CC8C8A1L llnAnCL

840.2302
LLC1u8L nC1L: ACkL1 1
AswaLh uamodaran
Aswotb uomoJotoo 0
1PL C8!LC1lvL ln CC8C8A1L
llnAnCL
lf you donL know where you are golng, lL does'nL
mauer how you geL Lhere
Aswotb uomoJotoo 1
2
llrsL rlnclples
Aswotb uomoJotoo
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The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should relfect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend whether
they prefer
dividends or
buybacks
Maximize the value of the business (rm)
3
1he Cb[ecuve ln ueclslon Maklng
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! ln Lradluonal corporaLe nance, Lhe ob[ecuve ln declslon maklng ls Lo
maxlmlze Lhe value of Lhe rm.
! A narrower ob[ecuve ls Lo maxlmlze sLockholder wealLh. When Lhe sLock
ls Lraded and markeLs are vlewed Lo be emclenL, Lhe ob[ecuve ls Lo
maxlmlze Lhe sLock prlce.
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Maximize
rm value
Maximize equity
value
Maximize market
estimate of equity
value
4
Maxlmlzlng SLock rlces ls Loo narrow an
ob[ecuve: A prellmlnary response
Aswotb uomoJotoo
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! Maxlmlzlng sLock prlce ls noL lncompauble wlLh
meeung employee needs/ob[ecuves. ln parucular:
! Lmployees are oen sLockholders ln many rms
! llrms LhaL maxlmlze sLock prlce generally are proLable
rms LhaL can aord Lo LreaL employees well.
! Maxlmlzlng sLock prlce does noL mean LhaL
cusLomers are noL crlucal Lo success. ln mosL
buslnesses, keeplng cusLomers happy ls Lhe rouLe Lo
sLock prlce maxlmlzauon.
! Maxlmlzlng sLock prlce does noL lmply LhaL a
company has Lo be a soclal ouLlaw.
5
Why Lradluonal corporaLe nanclal Lheory
focuses on maxlmlzlng sLockholder wealLh.
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! SLock prlce ls easlly observable and consLanLly updaLed
(unllke oLher measures of performance, whlch may noL
be as easlly observable, and cerLalnly noL updaLed as
frequenLly).
! lf lnvesLors are rauonal (are Lhey?), sLock prlces reecL
Lhe wlsdom of declslons, shorL Lerm and long Lerm,
lnsLanLaneously.
! 1he ob[ecuve of sLock prlce performance provldes some
very eleganL Lheory on:
! Allocaung resources across scarce uses (whlch lnvesLmenLs Lo
Lake and whlch ones Lo re[ecL)
! how Lo nance Lhese lnvesLmenLs
! how much Lo pay ln dlvldends
6
1he Classlcal Cb[ecuve luncuon
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STOCKHOLDERS
Maximize
stockholder
wealth

Hire & re
managers
- Board
- Annual Meeting
BONDHOLDERS/
LENDERS
Lend Money
Protect
bondholder
Interests
FINANCIAL MARKETS
SOCIETY Managers
Reveal
information
honestly and
on time
Markets are
efcient and
assess effect on
value
No Social Costs
All costs can be
traced to rm
7
WhaL can go wrong?
Aswotb uomoJotoo
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STOCKHOLDERS
Managers put
their interests
above stockholders

