Finding the Right Financing Mix: The

Capital Structure Decision

AswathDamodaran

SternSchoolofBusiness

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthe
financingmixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgenerated
andthetimingofthesecashflows;theyshouldalsoconsiderbothpositive
andnegativesideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateand
matchestheassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

The Choices in Financing

Thereareonlytwowaysinwhichabusinesscanmakemoney.
Thefirstisdebt.Theessenceofdebtisthatyoupromisetomakefixed
paymentsinthefuture(interestpaymentsandrepayingprincipal).Ifyou
failtomakethosepayments,youlosecontrolofyourbusiness.
Theotherisequity.Withequity,youdogetwhatevercashflowsareleft
overafteryouhavemadedebtpayments.

Aswath Damodaran

Debt versus Equity

Debt
FixedClaim
ResidualClaim
Hybrids(Combinations
Equity
DebtversusEquity
HighPriorityoncashflows
LowestPriorityoncashflows
ofdebtandequity)
TaxDeductible
NotTaxDeductible
FixedMaturity
Infinitelife
NoManagementControl
ManagementControl

Aswath Damodaran

The Choices

Equitycantakedifferentforms:
Forverysmallbusinesses:itcanbeownersinvestingtheirsavings
Forslightlylargerbusinesses:itcanbeventurecapital
Forpubliclytradedfirms:itiscommonstock

Debtcanalsotakedifferentforms
Forprivatebusinesses:itisusuallybankloans
Forpubliclytradedfirms:itcantaketheformofbonds

Aswath Damodaran

A Life Cycle View of Financing Choices

External
Externalfunding
Internalfinancing
Financing
Growthstage
Stage2
Time
Stage1
Stage4
Stage5
OwnersEquity
Earnings
Revenues
VentureCapital
Retiredebt
Debt
High,but
High,relative
Moderate,relative
Declining,asa
Low,asprojectsdry
Commonstock
Stage3
Low,relativeto
High,relativeto
Bondissues
Seasonedequityissue
InitalPublicoffering
Accessingprivateequity
Morethanfundingneeds
$Revenues/
Negativeor
Financing
needs
Transitions
RapidExpansion
Startup
MatureGrowth
Decline
BankDebt
CommonStock
Repurchasestock
constrainedby
tofirmvalue.
percentoffirm
up.
Warrants
HighGrowth
low
fundingneeds
Earnings
infrastructure
value
Convertibles

Aswath Damodaran

The Financing Mix Question

Indecidingtoraisefinancingforabusiness,isthereanoptimalmixof
debtandequity?
Ifyes,whatisthetradeoffthatletsusdeterminethisoptimalmix?
Ifnot,whynot?

Aswath Damodaran

Measuring a firms financing mix

Thesimplestmeasureofhowmuchdebtandequityafirmisusing
currentlyistolookattheproportionofdebtinthetotalfinancing.
Thisratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswellaslong
term.
Equitycanbedefinedeitherinaccountingterms(asbookvalueof
equity)orinmarketvalueterms(baseduponthecurrentprice).The
resultingdebtratioscanbeverydifferent.

Aswath Damodaran

Costs and Benefits of Debt

BenefitsofDebt
TaxBenefits
Addsdisciplinetomanagement

CostsofDebt
BankruptcyCosts
AgencyCosts
LossofFutureFlexibility

Aswath Damodaran

Tax Benefits of Debt

Whenyouborrowmoney,youareallowedtodeductinterestexpenses
fromyourincometoarriveattaxableincome.Thisreducesyour
taxes.Whenyouuseequity,youarenotallowedtodeductpayments
toequity(suchasdividends)toarriveattaxableincome.
Thedollartaxbenefitfromtheinterestpaymentinanyyearisa
functionofyourtaxrateandtheinterestpayment:
Taxbenefiteachyear=TaxRate*InterestPayment

Proposition1:Otherthingsbeingequal,thehigherthemarginaltax
rateofabusiness,themoredebtitwillhaveinitscapitalstructure.

Aswath Damodaran

10

The Effects of Taxes

Youarecomparingthedebtratiosofrealestatecorporations,whichpay
thecorporatetaxrate,andrealestateinvestmenttrusts,whicharenot
taxed, but are required to pay 95% of their earnings as dividends to
their stockholders. Which of these two groups would you expect to
havethehigherdebtratios?
Therealestatecorporations
Therealestateinvestmenttrusts
Cannottell,withoutmoreinformation

Aswath Damodaran

11

Implications of The Tax Benefit of Debt

Thedebtratiosoffirmswithhighertaxratesshouldbehigherthanthe
debt ratios of comparable firms with lower tax rates. In supporting
evidence,
Firmsthathavesubstantialnondebttaxshields,suchasdepreciation,
shouldbelesslikelytousedebtthanfirmsthatdonothavethesetax
shields.
Iftaxratesincreaseovertime,wewouldexpectdebtratiostogoup
overtimeaswell,reflectingthehighertaxbenefitsofdebt.
Althoughitisalwaysdifficulttocomparedebtratiosacrosscountries,
wewouldexpectdebtratiosincountrieswheredebthasamuchlarger
taxbenefittobehigherthandebtratiosincountrieswhosedebthasa
lowertaxbenefit.

Aswath Damodaran

12

Debt adds discipline to management

Ifyouaremanagersofafirmwithnodebt,andyougeneratehigh
incomeandcashflowseachyear,youtendtobecomecomplacent.
Thecomplacencycanleadtoinefficiencyandinvestinginpoor
projects.Thereislittleornocostbornebythemanagers
Forcingsuchafirmtoborrowmoneycanbeanantidotetothe
complacency.Themanagersnowhavetoensurethattheinvestments
theymakewillearnatleastenoughreturntocovertheinterest
expenses.Thecostofnotdoingsoisbankruptcyandthelossofsucha
job.

Aswath Damodaran

13

Debt and Discipline

Assume that you buy into this argument that debt adds discipline to
management. Which of the following types of companies will most
benefitfromdebtaddingthisdiscipline?
Conservativelyfinanced(verylittledebt),privatelyownedbusinesses
Conservativelyfinanced,publiclytradedcompanies,withstocksheld
by millions of investors, none of whom hold a large percent of the
stock.
Conservatively financed, publicly traded companies, with an activist
andprimarilyinstitutionalholding.
Aswath Damodaran

14

Empirical Evidence on the Discipline of Debt

Firmsthatareacquiredinhostiletakeoversaregenerallycharacterized
by poor performance in both accounting profitability and stock
returns.
There is evidence that increases in leverage are followed by
improvements in operating efficiency, as measured by operating
marginsandreturnsoncapital.
Palepu (1990) presents evidence of modest improvements in operating
efficiencyatfirmsinvolvedinleveragedbuyouts.
Kaplan(1989)andSmith(1990)alsofindthatfirmsearnhigherreturnson
capitalfollowingleveragedbuyouts.
Denis and Denis (1993) study leveraged recapitalizations and report a
medianincreaseinthereturnonassetsof21.5%.

Aswath Damodaran

15

Bankruptcy Cost

Theexpectedbankruptcycostisafunctionoftwovariables
thecostofgoingbankrupt
directcosts:LegalandotherDeadweightCosts
indirectcosts:Costsarisingbecausepeopleperceiveyoutobeinfinancial
trouble

theprobabilityofbankruptcy,whichwilldependuponhowuncertainyou
areaboutfuturecashflows

Asyouborrowmore,youincreasetheprobabilityofbankruptcyand
hencetheexpectedbankruptcycost.

Aswath Damodaran

16

Indirect Bankruptcy Costs should be highest

for.

Firms that sell durable products with long lives that require
replacementpartsandservice
Firmsthatprovidegoodsorservicesforwhichqualityisanimportant
attributebutwherequalitydifficulttodetermineinadvance
Firms producing products whose value to customers depends on the
services and complementary products supplied by independent
companies:
Firmsthatsellproductsrequiringcontinuousserviceandsupportfrom
themanufacturer

Aswath Damodaran

17

The Bankruptcy Cost Proposition

Proposition2:Otherthingsbeingequal,thegreatertheindirect
bankruptcycostand/orprobabilityofbankruptcyintheoperating
cashflowsofthefirm,thelessdebtthefirmcanaffordtouse.

Aswath Damodaran

18

Debt & Bankruptcy Cost

Rank the following companies on the magnitude of bankruptcy costs
frommosttoleast,takingintoaccountbothexplicitandimplicitcosts:

AGroceryStore

AnAirplaneManufacturer

HighTechnologycompany

Aswath Damodaran

19

Implications of Bankruptcy Cost Proposition

Firmsoperatinginbusinesseswithvolatileearningsandcashflows
shouldusedebtlessthanotherwisesimilarfirmswithstablecash
flows.
Iffirmscanstructuretheirdebtinsuchawaythatthecashflowson
thedebtincreaseanddecreasewiththeiroperatingcashflows,they
canaffordtoborrowmore.
Ifanexternalentity,suchasthegovernmentoranagencyofthe
government,providesprotectionagainstbankruptcythrougheither
insuranceorbailoutsfortroubledfirms,firmswilltendtoborrow
more.
Firmswithassetsthatcanbeeasilydividedandsoldshouldborrow
morethanfirmswithassetsthatarelessliquid.

Aswath Damodaran

20

Agency Cost

Anagencycostariseswheneveryouhiresomeoneelsetodosomethingfor
you.Itarisesbecauseyourinterests(astheprincipal)maydeviatefromthose
ofthepersonyouhired(astheagent).
Whenyoulendmoneytoabusiness,youareallowingthestockholderstouse
thatmoneyinthecourseofrunningthatbusiness.Stockholdersinterestsare
differentfromyourinterests,because
You(aslender)areinterestedingettingyourmoneyback
Stockholdersareinterestedinmaximizingyourwealth

Insomecases,theclashofinterestscanleadtostockholders
Investinginriskierprojectsthanyouwouldwantthemto
Payingthemselveslargedividendswhenyouwouldratherhavethemkeepthe
cashinthebusiness.

Proposition3:Otherthingsbeingequal,thegreatertheagencyproblems
associatedwithlendingtoafirm,thelessdebtthefirmcanaffordtouse.

Aswath Damodaran

21

Debt and Agency Costs

Assume that you are a bank. Which of the following businesses would you
perceivethegreatestagencycosts?

ALargePharmaceuticalcompany

ALargeRegulatedElectricUtility

Why?

Aswath Damodaran

22

How agency costs show up...

