Transcript Corporate Finance in a Day An Analysis of Grace Kennedy Aswath Damodaran Home Page: www.stern.nyu.edu/~adamodar www.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html E-Mail: [email protected] Stern School of Business Aswath Damodaran.

Corporate Finance in a Day
An Analysis of Grace Kennedy
Aswath Damodaran
Home Page: www.stern.nyu.edu/~adamodar
www.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html
E-Mail: [email protected]
Stern School of Business
Aswath Damodaran
1
A Financial View of the Firm…
Figure 1.1: A Simple View of a Business (Firm)
Assets
Existing Investm ent s
Generat e cashflows t oday
Invest ments already
made
Expected Value t hat will be
Invest men
t s yet to
created by future invest ment s be made
Aswath Damodaran
Liabilities
Debt
Equity
Borrowed m oney
Owner’s funds
2
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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: Maximize the Value of the Firm
Aswath Damodaran
3
The Objective in Decision Making



In traditional corporate finance, the objective in decision making is to
maximize the value of the business you run (firm).
A narrower objective is to maximize stockholder wealth. When the stock is
traded and markets are viewed to be efficient, the objective is to maximize the
stock price.
All other goals of the firm are intermediate ones leading to firm value
maximization, or operate as constraints on firm value maximization.
Aswath Damodaran
4
The Classical Objective Function
STOCKHOLDERS
Hire & fire
managers
- Board
- Annual Meeting
Lend Money
BONDHOLDERS
Maximize
stockholder
wealth
Managers
Protect
bondholder
Interests
Reveal
information
honestly and
on time
No Social Costs
SOCIETY
Costs can be
traced to firm
Markets are
efficient and
assess effect on
value
FINANCIAL MARKETS
Aswath Damodaran
5
What can go wrong?
STOCKHOLDERS
Have little control
over managers
Lend Money
BONDHOLDERS
Managers put
their interests
above stockholders
Managers
Significant Social Costs
SOCIETY
Bondholders can
Some costs cannot be
get ripped off
traced to firm
Delay bad
Markets make
news or
mistakes and
provide
misleading can over react
information
FINANCIAL MARKETS
Aswath Damodaran
6
When traditional corporate financial theory breaks down, the
solution is:



To choose a different mechanism for corporate governance. Japan and
Germany have corporate governance systems which are not centered around
stockholders.
To choose a different objective - maximizing earnings, revenues or market
share, for instance.
To maximize stock price, but reduce the potential for conflict and breakdown:
•
•
•
•
Aswath Damodaran
Making managers (decision makers) and employees into stockholders
Providing lenders with prior commitments and legal protection
By providing information honestly and promptly to financial markets
By converting social costs into economic costs.
7
The Only Self Correcting Objective
STOCKHOLDERS
1. More activist
investors
2. Hostile takeovers
Protect themselves
BONDHOLDERS
1. Covenants
2. New Types
Managers of poorly
run firms are put
on notice.
Managers
Firms are
punished
for misleading
markets
Corporate Good Citizen Constraints
SOCIETY
1. More laws
2. Investor/Customer Backlash
Investors and
analysts become
more skeptical
FINANCIAL MARKETS
Aswath Damodaran
8
An Analysis of Grace Kennedy
STOCKHOLDERS
Company has
adopted option plan
for managers.
Board of 14 members owns 10% of stock.
UK corporate gove rnance practices adopted.
(Independent compensat ion co mmittee,
Review of CEO)
Potential hot spots include
Loans primarily from local
banks who know company well.
BONDH OLDERS
Grace
Managers
Not followed by
analysts. Firm is
the primary
source of
information.
a. T ax
b. Culture and Environment
SOCIETY
Traded on Jamaica,
Trinidad and
Barbados
exchanges.
FINANCIAL MARKETS
Aswath Damodaran
9
Looking at Grace Kennedy’s top stockholders
O thers
I nves tment C ompanies 6 %
5%
D irec tors and Senior
M anagers
10%
P ublic ly lis ted c ompanies
10%
Top 10 stockholders
Jamaica Producers Group
Luli Limited
J.K. Investments
I ns uranc e & T rus t
C ompanies & P ens ion
funds
23%
Grace Kennedy Pension
P rivate and N ominee
c ompanies
15%
Life of Jamaica Equity Fund 1
National Insurance Fund
James S. Moss Solomon
Scojampen Limited
P rivate I ndividuals
31%
Joan E. Belcher
Celia Kennedy
Aswath Damodaran
10
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing
mix used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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.
•
Aswath Damodaran
The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm
11
What is Risk?

Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for
instance, defines risk as “exposing to danger or hazard”. The Chinese symbols
for risk, reproduced below, give a much better description of risk

The first symbol is the symbol for “danger”, while the second is the symbol
for “opportunity”, making risk a mix of danger and opportunity.
Aswath Damodaran
12
Models of Risk and Return
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
High Risk Investment
Low Risk Investm ent
Riskless Investm ent
E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that affects all investments (Market Risk)
Risk that is specific to investment (Firm Specific)
Cannot be diversified away since most assets
Can be diversified away in a diversified portfolio
are affected by it.
1. each investment is a small proportion of portfolio
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
Beta of asset relative to
Market portfolio (from
a regression)
Aswath Damodaran
The APM
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Multi-Factor Models
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
Betas of assets relative
to specified macro
economic factors (from
a regression)
Proxy Models
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)
13
The Riskfree Rate