Have little control
over managers
BONDHOLDERS
Lend Money
Bondholders can
get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad
news or
provide
misleading
information
Markets make
mistakes and
can over react
Signicant Social Costs
Some costs cannot be
traced to rm
8
l. SLockholder lnLeresLs vs. ManagemenL
lnLeresLs
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! ln Lheory: 1he sLockholders have slgnlcanL conLrol over
managemenL. 1he Lwo mechanlsms for dlsclpllnlng
managemenL are Lhe annual meeung and Lhe board of
dlrecLors. Speclcally, we assume LhaL
! SLockholders who are dlssaused wlLh managers can noL only
express Lhelr dlsapproval aL Lhe annual meeung, buL can use
Lhelr voung power aL Lhe meeung Lo keep managers ln check.
! 1he board of dlrecLors plays lLs Lrue role of represenung
sLockholders and acung as a check on managemenL.
! ln racuce: nelLher mechanlsm ls as eecuve ln
dlsclpllnlng managemenL as Lheory poslLs.
9
1he Annual Meeung as a dlsclpllnary venue
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! 1he power of sLockholders Lo acL aL annual meeungs ls
dlluLed by Lhree facLors
! MosL small sLockholders do noL go Lo meeungs because Lhe cosL
of golng Lo Lhe meeung exceeds Lhe value of Lhelr holdlngs.
! lncumbenL managemenL sLarLs o wlLh a clear advanLage when
lL comes Lo Lhe exerclse of proxles. roxles LhaL are noL voLed
becomes voLes for lncumbenL managemenL.
! lor large sLockholders, Lhe paLh of leasL reslsLance, when
confronLed by managers LhaL Lhey do noL llke, ls Lo voLe wlLh
Lhelr feeL.
! Annual meeungs are also ughLly scrlpLed and conLrolled
evenLs, maklng lL dlmculL for ouLslders and rebels Lo
brlng up lssues LhaL are noL Lo Lhe managemenL's llklng.
10
And lnsuLuuonal lnvesLors go along wlLh
lncumbenL managers.
Aswotb uomoJotoo
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11
8oard of ulrecLors as a dlsclpllnary mechanlsm
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! ulrecLors are pald well: ln 2010, Lhe medlan board member aL a lorLune
300 company was pald $212,312, wlLh 34 comlng ln sLock and Lhe
remalnlng 46 ln cash. lf a board member was a non-execuuve chalr, he
or she recelved abouL $130,000 more ln compensauon.
! Spend more ume on lL Lhan Lhey used Lo: A board member worked, on
average, abouL 227.3 hours a year (and LhaL ls belng generous), or 4.4
hours a week, accordlng Lo Lhe nauonal AssoclaLe of CorporaLe ulrecLors.
Cf Lhls, abouL 24 hours a year are for board meeungs. 1hose numbers are
up from whaL Lhey were a decade ago.
! Lven Lhose hours are noL very producuve: Whlle Lhe ume spenL on belng
a dlrecLor has gone up, a slgnlcanL poruon of LhaL ume was spenL on
maklng sure LhaL Lhey are legally proLecLed (regulauons & lawsulLs).
! And Lhey have many loyalues: Many dlrecLors serve on Lhree or more
boards, and some are full ume chlef execuuves of oLher companles.
12
1he CLC oen hand-plcks dlrecLors..
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! CLCs plck dlrecLors: A 1992 survey by korn/lerry revealed LhaL 74 of
companles relled on recommendauons from Lhe CLC Lo come up wlLh
new dlrecLors and only 16 used an ouLslde search rm. Whlle LhaL
number has changed ln recenL years, CLCs sull deLermlne who slLs on
Lhelr boards. Whlle more companles have ouLslders lnvolved ln plcklng
dlrecLors now, CLCs exerclse slgnlcanL lnuence over Lhe process.
! ulrecLors don'L have blg equlLy sLakes: ulrecLors oen hold only Loken
sLakes ln Lhelr companles. MosL dlrecLors ln companles Loday sull recelve
more compensauon as dlrecLors Lhan Lhey galn from Lhelr sLockholdlngs.
Whlle share ownershlp ls up among dlrecLors Loday, Lhey usually geL
Lhese shares from Lhe rm (raLher Lhan buy Lhem).
! And some dlrecLors are CLCs of oLher rms: Many dlrecLors are
Lhemselves CLCs of oLher rms. Worse sull, Lhere are cases where CLCs
slL on each oLhers boards.
13
ulrecLors lack Lhe experuse (and Lhe wllllngness)
Lo ask Lhe necessary Lough quesuons..
Aswotb uomoJotoo
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! 8oberL's 8ules of Crder? ln mosL boards, Lhe CLC
conunues Lo be Lhe chalr. noL surprlslngly, Lhe CLC seLs
Lhe agenda, chalrs Lhe meeung and conLrols Lhe
lnformauon provlded Lo dlrecLors.
! 8e a Leam player? 1he search for consensus overwhelms
any auempLs aL confronLauon.
! 1he CLC as auLhorlLy gure: SLudles of soclal psychology
have noLed LhaL loyalLy ls hardwlred lnLo human
behavlor. Whlle Lhls loyalLy ls an lmporLanL Lool ln
bulldlng up organlzauons, lL can also lead people Lo
suppress lnLernal eLhlcal sLandards lf Lhey conlcL wlLh
loyalLy Lo an auLhorlLy gure. ln a board meeung, Lhe
CLC generally becomes Lhe auLhorlLy gure.
14
1he worsL board ever? 1he ulsney Lxperlence -
1997
Aswotb uomoJotoo
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15
1he Calpers 1esLs for lndependenL 8oards
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! Calpers, Lhe Callfornla Lmployees enslon fund,
suggesLed Lhree LesLs ln 1997 of an lndependenL
board:
! Are a ma[orlLy of Lhe dlrecLors ouLslde dlrecLors?
! ls Lhe chalrman of Lhe board lndependenL of Lhe company
(and noL Lhe CLC of Lhe company)?
! Are Lhe compensauon and audlL commluees composed
enurely of ouLslders?
! ulsney was Lhe only S& 300 company Lo fall all
Lhree LesLs.
16
8uslness Week plles on. 1he WorsL 8oards ln
1997..
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17
Appllcauon 1esL: Whos on board?
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! Look aL Lhe board of dlrecLors for your rm.
! Pow many of Lhe dlrecLors are lnslde dlrecLors (Lmployees of Lhe rm,
ex-managers)?
! ls Lhere any lnformauon on how lndependenL Lhe dlrecLors ln Lhe rm
are from Lhe managers?
! Are Lhere any exLernal measures of Lhe quallLy of corporaLe
governance of your rm?
! ?ahoo! llnance now reporLs on a corporaLe governance score for
rms, where lL ranks rms agalnsL Lhe resL of Lhe markeL and agalnsL
Lhelr secLors.
! ls Lhere Langlble evldence LhaL your board acLs lndependenLly
of managemenL?
! Check news sLorles Lo see lf Lhere are acuons LhaL Lhe CLC has wanLed
Lo Lake LhaL Lhe board has sLopped hlm or her from Laklng or aL leasL
slowed hlm or her down.
18
So, whaL nexL? When Lhe caL ls ldle, Lhe mlce
wlll play ....
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! When managers do noL fear sLockholders, Lhey wlll oen puL
Lhelr lnLeresLs over sLockholder lnLeresLs
! Creenmall: 1he (managers of ) LargeL of a hosule Lakeover buy ouL Lhe
poLenual acqulrer's exlsung sLake, aL a prlce much greaLer Lhan Lhe
prlce pald by Lhe ralder, ln reLurn for Lhe slgnlng of a 'sLandsull'
agreemenL.
! Colden arachuLes: rovlslons ln employmenL conLracLs, LhaL allows
for Lhe paymenL of a lump-sum or cash ows over a perlod, lf
managers covered by Lhese conLracLs lose Lhelr [obs ln a Lakeover.
! olson llls: A securlLy, Lhe rlghLs or cashows on whlch are Lrlggered
by an ouLslde evenL, generally a hosule Lakeover, ls called a polson plll.
! Shark 8epellenLs: Anu-Lakeover amendmenLs are also almed aL
dlssuadlng hosule Lakeovers, buL dler on one very lmporLanL counL.
1hey requlre Lhe assenL of sLockholders Lo be lnsuLuLed.
! Cverpaylng on Lakeovers: Acqulsluons oen are drlven by
managemenL lnLeresLs raLher Lhan sLockholder lnLeresLs.
N
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A
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19
Cverpaylng on Lakeovers
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! 1he qulckesL and perhaps Lhe mosL declslve way Lo
lmpoverlsh sLockholders ls Lo overpay on a Lakeover.
! 1he sLockholders ln acqulrlng rms do noL seem Lo share
Lhe enLhuslasm of Lhe managers ln Lhese rms. SLock
prlces of blddlng rms decllne on Lhe Lakeover
announcemenLs a slgnlcanL proporuon of Lhe ume.
! Many mergers do noL work, as evldenced by a number
of measures.
! 1he proLablllLy of merged rms relauve Lo Lhelr peer groups,
does noL lncrease slgnlcanLly aer mergers.
! An even more damnlng lndlcLmenL ls LhaL a large number of
mergers are reversed wlLhln a few years, whlch ls a clear
admlsslon LhaL Lhe acqulsluons dld noL work.
A case sLudy ln value desLrucuon:
LasLman kodak & SLerllng urugs
kodak enters b|dd|ng war
! ln laLe 1987, LasLman kodak
enLered lnLo a blddlng war wlLh
Poman La 8oche for SLerllng
urugs, a pharmaceuucal
company.
! 1he blddlng war sLarLed wlLh
SLerllng urugs Lradlng aL abouL
$40/share.
! AL $72/share, Poman dropped
ouL of Lhe blddlng war, buL kodak
kepL blddlng.
! AL $89.30/share, kodak won and
clalmed poLenual synergles
explalned Lhe premlum.
kodak w|ns!!!!