If bondholders believe there is a significant chance that stockholder

actions might make them worse off, they can build this expectation
intobondpricesbydemandingmuchhigherratesondebt.
Ifbondholderscanprotectthemselvesagainstsuchactionsbywriting
inrestrictivecovenants,twocostsfollow
the direct cost of monitoring the covenants, which increases as the
covenantsbecomemoredetailedandrestrictive.
the indirect cost of lost investments, since the firm is not able to take
certainprojects,usecertaintypesoffinancing,orchangeitspayout;this
costwillalsoincreaseasthecovenantsbecomesmorerestrictive.

Aswath Damodaran

23

Implications of Agency Costs..

Theagencycostarisingfromriskshiftingislikelytobegreatestin
firmswhoseinvestmentscannotbeeasilyobservedandmonitored.
Thesefirmsshouldborrowlessthanfirmswhoseassetscanbeeasily
observedandmonitored.
Theagencycostassociatedwithmonitoringactionsandsecond
guessinginvestmentdecisionsislikelytobelargestforfirmswhose
projectsarelongterm,followunpredictablepaths,andmaytakeyears
tocometofruition.Thesefirmsshouldalsoborrowless.

Aswath Damodaran

24

Loss of future financing flexibility

Whenafirmborrowsuptoitscapacity,itlosestheflexibilityof
financingfutureprojectswithdebt.
Proposition4:Otherthingsremainingequal,themoreuncertainafirm
isaboutitsfuturefinancingrequirementsandprojects,thelessdebt
thefirmwilluseforfinancingcurrentprojects.

Aswath Damodaran

25

What managers consider important in deciding

on how much debt to carry...
AsurveyofChiefFinancialOfficersoflargeU.S.companiesprovided
thefollowingranking(frommostimportanttoleastimportant)forthe
factorsthattheyconsideredimportantinthefinancingdecisions
Factor
Ranking(05)
1.Maintainfinancialflexibility
4.55
2.Ensurelongtermsurvival
4.55
3.MaintainPredictableSourceofFunds
4.05
4.MaximizeStockPrice
3.99
5.Maintainfinancialindependence
3.88
6.Maintainhighdebtrating
3.56
7.Maintaincomparabilitywithpeergroup
2.47

Aswath Damodaran

26

Debt: Summarizing the Trade Off

AdvantagesofBorrowing

DisadvantagesofBorrowing

1.TaxBenefit:

1.BankruptcyCost:

Highertaxrates>Highertaxbenefit

Higherbusinessrisk>HigherCost

2.AddedDiscipline:

2.AgencyCost:

Greatertheseparationbetweenmanagers

Greatertheseparationbetweenstock

andstockholders>Greaterthebenefit

holders&lenders>HigherCost
3.LossofFutureFinancingFlexibility:
Greatertheuncertaintyaboutfuture

financingneeds>HigherCost

Aswath Damodaran

27

A Qualitative Analysis
Item
TaxBenefits

Boeing
Significant.Thefirmhasa
marginaltaxrateof35%.
Itdoeshavelarge
depreciationtaxshields.

TheHomeDepot
Significant.Thefirmhasa
marginaltaxrateof35%,
aswell.Itdoesnothave
verymuchinnoninterest
taxshields.

AddedDiscipline

Benefitswillbehigh,
sincemanagersarenot
largestockholders.
Directcostsarelikelyto
besmall,butindirectcosts
canbesubstantial..

AgencyCosts

Low.Assetsaregenerally
tangibleandmonitoring
shouldbefeasible.

Benefitsaresmaller,since
theCEOisafounderand
largestockholder.
Directcostsarelikelyto
besmall.Assetsare
mostlyrealestate.Indirect
costswillalsobesmall.
Low.Assetsarestoresand
realestate,tangibleand
marketable.

FlexibilityNeeds

Low.Firmhasalong
gestationperiodfor
projects,andknowshow
muchitneedstoinvestin
advance.

Lowinexistingbusiness,
buthigh,givenitsplansto
growoverseasandonline.
Expansionandacquisition
needscreateneed.

BankruptcyCost

Aswath Damodaran

InfoSoft
Significant.Theownersof
InfoSoftfacea42%tax
rate.Byborrowing
money,theincomethat
flowsthroughtothe
investorcanbereduced.
Benefitsarenonexistent.
Thisisaprivatefirm.
Costsmaybesmallbut
theownerhasallofhis
wealthinvestedinthe
firm.
High.Assetsare
intangibleanddifficultto
bothmonitorandto
liquidate.
High.Firmmighthaveto
changeitsproductand
businessmix,onshort
notice,astechnology
changes

28

Application Test: Would you expect your firm to

gain or lose from using a lot of debt?

Considering,foryourfirm,

Thepotentialtaxbenefitsofborrowing
Thebenefitsofusingdebtasadisciplinarymechanism
Thepotentialforexpectedbankruptcycosts
Thepotentialforagencycosts
Theneedforfinancialflexibility

Wouldyouexpectyourfirmtohaveahighdebtratiooralowdebt
ratio?
Doesthefirmscurrentdebtratiomeetyourexpectations?

Aswath Damodaran

29

A Hypothetical Scenario

Assumeyouoperateinanenvironment,where
(a)therearenotaxes
(b)thereisnoseparationbetweenstockholdersandmanagers.
(c)thereisnodefaultrisk
(d)thereisnoseparationbetweenstockholdersandbondholders
(e)firmsknowtheirfuturefinancingneeds

Aswath Damodaran

30

The Miller-Modigliani Theorem

Inanenvironment,wheretherearenotaxes,defaultriskoragency
costs,capitalstructureisirrelevant.
Thevalueofafirmisindependentofitsdebtratio.

Aswath Damodaran

31

Implications of MM Theorem
(a)Leverageisirrelevant.Afirm'svaluewillbedeterminedbyitsproject
cashflows.
(b)Thecostofcapitalofthefirmwillnotchangewithleverage.Asa
firmincreasesitsleverage,thecostofequitywillincreasejustenough
tooffsetanygainstotheleverage.

Aswath Damodaran

32

Can debt be irrelevant in a world with taxes?

Inthepresenceofpersonaltaxesonbothinterestincomeandincome
fromequity,itcanbearguedthatdebtcouldstillbeirrelevantifthe
cumulativetaxespaid(bythefirmandinvestors)ondebtandequity
arethesame.
Thus,iftdisthepersonaltaxrateoninterestincomereceivedby
investors,teisthepersonaltaxrateonincomeonequityandtcisthe
corporatetaxrate,debtwillbeirrelevantif:
(1td)=(1tc)(1te)

Aswath Damodaran

33

Is there an optimal capital structure? The

Empirical Evidence

Theempiricalevidenceonwhetherleverageaffectsvalueismixed.
Bradley,Jarrell,andKim(1984)notethatthedebtratioislowerforfirms
withmorevolatileoperatingincomeandforfirmswithsubstantialR&D
andadvertisingexpenses.
Barclay,SmithandWatts (1995)lookedat6780companiesbetween1963
and1993andconcludethatthemostimportantdeterminantofafirm'sdebt
ratio is its' investment opportunities. Firms with better investment
opportunities(asmeasuredbyahighpricetobookratio)tendtohavemuch
lowerdebtratiosthanfirmswithlowpricetobookratios.

Smith(1986) notes that leverageincreasing actions seem to be

accompaniedbypositiveexcessreturnswhileleveragereducingactions
seemtobefollowedbynegativereturns.Thisisnotconsistentwiththe
theory that there is an optimal capital structure, unless we assume that
firmstendtobeunderlevered.

Aswath Damodaran

34

How do firms set their financing mixes?

LifeCycle:Somefirmschooseafinancingmixthatreflectswhere
theyareinthelifecycle;startupfirmsusemoreequity,andmature
firmsusemoredebt.
Comparablefirms:Manyfirmsseemtochooseadebtratiothatis
similartothatusedbycomparablefirmsinthesamebusiness.
FinancingHeirarchy:Firmsalsoseemtohavestrongpreferenceson
thetypeoffinancingused,withretainedearningsbeingthemost
preferredchoice.Theyseemtoworkdownthepreferencelist,rather
thanpickingafinancingmixdirectly.

Aswath Damodaran

35

The Debt Equity Trade Off Across the Life

Cycle
AgencyCosts
AddedDisceipline
BamkruptcyCost
NeedforFlexibility
NetTradeOff
TaxBenefits
Debtbecomesamore
Debtwillprovide
Stage2
Stage1
Stage4
Stage5
Veryhigh,asfirm
Earnings
Revenues
Time
Low.Firmtakesfew
Low,asowners
Low.Evenif
Increasing,as
High.Managersare
Declining,asfirm
Stage3
$Revenues/
Zero,if
Low,asearnings
Increase,with
High,but
High
Veryhigh.Firmhas
Veryhigh.
High.Earningsare
Declining,asearnings
Low,butincreasesas
High.New
High.Lotsofnew
Declining,asassets
Veryhigh,asfirm
High.Expansion
High.Expansion
Low.Firmhaslow
Nonexistent.Firmhasno
Costsexceedbenefits
Costsstilllikely
Debtstartsyielding
ofDebt
benefits.
RapidExpansion
Startup
MatureGrowth
Decline
hasalmostno
newinvestments
runthefirm
public,firmis
managersownless
separatedfrom
doesnottakemany
HighGrowth
Earnings
losingmoney
arelimited
earnings
declining
noornegative
Earningsarelow
increasingbutstill
fromexistingassets
existingprojectsend.
investmentsare
investmentsand
inplacebecomea
looksforwaysto
needsarelargeand
needsremain
andmorepredictable
newinvestmentneeds.
Minimaldebt
toexceedbenefits.
netbenefitstothe
attractiveoption.
assets
closelyheld.
offirm
owners
newinvestments
earnings.
andvolatile
volatile
increase.
difficulttomonitor
unstablerisk.
largerportionoffirm.
establishitself
unpredicatble
unpredictable
investmentneeds.
Mostlyequity
firm

Aswath Damodaran

36

Comparable Firms

Whenwelookatthedeterminantsofthedebtratiosofindividual
firms,thestrongestdeterminantistheaveragedebtratioofthe
industriestowhichthesefirmsbelong.
Thisisnotinconsistentwiththeexistenceofanoptimalcapital
structure.Iffirmswithinabusinesssharecommoncharacteristics
(hightaxrates,volatileearningsetc.),youwouldexpectthemtohave
similarfinancingmixes.
Thisapproachcanleadtosuboptimalleverage,iffirmswithina
businessdonotsharecommoncharacteristics.

Aswath Damodaran

37

Rationale for Financing Hierarchy

Managersvalueflexibility.Externalfinancingreducesflexibilitymore
thaninternalfinancing.
Managersvaluecontrol.Issuingnewequityweakenscontrolandnew
debtcreatesbondcovenants.