For an investment to be riskfree, i.e., to have an actual return be equal to the
expected return, two conditions have to be met –
•
•

There has to be no default risk, which generally implies that the security has to be
issued by the government. Note, however, that not all governments can be viewed
as default free.
There can be no uncertainty about reinvestment rates, which implies that it is a zero
coupon security with the same maturity as the cash flow being analyzed.
Using a long term default-free government rate (even on a coupon bond) as
the riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value.
Aswath Damodaran
14
Estimating Riskfree Rates in Jamaican $ and US $


The ten-year treasury bond rate in the US on May 28, 2004 was 4.70%. This
would be the riskfree rate in US dollars.
The riskfree rate in Jamaica is much more difficult to estimate.
•
The Bank of Jamaica lowered the one-year open market rate to 16.4% from 16.9%
on May 6, 2004.
• The most recent debentures issued by the Government of Jamaica have coupon
rates of between 16 and 17%. The most recent 6-month T.Bill rate is 15.09%.
• On May 27, investors in savings accounts in Jamaica could expect to earn 11.37%.
The riskfree rate should be higher than this number.
My guess: The long term riskfree rate in Jamaican $ is about 15%.
Aswath Damodaran
15
The Risk Premium: What is it?


The risk premium is the premium that investors demand for investing in
an average risk investment, relative to the riskfree rate.
Assume that stocks are the only risky assets and that you are offered two
investment options:
•
•
a riskless investment (say a Government Security), on which you can make 5%
a mutual fund of all stocks, on which the returns are uncertain
How much of an expected return would you demand to shift your money from the
riskless asset to the mutual fund?
 Less than 5%
 Between 5 - 7%
 Between 7 - 9%
 Between 9 - 11%
 Between 11 - 13%
 More than 13%
Aswath Damodaran
16
One way to estimate risk premiums: Look at history
Historical Period
1928-2003
1963-2003
1993-2003
Arithmetic average
Stocks Stocks T.Bills
T.Bonds
7.92%
6.54%
6.09%
4.70%
8.43%
4.87%
Geometric Average
Stocks Stocks T.Bills
T.Bonds
5.99%
4.82%
4.85%
3.82%
6.68%
3.57%
What is the right premium?

Go back as far as you can. Otherwise, the standard error in the estimate will be large. (

Be consistent in your use of a riskfree rate.

Use arithmetic premiums for one-year estimates of costs of equity and geometric
premiums for estimates of long term costs of equity.
Data Source: Check out the returns by year and estimate your own historical premiums by
going to updated data on my web site.
Aswath Damodaran
17
Assessing Country Risk: The Caribbean Region (defined
loosely)
Country
Long-Term RatingDefaault spread over U.S. treasuries
Bahamas
A1
80
Barbados
A3
95
Bermuda
Aaa
0
Cayman Islands
Aa3
70
Dominican Republic
B2
550
Ecuador
Caa1
750
El Salvador
Baa2
130
Jamaica
Ba2
300
T rinidad
Baa1
120
Unit ed States
Aaa
0
Venezuela
Caa1
750
Aswath Damodaran
18
Adjusted Equity Risk Premium


Start with the U.S. historical risk premium as a base (4.82%)
Add the default spread of the country in which you plan to operate to the U.S.
risk premium to arrive at an equity risk premium for that market.
•
•
•
Aswath Damodaran
Jamaica Equity Risk Premium = 4.82% + 3% = 7.82%
Trinidad Equity Risk Premium = 4.82% + 1.20% = 6.02%
Barbados Equity Risk Premium = 4.82% + 0.95% = 5.77%
19
Estimating Beta



The beta of a stock measures the risk in a stock that cannot be diversified
away. It is determined by both how volatile a stock is and how it moves with
the market.
The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
The slope of the regression corresponds to the beta of the stock, and measures
the riskiness of the stock.
Aswath Damodaran
20
Beta Estimation in Practice: A Bloomberg Page
Aswath Damodaran
21
Determinants of Betas
Beta of Equity (Levered Beta)
Beta of Firm (Unlevered Beta)
Natur e of pr oduct or
s e r vice offe re d by
com pany:
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.
Ope r ating Leve r age (Fixe d
Cos ts as pe rce nt of total
cos ts ):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.
Impl icati ons
1. Cyclical companies should
have higher betas than noncyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
f irms should have higher betas
than low prices goods/services
f irms.
4. Grow th firms should have
higher betas.
Impl icati ons
1. Firms w ith high infrastructure
needs and rigid cost structures
should have higher betas than
f irms w ith flexible cost structures.
2. Smaller firms should have higher
betas than larger f irms.
3. Young f irms should have higher
betas than more mature firms.
Aswath Damodaran
Financial Le ve r age :
Other things remaining equal, the
greater the proportion of capital that
a f irm raises f rom debt,the higher its
equity beta w ill be
Impl ciati ons
Highly levered f irms should have highe betas
than f irms w ith less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))
22
Bottom-up Betas: Estimating betas by looking at comparable
firms
Business
Comparable firms
Food
Trading
Food Producers
0.81
496.5
Retailing
Miscellaneous
Retailers
0.79
Financial
Services
Banks and
Insurance
Companies
Maritime
Information
Services
Debt/Equi
ty Ratio
Levere
d Beta
21.75%
11.36%
0.87
21.81%
143.3
6.28%
11.36%
0.85
21.65%
0.51
991.3
43.43%
31.04%
0.62
19.81%
Maritime
Transportation
0.38
130.6
5.72%
11.36%
0.41
18.20%
Data Services
0.79
520.7
22.81%
11.36%
0.85
21.65%
0.65
2282.4
11.36%
0.70
20.46%
Grace
Kennedy
Aswath Damodaran
Unlever
ed Beta
Operating
Income
Weight
in Grace
Cost of
Equity (J$)
23
US Dollar Cost of Equity: By division and By investment
region (In US dollar terms)
Division
Food Trading
Retailing
Financial Services
Maritime
Information Services
Grace Kennedy
Jamaica
11.51%
11.35%
9.51%
7.90%
11.35%
10.16%
Trinidad
9.95%
9.82%
8.41%
7.16%
9.82%
8.90%
Barbados
9.73%
9.60%
8.25%
7.06%
9.60%
8.73%
United States
8.90%
8.80%
7.67%
6.67%
8.80%
8.07%
Riskfree rate used = US dollar riskfree rate of 4.70%
Risk premium =
7.82% for Jamaica
6.02% for Trinidad
5.77% for Barbados
4.82% for US
Aswath Damodaran
24
From Cost of Equity to Cost of Capital