21
Larnlngs and 8evenues aL SLerllng urugs
Aswotb uomoJotoo
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Sterling Drug under Eastman Kodak: Where is the synergy?
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
1988 1989 1990 1991 1992
Revenue Operating Earnings
22
kodak Says urug unlL ls noL for Sale . buL.
Aswotb uomoJotoo
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! An arucle ln Lhe n? 1lmes ln AugusL of 1993 suggesLed LhaL kodak was eager Lo
shed lLs drug unlL.
! ln response, LasLman kodak omclals say Lhey have no plans Lo sell kodaks SLerllng WlnLhrop
drug unlL.
! Louls Mams, Chalrman of SLerllng WlnLhrop, dlsmlssed Lhe rumors as masslve speculauon,
whlch les ln Lhe face of Lhe sLaLed lnLenL of kodak LhaL lL ls commlued Lo be ln Lhe healLh
buslness.
! A few monLhs laLer.1aklng a sLrlde ouL of Lhe drug buslness, LasLman kodak sald
LhaL Lhe Sano Croup, a lrench pharmaceuucal company, agreed Lo buy Lhe
prescrlpuon drug buslness of SLerllng WlnLhrop for $1.68 bllllon.
! Shares of LasLman kodak rose 73 cenLs yesLerday, closlng aL $47.30 on Lhe new ?ork SLock
Lxchange.
! Samuel u. lsaly an analysL , sald Lhe announcemenL was very good for Sano and very good
for kodak.
! When Lhe dlvesuLures are compleLe, kodak wlll be enurely focused on lmaglng, sald Ceorge
M. C. llsher, Lhe company's chlef execuuve.
! 1he resL of Lhe SLerllng WlnLhrop was sold Lo SmlLhkllne for $2.9 bllllon.
23
1he connecuon Lo corporaLe governance: P
buys AuLonomy. and explalns Lhe premlum
Aswotb uomoJotoo
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24
A year laLer. P admlLs a mlsLake.and explalns
lL.
Aswotb uomoJotoo
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25
Appllcauon 1esL: Who owns/runs your rm?
Aswotb uomoJotoo
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! Look aL: 8loomberg prlnLouL PuS for your rm
! Who are Lhe Lop sLockholders ln your rm?
! WhaL are Lhe poLenual conlcLs of lnLeresLs LhaL you see
emerglng from Lhls sLockholdlng sLrucLure?
Control of the firm
Outside stockholders
- Size of holding
- Active or Passive?
- Short or Long term?
Inside stockholders
% of stock held
Voting and non-voting shares
Control structure
Managers
- Length of tenure
- Links to insiders
Government
Employees Lenders
26
Case 1: SpllnLerlng of SLockholders
ulsneys Lop sLockholders ln 2003
Aswath Damodaran
27
Case 2: voung versus non-voung Shares &
Colden Shares: vale
Vale Equity
Common (voting) shares
3,172 million
Preferred (non-voting)
1,933 million
Golden (veto)
shares owned
by Brazilian govt
valespar
34
non-8razlllan
(Au8&8ovespa)
29
8razlllan lnsuLuuonal
6
8razlllan reLall
3
8razlllan
CovL.
6
valespar
1
non-8razlllan
(Au8&8ovespa)
39
8razlllan lnsuLuuonal
18
8razlllan reLall
18
8razlllan CovL.
4
!"#$% '()#"*"+(,- ./0112
3%$#)-4 5060 10172
8)(9$:+() 5060 ;<0;<2
="#:>" ? @-0 <A0;.2
8BC35'6D <<0E<2
!"#$%&"' )*+$'%,-&
Vale has eleven members on its board of directors, ten of
whom were nominated by Valepar and the board was
chaired by Don Conrado, the CEO of Valepar.
Aswath Damodaran
28
Case 3: Cross and yramld Poldlngs
1aLa MoLors Lop sLockholders ln 2013
Aswath Damodaran
29
Case 4: Legal rlghLs and CorporaLe
SLrucLures: 8aldu
! 1he 8oard: 1he company has slx dlrecLors, one of whom ls 8obln Ll,
who ls Lhe founder/CLC of 8aldu. Mr. Ll also owns a ma[orlLy sLake
of Class 8 shares, whlch have Len umes Lhe voung rlghLs of Class A
shares, granung hlm eecuve conLrol of Lhe company.
! 1he sLrucLure: 8aldu ls a Chlnese company, buL lL ls lncorporaLed ln
Lhe Cayman lslands, lLs prlmary sLock llsung ls on Lhe nASuAC and
Lhe llsLed company ls sLrucLured as a shell company, Lo geL around
Chlnese governmenL resLrlcuons of forelgn lnvesLors holdlng
shares ln Chlnese corporauons.
! 1he legal sysLem: 8aldu's operaung counLerparL ln Chlna ls
sLrucLured as a varlable lnLeresL LnuLy (vlL), and lL ls unclear how
much legal power Lhe shareholders ln Lhe shell company have Lo
enforce changes aL Lhe vlL.
Aswath Damodaran
30
1hlngs change.. ulsneys Lop sLockholders ln
2009
Aswotb uomoJotoo
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31
ll. SLockholders' ob[ecuves vs. 8ondholders'
ob[ecuves
Aswotb uomoJotoo
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! ln Lheory: Lhere ls no conlcL of lnLeresLs beLween
sLockholders and bondholders.
! ln pracuce: SLockholder and bondholders have
dlerenL ob[ecuves. 8ondholders are concerned
mosL abouL safeLy and ensurlng LhaL Lhey geL pald
Lhelr clalms. SLockholders are more llkely Lo Lhlnk
abouL upslde poLenual
32
Lxamples of Lhe conlcL..
Aswotb uomoJotoo
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! A dlvldend/buyback surge: When rms pay cash ouL as
dlvldends, lenders Lo Lhe rm are hurL and sLockholders
may be helped. 1hls ls because Lhe rm becomes rlskler
wlLhouL Lhe cash.
! 8lsk shllng: When a rm Lakes rlskler pro[ecLs Lhan
Lhose agreed Lo aL Lhe ouLseL, lenders are hurL. Lenders
base lnLeresL raLes on Lhelr percepuons of how rlsky a
rms lnvesLmenLs are. lf sLockholders Lhen Lake on
rlskler lnvesLmenLs, lenders wlll be hurL.
! 8orrowlng more on Lhe same asseLs: lf lenders do noL
proLecL Lhemselves, a rm can borrow more money and
make all exlsung lenders worse o.
33
An LxLreme Lxample: unproLecLed Lenders?
Aswotb uomoJotoo
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34
lll. llrms and llnanclal MarkeLs
Aswotb uomoJotoo
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! ln Lheory: llnanclal markeLs are emclenL. Managers
convey lnformauon honesLly and and ln a umely manner
Lo nanclal markeLs, and nanclal markeLs make
reasoned [udgmenLs of Lhe eecLs of Lhls lnformauon on
'Lrue value'. As a consequence-
! A company LhaL lnvesLs ln good long Lerm pro[ecLs wlll be
rewarded.
! ShorL Lerm accounung glmmlcks wlll noL lead Lo lncreases ln
markeL value.
! SLock prlce performance ls a good measure of company
performance.
! ln pracuce: 1here are some holes ln Lhe 'LmclenL
MarkeLs' assumpuon.
35
Managers conLrol Lhe release of lnformauon Lo
Lhe general publlc
Aswotb uomoJotoo
35
! lnformauon managemenL (umlng and spln):
lnformauon (especlally negauve) ls someumes
suppressed or delayed by managers seeklng a beuer
ume Lo release lL. When Lhe lnformauon ls released,
rms nd ways Lo spln" or frame" lL Lo puL
Lhemselves ln Lhe besL posslble llghL.
! CuLrlghL fraud: ln some cases, rms release
lnLenuonally mlsleadlng lnformauon abouL Lhelr
currenL condluons and fuLure prospecLs Lo nanclal
markeLs.
36
Lvldence LhaL managers delay bad news?
Aswotb uomoJotoo
36
DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by
Weekday
-6. 00%
-4. 00%
-2. 00%
0.00%
2.00%
4.00%
6.00%
8.00%
Monday Tuesday Wednesday Thur sday F r i da y
% Chg(EPS) % Chg(DPS)
37
Some crluques of markeL emclency..
Aswotb uomoJotoo
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! lnvesLor lrrauonallLy: 1he base argumenL ls LhaL
lnvesLors are lrrauonal and prlces oen move for noL
reason aL all. As a consequence, prlces are much more
volaule Lhan [usued by Lhe underlylng fundamenLals.
Larnlngs and dlvldends are much less volaule Lhan sLock
prlces.
! ManlfesLauons of lrrauonallLy
! 8eacuon Lo news: Some belleve LhaL lnvesLors overreacL Lo
news, boLh good and bad. CLhers belleve LhaL lnvesLors
someumes under reacL Lo blg news sLorles.
! An lnslder consplracy: llnanclal markeLs are manlpulaLed by
lnslders, rlces do noL have any relauonshlp Lo value.
! ShorL Lermlsm: lnvesLors are shorL-slghLed, and do noL conslder
Lhe long-Lerm lmpllcauons of acuons Laken by Lhe rm
38
Are markeLs shorL slghLed and Loo focused
on Lhe near Lerm? WhaL do you Lhlnk?
Aswotb uomoJotoo
38
! locuslng on markeL prlces wlll lead companles Lowards shorL
Lerm declslons aL Lhe expense of long Lerm value.
a. l agree wlLh Lhe sLaLemenL
b. l do noL agree wlLh Lhls sLaLemenL
! Allowlng managers Lo make declslons wlLhouL havlng Lo
worry abouL Lhe eecL on markeL prlces wlll lead Lo beuer
long Lerm declslons.
a. l agree wlLh Lhls sLaLemenL
b. l do noL agree wlLh Lhls sLaLemenL
! nelLher managers nor markeLs are LrusLworLhy. 8egulauons/
laws should be wrluen LhaL force rms Lo make long Lerm
declslons.
a. l agree wlLh Lhls sLaLemenL
b. l do noL agree wlLh Lhls sLaLemenL
39
Are markeLs shorL Lerm? Some evldence LhaL
Lhey are noL..
Aswotb uomoJotoo
39
! value of young rms: 1here are hundreds of sLarL-up and
small rms, wlLh no earnlngs expecLed ln Lhe near fuLure,
LhaL ralse money on nanclal markeLs. Why would a myoplc
markeL LhaL cares only abouL shorL Lerm earnlngs auach hlgh
prlces Lo Lhese rms?
! CurrenL earnlngs vs luLure growLh: lf Lhe evldence suggesLs
anyLhlng, lL ls LhaL markeLs do noL value currenL earnlngs and
cashows enough and value fuLure earnlngs and cashows
Loo much. Aer all, sLudles suggesL LhaL low L sLocks are
under prlced relauve Lo hlgh L sLocks
! MarkeL reacuon Lo lnvesLmenLs: 1he markeL response Lo
research and developmenL and lnvesLmenL expendlLures ls
generally posluve.
40
lf markeLs are so shorL Lerm, why do Lhey reacL Lo blg
lnvesLmenLs (LhaL poLenually lower shorL Lerm earnlngs) so
posluvely?
Aswotb uomoJotoo
40
41
8uL whaL abouL markeL crlses?
Aswotb uomoJotoo
41
! MarkeLs are Lhe problem: Many crlucs of markeLs polnL Lo markeL
bubbles and crlses as evldence LhaL markeLs do noL work. lor
lnsLance, Lhe markeL Lurmoll beLween SepLember and uecember
2008 ls polnLed Lo as backlng for Lhe sLaLemenL LhaL free markeLs
are Lhe source of Lhe problem and noL Lhe soluuon.
! 1he counLer: 1here are Lwo counLer argumenLs LhaL can be
oered:
! 1he evenLs of Lhe lasL quarLer of 2008 lllusLraLe LhaL we are more
dependenL on funcuonlng, llquld markeLs, wlLh rlsk Laklng lnvesLors, Lhan
ever before ln hlsLory. As we saw, no governmenL or oLher enuLy (bank,
8ueu) ls blg enough Lo sLep ln and save Lhe day.
! 1he rms LhaL caused Lhe markeL collapse (banks, lnvesLmenL banks) were
among Lhe mosL regulaLed buslnesses ln Lhe markeL place. lf anyLhlng,
Lhelr fallures can be Lraced Lo Lhelr auempLs Lo Lake advanLage of
regulaLory loopholes (badly deslgned lnsurance programs. caplLal
measuremenLs LhaL mlss rlsky asseLs, especlally derlvauves)
42
lv. llrms and SocleLy
Aswotb uomoJotoo
42
! ln Lheory: All cosLs and beneLs assoclaLed wlLh a
rms declslons can be Lraced back Lo Lhe rm.
! ln pracuce: llnanclal declslons can creaLe soclal cosLs
and beneLs.
! A soclal cosL or beneL ls a cosL or beneL LhaL accrues Lo
socleLy as a whole and noL Lo Lhe rm maklng Lhe declslon.
" LnvlronmenLal cosLs (polluuon, healLh cosLs, eLc..)
" CuallLy of Llfe' cosLs (Lramc, houslng, safeLy, eLc.)
! Lxamples of soclal beneLs lnclude:
" creaung employmenL ln areas wlLh hlgh unemploymenL
" supporung developmenL ln lnner clues
" creaung access Lo goods ln areas where such access does noL
exlsL
43
Soclal CosLs and 8eneLs are dlmculL Lo quanufy
because ..
Aswotb uomoJotoo
43
! CannoL know Lhe unknown: 1hey mlghL noL be known aL
Lhe ume of Lhe declslon. ln oLher words, a rm may
Lhlnk LhaL lL ls dellverlng a producL LhaL enhances
socleLy, aL Lhe ume lL dellvers Lhe producL buL dlscover
aerwards LhaL Lhere are very large cosLs. (AsbesLos was
a wonderful producL, when lL was devlsed, llghL and easy
Lo work wlLh. lL ls only aer decades LhaL Lhe healLh
consequences came Lo llghL)
! Lyes of Lhe beholder: 1hey are 'person-speclc', slnce
dlerenL declslon makers can look aL Lhe same soclal
cosL and welghL Lhem very dlerenLly.
! ueclslon paralysls: 1hey can be paralyzlng lf carrled Lo
exLremes.
44
A LesL of your soclal consclousness:
uL your money where you mouLh ls.
Aswotb uomoJotoo
44
! Assume LhaL you work for ulsney and LhaL you have an opporLunlLy
Lo open a sLore ln an lnner-clLy nelghborhood. 1he sLore ls
expecLed Lo lose abouL a mllllon dollars a year, buL lL wlll creaLe
much-needed employmenL ln Lhe area, and may help revlLallze lL.
! Would you open Lhe sLore?
! ?es
! no
! lf yes, would you Lell your sLockholders and leL Lhem voLe on Lhe
lssue?
! ?es
! no
! lf no, how would you respond Lo a sLockholder query on why you
were noL llvlng up Lo your soclal responslblllues?
45
So Lhls ls whaL can go wrong...
Aswotb uomoJotoo
45
STOCKHOLDERS
Managers put
their interests
above stockholders