Aswath Damodaran

38

Preference rankings : Results of a survey

Ranking

Source

Score

RetainedEarnings

5.61

StraightDebt

4.88

ConvertibleDebt

3.02

ExternalCommonEquity

2.42

StraightPreferredStock

2.22

ConvertiblePreferred

1.72

Aswath Damodaran

39

Financing Choices
YouarereadingtheWallStreetJournalandnoticeatombstoneadfora
company,offeringtosellconvertiblepreferredstock.Whatwouldyou
hypothesizeaboutthehealthofthecompanyissuingthesesecurities?
Nothing
Healthierthantheaveragefirm
Inmuchmorefinancialtroublethantheaveragefirm

Aswath Damodaran

40

The Search for an Optimal Financing Mix:

Approaches

TheOperatingIncomeApproach:Inthisapproach,theoptimaldebt
forafirmischosentoensurethattheprobabilitythatthefirmwill
defaultdoesnotexceedamanagementspecifiedlimit.
TheCostofCapitalApproach:Inthisapproach,theoptimaldebtratio
ischosentominimizecostofcapital,ifoperatingcashflowsare
unaffectedbyfinancingmix,ortomaximizefirmvalue.
TheAdjustedPresentValueApproach:Inthisapproach,theeffectof
addingdebttofirmvalueisevaluatedbymeasuringboththetaxbenefits
andthebankruptcycosts.
TheReturnDifferentialApproach:Inthisapproach,thedebtratiois
chosentomaximizethedifferencebetweenROEandcostofequity.
ComparablesApproach:Thedebtratioischosenbylookingathow
comparablefirmsarefunded.

Aswath Damodaran

41

I. The Operating Income Approach

Assess the firms capacity to generate operating income based upon past
history. The result is a distribution for expected operating income, with
probabilitiesattachedtodifferentlevelsofincome.
For any given level of debt, we estimate the interest and principal payments
thathavetobemadeovertime.
Given the probability distribution of operating cash flows, we estimate the
probabilitythatthefirmwillbeunabletomakedebtpayments.
Wesetalimitontheprobability ofitsbeingunable tomeetdebtpayments.
Clearly, the more conservative the management of the firm, the lower this
probabilityconstraintwillbe.
Wecomparetheestimatedprobabilityofdefaultatagivenlevelofdebttothe
probability constraint. If the probability of default is higher than the
constraint, the firm chooses a lower level of debt; if it is lower than the
constraint,thefirmchoosesahigherlevelofdebt.

Aswath Damodaran

42

Boeing: Assessing the Probability Distribution

4.5

3.5

2.5

1.5

0.5

0
<-30%

Aswath Damodaran

-10% to -30%

+ 10% to - 10%

10 to 30%

30-50%

>50%

43

Estimating Debt Payments

We estimate the interest and principal payments on a proposed bond

issueof$5billionbyassumingthatthedebtwillberatedA,lowerthan
Boeings current bond rating of AA. Based upon this rating, we
estimatedaninterestrateof6%onthedebt.Inaddition,weassumethat
thesinkingfundpaymentsetasidetorepaythebondsis5%ofthebond
issue.Thisresultsinanannualdebtpaymentof$550million.

AdditionalDebtPayment=InterestExpense
+SinkingFundPayment
=0.06*5,000 +.05*5,000
=$550million

The total debt payment then can be computed by adding the interest
paymentonexistingdebtin1998$453milliontotheadditional
debtpaymentcreatedbytakingon$5billioninadditionaldebt.

TotalDebtPayment=InterestonExistingDebt+AdditionalDebtPayment
=$453million+$550million=$1,003million
Aswath Damodaran

44

Estimating Probability of Default

We can now estimatethe probability of default from the distribution
of operating income by assuming that the percentage changes in
operating income are normally distributed and by considering the
earnings before interest, taxes, depreciation and amortization
(EBITDA)of$3,237millionthatBoeingearnedin1998asthebase
yearincome.
Tstatistic=(CurrentEBITDADebtPayment)/OI(CurrentOperating
Income)
=($3,237$1,003million)/(.3583*$3237)=1.93
Baseduponthiststatistic,theprobabilityofdefault<3%.

Aswath Damodaran

45

Management Constraints and Maximum Debt

Capacity

AssumethatthemanagementatBoeingsetaconstraintthattheprobability
ofdefaultbenogreaterthan5%.

If the distribution of operating income changes is normal, we can estimate

the level of debt payments Boeing can afford to make for a probability of
defaultof5%.
Tstatisticfor5%probabilitylevel=1.645
($3,237X)/(.3583*$3,237)=1.645
BreakEvenDebtPayment=$1,329million
Ifweassumethattheinterestrateremainsunchangedat6%andthesinking
fundwillremainat5%oftheoutstandingdebt,thisyieldsanoptimaldebt
levelof$12,082million.

OptimalDebt=BreakEvenDebtPayment/(InterestRate+SinkingFundRate)
=$1,329/(.06+.05)=$12,082million

Aswath Damodaran

46

II. The Cost of Capital Approach

Itwilldependupon:
(a)thecomponentsoffinancing:Debt,EquityorPreferredstock
(b)thecostofeachcomponent

Insummary,thecostofcapitalisthecostofeachcomponent
weightedbyitsrelativemarketvalue.
WACC=ke(E/(D+E))+kd(D/(D+E))

Aswath Damodaran

47

Recapping the Measurement of cost of capital

Thecostofdebtisthemarketinterestratethatthefirmhastopayon
itsborrowing.Itwilldependuponthreecomponents
(a)Thegenerallevelofinterestrates
(b)Thedefaultpremium
(c)Thefirm'staxrate

Thecostofequityis
1.therequiredrateofreturngiventherisk
2.inclusiveofbothdividendyieldandpriceappreciation

Theweightsattachedtodebtandequityhavetobemarketvalue
weights,notbookvalueweights.

Aswath Damodaran

48

Costs of Debt & Equity

A recent article in an Asian business magazine argued that equity was
cheaper than debt, because dividend yields are much lower than
interestratesondebt.Doyouagreewiththisstatement
Yes
No
Canequityeverbecheaperthandebt?
Yes
No

Aswath Damodaran

49

Issue: Use of Book Value

ManyCFOsarguethatusingbookvalueismoreconservativethanusing
market value, because the market value of equity is usually much
higher than book value. Is this statement true, from a cost of capital
perspective? (Will you get a more conservative estimate of cost of
capitalusingbookvalueratherthanmarketvalue?)
Yes
No

Aswath Damodaran

50

Why does the cost of capital matter?

ValueofaFirm=PresentValueofCashFlowstotheFirm,
discountedbackatthecostofcapital.
Ifthecashflowstothefirmareheldconstant,andthecostofcapitalis
minimized,thevalueofthefirmwillbemaximized.

Aswath Damodaran

51

Firm Value, Cost of Capital and Debt Ratios: A

Simple Example

StrunksInc.,aleadingmanufacturerofchocolatesandothercandies,
hascashflowstothefirmof$200million.
Strunksisinarelativelystablemarket,andthesecashflowsare
expectedtogrowat6%forever,andtobeunaffectedbythedebtratio
ofthefirm.
Thevalueofthefirmatanycostofcapitalcanbewrittenas:
FirmValue=Cashflowtothefirm(1+g)/(Costofcapitalg)
=200(1.06)/(Costofcapital.06)

Aswath Damodaran

52

Cost of Capital and Firm Value

D/(D+E)
0
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%

Aswath Damodaran

CostofEquity
10.50%
11.00%
11.60%
12.30%
13.10%
14.00%
15.00%
16.10%
17.20%
18.40%
19.70%

CostofDebt
4.80%
5.10%
5.40%
5.52%
5.70%
6.30%
7.20%
8.10%
9.00%
10.20%
11.40%

WACC
10.50%
10.41%
10.36%
10.27%
10.14%
10.15%
10.32%
10.50%
10.64%
11.02%
11.40%

FirmValue
$4,711
$4,807
$4,862
$4,970
$5,121
$5,108
$4,907
$4,711
$4,569
$4,223
$3,926

53

A Pictorial View

11.60%

$6,000

11.40%

$5,000
11.20%

11.00%

$4,000

10.80%

10.60%

WACC
$3,000

FirmValue

10.40%

10.20%

$2,000

10.00%

9.80%
$1,000

9.60%

9.40%

$0

Aswath Damodaran

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

54

Current Cost of Capital: Boeing

ThebetaforBoeing'sstockinMarch1999was1.01.Thetreasurybond
rateatthattimewas5%.Usinganestimatedmarketriskpremiumof
5.5%,weestimatedthecostofequityforBoeingtobe10.58%:
CostofEquity=Riskfreerate+Beta*(MarketPremium)
=5.00%+1.01(5.5%)=10.58%
Boeing'sseniordebtwasratedAA;,theestimatedpretaxcostofdebt
forBoeingis5.50%.Thetaxrateusedfortheanalysisis35%.
AftertaxCostofdebt =Pretaxinterestrate(1taxrate)
=5.50%(10.35)=3.58%
CostofCapital=CostofEquity(Equity/(Equity+Debt))+Aftertax
CostofDebt(Debt/(Debt+Equity))
=10.58%[32,595/(32595+8194)]+3.58%[8,194/(32595+8194)]=9.17%

Aswath Damodaran

55

Mechanics of Cost of Capital Estimation

1.EstimatetheCostofEquityatdifferentlevelsofdebt:
Equitywillbecomeriskier>Betawillincrease>CostofEquitywill
increase.
Estimationwilluseleveredbetacalculation

2.EstimatetheCostofDebtatdifferentlevelsofdebt:
Defaultriskwillgoupandbondratingswillgodownasdebtgoesup>
CostofDebtwillincrease.
Toestimatingbondratings,wewillusetheinterestcoverageratio
(EBIT/Interestexpense)

3.EstimatetheCostofCapitalatdifferentlevelsofdebt
4.CalculatetheeffectonFirmValueandStockPrice.

Aswath Damodaran

56

Ratings and Financial Ratios

EB

IT

EB

IT

int

unds

Fr

er

fl

eeop

in

ow

er

f lo

Re

t u r noncap

pe

/ t ota

r .in

e s tcov.

( x )

t e r e s t c ov.