The cost of capital is a composite cost to the firm of raising financing to fund
its projects.
In addition to equity, firms can raise capital from debt. To get to the cost of
capital, we need to
•
•

First estimate the cost of borrowing money
And then weight debt and equity in the proportions that they are used in financing.
The cost of debt for a firm is the rate at which it can borrow money today. It
should a be a direct function of how much risk of default a firm carries and
can be written as
•
Aswath Damodaran
Cost of Debt = Riskfree Rate + Default Spread
25
Default Spreads and Bond Ratings



Many firms in the United States are rated by bond ratings agencies like
Standard and Poor’s and Moody’s for default risk. If you have a rating, you
can estimate the default spread from it.
If your firm is not rated, you can estimate a “synthetic rating” using the
financial characteristics of the firm. In its simplest form, the rating can be
estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
For Grace Kennedy, the interest coverage ratio in 2003 is estimated from the
operating income of 1986.292 million J$ and the interest expenses of 321.902
million J$.
Interest Coverage Ratio = 1986/322 = 5.00
Aswath Damodaran
26
Interest Coverage Ratios, Ratings and Default Spreads
If Interest Coverage Ratio is
>12.50
9.5-12.5
7.5-9.5
6-7.5
4.5-6
4-4.5
3.5-4
3-3.5
2.5-3
2-2.5
1.5-2
1.25-1.5
0.8-1.25
0.5-0.8
<0.5
Aswath Damodaran
Estimated Bond Rating
AAA
AA
A+
A
A–
BBB
BB+
BB
B+
B
B–
CCC
CC
C
D
Default Spread(2004)
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
27
6

Based upon the interest coverage ratio of 5, we would assign a bond rating of
A- to Grace Kennedy, leading to a default spread of 1% over a US dollar
riskfree rate. Since the riskfree rate in Jamaica is roughly three times higher,
we will triple this default spread, leading to a pre-tax cost of debt of
•
•

Grace Kennedy’s Cost of Debt
Cost of debt = Riskfree Rate + Default Spread = 15% + 3% = 18%
Cost of debt (US $) = Riskfree Rate + Default spread =4.70% + 1% = 5.70%
With a tax rate of 33.33%, the after-tax cost of debt can be computed:
•
•
Aswath Damodaran
Aftet-tax cost of debt in J$ = 18% (1-.3333) = 12%
After-tax cost of debt in US $ = 5.70% (1-.3333) = 3.80%
28
Estimating Market Value Weights

Market Value of Equity should include the following
•
•
•

Market Value of Shares outstanding
Market Value of Warrants outstanding
Market Value of Conversion Option in Convertible Bonds
Market Value of Debt is more difficult to estimate because few firms have
only publicly traded debt. There are two solutions:
•
•
Aswath Damodaran
Assume book value of debt is equal to market value
Estimate the market value of debt from the book value
29
Estimating Cost of Capital in J$: Grace Kennedy
Bus ines s
Cos t of Equity
Food T rading
2 1 .8 1 %
Retailing
2 1 .6 5 %
Financ ial Servic es
1 9 .8 1 %
M aritime
1 8 .2 0 %
I nformation Servic es
2 1 .6 5 %
G rac e Kennedy
2 0 .4 6 %
Aswath Damodaran
After-tax Cos t of Debt
1 2 .0 0 %
1 2 .0 0 %
1 2 .0 0 %
1 2 .0 0 %
1 2 .0 0 %
1 2 .0 0 %
Debt to Capital Ratio
1 0 .2 0 %
1 0 .2 0 %
2 3 .6 9 %
1 0 .2 0 %
1 0 .2 0 %
1 0 .2 0 %
Cos t of Capital
2 0 .8 1 %
2 0 .6 6 %
1 7 .9 6 %
1 7 .5 6 %
2 0 .6 6 %
1 9 .6 0 %
30
US Dollar Cost of Capital: By division and By investment
region (In US dollar terms)
Division
Food Trading
Retailing
Financial Services
Maritime
Information Services
Grace Kennedy
Aswath Damodaran
Jamaica
10.73%
10.58%
8.16%
7.48%
10.58%
9.51%
Trinidad
8.67%
8.57%
7.58%
6.57%
8.57%
7.90%
Barbados
9.73%
9.60%
8.25%
7.06%
9.60%
8.73%
United States
8.90%
8.80%
7.67%
6.67%
8.80%
8.07%
31
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and
the timing of these cash flows; they should also consider both positive and
negative side effects of these projects.
Choose a financing mix that minimizes 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.
•
Aswath Damodaran
The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm
32
Measures of return: earnings versus cash flows

