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

odaran93

Firm

with m

ismatched debt

Firm

Value

Value of D

ebt

Asw

ath Dam

odaran94

Firm

with m

atched Debt

Firm

Value

Va

lue

of D

eb

t

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.