/ tot

.ca

a ldeb

s h

l debt

CCC

12.9

9.2

7.2

4.1

2.5

1.2

( 0.9

18.7

14.0

10.0

6.3

3.9

2.3

0.2

89.7

67.0

49.5

32.2

20.1

10.5

7.4

40.5

21.6

17.4

6.3

1.0

( 4.0

30.6

25.1

19.6

15.4

12.6

9.2

( 8.8

30.9

25.2

17.9

15.8

14.4

11.2

5.0

21.4

29.3

33.3

40.8

55.3

68.8

71.5

( 25.4

(%)

i ta

c ome

/ s a le

l(%)

(%)

Long

deb

t /c

Aswath Damodaran

e r m

a pit

a l (%)

57

Synthetic Ratings

Thesyntheticratingforafirmcanbeestimatedby
Usingoneofthefinancialratiosspecifiedabove
Usingascorebaseduponallofthefinancialratiosspecifiedabove

Ifyouuseonlyonefinancialratio,youwanttopicktheratiothathas
thegreatestpowerinexplainingdifferencesinratings.
Formanufacturingfirms,thisistheinterestcoverageratio.

Ifyouwanttousemultipleratios,youhavetodeterminehowyouwill
weighteachratioincomingupwithascore.
Oneapproachusedisamultiplediscriminantanalysis,wheretheweights
arebaseduponhowwelltheratiospredictultimatedefault.(AltmanZ
scoreisoneexample).

Aswath Damodaran

58

Process of Ratings and Rate Estimation

Weusethemedianinterestcoverageratiosforlargemanufacturing
firmstodevelopinterestcoverageratiorangesforeachratingclass.
Wethenestimateaspreadoverthelongtermbondrateforeach
ratingsclass,baseduponyieldsatwhichthesebondstradeinthe
marketplace.(Weusedasamplingof5corporatebondswithineach
ratingsclasstomaketheseestimates)

Aswath Damodaran

59

Interest Coverage Ratios and Bond Ratings

IfInterestCoverageRatiois

EstimatedBondRating

>8.50
6.508.50
5.506.50
4.255.50
3.004.25
2.503.00
2.002.50
1.752.00
1.501.75
1.251.50
0.801.25
0.650.80
0.200.65
<0.20

AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

Aswath Damodaran

60

Spreads over long bond rate for ratings

classes: February 1999
Rating Spread InterestRateonDebt
AAA
0.20%
5.20%
AA
0.50%
5.50%
A+
0.80%
5.80%
A
1.00%
6.00%
A
1.25%
6.25%
BBB
1.50%
6.50%
BB
2.00%
7.00%
B+
2.50%
7.50%
B
3.25%
8.25%
B
4.25%
9.25%
CCC
5.00%
10.00%
CC
6.00%
11.00%
C
7.50%
12.50%
D
10.00%
15.00%

Aswath Damodaran

61

Current Income Statement for Boeing: 1998

Sales&OtherOperatingRevenues
$56,154.00
OperatingCosts&Expenses
$52,917.00
EBITDA
$3,237.00
Depreciation
$1,517.00
EBIT
$1,720.00
+ExtraordinaryIncome
$130.00
EBITwithextraordinaryincome
$1,850.00
InterestExpenses
$453.00
EarningsbeforeTaxes
$1,397.00
IncomeTaxes
$277.00
NetEarnings(Loss)
$1,120.00
AdjustedOperatingIncome(forleases)=$1,720million+Imputedinterest
expenseonoperatingleasedebt=$1,720+$31=$1,751million

Aswath Damodaran

62

Estimating Cost of Equity

Toestimatethecostofequityateachdebtratio,wefirstestimatethe
leveredbetaateachdebtratio:
levered=unlevered[1+(1taxrate)(Debt/Equity)]

Theleveredbetaisusedinconjunctionwiththeriskfreerateandrisk
premiumtoestimateacostofequityateachdebtratio:
CostofEquity=Riskfreerate+Beta*RiskPremium

Aswath Damodaran

63

Estimating Cost of Equity: Boeing at Different

Debt Ratios
UnleveredBeta=0.87(BottomupBeta,baseduponcomparablefirms)
Marketpremium=5.5%
TreasuryBondrate=5.00%
t=35%
DebtRatio
0% 0.87
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
9.79%
0.93
1.01
1.11
1.25
1.51
1.92
2.56
3.83
7.67

CostofEquity
10.14%
10.57%
11.13%
11.87%
13.28%
15.54%
19.06%
26.09%
47.18%

64

Estimating Cost of Debt

FirmValue=Marketvalueofdebt+MarketvalueofEquity= 32,595+8,194
D/(D+E)
0.00%
10.00%
SecondIteration
D/E
0.00%
11.11%
$Debt
$0
$4,079
$4,079
EBITDA
Depreciation
EBIT
InterestExpense
PretaxInt.cov
LikelyRating
InterestRate
Eff.TaxRate
CostofDebt

Aswath Damodaran

$3,268
$1,517
$1,751
$0

AAA
5.20%
35.00%
3.38%

$3,268
$1,517
$1,751
$212 $224
8.26 7.80
AA AA
5.50% 5.50%
35.00%
3.58%

$3,268
$1,517
$1,751

35.00%

65

The Ratings Table

IfInterestCoverageRatiois

EstimatedBondRating Defaultspread

>8.50
6.508.50
5.506.50
4.255.50
3.004.25
2.503.00
2.002.50
1.752.00
1.501.75
1.251.50
0.801.25
0.650.80
0.200.65
<0.20

AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

Aswath Damodaran

0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%

66

A Test: Can you do the 20% level?

D/(D+E)
D/E
$Debt

0.00%
0.00%
$0

10.00%
11.11%
$4,079

20%

EBITDA
Depreciation
EBIT
InterestExpense
PretaxInt.cov
LikelyRating
InterestRate
Eff.TaxRate
CostofDebt

$3,268
$1,517
$1,751
$0

AAA
5.20%
35.00%
3.38%

$3,268
$1,517
$1,751
$224
7.80
AA
5.50%
35.00%
3.58%

$3,268
$1,517
$1,751

Aswath Damodaran

SecondIteration

67

Bond Ratings, Cost of Debt and Debt Ratios

EBITDA
Depreciation
EBIT
Interest
Pre-tax Int. cov
Likely Rating
Interest Rate
Eff. Tax Rate
Cost of Debt

Aswath Damodaran

0%
$ 3,268
$ 1,517
$ 1,751
$
AAA
5.20%
35.00%
3.38%

105
$ 3,268
$ 1,517
$ 1,751
$ 224
7.80
AA
5.50%
35.00%
3.58%

20%
$ 3,268
$ 1,517
$ 1,751
$ 510
3.43
A6.25%
35.00%
4.06%

30%
$ 3,268
$ 1,517
$ 1,751
$ 857
2.04
BB
7.00%
35.00%
4.55%

40%
$ 3,268
$ 1,517
$ 1,751
$ 1,632
1.07
CCC
10.00%
35.00%
6.50%

50%
$ 3,268
$ 1,517
$ 1,751
$ 2,039
0.86
CCC
10.00%
30.05%
7.00%

60%
$ 3,268
$ 1,517
$ 1,751
$ 2,692
0.65
CC
11.00%
22.76%
8.50%

70%
$ 3,268
$ 1,517
$ 1,751
$ 3,569
0.49
C
12.50%
17.17%
10.35%

80%
$ 3,268
$ 1,517
$ 1,751
$ 4,079
0.43
C
12.50%
15.02%
10.62%

90%
$ 3,268
$ 1,517
$ 1,751
$ 4,589
0.38
C
12.50%
13.36%
10.83%

68

Why does the tax rate change?

Youneedtaxableincomeforinteresttoprovideataxsavings

40%
50%
EBIT
$ 1,751
$ 1,751
Interest Expense
$ 1,632
$ 2,039
Coverage ratio
1.07
0.86
Rating
CCC
CCC
Interest rate
10.00%
10.00%
Tax Rate
35.00%
30.05%
Cost of Debt
6.50%
7.00%
Maximum Tax Benefit = 35% of $1,751 = $613 million
Tax Rate to use for cost of debt = 613/2039 = 30.05%

Aswath Damodaran

69

Boeings Cost of Capital Schedule

Debt Ratio Beta
0%
0.87
10%
0.93
20%
1.01
30%
1.11
40%
1.25
50%
1.48
60%
1.88
70%
2.56
80%
3.83
90%
7.67

Aswath Damodaran

Cost of Equity
9.79%
10.14%
10.57%
11.13%
11.87%
13.15%
15.35%
19.06%
26.09%
47.18%

Cost of Debt
3.38%
3.58%
4.06%
4.55%
6.50%
7.00%
8.50%
10.35%
10.62%
10.83%

Cost of Capital
9.79%
9.48%
9.27%
9.16%
9.72%
10.07%
11.24%
12.97%
13.72%
14.47%

70

Boeing: Cost of Capital Chart

50.00%

15.00%

45.00%

14.00%

40.00%

13.00%

35.00%

30.00%

12.00%

25.00%

11.00%

OptimalDebtRatio
20.00%

15.00%

10.00%

10.00%

9.00%

5.00%

0.00%

8.00%

0%

Aswath Damodaran

10%

20%

30%

40%

50%

60%

70%

80%

90%

71

The Home Depot: Cost of Capital Schedule

Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta Cost of Equity Rating Interest rate Tax Rate Cost of Debt (After-tax)
Cost of Capital
0.84
9.64% AAA
5.20% 35.00%
3.38%
9.64%
0.90
9.98%
A
6.00% 35.00%
3.90%
9.37%
0.98
10.40%
BB
7.00% 35.00%
4.55%
9.23%
1.08
10.93% CCC
10.00% 35.00%
6.50%
9.60%
1.27
11.96%
CC
11.00% 24.95%
8.26%
10.48%
1.54
13.47%
C
12.50% 17.56%
10.30%
11.89%
1.92
15.58%
C
12.50% 14.63%
10.67%
12.64%
2.57
19.11%
C
12.50% 12.54%
10.93%
13.39%
3.85
26.17%
C
12.50% 10.98%
11.13%
14.14%
7.70
47.34%
C
12.50%
9.76%
11.28%
14.89%

72

Effect of Moving to the Optimal on Firm Value

Reestimatefirmvalueateachdebtratio,usingthenewcostofcapital.
Forastablegrowthfirm,thiswouldbe
FirmValue=CFtoFirm(1+g)/(WACCg)
Forahighgrowthfirm,thiswouldrequirethatthecashflowsduringthe
highgrowthphasebeestimatedanddiscountedback.