Principles Governing Accounting Earnings Measurement
•
•

Accrual Accounting: Show revenues when products and services are sold or
provided, not when they are paid for. Show expenses associated with these
revenues rather than cash expenses.
Operating versus Capital Expenditures: Only expenses associated with creating
revenues in the current period should be treated as operating expenses. Expenses
that create benefits over several periods are written off over multiple periods (as
depreciation or amortization)
To get from accounting earnings to cash flows:
•
•
•
Aswath Damodaran
you have to add back non-cash expenses (like depreciation)
you have to subtract out cash outflows which are not expensed (such as capital
expenditures)
you have to make accrual revenues and expenses into cash revenues and expenses
(by considering changes in working capital).
33
Measuring Returns Right: The Basic Principles



Use cash flows rather than earnings. You cannot spend earnings.
Use “incremental” cash flows relating to the investment decision, i.e.,
cashflows that occur as a consequence of the decision, rather than total cash
flows.
Use “time weighted” returns, i.e., value cash flows that occur earlier more than
cash flows that occur later.
The Return Mantra: “Time-weighted, Incremental Cash Flow Return”
Aswath Damodaran
34
Earnings versus Cash Flows: A Proposed Grace Kennedy
Investment - American Roti



Grace Kennedy is planning to introduce a new line of frozen Jamaican dinners
and snacks under the brand name American Roti and aimed at broad US
market. It has already spent $ 5 million in market testing and collecting
information.
To make the investment, Grace Kennedy believes that it will need to invest $
50 million upfront and that this investment can be depreciated straight line
over 5 years down to a salvage value of $ 10 million. In addition, it will need
to maintain a working capital investment equal to 20% of its revenues, with
the investment at the beginning of each year.
The market testing has yielded potential market share estimates and revenues
(shown on the next page). Grace Kennedy will allocate 20% of its General and
administrative expenses to this investment, though 60% of this cost is fixed.
Aswath Damodaran
35
Estimated Earnings on Project
Revenues
- O perating E xpens es
- A dvertis ing
- A lloc ated G &A
- D eprec iation
O perating I nc ome
- T axes
O perating I nc ome after-tax
Aswath Damodaran
1
$ 8 0 .0 0
$ 4 0 .0 0
$ 2 8 .0 0
$ 1 5 .0 0
$ 8 .0 0
- $ 1 1 .0 0
- $ 3 .6 7
- $ 7 .3 3
2
$ 1 0 0 .0 0
$ 5 0 .0 0
$ 2 4 .0 0
$ 2 5 .0 0
$ 8 .0 0
- $ 7 .0 0
- $ 2 .3 3
- $ 4 .6 7
3
$ 1 2 5 .0 0
$ 6 2 .5 0
$ 1 5 .0 0
$ 3 1 .2 5
$ 8 .0 0
$ 8 .2 5
$ 2 .7 5
$ 5 .5 0
4
$ 1 6 0 .0 0
$ 8 0 .0 0
$ 1 5 .0 0
$ 4 0 .0 0
$ 8 .0 0
$ 1 7 .0 0
$ 5 .6 7
$ 1 1 .3 3
5
$ 2 0 0 .0 0
$ 1 0 0 .0 0
$ 1 5 .0 0
$ 5 0 .0 0
$ 8 .0 0
$ 2 7 .0 0
$ 9 .0 0
$ 1 8 .0 0
Notes
From market tes t
(5 0 % of revenues )
( T apered down over time)
(From headquarters )
(Straight line on 4 0 m)
(3 3 .3 3 % tax rate)
36
Currency Conversions
If you wanted to convert these US dollar cashflows into Jamaican dollar
cashflows, what exchange rate would you use?
 The current exchange rate
 Expected future exchange rates
Why?

Aswath Damodaran
37
And The Accounting View of Return
C apital I nves ted
Fixed A s s ets
Working C apital
C apital inves ted
Y ear
1
2
3
4
5
A verage
Aswath Damodaran
O perating I nc ome after tax
- $ 7 .3 3
- $ 4 .6 7
$ 5 .5 0
$ 1 1 .3 3
$ 1 8 .0 0
1
50
16
66
Book C apital (beginning)
66
62
59
58
58
2
42
20
62
Book C apital (E nding)
62
59
58
58
50
3
34
25
59
Book C apital (A verage)
64
6 0 .5
5 8 .5
58
54
4
26
32
58
5
18
40
58
Return on C apital
- 1 1 .4 6 %
- 7 .7 1 %
9 .4 0 %
1 9 .5 4 %
3 3 .3 4 %
8 .6 2 %
38
Would lead use to conclude that...