Have little control
over managers
BONDHOLDERS
Lend Money
Bondholders can
get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad
news or
provide
misleading
information
Markets make
mistakes and
can over react
Signicant Social Costs
Some costs cannot be
traced to rm
46
1radluonal corporaLe nanclal Lheory breaks
down when ...
Aswotb uomoJotoo
46
! Managerlal self-lnLeresL: 1he lnLeresLs/ob[ecuves of Lhe
declslon makers ln Lhe rm conlcL wlLh Lhe lnLeresLs of
sLockholders.
! unproLecLed debL holders: 8ondholders (Lenders) are
noL proLecLed agalnsL exproprlauon by sLockholders.
! lnemclenL markeLs: llnanclal markeLs do noL operaLe
emclenLly, and sLock prlces do noL reecL Lhe underlylng
value of Lhe rm.
! Large soclal slde cosLs: SlgnlcanL soclal cosLs can be
creaLed as a by-producL of sLock prlce maxlmlzauon.
47
When Lradluonal corporaLe nanclal Lheory
breaks down, Lhe soluuon ls:
Aswotb uomoJotoo
47
! A non-sLockholder based governance sysLem: 1o choose a
dlerenL mechanlsm for corporaLe governance, l.e, asslgn Lhe
responslblllLy for monlLorlng managers Lo someone oLher
Lhan sLockholders.
! A beuer ob[ecuve Lhan maxlmlzlng sLock prlces? 1o choose a
dlerenL ob[ecuve for Lhe rm.
! Maxlmlze sLock prlces buL mlnlmlze slde cosLs: 1o maxlmlze
sLock prlce, buL reduce Lhe poLenual for conlcL and
breakdown:
! Maklng managers (declslon makers) and employees lnLo sLockholders
! roLecL lenders from exproprlauon
! 8y provldlng lnformauon honesLly and prompLly Lo nanclal markeLs
! Mlnlmlze soclal cosLs
48
l. An AlLernauve CorporaLe Covernance SysLem
Aswotb uomoJotoo
48
! Cermany and !apan developed a dlerenL mechanlsm for
corporaLe governance, based upon corporaLe cross holdlngs.
! ln Cermany, Lhe banks form Lhe core of Lhls sysLem.
! ln !apan, lL ls Lhe kelreLsus
! CLher Aslan counLrles have modeled Lhelr sysLem aer !apan, wlLh famlly
companles formlng Lhe core of Lhe new corporaLe famllles
! AL Lhelr besL, Lhe mosL emclenL rms ln Lhe group work aL brlnglng
Lhe less emclenL rms up Lo par. 1hey provlde a corporaLe welfare
sysLem LhaL makes for a more sLable corporaLe sLrucLure
! AL Lhelr worsL, Lhe leasL emclenL and poorly run rms ln Lhe group
pull down Lhe mosL emclenL and besL run rms down. 1he naLure
of Lhe cross holdlngs makes lLs very dlmculL for ouLslders (lncludlng
lnvesLors ln Lhese rms) Lo gure ouL how well or badly Lhe group
ls dolng.
49
ll. Choose a ulerenL Cb[ecuve luncuon
Aswotb uomoJotoo
49
! llrms can always focus on a dlerenL ob[ecuve funcuon.
Lxamples would lnclude
! maxlmlzlng earnlngs
! maxlmlzlng revenues
! maxlmlzlng rm slze
! maxlmlzlng markeL share
! maxlmlzlng LvA
! 1he key Lhlng Lo remember ls LhaL Lhese are
lnLermedlaLe ob[ecuve funcuons.
! 1o Lhe degree LhaL Lhey are correlaLed wlLh Lhe long Lerm healLh
and value of Lhe company, Lhey work well.
! 1o Lhe degree LhaL Lhey do noL, Lhe rm can end up wlLh a
dlsasLer
50
lll. Maxlmlze SLock rlce, sub[ecL Lo ..
Aswotb uomoJotoo
50
! 1he sLrengLh of Lhe sLock prlce maxlmlzauon ob[ecuve
funcuon ls lLs lnLernal self correcuon mechanlsm. Lxcesses on
any of Lhe llnkages lead, lf unregulaLed, Lo counLer acuons
whlch reduce or ellmlnaLe Lhese excesses
! ln Lhe conLexL of our dlscusslon,
! managers Laklng advanLage of sLockholders has led Lo a much more
acuve markeL for corporaLe conLrol.
! sLockholders Laklng advanLage of bondholders has led Lo bondholders
proLecung Lhemselves aL Lhe ume of Lhe lssue.
! rms reveallng lncorrecL or delayed lnformauon Lo markeLs has led Lo
markeLs becomlng more skepucal and punluve
! rms creaung soclal cosLs has led Lo more regulauons, as well as
lnvesLor and cusLomer backlashes.
51
1he SLockholder 8acklash
Aswotb uomoJotoo
51
! AcuvlsL lnsuLuuonal lnvesLors have become much more
acuve ln monlLorlng companles LhaL Lhey lnvesL ln and
demandlng changes ln Lhe way ln whlch buslness ls done.
1hey have been [olned by prlvaLe equlLy funds llke kk8 and
8lacksLone.
! AcuvlsL lndlvlduals llke Carl lcahn speclallze ln Laklng large
posluons ln companles whlch Lhey feel need Lo change Lhelr
ways (8lockbusLer, 1lme Warner, MoLorola & Apple) and
push for change.
! vocal sLockholders, armed wlLh more lnformauon and new
powers: AL annual meeungs, sLockholders have Laken Lo
expresslng Lhelr dlspleasure wlLh lncumbenL managemenL by
voung agalnsL Lhelr compensauon conLracLs or Lhelr board of
dlrecLors
52
1he Posule Acqulsluon 1hreaL
Aswotb uomoJotoo
52
! 1he Lyplcal LargeL rm ln a hosule Lakeover has
! a reLurn on equlLy almosL 3 lower Lhan lLs peer group
! had a sLock LhaL has slgnlcanLly under performed Lhe
peer group over Lhe prevlous 2 years
! has managers who hold llule or no sLock ln Lhe rm
! ln oLher words, Lhe besL defense agalnsL a hosule
Lakeover ls Lo run your rm well and earn good
reLurns for your sLockholders
! Conversely, when you do noL allow hosule
Lakeovers, Lhls ls Lhe rm LhaL you are mosL llkely
proLecung (and noL a well run or well managed rm)
53
ln response, boards are becomlng more
lndependenL.
Aswotb uomoJotoo
53
! 8oards have become smaller over ume. 1he medlan slze of a board
of dlrecLors has decreased from 16 Lo 20 ln Lhe 1970s Lo beLween 9
and 11 ln 1998. 1he smaller boards are less unwleldy and more
eecuve Lhan Lhe larger boards.
! 1here are fewer lnslders on Lhe board. ln conLrasL Lo Lhe 6 or more
lnslders LhaL many boards had ln Lhe 1970s, only Lwo dlrecLors ln
mosL boards ln 1998 were lnslders.
! ulrecLors are lncreaslngly compensaLed wlLh sLock and opuons ln
Lhe company, lnsLead of cash. ln 1973, only 4 of dlrecLors
recelved compensauon ln Lhe form of sLock or opuons, whereas
78 dld so ln 1998.
! More dlrecLors are ldenued and selecLed by a nomlnaung
commluee raLher Lhan belng chosen by Lhe CLC of Lhe rm. ln
1998, 73 of boards had nomlnaung commluees, Lhe comparable
sLausuc ln 1973 was 2.
54
ulsney: Llsner's rlse & fall from grace
! ln hls early years aL ulsney, Mlchael Llsner broughL abouL long-delayed changes ln
Lhe company and puL lL on Lhe paLh Lo belng an enLerLalnmenL glanL LhaL lL ls
Loday. Pls success allowed hlm Lo consolldaLe power and Lhe boards LhaL he
creaLed were lncreaslngly capuve ones (see Lhe 1997 board).
! ln 1996, Llsner spearheaded Lhe push Lo buy A8C and Lhe board rubbersLamped
hls declslon, as Lhey had wlLh oLher ma[or declslons. ln Lhe years followlng, Lhe
company ran lnLo problems boLh on lLs A8C acqulsluon and on lLs oLher
operauons and sLockholders sLarLed Lo geL resuve, especlally as Lhe sLock prlce
halved beLween 1998 and 2002.
! ln 2003, 8oy ulsney and SLanley Cold reslgned from Lhe ulsney board, argulng
agalnsL Llsner's auLocrauc sLyle.
! ln early 2004, ComcasL made a hosule bld for ulsney and laLer ln Lhe year, 43 of
ulsney shareholders wlLhheld Lhelr voLes for Llsner's reelecuon Lo Lhe board of
dlrecLors. lollowlng LhaL voLe, Lhe board of dlrecLors aL ulsney voLed unanlmously
Lo elecL Ceorge MlLchell as Lhe Chalr of Lhe board, replaclng Llsner, who vowed Lo
sLay on as CLC.
Aswath Damodaran
55
Llsners concesslon: ulsneys 8oard ln 2003
Aswotb uomoJotoo
55
Board Members Occupation
Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo ODonovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.
56
Changes ln corporaLe governance aL ulsney
Aswotb uomoJotoo
56
1. 8equlred aL leasL Lwo execuuve sesslons of Lhe board, wlLhouL Lhe CLC
or oLher members of managemenL presenL, each year.
2. CreaLed Lhe posluon of non-managemenL presldlng dlrecLor, and
appolnLed SenaLor Ceorge MlLchell Lo lead Lhose execuuve sesslons and
asslsL ln semng Lhe work agenda of Lhe board.
3. AdopLed a new and more rlgorous denluon of dlrecLor lndependence.
4. 8equlred LhaL a subsLanual ma[orlLy of Lhe board be comprlsed of
dlrecLors meeung Lhe new lndependence sLandards.
3. rovlded for a reducuon ln commluee slze and Lhe roLauon of
commluee and chalrmanshlp asslgnmenLs among lndependenL
dlrecLors.
6. Added new provlslons for managemenL successlon plannlng and
evaluauons of boLh managemenL and board performance
7. rovlded for enhanced conunulng educauon and Lralnlng for board
members.
57
Llsners exlL. and a new age dawns? ulsneys
board ln 2008
Aswotb uomoJotoo
57
58
8uL as a CLC's Lenure lengLhens, does
corporaLe governance suer?
1. Whlle Lhe board slze has sLayed compacL (aL Lwelve members),
Lhere has been only one change slnce 2008, wlLh Sheryl
Sandberg, CCC of lacebook, replaclng Lhe deceased SLeve !obs.
2. 1he board voLed relnsLaLe lger as chalr of Lhe board ln 2011,
reverslng a declslon made Lo separaLe Lhe CLC and Chalr
posluons aer Lhe Llsner years.
3. ln 2011, lger announced hls lnLenL Lo sLep down as CLC ln 2013
buL ulsney's board convlnced lger Lo sLay on as CLC for an exLra
year, for Lhe Lhe good of Lhe company".
4. 1here were slgns of resuveness among ulsney's sLockholders,
especlally Lhose lnLeresLed ln corporaLe governance. AcuvlsL
lnvesLors (CalS18S) sLarung maklng nolse and lnsuLuuonal
Shareholder Servlces (lSS), whlch gauges corporaLe governance aL
companles, ralsed red ags abouL compensauon and board
monlLorlng aL ulsney.
Aswath Damodaran
59
WhaL abouL leglslauon?
Aswotb uomoJotoo
59
! Lvery corporaLe scandal creaLes lmpeLus for a
leglslauve response. 1he scandals aL Lnron and
WorldCom lald Lhe groundwork for Sarbanes-Cxley.
! ?ou cannoL leglslaLe good corporaLe governance.
! 1he cosLs of meeung legal requlremenLs oen exceed Lhe
beneLs
! Laws always have unlnLended consequences
! ln general, laws Lend Lo be blunderbusses LhaL penallze
good companles more Lhan Lhey punlsh Lhe bad
companles.
60
ls Lhere a payo Lo beuer corporaLe
governance?
Aswotb uomoJotoo
60
! ln Lhe mosL comprehenslve sLudy of Lhe eecL of corporaLe governance
on value, a governance lndex was creaLed for each of 1300 rms based
upon 24 dlsuncL corporaLe governance provlslons.
! 8uylng sLocks LhaL had Lhe sLrongesL lnvesLor proLecuons whlle slmulLaneously
selllng shares wlLh Lhe weakesL proLecuons generaLed an annual excess reLurn of
8.3.
! Lvery one polnL lncrease ln Lhe lndex Lowards fewer lnvesLor proLecuons decreased
markeL value by 8.9 ln 1999
! llrms LhaL scored hlgh ln lnvesLor proLecuons also had hlgher proLs, hlgher sales
growLh and made fewer acqulsluons.
! 1he llnk beLween Lhe composluon of Lhe board of dlrecLors and rm value
ls weak. Smaller boards do Lend Lo be more eecuve.
! Cn a purely anecdoLal basls, a common Lheme aL problem companles and
ls an lneecuve board LhaL falls Lo ask Lough quesuons of an lmperlal
CLC.
61
1he 8ondholders uefense AgalnsL SLockholder
Lxcesses
Aswotb uomoJotoo
61
! More resLrlcuve covenanLs on lnvesLmenL, nanclng and dlvldend
pollcy have been lncorporaLed lnLo boLh prlvaLe lendlng
agreemenLs and lnLo bond lssues, Lo prevenL fuLure nablscos.
! new Lypes of bonds have been creaLed Lo expllclLly proLecL
bondholders agalnsL sudden lncreases ln leverage or oLher acuons
LhaL lncrease lender rlsk subsLanually. 1wo examples of such bonds
! uuable 8onds, where Lhe bondholder can puL Lhe bond back Lo Lhe rm
and geL face value, lf Lhe rm Lakes acuons LhaL hurL bondholders
! 8aungs Sensluve noLes, where Lhe lnLeresL raLe on Lhe noLes ad[usLs Lo
LhaL approprlaLe for Lhe raung of Lhe rm
! More hybrld bonds (wlLh an equlLy componenL, usually ln Lhe form
of a converslon opuon or warranL) have been used. 1hls allows
bondholders Lo become equlLy lnvesLors, lf Lhey feel lL ls ln Lhelr
besL lnLeresLs Lo do so.
62
1he llnanclal MarkeL 8esponse
Aswotb uomoJotoo
62
! Whlle analysLs are more llkely sull Lo lssue buy raLher
Lhan sell recommendauons, Lhe payo Lo uncoverlng
negauve news abouL a rm ls large enough LhaL such
news ls eagerly soughL and qulckly revealed (aL leasL Lo a
llmlLed group of lnvesLors).
! As lnvesLor access Lo lnformauon lmproves, lL ls
becomlng much more dlmculL for rms Lo conLrol when
and how lnformauon geLs ouL Lo markeLs.
! As opuon Lradlng has become more common, lL has
become much easler Lo Lrade on bad news. ln Lhe
process, lL ls revealed Lo Lhe resL of Lhe markeL.
! When rms mlslead markeLs, Lhe punlshmenL ls noL only
qulck buL lL ls savage.
63
1he SocleLal 8esponse
Aswotb uomoJotoo
63
! lf rms conslsLenLly ouL socleLal norms and creaLe
large soclal cosLs, Lhe governmenLal response
(especlally ln a democracy) ls for laws and
regulauons Lo be passed agalnsL such behavlor.
! lor rms caLerlng Lo a more soclally consclous
cllenLele, Lhe fallure Lo meeL socleLal norms (even lf
lL ls legal) can lead Lo loss of buslness and value.
! llnally, lnvesLors may choose noL Lo lnvesL ln sLocks
of rms LhaL Lhey vlew as soclally lrresponslble.
64
1he CounLer 8eacuon
Aswotb uomoJotoo
64
STOCKHOLDERS
Managers of poorly
run rms are put
on notice.