Estimatetheannualsavingsinfinancingcostsfromthechangeincost
ofcapitalandcomputethepresentvalueofthesesavingsinperpetuity.
AnnualSavings=(CostofcapitalbeforeCostofcapitalafter)FirmValue
Ifyouassumenogrowthinfirmvalue,thiswouldyield
AnnualSaving/Costofcapitalafter
Ifyouassumeperpetualgrowthinsavings,thiswouldyield

AnnualSaving/(Costofcapitalafterg)

Aswath Damodaran

73

But what growth rate do we use? One solution

Theestimateofgrowthusedinvaluingafirmcanclearlyhave
significantimplicationsforthefinalnumber.
Onewaytobypassthisestimationistoestimatethegrowthrate
impliedintodaysmarketvalue.Forinstance,
Boeingscurrentmarketvalue=32,595+8,194=$40,789million
Boeingsfreecashflowtothefirm=$1,176million
Boeingscurrentcostofcapital=9.17%
Assumingaperpetualgrowthmodel,
FirmValue=Cashflowtofirm(1+g)/(Costofcapitalg)
40,789=1,176(1+g)/(.0917g)
Solvingforg,
Impliedgrowthrate=.0611or6.11%

Aswath Damodaran

74

Change in Firm Value for Boeing: Firm

Valuation Approach

Boeingsfreecashflowtothefirm=$1,176million
Boeingsimpliedgrowthrate=6.11%
Newcostofcapital=9.16%
Boeingsnewfirmvalue=1,176*1.0611/(.0916.0611)
=$40,990million
Boeingscurrentfirmvalue=$40,789million
Changeinfirmvalue=$40,990$40,789=$201million

Aswath Damodaran

75

Effect on Firm Value on Boeing: Annual

Savings Approach

FirmValuebeforethechange=32,595+8,194=$40,789million
WACCb=9.17%
WACCa=9.16%
WACC=0.01%

AnnualCost=$62,068*12.22%=$7,583million
AnnualCost=$62,068*11.64%=$7,226million
ChangeinAnnualCost
=$6.14million

Ifthereisnogrowthinthefirmvalue,(ConservativeEstimate)
Increaseinfirmvalue=$6.14/.0916=$67million
ChangeinStockPrice=$67/1010.7=$0.07pershare

Ifthereisgrowth(of6.11%)infirmvalueovertime,
Increaseinfirmvalue=$6.14/(.0916.0611)=$206million
ChangeinStockPrice=$206/1010.7=$0.20pershare

Aswath Damodaran

76

Effect on Firm Value of Moving to the Optimal:

The Home Depot

FirmValuebeforethechange=85,668+4,081=$89,749million
WACCb=9.51%
WACCa=9.23%
WACC=0.28%

AnnualCost=$89,749*9.51%=$8,537million
AnnualCost=$89,749*9.23%=$8,281million
ChangeinAnnualCost
=$256million

Ifthereisgrowth(of6%)infirmvalueovertime,
Increaseinfirmvalue=$256(1.06)/(.0923.06)=$8,406million
ChangeinStockPrice=$8,406/1478.63=$5.69pershare

Aswath Damodaran

77

A Test: The Repurchase Price

LetussupposethattheCFOofTheHomeDepotapproachedyou
aboutbuyingbackstock.Hewantstoknowthemaximumpricethat
heshouldbewillingtopayonthestockbuyback.(Thecurrentpriceis
$57.94)Assumingthatfirmvaluewillgrowby6%ayear,estimate
themaximumprice.

Whatwouldhappentothestockpriceafterthebuybackifyouwere
abletobuystockbackat$57.94?

Aswath Damodaran

78

The Downside Risk

DoingWhatifanalysisonOperatingIncome
A.StandardDeviationApproach

StandardDeviationInPastOperatingIncome
StandardDeviationInEarnings(IfOperatingIncomeIsUnavailable)
ReduceBaseCaseByOneStandardDeviation(OrMore)

B.PastRecessionApproach
LookAtWhatHappenedToOperatingIncomeDuringTheLastRecession.
(HowMuchDidItDropIn%Terms?)
ReduceCurrentOperatingIncomeBySameMagnitude

ConstraintonBondRatings

Aswath Damodaran

79

Boeings Operating Income History

Year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

Aswath Damodaran

EBITDA
$1,217
$2,208
$2,785
$2,988
$2,722
$2,302
$1,998
$3,750
$2,301
$3,106

%Change
19.54%
81.46%
26.15%
7.30%
8.91%
15.42%
13.21%
87.69%
38.64%
34.98%

80

Boeing: Operating Income and Optimal Capital

Structure

Aswath Damodaran

%DropinEBITDA

EBITDA

OptimalDebtRatio

0%

$3,268

30%

5%

$3,105

20%

10%

$2,941

20%

15%

$2,778

10%

20%

$2,614

0%

81

Constraints on Ratings

Managementoftenspecifiesa'desiredRating'belowwhichtheydo
notwanttofall.
Theratingconstraintisdrivenbythreefactors
itisonewayofprotectingagainstdownsideriskinoperatingincome(so
donotdoboth)
adropinratingsmightaffectoperatingincome
thereisanegofactorassociatedwithhighratings

Caveat:EveryRatingConstraintHasACost.
ProvideManagementWithAClearEstimateOfHowMuchTheRating
ConstraintCostsByCalculatingTheValueOfTheFirmWithoutThe
RatingConstraintAndComparingToTheValueOfTheFirmWithThe
RatingConstraint.

Aswath Damodaran

82

Ratings Constraints for Boeing

AssumethatBoeingimposesaratingconstraintofBBBorgreater.
TheoptimaldebtratioforBoeingisthen20%(seenextpage)
Thecostofimposingthisratingconstraintcanthenbecalculatedas
follows:
Valueat30%Debt
=$41,003million
Valueat20%Debt
=$39,416million
CostofRatingConstraint
=$1,587million

Aswath Damodaran

83

What if you do not buy back stock..

Theoptimaldebtratioisultimatelyafunctionoftheunderlying
riskinessofthebusinessinwhichyouoperateandyourtaxrate
Willtheoptimalbedifferentifyoutookprojectsinsteadofbuying
backstock?
NO.Aslongastheprojectsfinancedareinthesamebusinessmixthat
thecompanyhasalwaysbeeninandyourtaxratedoesnotchange
significantly.
YES,iftheprojectsareinentirelydifferenttypesofbusinessesorifthe
taxrateissignificantlydifferent.

Aswath Damodaran

84

Analyzing Financial Service Firms

Theinterestcoverageratios/ratingsrelationshipislikelytobe
differentforfinancialservicefirms.
Thedefinitionofdebtismessyforfinancialservicefirms.Ingeneral,
usingalldebtforafinancialservicefirmwillleadtohighdebtratios.
Useonlyinterestbearinglongtermdebtincalculatingdebtratios.
Theeffectofratingsdropswillbemuchmorenegativeforfinancial
servicefirms.
Therearelikelytoregulatoryconstraintsoncapital

Aswath Damodaran

85

Long Term Interest Coverage Ratios for

Financial Service Firms
LongTermInterestCoverageRatio
<0.25
0.250.50
0.500.75
0.750.90
0.901.00
1.001.25
1.251.50
1.502.00
2.002.25
2.253.00
3.003.90
3.904.85
4.856.65
>6.65

Aswath Damodaran

Ratingis
D
C
CC
CCC
B
B
B+
BB
BBB
A
A
A+
AA
AAA

Spreadis OperatingIncomeDecline
12.00%
50%
9.00%
40%
7.50%
40%
6.00%
40%
5.00%
25%
4.00%
20%
3.00%
20%
2.50%
20%
2.00%
10%
1.50%
5%
1.25%
5%
1.00%
5%
0.70%
5%
0.30%
0%

86

J.P. Morgan: Optimal Capital Structure

Aswath Damodaran

DebtRatio
0%
10%
20%

CostofCapital
12.39%
11.97%
11.54%

FirmValue
$19,333
$20,315
$20,332

30%

11.19%

$21,265

40%
50%

10.93%
10.80%

$20,858
$18,863

60%

10.68%

$19,198

70%
80%
90%

11.06%
13.06%
15.76%

$13,658
$10,790
$7,001

87

Analyzing Companies after Abnormal Years

Theoperatingincomethatshouldbeusedtoarriveatanoptimaldebt
ratioisanormalizedoperatingincome
Anormalizedoperatingincomeistheincomethatthisfirmwould
makeinanormalyear.
Foracyclicalfirm,thismaymeanusingtheaverageoperatingincome
overaneconomiccycleratherthanthelatestyearsincome
Forafirmwhichhashadanexceptionallybadorgoodyear(duetosome
firmspecificevent),thismaymeanusingindustryaveragereturnson
capitaltoarriveatanoptimalorlookingatpastyears
Foranyfirm,thiswillmeannotcountingonetimechargesorprofits

Aswath Damodaran

88

Analyzing a Private Firm

Theapproachremainsthesamewithimportantcaveats
Itisfarmoredifficultestimatingfirmvalue,sincetheequityandthedebt
ofprivatefirmsdonottrade
Mostprivatefirmsarenotrated.
Ifthecostofequityisbaseduponthemarketbeta,itispossiblethatwe
mightbeoverstatingtheoptimaldebtratio,sinceprivatefirmowners
oftenconsiderallrisk.

Aswath Damodaran

89

Estimating the Optimal Debt Ratio for a Private

Software Firm

We first estimate the market value of the firm using the average
Value/EBITDA multiple of 21.8 for the software industry and the
EBITDAforInfoSoftof$3million:
FirmValue=$3million*21.8=$65.4million
We then estimate a synthetic rating for the firm, using its current
interest coverage ratio and the ratings table designed for smaller and
riskierfirms.ThecurrentinterestcoverageratioforInfoSoftwas:
InterestCoverageRatio=EBIT/InterestExpense=$2million/$
315,000=6.35

Aswath Damodaran

90

Interest Coverage Ratios, Spreads and Ratings:

Small Firms
InterestCoverageRatio
>12.5
9.5012.50
7.59.5
6.07.5
4.56.0
3.54.5
3.03.5
2.53.0
2.02.5
1.52.0
1.251.5
0.81.25
0.50.8
<0.5

Aswath Damodaran

Rating
AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C
D

SpreadoverTBondRate
0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%

91

Optimal Debt Ratio for InfoSoft

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
1.43
1.52
1.64
1.82
2.16
2.63
3.29
4.39
6.58
13.16

CostofEquity
12.87%
13.38%
14.01%
15.02%
16.86%
19.48%
23.10%
29.13%
41.20%
77.40%

Rating
AAA
A
B
CC
C
D
D
D
D
D

Interestrate CostofDebt(Aftertax) CostofCapital

5.20%
3.02%
12.87%
6.25%
3.63%
12.40%
9.25%
5.37%
12.28%
11.00%
7.00%
12.61%
12.50%
9.50%
13.91%
15.00%
12.60%
16.04%
15.00%
13.00%
17.04%
15.00%
13.29%
18.04%
15.00%
13.50%
19.04%
15.00%
13.67%
20.04%

92

Determinants of Optimal Debt Ratios

FirmSpecificFactors

1.TaxRate
Highertaxrates
>HigherOptimalDebtRatio
Lowertaxrates
>LowerOptimalDebtRatio
2.Cashflowgeneration=EBITDA/MVofFirm
HigherPretaxReturns
>HigherOptimalDebtRatio
LowerPretaxReturns
>LowerOptimalDebtRatio
3.VarianceinEarnings[Showsupwhenyoudo'whatif'analysis]
HigherVariance >LowerOptimalDebtRatio
LowerVariance >HigherOptimalDebtRatio

MacroEconomicFactors

1.DefaultSpreads
Higher
Lower

Aswath Damodaran

>LowerOptimalDebtRatio
>HigherOptimalDebtRatio

93

Application Test: Your firms optimal

financing mix

Usingtheoptimalcapitalstructurespreadsheetprovided:

Estimatetheoptimaldebtratioforyourfirm
Estimatethenewcostofcapitalattheoptimal
Estimatetheeffectofthechangeinthecostofcapitalonfirmvalue
Estimatetheeffectonthestockprice

Intermsofthemechanics,whatwouldyouneedtodotogettothe
optimalimmediately?