Do not invest in American Roti. The US $ return on capital of 8.62% is
lower than the US$ cost of capital for food division investments in the
United States of 8.90% This would suggest that the project should not be
taken.
Given that we have computed the average over an arbitrary period of 5 years,
while the investment would have a life greater than 5 years, would you feel
comfortable with this conclusion?
Yes
No
Aswath Damodaran
39
The cash flow view of this project..
•
A fter- tax O perating I nc ome
+ D eprec iation
- C apital E xpenditures
- C hange in Working C apital
C as hflow
0
- $ 5 0 .0 0
- $ 1 6 .0 0
- $ 6 6 .0 0
1
- $ 7 .3 3
$ 8 .0 0
2
- $ 4 .6 7
$ 8 .0 0
3
$ 5 .5 0
$ 8 .0 0
4
$ 1 1 .3 3
$ 8 .0 0
- $ 4 .0 0
- $ 3 .3 3
- $ 5 .0 0
- $ 1 .6 7
- $ 7 .0 0
$ 6 .5 0
- $ 8 .0 0
$ 1 1 .3 3
5
$ 1 8 .0 0
$ 8 .0 0
$ 1 0 .0 0
$ 4 0 .0 0
$ 7 6 .0 0
To get from income to cash flow, we
added back all non-cash charges such as depreciation
subtracted out the capital expenditures
subtracted out the change in non-cash working capital
Aswath Damodaran
40
Depreciation Methods





We used straight line depreciation to estimate the cashflows. Assume that you
had been able to depreciate more of the asset in the earlier years and less in
later years (though the total depreciation would remain unchanged). Switching
to an accelerated depreciation method would
Increase earnings in the early years and decrease the cashflows
Decrease earnings in the early years but increase the cashflow
Decrease both earnings and cashflow in the early years
Increase both earnings and cashflow in the early years
Aswath Damodaran
41
The incremental cash flows on the project
0
A fter- tax O perating I nc ome
+ D eprec iation
- C apital E xpenditures
- C hange in Working C apital
C as hflow
+ N on-inc rement G &A (1 -t)
I nc remental C as hflow
- $ 5 0 .0 0
- $ 1 6 .0 0
- $ 6 6 .0 0
- $ 6 6 .0 0
1
- $ 7 .3 3
$ 8 .0 0
2
- $ 4 .6 7
$ 8 .0 0
3
$ 5 .5 0
$ 8 .0 0
4
$ 1 1 .3 3
$ 8 .0 0
- $ 4 .0 0
- $ 3 .3 3
$ 6 .0 0
$ 2 .6 7
- $ 5 .0 0
- $ 1 .6 7
$ 1 0 .0 0
$ 8 .3 3
- $ 7 .0 0
$ 6 .5 0
$ 1 2 .5 0
$ 1 9 .0 0
- $ 8 .0 0
$ 1 1 .3 3
$ 1 6 .0 0
$ 2 7 .3 3
5
$ 1 8 .0 0
$ 8 .0 0
$ 1 0 .0 0
$ 4 0 .0 0
$ 7 6 .0 0
$ 2 0 .0 0
$ 9 6 .0 0
To get from cash flow to incremental cash flows, we
Ignore the investment in market testing because it has occurred already
and cannot be recovered.
 Add back the non-incremental allocated costs (in after-tax terms)
Aswath Damodaran
42
To Time-Weighted Cash Flows

Net Present Value (NPV): The net present value is the sum of the present
values of all cash flows from the project (including initial investment).
NPV = Sum of the present values of all cash flows on the project, including the initial
investment, with the cash flows being discounted at the appropriate hurdle rate
(cost of capital, if cash flow is cash flow to the firm, and cost of equity, if cash flow
is to equity investors)
• Decision Rule: Accept if NPV > 0

Internal Rate of Return (IRR): The internal rate of return is the discount rate
that sets the net present value equal to zero. It is the percentage rate of return,
based upon incremental time-weighted cash flows.
•
Aswath Damodaran
Decision Rule: Accept if IRR > hurdle rate
43
Which yields a NPV of..
Y ear I nc remental C as hflowP V at 8 .9 0 %
0
- $ 6 6 .0 0
- $ 6 6 .0 0
1
$ 2 .6 7
$ 2 .4 5
2
$ 8 .3 3
$ 7 .0 3
3
$ 1 9 .0 0
$ 1 4 .7 1
4
$ 2 7 .3 3
$ 1 9 .4 4
5
$ 9 6 .0 0
$ 6 2 .6 8
NPV
$ 4 0 .3 1
Aswath Damodaran
44
Which makes the argument that..


The project should be accepted. The positive net present value suggests that
the project will add value to the firm, and earn a return in excess of the cost of
capital.
By taking the project, Grace Kennedy will increase its value as a firm by
$40.31 million.
Aswath Damodaran
45
The IRR of this project
American Roti: Net Present Value Profile
$ 1 0 0 .0 0
$ 8 0 .0 0
$ 6 0 .0 0
$ 4 0 .0 0
$ 2 0 .0 0
Internal Rate of Return = 22%
$ 0 .0 0
0% 2% 4% 6% 8% 10% 12%14% 16%18% 20% 22%24% 26%28% 30%32% 34%36% 38%40%
($ 2 0 .0 0 )
($ 4 0 .0 0 )
Aswath Damodaran
46
The IRR suggests..


