flow
s low
now but high
exp. growth
Special Features
on Debt
- Options to m
ake cash flow
s on debt m
atch cash flows
on assets
Start with the
Cash F
lows
on Assets/
Projects
Overlay tax
preferencesD
eductibility of cash flows
for tax purposesD
ifferences in tax ratesacross different locales
Consider
ratings agency&
analyst concernsA
nalyst Concerns
- Effect on E
PS- V
alue relative to comparables
Ratings A
gency- E
ffect on Ratios
- Ratios relative to com
parables
Regulatory C
oncerns- M
easures used
Factor in agency
conflicts between stock
and bond holders
Observability of C
ash Flows
by Lenders
- Less observable cash flow
s lead to m
ore conflicts
Type of A
ssets financed- T
angible and liquid assets create less agency problem
sE
xisting Debt covenants
- Restrictions on Financing
Consider Inform
ation A
symm
etriesU
ncertainty about Future Cashflow
s- W
hen there is more uncertainty, it
may be better to use short term
debt
Credibility &
Quality of the Firm
- Firms w
ith credibility problems
will issue m
ore short term debt
If agency problems are substantial, consider issuing convertible bonds
Can securities be designed that can m
ake these different entities happy?
If tax advantages are large enough, you might override results of previous step
Zero C
oupons
Operating L
easesM
IPsSurplus N
otes
Convertibiles
Puttable Bonds
Rating Sensitive
Notes
LY
ON
s
Com
modity B
ondsC
atastrophe Notes
Design debt to have cash flow
s that match up to cash flow
s on the assets financed
Asw
ath Dam
odaran103
Approaches for evaluating A
sset Cash F
lows
I. Intuitive Approach
•A
re the projects typically long term or short term
? What is the cash flow
pattern on projects?
•H
ow m
uch growth potential does the firm
have relative to currentprojects?
•H
ow cyclical are the cash flow
s? What specific factors determ
ine the cashflow
s on projects?
II. Project Cash Flow
Approach
•Project cash flow
s on a typical project for the firm
•D
o scenario analyses on these cash flows, based upon different m
acroeconom
ic scenarios
III. Historical D
ata•
Operating C
ash Flows
•Firm
Value
Asw
ath Dam
odaran104
Com
ing up with the financing details: Intuitive
Approach
Business
Project C
ash Flow
Characteristics
Type of F
inancing
Creative
Content
Projects are likely to
1. be short term
2. have cash outflows are prim
arily in dollars (but cash inflows
could have a substantial foreign currency component
3. have net cash flows w
hich are heavily driven by whether the
movie or T
.V series is a “hit”
Debt should be
1. short term
2. primarily dollar
3. if possible, tied to the
success of movies.
Retailing
Projects are likely to be
1. medium
term (tied to store life)
2. primarily in dollars (m
ost in US still)
3. cyclical
Debt should be in the form
of operating leases.
Broadcasting
Projects are likely to be
1. short term
2. primarily in dollars, though foreign com
ponent is growing
3. driven by advertising revenues and show success
Debt should be
1. short term
2. primarily dollar debt
3. if possible, linked to
network ratings.
Asw
ath Dam
odaran105
Financing D
etails: Other D
ivisions
Them
e Parks
Projects are likely to be
1. very long term
2. primarily in dollars, but a significant proportion of revenues
come from
foreign tourists.
3. affected by success of movie and broadcasting divisions.
Debt should be
1. long term
2. mix of currencies, based
upon tourist make up.
Real E
stateP
rojects are likely to be
1. long term
2. primarily in dollars.
3. affected by real estate values in the area
Debt should be
1. long term
2. dollars
3. real-estate linked
(Mortgage B
onds)
Asw
ath Dam
odaran106
Application T
est: Choosing your F
inancingT
ype
Based upon the business that your firm
is in, and the typicalinvestm
ents that it makes, w
hat kind of financing would you expect
your firm to use in term
s of•
Duration (long term
or short term)
•C
urrency
•Fixed or Floating rate
•Straight or C
onvertible
Asw
ath Dam
odaran107
II. QU
AN
TIT
AT
IVE
AP
PR
OA
CH
1. Operating C
ash Flows
• T
he question of how sensitive a firm
’s asset cash flows are to a variety of
factors, such as interest rates, inflation, currency rates and the economy,
can be directly tested by regressing changes in the operating income
against changes in these variables.
•C
hange in Operating Incom
e(t)= a +
b Change in M
acro Econom
icV
ariable(t)
•T
his analysis is useful in determining the coupon/interest paym
entstructure of the debt.