1. More activist
investors
2. Hostile takeovers
BONDHOLDERS
Protect themselves
1. Covenants
2. New Types
FINANCIAL MARKETS
SOCIETY Managers
Firms are
punished
for misleading
markets
Investors and
analysts become
more skeptical
Corporate Good Citizen Constraints
1. More laws
2. Investor/Customer Backlash
65
So whaL do you Lhlnk?
Aswotb uomoJotoo
65
! AL Lhls polnL ln ume, Lhe followlng sLaLemenL besL descrlbes
where l sLand ln Lerms of Lhe rlghL ob[ecuve funcuon for
declslon maklng ln a buslness
a. Maxlmlze sLock prlce, wlLh no consLralnLs
b. Maxlmlze sLock prlce, wlLh consLralnLs on belng a good soclal cluzen.
c. Maxlmlze sLockholder wealLh, wlLh good cluzen consLralnLs, and
hope/pray LhaL Lhe markeL caLches up wlLh you.
d. Maxlmlze proLs or proLablllLy
e. Maxlmlze earnlngs growLh
f. Maxlmlze markeL share
g. Maxlmlze revenues
h. Maxlmlze soclal good
l. none of Lhe above
66
1he Modled Cb[ecuve luncuon
Aswotb uomoJotoo
66
! lor publlcly Lraded rms ln reasonably emclenL markeLs,
where bondholders (lenders) are proLecLed:
! Maxlmlze SLock rlce: 1hls wlll also maxlmlze rm value
! lor publlcly Lraded rms ln lnemclenL markeLs, where
bondholders are proLecLed:
! Maxlmlze sLockholder wealLh: 1hls wlll also maxlmlze rm value,
buL mlghL noL maxlmlze Lhe sLock prlce
! lor publlcly Lraded rms ln lnemclenL markeLs, where
bondholders are noL fully proLecLed
! Maxlmlze rm value, Lhough sLockholder wealLh and sLock
prlces may noL be maxlmlzed aL Lhe same polnL.
! lor prlvaLe rms, maxlmlze sLockholder wealLh (lf
lenders are proLecLed) or rm value (lf Lhey are noL)
1PL lnvLS1MLn1 8lnClLL: 8lSk
Anu 8L1u8n MCuLLS