The project is a good one. Using time-weighted, incremental cash flows, this
project provides a return of 22%. This is greater than the cost of capital of
8.90%.
The IRR and the NPV will yield similar results most of the time, though there
are differences between the two approaches that may cause project rankings to
vary depending upon the approach used.
Aswath Damodaran
47
The Importance of Working Capital
60
35.00%
30.00%
50
25.00%
40
IRR
NPV
20.00%
30
NP V
IRR
15.00%
20
10.00%
10
5.00%
0
0.00%
0%
5%
10%
15%
20%
25%
30%
Working Capital as % of Revenues
Aswath Damodaran
48
The Role of Sensitivity Analysis



Our conclusions on a project are clearly conditioned on a large number of
assumptions about revenues, costs and other variables over very long time
periods.
To the degree that these assumptions are wrong, our conclusions can also be
wrong.
One way to gain confidence in the conclusions is to check to see how sensitive
the decision measure (NPV, IRR..) is to changes in key assumptions.
Aswath Damodaran
49
Side Costs and Benefits




Most projects considered by any business create side costs and benefits for
that business.
The side costs include the costs created by the use of resources that the
business already owns (opportunity costs) and lost revenues for other projects
that the firm may have.
The benefits that may not be captured in the traditional capital budgeting
analysis include project synergies (where cash flow benefits may accrue to
other projects) and options embedded in projects (including the options to
delay, expand or abandon a project).
The returns on a project should incorporate these costs and benefits.
Aswath Damodaran
50
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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.
•
Aswath Damodaran
The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
51
Debt: The Trade-Off
Advantages of Borrowing
Disadvantages of Borrowing
1. Tax Benefit:
1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit
Higher business risk --> Higher Cost
2. Added Discipline:
2. Agency Cost:
Greater the separation between managers
Greater the separation between stock-
and stockholders --> Greater the benefit
holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
Aswath Damodaran
52
A Hypothetical Scenario

Assume you operate in an environment, where
•
•
•
•
•
Aswath Damodaran
(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know their future financing needs
53
The Miller-Modigliani Theorem


In an environment, where there are no taxes, default risk or agency costs,
capital structure is irrelevant.
The value of a firm is independent of its debt ratio.
Aswath Damodaran
54
An Alternate View : The cost of capital can change as you
change your financing mix




The trade-off between debt and equity becomes more complicated when there
are both tax advantages and bankruptcy risk to consider. When debt has a tax
advantage and increases default risk, the firm value will change as the
financing mix changes. The optimal financing mix is the one that maximizes
firm value.
The cost of capital has embedded in it, both the tax advantages of debt
(through the use of the after-tax cost of debt) and the increased default risk
(through the use of a cost of equity and the cost of debt)
Value of a Firm = Present Value of Cash Flows 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 is
minimized, the value of the firm will be maximized.
Aswath Damodaran
55
The Cost of Capital: The Textbook Example
Aswath Damodaran
D/(D+E)
ke
kd
After-tax Cost of Debt
WA CC
0
10.50%
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%
56
WACC and Debt Ratios
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
11.40%
11.20%
11.00%
10.80%
10.60%
10.40%
10.20%
10.00%
9.80%
9.60%
9.40%
0
WACC
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
Aswath Damodaran
57
Current Cost of Capital: Grace Kennedy

Equity
•
•
•

10.16%
29,076.75 million J$
89.8%
Debt
•
•
•

Cost of Equity =
Market Value of Equity =
Equity/(Debt+Equity ) =
After-tax Cost of debt = 5.70% (1-.3333) =
Market Value of Debt =
Debt/(Debt +Equity) =
3.80%
3,303 million J$
10.2%
Cost of Capital = 10.16%(.898)+ 3.80%(.102) = 9.51%
Aswath Damodaran
58
Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt
will increase.
To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest
expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.
Aswath Damodaran
59
Estimating Cost of Equity from Betas: Grace Kennedy at
different debt ratios
Current Beta = 0.70
Market premium = 7.82%
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Aswath Damodaran
Beta
0.65
0.70
0.76
0.84
0.94
1.12
1.43
1.90
2.98
5.97
Unlevered Beta = 0.65
T.Bond Rate = 4.70%t= 33.33%
Cost of Equity
9.79%
10.17%
10.64%
11.24%
12.05%
13.46%
15.86%
19.59%
28.04%
51.37%
60
Bond Ratings, Cost of Debt and Debt Ratios: Grace Kennedy
at different debt ratios
D/(D+E)
D/E
$ Debt
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%
0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%
$0
$3,238 $6,476 $9,714 $12,952 $16,190 $19,428 $22,666 $25,904 $29,141
EBITDA
Depreciation
EBIT
Interest
P re-tax Int. cov
Likely Rating
P re-tax cost of debt
Eff. Tax Rate
Cost of debt
$2,456
$470
$1,986
$0
•
AAA
5.05%
33.33%
3.37%
Aswath Damodaran
$2,456
$470
$1,986
$168
11.80
AA
5.20%
33.33%
3.47%
$2,456
$470
$1,986
$369
5.38
A5.70%
33.33%
3.80%
$2,456
$470
$1,986
$772
2.57
B+
7.95%
33.33%
5.30%
$2,456
$470
$1,986
$1,904
1.04
CC
14.70%
33.33%
9.80%
$2,456
$470
$1,986
$2,380
0.83
CC
14.70%
27.81%
10.61%
$2,456
$470
$1,986
$3,244
0.61
C
16.70%
20.40%
13.29%
$2,456
$470
$1,986
$3,785
0.52
C
16.70%
17.49%
13.78%
$2,456
$470
$1,986
$6,398
0.31
D
24.70%
10.35%
22.14%
$2,456
$470
$1,986
$7,198
0.28
D
24.70%
9.20%
22.43%
61
Grace Kennedy’s Cost of Capital Schedule
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Aswath Damodaran
Beta
0.65
0.70
0.76
0.84
0.94
1.12
1.43
1.90
2.98
5.97
Cost of Equity
Cost of Debt (after-tax)
9.79%
3.37%
10.17%
3.47%
10.64%
3.80%
11.24%
5.30%
12.05%
9.80%
13.46%
10.61%
15.86%
13.29%
19.59%
13.78%
28.04%
22.14%
51.37%
22.43%
WACC
9.79%
9.50%
9.27%
9.46%
11.15%
12.04%
14.32%
15.52%
23.32%
25.32%
62
Grace Kennedy: Cost of Capital Chart
Cost of Capital and Debt Ratios
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Debt Ratio
Aswath Damodaran
63
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
64
Grace Kennedy: 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
65
Designing Debt: The Fundamental Principle