2. Firm V
alue•
The firm
value is clearly a function of the level of operating income, but it
also incorporates other factors such as expected growth &
cost of capital.
•T
he firm value analysis is useful in determ
ining the overall structure ofthe debt, particularly m
aturity.
Asw
ath Dam
odaran108
The H
istorical Data
Year
Firm V
alue%
Change
Operating Incom
e%
Change
19811,707
$ 119.35
$ 1982
2,108$
23.46%141.39
$ 18.46%
19831,817
$ -13.82%
133.87$
-5.32%1984
2,024$
11.4%142.60
$ 6.5%
19853,655
$ 80.6%
205.60$
44.2%1986
5,631$
54.1%280.58
$ 36.5%
19878,371
$ 48.7%
707.00$
152.0%1988
9,195$
9.8%789.00
$ 11.6%
198916,015
$ 74.2%
1,109.00$
40.6%1990
14,963$
-6.6%1,287.00
$ 16.1%
199117,122
$ 14.4%
1,004.00$
-22.0%1992
24,771$
44.7%1,287.00
$ 28.2%
199325,212
$ 1.8%
1,560.00$
21.2%1994
26,506$
5.1%1,804.00
$ 15.6%
199533,858
$ 27.7%
2,262.00$
25.4%1996
39,561$
16.8%3,024.00
$ 33.7%
Asw
ath Dam
odaran109
The M
acroeconomic D
ata
Long Bond Rateange in Interest RReal GNP
GNP GrowthW
eighted DollaChange in DollaInflation RateChange in Inflat
13.98%3854
115.658.90%
10.47%-3.51%
3792-1.6%
123.146.48%
3.80%-5.10%
11.80%1.33%
40476.7%
128.654.47%
3.80%0.00%
11.51%-0.29%
42164.2%
138.898.0%
4.00%0.20%
8.99%-2.52%
43503.2%
125.95-9.3%
3.80%-0.20%
7.22%-1.77%
44311.9%
112.89-10.4%
1.20%-2.60%
8.86%1.64%
46334.6%
95.88-15.1%
4.40%3.20%
9.14%0.28%
47893.4%
95.32-0.6%
4.40%0.00%
7.93%-1.21%
48751.8%
102.267.3%
4.60%0.20%
8.07%0.14%
48950.4%
96.25-5.9%
6.10%1.50%
6.70%-1.37%
48940.0%
98.822.7%
3.10%-3.00%
6.69%-0.01%
50613.4%
104.585.8%
2.90%-0.20%
5.79%-0.90%
52193.1%
105.220.6%
2.70%-0.20%
7.82%2.03%
54163.8%
98.6-6.3%
2.70%0.00%
5.57%-2.25%
55031.6%
95.1-3.5%
2.50%-0.20%
6.42%0.85%
56793.2%
101.56.7%
3.30%0.80%
Asw
ath Dam
odaran110
Sensitivity to Interest R
ate Changes
The answ
er to this question is important because it
•it provides a m
easure of the duration of the firm’s projects
•it provides insight into w
hether the firm should be using fixed or floating
rate debt.
Asw
ath Dam
odaran111
Firm
Value versus Interest R
ate Changes
Regressing changes in firm
value against changes in interest rates overthis period yields the follow
ing regression –
Change in Firm
Value =
0.22 - 7.43 ( C
hange in Interest Rates)
(3.09)(1.69)
T statistics are in brackets.
Conclusion: T
he duration (interest rate sensitivity) of Disney’s asset
values is about 7.43 years. Consequently, its debt should have at least
as long a duration.
Asw
ath Dam
odaran112
Regression C
onstraints
Which of the follow
ing aspects of this regression would bother you the
most?
The low
R-squared of only 10%
The fact that D
isney today is a very different firm from
the firmcaptured in the data from
1981 to 1996
Both
Neither
Asw
ath Dam
odaran113
Why the coefficient on the regression is
duration..
The duration of a straight bond or loan issued by a com
pany can bew
ritten in terms of the coupons (interest paym
ents) on the bond (loan)and the face value of the bond to be –
Holding other factors constant, the duration of a bond w
ill increasew
ith the maturity of the bond, and decrease w
ith the coupon rate on thebond.