?ou cannoL swlng upon a rope LhaL ls auached only
Lo your own belL.
Aswotb uomoJotoo 67
68
llrsL rlnclples
Aswotb uomoJotoo
68
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should relfect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend whether
they prefer
dividends or
buybacks
Maximize the value of the business (rm)
69
1he nouon of a benchmark
Aswotb uomoJotoo
69
! Slnce nanclal resources are nlLe, Lhere ls a hurdle LhaL
pro[ecLs have Lo cross before belng deemed accepLable.
1hls hurdle should be hlgher for rlskler pro[ecLs Lhan for
safer pro[ecLs.
! A slmple represenLauon of Lhe hurdle raLe ls as follows:
Purdle raLe = 8lskless 8aLe + 8lsk remlum
! 1he Lwo baslc quesuons LhaL every rlsk and reLurn model
ln nance Lrles Lo answer are:
! Pow do you measure rlsk?
! Pow do you LranslaLe Lhls rlsk measure lnLo a rlsk premlum?
70
WhaL ls 8lsk?
Aswotb uomoJotoo
70
! 8lsk, ln Lradluonal Lerms, ls vlewed as a negauve.
WebsLers dlcuonary, for lnsLance, denes rlsk as exposlng
Lo danger or hazard. 1he Chlnese symbols for rlsk,
reproduced below, glve a much beuer descrlpuon of rlsk