The objective in designing debt is to make the cash flows on debt match up as
closely as possible with the cash flows that the firm makes on its assets.
By doing so, we reduce our risk of default, increase debt capacity and increase
firm value.
Aswath Damodaran
66
Design the perfect financing instrument

The perfect financing instrument will
•
•
Start with the
Cash Flows
on Assets/
Projects
Define Debt
Characteristics
Have all of the tax advantages of debt
While preserving the flexibility offered by equity
Duration
Duration/
Mat urit y
Currency
Currency
Mix
Effect of Inflation
Uncertaint y about Fut ure
Fixed vs. Floating Rate
* M ore float ing rat e
- if CF m ove with
inflation
- wit h greater uncert aint y
on fut ure
Growt h P att erns
Straight versus
Convertible
- Convert ible if
cash flows low
now but high
exp. growt h
Cyclicalit y &
Ot her Effect s
Special Features
on Debt
- Options t o make
cash flows on debt
match cash flows
on asset s
Commodit y Bonds
Catast rophe Notes
Design debt to have cash flows that m atch up to cash flows on the assets financed
Aswath Damodaran
67
Coming up with the financing details: Intuitive Approach
Business
Food Trading
Retailing
Financial Services
Maritime
Information
Processing
Aswath Damodaran
Typical Project
The manufacturing facilities may
medium term but the product (and
associated brand name) can have long
life. Increas ing sales outside of Jamaica.
Debt
Medium to long term debt, with currency
depending upon where the product revenues are
growing. In markets where Grace Kennedy has
pricing power (like Jamaica), it can be floating
rate debt.
Medium term for both supermarker/
Operating leases beca use they link the debt to
hypermarket stores and hardware
the store and allow Grace Kennedy to abandon
retailing .
lease if the store is doing badly.
Mix of long term (bank branches) and
Long term debt for long term cap ital needed for
short term (money management,
expansion and to meet capital ratio
insurance). Money management business requirements.
focused on attracting international
investment. Driven by regul atory
concerns.
Wharf and stevedoring business requires Long term, fixed rate, Jamaican dollar debt
investment in long term assets. Entirely
in Jamaica.
Short term, especially for software
Short term, fixed rate, Jamaican dollar debt,
products since they have short lifetimes.
68
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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.
•
Aswath Damodaran
The form of returns - dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
69
Dividends are sticky..
Aswath Damodaran
70
Dividends tend to follow earnings
Aswath Damodaran
71
Questions to Ask in Dividend Policy Analysis



How much could the company have paid out during the period under
question?
How much did the the company actually pay out during the period in
question?
How much do I trust the management of this company with excess cash?
•
•
Aswath Damodaran
How well did they make investments during the period in question?
How well has my stock performed during the period in question?
72
Measuring Potential Dividends
Aswath Damodaran
73
How much can you return to stockholders?
Grace Kennedy’s Free Cashflow to Equity
N et I nc ome
+ D eprec iation
- C apital E xpenditures
- C hange in non- c as h Working C apital
- D ebt Repaid
+ N ew D ebt I s s ued
FC FE
Aswath Damodaran
2002
2003
$ 1 ,6 0 3 .2 7 $ 1 ,9 8 0 .1 9
$ 3 6 3 .6 6 $ 4 6 9 .7 3
$ 5 4 7 .0 1 $ 8 3 7 .3 9
$ 5 2 2 .0 8 $ 1 ,9 7 8 .8 0
$ 2 3 2 .4 9 $ 2 9 9 .4 5
$ 1 4 2 .4 4 $ 1 ,2 0 2 .0 1
$ 8 0 7 .8 0 $ 5 3 6 .2 9
74
How much did your return? Grace Kennedy’s Dividends
Dividends versus FCFE
$900.00
$800.00
$700.00
$600.00
$500.00
FCFE
Dividends P aid
$400.00
$300.00
$200.00
$100.00
$0.00
2002
Aswath Damodaran
2003
75
Can you trust Grace Kennedy’s management?