Duration of B
ond = dP
/P
dr/r =
t*C
oupon
(1+
r)
N*
Face V
alue
(1+
r)
Coupon
(1+
r)
Face V
alue
(1+
r)
tt
t=1
t=N
N
tt
t=1
t=N
N
∑
∑
+
+
Asw
ath Dam
odaran114
Duration of a F
irm’s A
ssets
This m
easure of duration can be extended to any asset with expected
cash flows on it. T
hus, the duration of a project or asset can beestim
ated in terms of the pre-debt operating cash flow
s on that project.
where,
CFt =
After-tax operating cash flow
on the project in year t
Term
inal Value =
Salvage Value at the end of the project lifetim
e
N =
Life of the project
The duration of any asset provides a m
easure of the interest rate riskem
bedded in that asset.
Duration of P
roject/Asset =
dPV
/PV
dr/r =
t*C
F(1
+r)
N*
Term
inal Value
(1+
r)
CF
(1+
r)T
erminal V
alue(1
+r)
ttt=1
t=N
N
tt
t=1
t=N
N
∑∑
+
+
Asw
ath Dam
odaran115
Duration of D
isney Them
e Park
Year
FC
FF
Term
inal Value
Total F
CF
FP
V of F
CF
FP
V * t
1($39,078 B
t)($
39,078 Bt)
(31,180 Bt)
-31180.4
2($36,199 B
t)($
36,199 Bt)
(23,046 Bt)
-46092.4
3($11,759 B
t)($
11,759 Bt)
(5,973 Bt)
-17920
416,155 B
t16,155 B
t6,548 B
t26193.29
521,548 B
t21,548 B
t6,969 B
t34844.55
633,109 B
t33,109 B
t8,544 B
t51264.53
746,692 B
t46,692 B
t9,614 B
t67299.02
858,169 B
t58,169 B
t9,557 B
t76454.39
970,423 B
t838,720 B
t909,143 B
t119,182 B
t1072635
Sum100,214 B
t1,233,498
Duration of the Project = 1,233,498/100,214 =
12.30 years
Asw
ath Dam
odaran116
Duration: C
omparing A
pproaches
δP/δr=
Percentage C
hange in V
alue for apercentage change in Interest R
ates
Traditional Duration
Measures
Regression:
δP =
a + b (δr)
Uses:
1. Projected C
ash Flow
sA
ssumes:
1. Cash F
lows are unaffected by
changes in interest rates2. C
hanges in interest rates are sm
all.
Uses:
1. Historical data on changes in
firm value (m
arket) and interest ratesA
ssumes:
1. Past project cash flow
s are sim
ilar to future project cash flow
s.2. R
elationship between cash
flows and interest rates is
stable.3. C
hanges in market value
reflect changes in the value of the firm
.
Asw
ath Dam
odaran117
Operating Incom
e versus Interest Rates
Regressing changes in operating cash flow
against changes in interestrates over this period yields the follow
ing regression –
Change in O
perating Income =
0.31 - 4.99 ( Change in Interest R
ates)
(2.90)(0.78)
•C
onclusion: Disney’s operating incom
e, like its firm value, has been very
sensitive to interest rates, which confirm
s our conclusion to use long termdebt.
Generally speaking, the operating cash flow
s are smoothed out m
orethan the value and hence w
ill exhibit lower duration that the firm
value.
Asw
ath Dam
odaran118
Sensitivity to C
hanges in GN
P
The answ
er to this question is important because
•it provides insight into w
hether the firm’s cash flow
s are cyclical and
•w
hether the cash flows on the firm
’s debt should be designed to protectagainst cyclical factors.
If the cash flows and firm
value are sensitive to movem
ents in theeconom
y, the firm w
ill either have to issue less debt overall, or addspecial features to the debt to tie cash flow
s on the debt to the firm’s
cash flows.
Asw
ath Dam
odaran119
Regression R
esults
Regressing changes in firm
value against changes in the GN
P over thisperiod yields the follow
ing regression –
Change in Firm
Value =
0.31 - 1.71 ( G
NP G
rowth)
(2.43)(0.45)
• C
onclusion: Disney is only m
ildly sensitive to cyclical movem
ents in theeconom
y.
Regressing changes in operating cash flow
against changes in GN
Pover this period yields the follow
ing regression –
Change in O
perating Income =
0.17 + 4.06 ( G
NP G
rowth)
(1.04)(0.80)
•C
onclusion: Disney’s operating incom
e is slightly more sensitive to the
economic cycle. T
his may be because of the lagged effect of G
NP grow
thon operating incom
e.
Asw
ath Dam
odaran120
Sensitivity to C
urrency Changes
The answ
er to this question is important, because
•it provides a m
easure of how sensitive cash flow
s and firm value are to
changes in the currency
•it provides guidance on w
hether the firm should issue debt in another
currency that it may be exposed to.