Aswath Damodaran

94

III. The APV Approach to Optimal Capital

Structure
Intheadjustedpresentvalueapproach,thevalueofthefirmiswritten
asthesumofthevalueofthefirmwithoutdebt(theunleveredfirm)
andtheeffectofdebtonfirmvalue
FirmValue=UnleveredFirmValue+(TaxBenefitsofDebtExpected
BankruptcyCostfromtheDebt)
Theoptimaldollardebtlevelistheonethatmaximizesfirmvalue

Aswath Damodaran

95

Implementing the APV Approach

Step1:Estimatetheunleveredfirmvalue.Thiscanbedoneinoneof
twoways:
Estimatingtheunleveredbeta,acostofequitybasedupontheunlevered
betaandvaluingthefirmusingthiscostofequity(whichwillalsobethe
costofcapital,withanunleveredfirm)
Alternatively,UnleveredFirmValue=CurrentMarketValueofFirmTax
BenefitsofDebt(Current)+ExpectedBankruptcycostfromDebt

Step2:Estimatethetaxbenefitsatdifferentlevelsofdebt.Thesimplest
assumptiontomakeisthatthesavingsareperpetual,inwhichcase
Taxbenefits=DollarDebt*TaxRate

Step3:Estimateaprobabilityofbankruptcyateachdebtlevel,and
multiplybythecostofbankruptcy(includingbothdirectandindirect
costs)toestimatetheexpectedbankruptcycost.

Aswath Damodaran

96

Estimating Expected Bankruptcy Cost

ProbabilityofBankruptcy
Estimatethesyntheticratingthatthefirmwillhaveateachlevelofdebt
Estimatetheprobabilitythatthefirmwillgobankruptovertime,atthat
levelofdebt(Usestudiesthathaveestimatedtheempiricalprobabilities
ofthisoccurringovertimeAltmandoesanupdateeveryyear)

CostofBankruptcy
Thedirectbankruptcycostistheeasiercomponent.Itisgenerally
between510%offirmvalue,baseduponempiricalstudies
Theindirectbankruptcycostismuchtougher.Itshouldbehigherfor
sectorswhereoperatingincomeisaffectedsignificantlybydefaultrisk
(likeairlines)andlowerforsectorswhereitisnot(likegroceries)

Aswath Damodaran

97

Ratings and Default Probabilities

Rating
AAA
AA
A+
A
A
BBB
BB
B+
B
B
CCC
CC
C

DefaultRisk
0.01%
0.28%
0.40%
0.53%
1.41%
2.30%
12.20%
19.28%
26.36%
32.50%
46.61%
52.50%
60%

75%

Aswath Damodaran

98

Boeing: Estimating Unlevered Firm Value

Value of Boeing in 1999 = Value of Equity + Value of Debt =
$32,595+$8,194=$40,789
PVofTaxSavingsfromExistingDebt
=ExistingDebt*TaxRate
=$8,194*0.35
=$2,868million
Based upon Boeings currentratingof AA, weestimate a probability
ofbankruptcyof0.28%.Thebankruptcycostisassumedtobe30%of
thefirmvalue,priortothetaxsavings.
PVofExpectedBankruptcyCost =ProbabilityofDefault*Bankruptcy
cost=0.28%*(0.30*(40,7892,868)) =$32
ValueofBoeingasanUnleveredFirm
=MarketValuePVofTaxSavings+ExpectedBankruptcyCosts
=$40,789+$2,868$32=$37,953million

Aswath Damodaran

99

Tax Benefits at Debt Ratios

DebtRatio
$Debt
TaxRate
TaxBenefits
0%$0
35.00%
$0
10%
$4,079
35.00%
$1,428
20%
$8,158
35.00%
$2,855
30%
$12,237
35.00%
$4,283
40%
$16,316
35.00%
$5,710
50%
$20,394
30.05%
$6,128
60%
$24,473
22.76%
$5,571
70%
$28,552
17.17%
$4,903
80%
$32,631
15.02%
$4,903
90%
$36,710
13.36%
$4,903
TaxBenefitscappedwheninterestexpensesexceedEBIT
Aswath Damodaran

100

Expected Bankruptcy Costs

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

BondRating ProbabilityofDefault ExpectedBankruptcyCost

AA
0.28%
$32
AA
0.28%
$32
A
1.41%
$161
BB
12.20%
$1,389
CCC
50.00%
$5,693
CCC
50.00%
$5,693
CC
65.00%
$7,401
C
80.00%
$9,109
C
80.00%
$9,109
C
80.00%
$9,109

101

Boeing: APV at Debt Ratios

DebtRatio
LeveredFirm
0%
10%
20%
30%
40%
50%
60%
70%
80%

UnleveredValue

TaxBenefits

Bankruptcy Valueof Costs

$37,953
$37,953
$37,953
$37,953
$37,953
$37,953
$37,953
$37,953
$37,953

$0
$1,428
$2,855
$4,283
$5,710
$6,128
$5,571
$4,903
$4,903

$32
$32
$161
$1,389
$5,693
$5,693
$7,401
$9,109
$9,109

$37,921
$39,349
$40,648
$40,847
$37,970
$38,388
$36,123
$33,747
$33,747

90%

$37,953

$4,903

$9,109

$33,747

Exp.Bk.Cst:ExpectedBankruptcycost

Aswath Damodaran

102

Relative Analysis
Thesafestplaceforanyfirmtobeisclosetotheindustryaverage.
Subjectiveadjustmentscanbemadetotheseaveragestoarriveatthe
rightdebtratio.

Aswath Damodaran

Highertaxrates>Higherdebtratios(Taxbenefits)
Lowerinsiderownership>Higherdebtratios(Greaterdiscipline)
Morestableincome>Higherdebtratios(Lowerbankruptcycosts)
Moreintangibleassets>Lowerdebtratios(Moreagencyproblems)

103

Examining Industry Averages

Boeing
MarketDebtRatio 18.97%

Aerospace
23.94%

BookDebtRatio

38.94%
BuildingSupplies
27.09%

36.15%
HomeDepot
MarketDebtRatio 1.65%
BookDebtRatio

Aswath Damodaran

15.31%

29.95%

104

The Home Depots Comparables

Company Name
Market D/(D+E) Net Plant/Total Assets Cap Ex/Total Assets
Building Materials
47.23%
34.74%
3.90%
Catalina Lighting
51.17%
28.21%
1.95%
Cont'l Materials Corp
19.74%
36.02%
0.22%
Eagle Hardware
12.02%
52.54%
8.88%
Emco Limited
39.04%
22.64%
4.23%
Fastenal Co.
1.21%
27.82%
13.97%
Home Depot
1.65%
57.97%
13.19%
HomeBase Inc.
40.76%
36.15%
3.07%
Hughes Supply
37.97%
11.19%
2.94%
Lowe's Cos.
5.14%
57.58%
14.81%
National Home Centers
81.27%
47.40%
0.65%
Westburne Inc.
5.87%
11.19%
2.09%
White Cap Industries
13.04%
7.83%
3.08%
Wolohan Lumber
23.40%
28.21%
3.42%

Aswath Damodaran

105

Examining the Determinants of Capital

Structure: Home Improvement Business
Usingasampleofhomeimprovementfirms,wearrivedatthe
followingregression:
Debt=0.174+0.50(NetPlant/FirmValue)1.39(CapExp/Assets)
(1.61) (2.86)
(1.42)
TheRsquaredoftheregressionis60%.Thisregressioncanbeusedto
arriveatapredictedvalueforTheHomeDepotof:
DFRHomeDepot=0.174+0.50(0.0699)1.39(0.1319)=0.0256or2.56%

Baseduponthecapitalstructureofotherfirmsinthehome
improvementindustry,theHomeDepotshouldhaveamarketvalue
debtratioof2.56%.

Aswath Damodaran

106

Cross Sectional Regression: 1998 Data

Using1998datafor3000firmslistedontheNYSE,AMEXand
NASDAQdatabases,wecategorizedfirmsbySICcode.The
regressionacrossthesesectorsprovidesthefollowingresults

DFR=0.16080.3411OISTD+.2153CLSH0.3159CPXFR+1.4185E/V
(26.41a) (3.15a)
(1.95b)
(1.68b)
(8.21a)
where,
DFR
=Debt/(Debt+MarketValueofEquity)
OISTD =StandardDeviationinOperatingIncome(previous5years)
CLSH =Closelyheldsharesasapercentofoutstandingshares
CPXFR =CapitalExpenditures/TotalAssets
E/V
=EBITDA/FirmValue

TheRsquaredoftheregressionis57%.