During the period 2002-2203, Grace Kennedy
•
•
•
•
Had an average return on equity of 18.7% on projects taken
Saw it’s stock almost double between 2002 and 2003
Faced a cost of equity of about 20.46%
Has accumulated a cash balance of 24,805 million J$
If you were a Grace Kennedy stockholder, would you be comfortable with it’s
dividend policy?
 Yes
 No
Aswath Damodaran
76
The Bottom Line on Grace Kennedy Dividends



Grace Kennedy could have afforded to pay more in dividends during the
period of the analysis.
It chose not to, and has accumulated the cash.
Whether it can continue to hold this cash will depend upon how well it invests
in the coming years.
Aswath Damodaran
77
A Practical Framework for Analyzing Dividend Policy
How much did the firm pay out? How much could it have afforded to pay out?
What it could have paid out
What it actually paid out
Net Income
Dividends
- (Cap Ex - Depr’n) (1-DR)
+ Equity Repurchase
- Chg Working Capital (1-DR)
= FCFE
Firm pays out too little
FCFE > Dividends
Firm pays out too much
FCFE < Dividends
Do you trust managers in the company with
your cash?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
Aswath Damodaran
What investment opportunities does the
firm have?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
Firm has history of
good project choice
and good projects in
the future
Firm has history
of poor project
choice
Firm has good
projects
Give managers the
flexibility to keep
cash and set
dividends
Force managers to
justify holding cash
or return cash to
stockholders
Firm should
cut dividends
and reinvest
more
Firm has poor
projects
Firm should deal
with its investment
problem first and
then cut dividends
78
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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: Maximize the Value of the Firm
Aswath Damodaran
79
Grace Kennedy: Status Quo (US $)
Reinvestment Rate
44.51%
Cur re nt Cas hflow to Firm
EBIT(1-t) :
27
- Nt CpX
3
- Chg WC
39
= FCFF
-$15
Reinvestment Rate =42/27 = 154%
Return on Capital
14.19%
Terminal Value5= 27.6/(.0996-.047) = 526
$ Cashflow s
Op. Assets $ 340
+ Cash, Mksec 121
- Debt
55
- Minor. Int.
17
=Equity
389
-Options
0
Value/Sh $1.21
j$ 72.66/sh
Year
EBIT (1-t)
- Reinvest ment
FCFF
1
$28.8
$12.8
$16.0
2
$30.6
$13.6
$17.0
3
$32.6
$14.5
$18.1
4
$34.6
$15.4
$19.2
5
$36.8
$16.4
$20.4
6
$39.1
$17.4
$21.7
7
$41.6
$18.5
$23.1
8
$44.2
$19.7
$24.6
9
$47.0
$20.9
$26.1
10
$50.0
$22.3
$27.8
Term Yr
52.4
- 24.8
= 27.6
Discount at$ Cost of Capital (WACC) = 10.17% (.898) + 3.80% (0.102) = 9.52%
Cos t of Equity
10.17 %
Ris k fre e Rate:
$ Riskfree Rate= 4.70%
On May 28, 2004
Grace Kennedy price = 90 J$
Cos t of De bt
(4.70% +1% )(1-.3333)
= 3.80%
+
Be ta
0.70
Unlevered Beta f or
Sectors: 0.65
Aswath Damodaran
Stable Grow th
g = 4.70% ; Beta = 0.80;
Cost of capital = 9.96%
ROC= 9.96%;
Tax rate=33.33%
Reinvestment Rate=g/ROC
=4.70/9.96= 47.20%
Expecte d Gr ow th
in EBIT (1-t)
.4451*.1419=.0631
6.31 %
We ights
E = 89.8% D = 10.2%
X
Firm’s D/E
Ratio: 11%
Equity Risk Premium
7.82%
Mature market
premium
4.82%
+
Country Equity Risk
Premium
3.00%
80
The Paths to Value Creation

Using the DCF framework, there are four basic ways in which the value of a
firm can be enhanced:
•
The cash flows from existing assets to the firm can be increased, by either
– increasing after-tax earnings from assets in place or
– reducing reinvestment needs (net capital expenditures or working capital)
•
The expected growth rate in these cash flows can be increased by either
– Increasing the rate of reinvestment in the firm
– Improving the return on capital on those reinvestments
•
•
The length of the high growth period can be extended to allow for more years of
high growth.
The cost of capital can be reduced by
– Reducing the operating risk in investments/assets
– Changing the financial mix
– Changing the financing composition
Aswath Damodaran
81
Increase Cash Flows
More ef f icient
operations and
cost cuttting:
Higher Margins
Reduce the cost of capi tal
Make your
product/service less
discretionary
Revenues
* Operating Margin
Reduce beta
= EBIT
Divest assets that
have negative EBIT
- Tax Rate * EBIT
Cost of Equity * (Equity/Capital) +
Pre-tax Cost of Debt (1- tax rate) *
(Debt/Capital)
= EBIT (1-t)
Reduce tax rate
- moving income to low er tax locales
- transf er pricing
- risk management
Reduce
Operating
leverage
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF
Live off past overinvestment
Better inventory
management and
tighter credit policies
Shif t interest
expenses to
Match your financing
higher tax locales
to your assets:
Reduce your def ault
risk and cost of debt
Change f inancing
mix to reduce
cost of capital
Firm Value
Increase Expected Growth
Reinvest more in
projects
Increase operating
margins
Aswath Damodaran
Increase l ength of growth peri od
Do acquisitions
Reinvestment Rate
* Return on Capital
Increase capital turnover ratio
Build on existing
competitive
advantages
Create new
competitive
advantages
= Expected Grow th Rate
82
First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
•
•


The hurdle rate should be higher for riskier projects and reflect the financing mix
used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative
side effects of these projects.
Choose a financing mix that minimizes 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: Maximize the Value of the Firm
Aswath Damodaran
83