If cash flows and firm
value are sensitive to changes in the dollar, thefirm
should•
figure out which currency its cash flow
s are in;
•and issued som
e debt in that currency
Asw
ath Dam
odaran121
Regression R
esults
Regressing changes in firm
value against changes in the dollar overthis period yields the follow
ing regression –
Change in Firm
Value =
0.26 - 1.01 ( C
hange in Dollar)
(3.46)(0.98)
•C
onclusion: Disney’s value has not been very sensitive to changes in the
dollar over the last 15 years.
Regressing changes in operating cash flow
against changes in thedollar over this period yields the follow
ing regression –
Change in O
perating Income =
0.26 - 3.03 ( C
hange in Dollar)
(3.14)(2.59)
• C
onclusion: Disney’s operating incom
e has been much m
ore significantlyim
pacted by the dollar. A stronger dollar seem
s to hurt operating income.
Asw
ath Dam
odaran122
Sensitivity to Inflation
The answ
er to this question is important, because
•it provides a m
easure of whether cash flow
s are positively or negativelyim
pacted by inflation.
•it then helps in the design of debt; w
hether the debt should be fixed orfloating rate debt.
If cash flows m
ove with inflation, increasing (decreasing) as inflation
increases (decreases), the debt should have a larger floating ratecom
ponent.
Asw
ath Dam
odaran123
Regression R
esults
Regressing changes in firm
value against changes in inflation over thisperiod yields the follow
ing regression –
Change in Firm
Value
= 0.26
- 0.22 (Change in Inflation R
ate)
(3.36)(0.05)
• C
onclusion: Disney’s firm
value does not seem to be affected too m
uchby changes in the inflation rate.
Regressing changes in operating cash flow
against changes in inflationover this period yields the follow
ing regression –
Change in O
perating Income =
0.32 + 10.51 ( C
hange in Inflation Rate)
(3.61) (2.27)
•C
onclusion: Disney’s operating incom
e seems to increase in periods w
heninflation increases. H
owever, this increase in operating incom
e seems to
be offset by the increase in discount rates leading to a much m
ore muted
effect on value.
Asw
ath Dam
odaran124
Bottom
-up Estim
ates
Bu
sine
ssC
om
pa
rab
le F
irms
Divisio
n W
eig
ht
Du
ratio
nC
yc
lica
lityIn
flatio
nC
urre
nc
yC
rea
tive C
on
ten
tM
otio
n P
icture
an
d T
V p
rog
ram
pro
du
cers
35
.71
%-3
.34
1.3
92
.30
-1.8
6R
eta
iling
Hig
h E
nd
Sp
ecia
lty Re
taile
rs3
.57
%-5
.50
2.6
32
.10
-0.7
5B
roa
dca
sting
TV
Bro
ad
castin
g co
mp
an
ies
30
.36
%-4
.50
0.7
03
.03
-1.1
5T
he
me
Pa
rksT
he
me
Pa
rk an
d E
nte
rtain
me
nt C
om
ple
xes
26
.79
%-1
0.4
70
.22
0.7
2-2
.54
Re
al E
state
RE
ITs sp
ecia
lizing
in h
ote
l an
d va
catio
n p
rop
ertie
rs3
.57
%-8
.46
0.8
9-0
.08
0.9
71
00
.00
%-5
.86
0.8
92
.00
-1.6
9D
isn
ey
Asw
ath Dam
odaran125
Analyzing D
isney’s Current D
ebt
Description
Am
ou
nt
Duration
Non-U
S $
Floating R
ateC
omm
ercial paper$
4,1
85
0.5
00
0U
S $ notes &
debentures$
4,3
99
14
.00
00
Dual C
urrency notes$
1,9
87
1.2
01
00
00
Senior notes
$1
,09
92
.50
00
Oth
er
$6
72
5.0
00
0T
otal
$1
2,3
42
5.8
51
00
00
Asw
ath Dam
odaran126
Financing R
ecomm
endations
The duration of the debt is alm
ost exactly the duration estimated using
the bottom-up approach, though it is low
er than the duration estimated
from the firm
-specific regression.
Less than 10%
of the debt is non-dollar debt and it is primarily in
Japanese yen, Australian dollars and Italian lire, and little of the debt is
floating rate debt.
Based on our analysis, w
e would recom
mend m
ore non-dollar debtissues, w
ith a shift towards floating rate debt, at least in those sectors
where D
isney retains significant pricing power.