! 1he rsL symbol ls Lhe symbol for danger, whlle Lhe second
ls Lhe symbol for opporLunlLy, maklng rlsk a mlx of danger
and opporLunlLy. ?ou cannoL have one, wlLhouL Lhe oLher.
! 8lsk ls Lherefore nelLher good nor bad. lL ls [usL a facL of llfe.
1he quesuon LhaL buslnesses have Lo address ls Lherefore noL
wheLher Lo avold rlsk buL how besL Lo lncorporaLe lL lnLo Lhelr
declslon maklng.
71
A good rlsk and reLurn model should.
Aswotb uomoJotoo
71
1. lL should come up wlLh a measure of rlsk LhaL applles Lo all asseLs
and noL be asseL-speclc.
2. lL should clearly dellneaLe whaL Lypes of rlsk are rewarded and
whaL are noL, and provlde a rauonale for Lhe dellneauon.
3. lL should come up wlLh sLandardlzed rlsk measures, l.e., an
lnvesLor presenLed wlLh a rlsk measure for an lndlvldual asseL
should be able Lo draw concluslons abouL wheLher Lhe asseL ls
above-average or below-average rlsk.
4. lL should LranslaLe Lhe measure of rlsk lnLo a raLe of reLurn LhaL
Lhe lnvesLor should demand as compensauon for bearlng Lhe
rlsk.
3. lL should work well noL only aL explalnlng pasL reLurns, buL also ln
predlcung fuLure expecLed reLurns.
72
1he CaplLal AsseL rlclng Model
Aswotb uomoJotoo
72
1. uses varlance of acLual reLurns around an expecLed
reLurn as a measure of rlsk.
2. Specles LhaL a poruon of varlance can be dlversled
away, and LhaL ls only Lhe non-dlverslable poruon
LhaL ls rewarded.
3. Measures Lhe non-dlverslable rlsk wlLh beLa, whlch ls
sLandardlzed around one.
4. 1ranslaLes beLa lnLo expecLed reLurn -
LxpecLed 8eLurn = 8lskfree raLe + 8eLa * 8lsk remlum
3. Works as well as Lhe nexL besL alLernauve ln mosL
cases.
73
1. 1he Mean-varlance lramework
Aswotb uomoJotoo
73
! 1he varlance on any lnvesLmenL measures Lhe dlsparlLy
beLween acLual and expecLed reLurns.
Expected Return
Low Variance Investment
High Variance Investment
74
Pow rlsky ls ulsney? A look aL Lhe pasL.
Aswotb uomoJotoo
74
-23.00
-20.00
-13.00
-10.00
-3.00
0.00
3.00
10.00
13.00
20.00
23.00
C
c
L
-
0
8

u
e
c
-
0
8

l
e
b
-
0
9

A
p
r
-
0
9

!
u
n
-
0
9

A
u
g
-
0
9

C
c
L
-
0
9

u
e
c
-
0
9

l
e
b
-
1
0

A
p
r
-
1
0

!
u
n
-
1
0

A
u
g
-
1
0

C
c
L
-
1
0

u
e
c
-
1
0

l
e
b
-
1
1

A
p
r
-
1
1

!
u
n
-
1
1

A
u
g
-
1
1

C
c
L
-
1
1

u
e
c
-
1
1

l
e
b
-
1
2

A
p
r
-
1
2

!
u
n
-
1
2

A
u
g
-
1
2

C
c
L
-
1
2

u
e
c
-
1
2

l
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b
-
1
3

A
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-
1
3

!
u
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-
1
3

A
u
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-
1
3

ketotos oo ulsoey - 2008-201J
Average monLhly reLurn = 1.63
Average monLhly sLandard devlauon = 7.64
Average annual reLurn = 21.70
Average annual sLandard devlauon = 26.47
75
uo you llve ln a mean-varlance world?
Aswotb uomoJotoo
75
! Assume LhaL you had Lo plck beLween Lwo lnvesLmenLs. 1hey
have Lhe same expecLed reLurn of 13 and Lhe same
sLandard devlauon of 23, however, lnvesLmenL A oers a
very small posslblllLy LhaL you could quadruple your money,
whlle lnvesLmenL 8s hlghesL posslble payo ls a 60 reLurn.
Would you
a. be lndlerenL beLween Lhe Lwo lnvesLmenLs, slnce Lhey have Lhe
same expecLed reLurn and sLandard devlauon?
b. prefer lnvesLmenL A, because of Lhe posslblllLy of a hlgh payo?
b. prefer lnvesLmenL 8, because lL ls safer?
! Would your answer change lf you were noL Lold LhaL Lhere ls
a small posslblllLy LhaL you could lose 100 of your money on
lnvesLmenL A buL LhaL your worsL case scenarlo wlLh
lnvesLmenL 8 ls -30?
76
1he lmporLance of ulverslcauon: 8lsk 1ypes
Aswotb uomoJotoo
76
Actions/Risk that
affect only one
firm
Actions/Risk that
affect all investments
Firm-specific Market
Projects may
do better or
worse than
expected
Competition
may be stronger
or weaker than
anticipated
Entire Sector
may be affected
by action
Exchange rate
and Political
risk
Interest rate,
Inflation &
news about
economy
Figure 3.5: A Break Down of Risk
Affects few
firms
Affects many
firms
Firm can
reduce by
Investing in lots
of projects
Acquiring
competitors
Diversifying
across sectors
Diversifying
across countries
Cannot affect
Investors
can
mitigate by
Diversifying across domestic stocks Diversifying across
asset classes
Diversifying globally
77
Why dlverslcauon reduces/ellmlnaLes
rm speclc rlsk
Aswotb uomoJotoo
77
! llrm-speclc rlsk can be reduced, lf noL ellmlnaLed, by
lncreaslng Lhe number of lnvesLmenLs ln your poruollo
(l.e., by belng dlversled). MarkeL-wlde rlsk cannoL. 1hls
can be [usued on elLher economlc or sLausucal
grounds.
! Cn economlc grounds, dlverslfylng and holdlng a larger
poruollo ellmlnaLes rm-speclc rlsk for Lwo reasons-
a. Lach lnvesLmenL ls a much smaller percenLage of Lhe poruollo,
muung Lhe eecL (posluve or negauve) on Lhe overall
poruollo.
b. llrm-speclc acuons can be elLher posluve or negauve. ln a
large poruollo, lL ls argued, Lhese eecLs wlll average ouL Lo
zero. (lor every rm, where someLhlng bad happens, Lhere
wlll be some oLher rm, where someLhlng good happens.)
78
1he 8ole of Lhe Marglnal lnvesLor
Aswotb uomoJotoo
78
! 1he marglnal lnvesLor ln a rm ls Lhe lnvesLor who ls
mosL llkely Lo be Lhe buyer or seller on Lhe nexL Lrade
and Lo lnuence Lhe sLock prlce.
! Cenerally speaklng, Lhe marglnal lnvesLor ln a sLock has
Lo own a loL of sLock and also Lrade LhaL sLock on a
regular basls.
! Slnce Lradlng ls requlred, Lhe largesL lnvesLor may noL be
Lhe marglnal lnvesLor, especlally lf he or she ls a
founder/manager of Lhe rm (Larry Llllson aL Cracle,
Mark Zuckerberg aL lacebook)
! In a|| r|sk and return mode|s |n hnance, we assume that
the marg|na| |nvestor |s we|| d|vers|hed.
79
ldenufylng Lhe Marglnal lnvesLor ln your rm.
Aswotb uomoJotoo
79
Percent of Stock held by
Institutions
Percent of Stock held by
Insiders
Marginal Investor
High Low Institutional Investor
a

High High Institutional Investor, with
insider influence
Low High (held by
founder/manager of firm)
Tough to tell; Could be
insiders but only if they
trade. If not, it could be
individual investors.
Low High (held by wealthy
individual investor)
Wealthy individual
investor, fairly diversified
Low Low Small individual investor
with restricted
diversification