Aswath Damodaran

107

Applying the Market Regression

Boeing
StandardDeviationinOperatingIncome
25.35%
InsiderHoldingsaspercentofoutstandingstock 1%
CapitalExpenditures/TotalAssets
4.32%
EBITDA/FirmValue
7.94%

TheHomeDepot
24.06%
23%
13.19%
3.38%

PredictedDebtRatio

13.45%

Aswath Damodaran

17.55%

108

Reconciling the Different Analysis

Boeing

TheHomeDepot

Withoutoperatingleases

18.97%

1.65%

Withoperatingleases

20.09%

4.55%

28.41%

17.56%

Withnoconstraints

30.00%

20.00%

WithBBBconstraint

20.00%

15.00%

III.ReturnDifferential

20.00%

30.00%

IV.APV

30.00%

20.00%

ToIndustry

22.56%

2.56%

ToMarket

17.55%

13.45%

ActualDebtRatio

Optimal
I.OperatingIncome
II.CostofCapital

V.Comparable

Aswath Damodaran

109

Analytical Conclusions

Boeingisclosetoitsoptimaldebtratio.
TheHomeDepotisunderlevered.EvenwithaBBBratingconstraint,
theHomeDepotcanaffordtoborrowsignificantlymorethanitdoes
now.

Aswath Damodaran

110

A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal

Overlevered

Actual < Optimal

Underlevered

Is the firm under bankruptcy threat?

Yes

No

Reduce Debt quickly

1. Equity for Debt swap
2. Sell Assets; use cash
to pay off debt
3. Renegotiate with lenders

Does the firm have good

projects?
ROE > Cost of Equity
ROC > Cost of Capital

Yes
No
Take good projects with
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.

Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.

No
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital

Yes
Take good projects with
debt.

No
Do your stockholders like
dividends?

Yes
Pay Dividends

Aswath Damodaran

No
Buy back stock

111

The Home Depot: Applying the Framework

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal

Overlevered

Actual < Optimal

Underlevered

Is the firm under bankruptcy threat?

Yes

No

Reduce Debt quickly

1. Equity for Debt swap
2. Sell Assets; use cash
to pay off debt
3. Renegotiate with lenders

Does the firm have good

projects?
ROE > Cost of Equity
ROC > Cost of Capital

Yes
No
Take good projects with
1. Pay off debt with retained
new equity or with retained earnings.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.

Is the firm a takeover target?

Yes
Increase leverage
quickly
1. Debt/Equity swaps
2. Borrow money&
buy shares.

No
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital

Yes
Take good projects with
debt.

No
Do your stockholders like
dividends?

Yes
Pay Dividends

Aswath Damodaran

No
Buy back stock

112

Application Test: Getting to the Optimal

Baseduponyouranalysisofboththefirmscapitalstructureand
investmentrecord,whatpathwouldyoumapoutforthefirm?
Immediatechangeinleverage
Gradualchangeinleverage
Nochangeinleverage
Wouldyourecommendthatthefirmchangeitsfinancingmixby
Payingoffdebt/Buyingbackequity
Takeprojectswithequity/debt

Aswath Damodaran

113

Designing Debt: The Fundamental Principle

Theobjectiveindesigningdebtistomakethecashflowsondebt
matchupascloselyaspossiblewiththecashflowsthatthefirm
makesonitsassets.
Bydoingso,wereduceourriskofdefault,increasedebtcapacityand
increasefirmvalue.

Aswath Damodaran

114

Firm with mismatched debt

ValueValue
Firm
of Debt

Aswath Damodaran

115

Firm with matched Debt

Firm Value
Value
of Debt

Aswath Damodaran

116

Design the perfect financing instrument

Theperfectfinancinginstrumentwill
Haveallofthetaxadvantagesofdebt
Whilepreservingtheflexibilityofferedbyequity

CommodityBonds
EffectofInflation
Duration
Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced
Cyclicality&
GrowthPatterns
DefineDebt
Duration/
Currency
Fixedvs.FloatingRate
Straightversus
SpecialFeatures
Startwiththe
UncertaintyaboutFuture
OtherEffects
Characteristics
Maturity
Mix
*Morefloatingrate
Convertible
onDebt
CashFlows
CatastropheNotes
ifCFmovewith
Convertibleif
Optionstomake
onAssets/
inflation
cashflowslow
cashflowsondebt
Projects
withgreateruncertainty
nowbuthigh
matchcashflows
onfuture
exp.growth
onassets

Aswath Damodaran

117

Ensuring that you have not crossed the line

drawn by the tax code

Allofthisdesignworkislost,however,ifthesecuritythatyouhave
designeddoesnotdeliverthetaxbenefits.
Inaddition,theremaybeatradeoffbetweenmismatchingdebtand
gettinggreatertaxbenefits.

Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
Overlaytax
ZeroCoupons
Deductibilityofcashflows
Differencesintaxrates
preferences
fortaxpurposes
acrossdifferentlocales

Aswath Damodaran

118

While keeping equity research analysts, ratings

agencies and regulators applauding

Ratingsagencieswantcompaniestoissueequity,sinceitmakesthem
safer.Equityresearchanalystswantthemnottoissueequitybecause
itdilutesearningspershare.Regulatoryauthoritieswanttoensurethat
youmeettheirrequirementsintermsofcapitalratios(usuallybook
value).Financingthatleavesallthreegroupshappyisnirvana.

Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?
OperatingLeases
Consider
AnalystConcerns
RatingsAgency
RegulatoryConcerns
MIPs
ratingsagency
EffectonEPS
EffectonRatios
Measuresused
SurplusNotes
&analystconcerns
Valuerelativetocomparables
Ratiosrelativetocomparables

Aswath Damodaran

119

Debt or Equity: The Strange Case of Trust

Preferred

Trustpreferredstockhas
Afixeddividendpayment,specifiedatthetimeoftheissue
Thatistaxdeductible
Andfailingtomakethepaymentcancause?(Canitcausedefault?)

Whentrustpreferredwasfirstcreated,ratingsagenciestreateditas
equity.Astheyhavebecomemoresavvy,ratingsagencieshave
startedgivingfirmsonlypartialequitycreditfortrustpreferred.

Aswath Damodaran

120

Debt, Equity and Quasi Equity

Assumingthattrustpreferredstockgetstreatedasequitybyratings
agencies,whichofthefollowingfirmsisthemostappropriatefirmto
beissuingit?
Afirmthatisunderlevered,buthasaratingconstraintthatwouldbe
violatedifitmovedtoitsoptimal
Afirmthatisoverleveredthatisunabletoissuedebtbecauseofthe
ratingagencyconcerns.

Aswath Damodaran

121

Soothe bondholder fears

Therearesomefirmsthatfaceskepticismfrombondholderswhen
theygoouttoraisedebt,because
Oftheirpasthistoryofdefaultsorotheractions
Theyaresmallfirmswithoutanyborrowinghistory

Bondholderstendtodemandmuchhigherinterestratesfromthese
Convertibiles firmstoreflecttheseconcerns.
Factorinagency
ObservabilityofCashFlows
TypeofAssetsfinanced
ExistingDebtcovenants
Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds

RestrictionsonFinancing
PuttableBonds
conflictsbetweenstock
byLenders
Tangibleandliquidassets
RatingSensitive
andbondholders
Lessobservablecashflows
createlessagencyproblems
leadtomoreconflicts
Notes
LYONs

Aswath Damodaran

122

And do not lock in market mistakes that work

against you

Ratingsagenciescansometimesunderrateafirm,andmarketscan
underpriceafirmsstockorbonds.Ifthisoccurs,firmsshouldnot
lockinthesemistakesbyissuingsecuritiesforthelongterm.In
particular,
Issuingequityorequitybasedproducts(includingconvertibles),when
equityisunderpricedtransferswealthfromexistingstockholderstothe
newstockholders
Issuinglongtermdebtwhenafirmisunderratedlocksinratesatlevels
thatarefartoohigh,giventhefirmsdefaultrisk.

Whatisthesolution
Ifyouneedtouseequity?
Ifyouneedtousedebt?

Aswath Damodaran

123

Designing Debt: Bringing it all together

Startwiththe

CashFlows
onAssets/
Projects

DefineDebt
Characteristics

Duration

Currency

EffectofInflation
UncertaintyaboutFuture

Duration/
Maturity

Currency
Mix

Fixedvs.FloatingRate
*Morefloatingrate
ifCFmovewith
inflation
withgreateruncertainty
onfuture

Cyclicality&
OtherEffects

GrowthPatterns

Straightversus
Convertible
Convertibleif
cashflowslow
nowbuthigh
exp.growth

SpecialFeatures
onDebt
Optionstomake
cashflowsondebt
matchcashflows
onassets

CommodityBonds
CatastropheNotes

Designdebttohavecashflowsthatmatchuptocashflowsontheassetsfinanced

Overlaytax
preferences
Consider
ratingsagency
&analystconcerns

Deductibilityofcashflows
fortaxpurposes

Differencesintaxrates
acrossdifferentlocales

ZeroCoupons

Iftaxadvantagesarelargeenough,youmightoverrideresultsofpreviousstep
AnalystConcerns
EffectonEPS
Valuerelativetocomparables

RatingsAgency
EffectonRatios
Ratiosrelativetocomparables

RegulatoryConcerns
Measuresused

OperatingLeases
MIPs
SurplusNotes

Cansecuritiesbedesignedthatcanmakethesedifferententitieshappy?

Factorinagency
conflictsbetweenstock
andbondholders

ObservabilityofCashFlows
byLenders
Lessobservablecashflows
leadtomoreconflicts

TypeofAssetsfinanced
Tangibleandliquidassets
createlessagencyproblems

ExistingDebtcovenants
RestrictionsonFinancing

Ifagencyproblemsaresubstantial,considerissuingconvertiblebonds

ConsiderInformation
Asymmetries
Aswath Damodaran

UncertaintyaboutFutureCashflows
Whenthereismoreuncertainty,it
maybebettertouseshorttermdebt

Credibility&QualityoftheFirm
Firmswithcredibilityproblems
willissuemoreshorttermdebt

Convertibiles
PuttableBonds
RatingSensitive
Notes
LYONs

124

Approaches for evaluating Asset Cash Flows

I.IntuitiveApproach
Aretheprojectstypicallylongtermorshortterm?Whatisthecashflow
patternonprojects?
Howmuchgrowthpotentialdoesthefirmhaverelativetocurrentprojects?
Howcyclicalarethecashflows?Whatspecificfactorsdeterminethecash
flowsonprojects?

II.ProjectCashFlowApproach
Projectcashflowsonatypicalprojectforthefirm
Doscenarioanalysesonthesecashflows,basedupondifferentmacro
economicscenarios

III.HistoricalData
OperatingCashFlows
FirmValue

Aswath Damodaran

125

Coming up with the financing details: Intuitive

Approach - The Home Depot

Historically,theHomeDepotstypicalprojecthasbeenanewhome
improvementproductsstoreofroughly100,000squarefeet,witha
fairlylonglifeandasubstantialrealestateinvestment.
Theconstructionofthestoretakesarelativelyshorttime(12years),
andthestoresstartgeneratingcashflowsimmediately.
Inaddition,mostofthegrowthforthefirmsinceitsinceptionhas
comefromtheUnitedStates.

Aswath Damodaran

126

The Home Depot: The Right Debt

It should be long term, with a life roughly matching the life of the
store.
The debt should have a fixed rate or fixed payments each year,
becausethestoresstarttogeneratecashflowsimmediatelyandthere
isanabsenceofpricingpowerinthisbusiness.IftheHomeDepothad
more pricing power, it could consider using floating rate debt, since
cashflowsaremorelikelytomovewithinflation.
The debt should be in U.S. dollars, at least for new stores in the
UnitedStates.
Ifpossible,thevalueofthedebtshouldbetiedtothevalueofthereal
estateunderlyingthestore

Aswath Damodaran

127

 Application Test: Choosing your Financing

Type

Baseduponthebusinessthatyourfirmisin,andthetypical
investmentsthatitmakes,whatkindoffinancingwouldyouexpect
yourfirmtouseintermsof

Aswath Damodaran

Duration(longtermorshortterm)
Currency
FixedorFloatingrate
StraightorConvertible

128

Quantitative Approach
1.OperatingCashFlows
Thequestionofhowsensitiveafirmsassetcashflowsaretoavarietyof
factors,suchasinterestrates,inflation,currencyratesandtheeconomy,can
bedirectlytestedbyregressingchangesintheoperatingincomeagainst
changesinthesevariables.
ChangeinOperatingIncome(t)=a+bChangeinMacroEconomic
Variable(t)
Thisanalysisisusefulindeterminingthecoupon/interestpaymentstructure
ofthedebt.

2.FirmValue
Thefirmvalueisclearlyafunctionofthelevelofoperatingincome,butit
alsoincorporatesotherfactorssuchasexpectedgrowth&costofcapital.
Thefirmvalueanalysisisusefulindeterminingtheoverallstructureofthe
debt,particularlymaturity.
Aswath Damodaran

129

Historical Data

Period Operating
Income
1998
$2,661
1997
$2,016
1996
$1,534
1995
$1,232
1994
$1,039
1993
$744
1992
$549
1991
$382
1990
$266
1989
$185

Aswath Damodaran

FirmValue
$90,845
$45,603
$25,034
$22,251
$22,654
$18,538
$22,513
$13,282
$5,595
$3,116

ChangeinLTBond Changein
Rate
GDP
1.03%
4.22%
0.63%
3.83%
0.80%
3.90%
2.09%
2.06%
1.92%
3.27%
0.83%
2.38%
0.02%
3.61%
1.26%
0.43%
0.12%
0.21%

Changein
Inflation
0.10%
1.55%
0.78%
0.19%
0.00%
0.19%
0.19%
2.83%
1.15%

Changein
Currency
4.38%
9.80%
6.73%
3.55%
6.29%
0.61%
5.83%
2.67%
5.88%

130

Sensitivity to Interest Rate Changes

Theanswertothisquestionisimportantbecauseit
itprovidesameasureofthedurationofthefirmsprojects
itprovidesinsightintowhetherthefirmshouldbeusingfixedorfloating
ratedebt.

Aswath Damodaran

131

Firm Value versus Interest Rate Changes

Regressingchangesinfirmvalueagainstchangesininterestratesover
thisperiodyieldsthefollowingregression
ChangeinFirmValue=0.51
7.49(ChangeinInterestRates)
(2.68)
(0.46)
Tstatisticsareinbrackets.
Conclusion:Theduration(interestratesensitivity)ofTheHome
Depotsassetvaluesisabout7.49years.Consequently,itsdebtshould
haveatleastaslongaduration.

Aswath Damodaran

132

Why the coefficient on the regression is

duration..

Thedurationofastraightbondorloanissuedbyacompanycanbe
writtenintermsofthecoupons(interestpayments)onthebond(loan)
andthefacevalueofthebondtobe
t=N t* Coupon N * Face Value

t +

t
N
(1+r)

dP/P
t=1 (1+r)

Duration of Bond
=
=
dr/r
t=N Coupon Face Value

t +
(1+r)N

t=1 (1+r)

Holdingotherfactorsconstant,thedurationofabondwillincrease
withthematurityofthebond,anddecreasewiththecouponrateon
thebond.

Aswath Damodaran

133

Duration of a Firms Assets

Thismeasureofdurationcanbeextendedtoanyassetwithexpected
cashflowsonit.Thus,thedurationofaprojectorassetcanbe
estimatedintermsofthepredebtoperatingcashflowsonthatproject.
t=N t * CF N * Terminal Value

t +

t
N
(1+r)

dPV/PV
t=1 (1+r)

Duration of Project/Asset
=
=
dr
t=N CF

Terminal Value
t

t +
(1+r)
(1+r)N

t=1

where,
CFt=Aftertaxoperatingcashflowontheprojectinyeart
TerminalValue=SalvageValueattheendoftheprojectlifetime
N=Lifeoftheproject

Thedurationofanyassetprovidesameasureoftheinterestraterisk
embeddedinthatasset.

Aswath Damodaran

134

Duration: Comparing Approaches

Traditional
Regression:
Uses:
Duration
P/r=
Measures
1.
Projected
Historical
data
Cashon
Flows
changes in
Percentage
P
= a + b (r)
Change
Assumes:
firm
value
and interest
in Value
for(market)
a
1.
rates
Cash
Flows
are
unaffected
by
percentage change in
changes
Assumes:
in interest rates
Interest Rates
2. Past
1.
Changes
project
in interest
cash flows
rates
are
are
small. to future project cash
similar
flows.
2. Relationship between cash
flows and interest rates is
stable.
3. Changes in market value
reflect changes in the value of
the firm.

Aswath Damodaran

135

Operating Income versus Interest Rates

ChangeinOperatingIncome=0.36+2.55(ChangeinInterestRates)
(11.28) (0.95)

Generallyspeaking,theoperatingcashflowsaresmoothedoutmore
thanthevalueandhencewillexhibitlowerdurationthatthefirm
value.

Aswath Damodaran

136

Sensitivity to Changes in GNP

Theanswertothisquestionisimportantbecause
itprovidesinsightintowhetherthefirmscashflowsarecyclicaland
whetherthecashflowsonthefirmsdebtshouldbedesignedtoprotect
againstcyclicalfactors.

Ifthecashflowsandfirmvaluearesensitivetomovementsinthe
economy,thefirmwilleitherhavetoissuelessdebtoverall,oradd
specialfeaturestothedebttotiecashflowsonthedebttothefirms
cashflows.

Aswath Damodaran

137

Regression Results
RegressingchangesinfirmvalueagainstchangesintheGNPoverthis
periodyieldsthefollowingregression
ChangeinFirmValue=0.74
7.82(GDPGrowth)
(2.05)
(0.65)
Conclusion:TheHomeDepotiscountercyclical(?)
RegressingchangesinoperatingcashflowagainstchangesinGNP
overthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.41 2.25(GNPGrowth)
(6.86) (1.14)
Conclusion:TheHomeDepotsoperatingincomeisslightlylesssensitive
totheeconomiccycle,butalsocountercyclical.

Aswath Damodaran

138

Sensitivity to Currency Changes

Theanswertothisquestionisimportant,because
itprovidesameasureofhowsensitivecashflowsandfirmvalueareto
changesinthecurrency
itprovidesguidanceonwhetherthefirmshouldissuedebtinanother
currencythatitmaybeexposedto.

Ifcashflowsandfirmvaluearesensitivetochangesinthedollar,the
firmshould
figureoutwhichcurrencyitscashflowsarein;
andissuedsomedebtinthatcurrency

Aswath Damodaran

139

Regression Results
Regressingchangesinfirmvalueagainstchangesinthedollarover
thisperiodyieldsthefollowingregression
ChangeinFirmValue=
0.52
+1.13(ChangeinDollar)
(2.86) (0.34)

Conclusion:TheHomeDepotsvaluehasnotbeenverysensitiveto
changesinthedollaroverthelast15years.

Regressingchangesinoperatingcashflowagainstchangesinthe
dollaroverthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=0.35
0.14(ChangeinDollar)
(10.83) (0.24)

Conclusion:TheHomeDepotsoperatingincomehasalsobeen
unaffectedbychangesinexchangerates.

Aswath Damodaran

140

Sensitivity to Inflation

Theanswertothisquestionisimportant,because
itprovidesameasureofwhethercashflowsarepositivelyornegatively
impactedbyinflation.
itthenhelpsinthedesignofdebt;whetherthedebtshouldbefixedor
floatingratedebt.

Ifcashflowsmovewithinflation,increasing(decreasing)asinflation
increases(decreases),thedebtshouldhavealargerfloatingrate
component.

Aswath Damodaran

141

Regression Results
Regressingchangesinfirmvalueagainstchangesininflationoverthis
periodyieldsthefollowingregression
ChangeinFirmValue
=0.45 23.39(ChangeinInflationRate)
(2.78) (1.68)

Conclusion:TheHomeDepotsfirmvalueisnegativelyaffectedby
increasesininflation.

Regressingchangesinoperatingcashflowagainstchangesininflation
overthisperiodyieldsthefollowingregression
ChangeinOperatingIncome=1.40 1.40(ChangeinInflationRate)

(10.37)(0.50)

Conclusion:TheHomeDepotsoperatingincomeisalsonegatively
affectedbyincreasesininflation,thoughtheeffectissmaller.

Aswath Damodaran

142

Bottom-up Estimates
ChangeinFirmValueversus
InterestRates GDPGrowth Inflation
Currency
BuildingSupplies 6.56

0.73

5.11

1.93

Onabottomupbasis,
TheHomeDepotshouldhavedebt
Withadurationof6.56years
Thatisunaffectedbyeconomiccycles
Isisfixedrate(Valuedoesnotincreaseasinflationgoesup)
Indollars

Aswath Damodaran

143

Analyzing The Home Depots Current Debt

TheHomeDepotsexistingdebtisalmostentirelyintheformoflongterm
leasesonU.S.stores.
Consequently,itsexistingdebtisinlinewithwhatyouwouldexpectthe
HomeDepottohave.

Aswath Damodaran

144

Analyzing Boeings existing debt

Duration
FloatingRateComponent
ForeignCurrencyDebt
ConvertibleDebt

ExistingDebt
7.55
12%
8%
0%

Optimal
9.05
Low
47.24%
0%

Boeingshouldincreaseitsproportionofforeigncurrencydebtand
increasethematurityofitsdebtshortly.
Theoptimaldebtratioswereestimatedbaseduponbottomupestimates
fortheaerospaceanddefensebusinesses.

Aswath Damodaran

145