80
Cauglng Lhe marglnal lnvesLor: ulsney ln
2013
Aswath Damodaran
81
LxLendlng Lhe assessmenL of Lhe lnvesLor
base
! ln all ve of Lhe publlcly Lraded companles LhaL we
are looklng aL, lnsuLuuons are blg holders of Lhe
company's sLock.
Aswath Damodaran
82
1he Llmlung Case: 1he MarkeL oruollo
Aswotb uomoJotoo
82
! 1he blg assumpuons & Lhe follow up: Assumlng dlverslcauon
cosLs noLhlng (ln Lerms of Lransacuons cosLs), and LhaL all asseLs
can be Lraded, Lhe llmlL of dlverslcauon ls Lo hold a poruollo of
every slngle asseL ln Lhe economy (ln proporuon Lo markeL value).
1hls poruollo ls called Lhe markeL poruollo.
! 1he consequence: lndlvldual lnvesLors wlll ad[usL for rlsk, by
ad[usung Lhelr allocauons Lo Lhls markeL poruollo and a rlskless
asseL (such as a 1-8lll):
ltefetteJ tlsk level Allocouoo Jeclsloo
no rlsk 100 ln 1-8llls
Some rlsk 30 ln 1-8llls, 30 ln MarkeL oruollo,
A llule more rlsk 23 ln 1-8llls, 73 ln MarkeL oruollo
Lven more rlsk 100 ln MarkeL oruollo
A rlsk hog.. 8orrow money, lnvesL ln markeL poruollo
83
1he 8lsk of an lndlvldual AsseL
Aswotb uomoJotoo
83
! 1he essence: 1he rlsk of any asseL ls Lhe rlsk LhaL lL adds Lo
Lhe markeL poruollo SLausucally, Lhls rlsk can be measured by
how much an asseL moves wlLh Lhe markeL (called Lhe
covarlance)
! 1he measure: 8eLa ls a sLandardlzed measure of Lhls
covarlance, obLalned by dlvldlng Lhe covarlance of any asseL
wlLh Lhe markeL by Lhe varlance of Lhe markeL. lL ls a
measure of Lhe non-dlverslable rlsk for any asseL can be
measured by Lhe covarlance of lLs reLurns wlLh reLurns on a
markeL lndex, whlch ls dened Lo be Lhe asseL's beLa.
! 1he resulL: 1he requlred reLurn on an lnvesLmenL wlll be a
llnear funcuon of lLs beLa:
! LxpecLed 8eLurn = 8lskfree 8aLe+ 8eLa * (LxpecLed 8eLurn on Lhe
MarkeL oruollo - 8lskfree 8aLe)
84
LlmlLauons of Lhe CAM
Aswotb uomoJotoo
84
1. 1he model makes unreallsuc assumpuons
2. 1he parameLers of Lhe model cannoL be esumaLed
preclsely
! 1he markeL lndex used can be wrong.
! 1he rm may have changed durlng Lhe 'esumauon' perlod'
3. 1he model does noL work well
! - lf Lhe model ls rlghL, Lhere should be:
" A llnear relauonshlp beLween reLurns and beLas
" 1he only varlable LhaL should explaln reLurns ls beLas
! - 1he reallLy ls LhaL
" 1he relauonshlp beLween beLas and reLurns ls weak
" CLher varlables (slze, prlce/book value) seem Lo explaln
dlerences ln reLurns beuer.
85
AlLernauves Lo Lhe CAM
Aswotb uomoJotoo
85
The risk in an investment can be measured by the variance in actual returns around an
expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
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.
The CAPM The APM Multi-Factor Models Proxy Models
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:
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
Beta of asset relative to
Market portfolio (from
a regression)
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
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 assets relative
to specified macro
economic factors (from
a regression)
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)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
86
Why Lhe CAM perslsLs.
Aswotb uomoJotoo
86
! 1he CAM, noLwlLhsLandlng lLs many crlucs and llmlLauons,
has survlved as Lhe defaulL model for rlsk ln equlLy valuauon
and corporaLe nance. 1he alLernauve models LhaL have
been presenLed as beuer models (AM, MulufacLor model..)
have made lnroads ln performance evaluauon buL noL ln
prospecuve analysls because:
! 1he alLernauve models (whlch are rlcher) do a much beuer [ob Lhan
Lhe CAM ln explalnlng pasL reLurn, buL Lhelr eecuveness drops o
when lL comes Lo esumaung expecLed fuLure reLurns (because Lhe
models Lend Lo shl and change).
! 1he alLernauve models are more compllcaLed and requlre more
lnformauon Lhan Lhe CAM.
! lor mosL companles, Lhe expecLed reLurns you geL wlLh Lhe Lhe
alLernauve models ls noL dlerenL enough Lo be worLh Lhe exLra
Lrouble of esumaung four addluonal beLas.
87
Appllcauon 1esL: Who ls Lhe marglnal lnvesLor
ln your rm?
Aswotb uomoJotoo
87
! ?ou can geL lnformauon on lnslder and lnsuLuuonal
holdlngs ln your rm from:
! hup://nance.yahoo.com/
! LnLer your companys symbol and choose prole.
! Looklng aL Lhe breakdown of sLockholders ln your
rm, conslder wheLher Lhe marglnal lnvesLor ls
! An lnsuLuuonal lnvesLor
! An lndlvldual lnvesLor
! An lnslder

l8CM 8lSk & 8L1u8n MCuLLS 1C
Pu8uLL 8A1LS:
LS1lMA1lCn CPALLLnCLS

1he prlce of purlLy ls purlsLs.
Anonymous
Aswotb uomoJotoo 88
89
lnpuLs requlred Lo use Lhe CAM -
Aswotb uomoJotoo
89
! 1he caplLal asseL prlclng model ylelds Lhe followlng
expecLed reLurn:
! LxpecLed 8eLurn = 8lskfree 8aLe+ 8eLa * (LxpecLed 8eLurn
on Lhe MarkeL oruollo - 8lskfree 8aLe)
! 1o use Lhe model we need Lhree lnpuLs:
a. 1he currenL rlsk-free raLe
b. 1he expecLed markeL rlsk premlum, Lhe premlum
expecLed for lnvesung ln rlsky asseLs, l.e. Lhe markeL
poruollo, over Lhe rlskless asseL.
c. 1he beLa of Lhe asseL belng analyzed.
90
1he 8lskfree 8aLe and 1lme Porlzon
Aswotb uomoJotoo
90
! Cn a rlskfree asseL, Lhe acLual reLurn ls equal Lo Lhe
expecLed reLurn. 1herefore, Lhere ls no varlance around
Lhe expecLed reLurn.
! lor an lnvesLmenL Lo be rlskfree, l.e., Lo have an acLual
reLurn be equal Lo Lhe expecLed reLurn, Lwo condluons
have Lo be meL -
! 1here has Lo be no defaulL rlsk, whlch generally lmplles LhaL Lhe
securlLy has Lo be lssued by Lhe governmenL. noLe, however,
LhaL noL all governmenLs can be vlewed as defaulL free.
! 1here can be no uncerLalnLy abouL relnvesLmenL raLes, whlch
lmplles LhaL lL ls a zero coupon securlLy wlLh Lhe same maLurlLy
as Lhe cash ow belng analyzed.
91
8lskfree 8aLe ln racuce
Aswotb uomoJotoo
91
! 1he rlskfree raLe ls Lhe raLe on a zero coupon
governmenL bond maLchlng Lhe ume horlzon of Lhe
cash ow belng analyzed.
! 1heoreucally, Lhls LranslaLes lnLo uslng dlerenL
rlskfree raLes for each cash ow - Lhe 1 year zero
coupon raLe for Lhe cash ow ln year 1, Lhe 2-year
zero coupon raLe for Lhe cash ow ln year 2 ...
! racucally speaklng, lf Lhere ls subsLanual
uncerLalnLy abouL expecLed cash ows, Lhe presenL
value eecL of uslng ume varylng rlskfree raLes ls
small enough LhaL lL may noL be worLh lL.
92
1he 8ouom Llne on 8lskfree 8aLes
! uslng a long Lerm governmenL raLe (even on a coupon bond) as Lhe
rlskfree raLe on all of Lhe cash ows ln a long Lerm analysls wlll yleld a
close approxlmauon of Lhe Lrue value. lor shorL Lerm analysls, lL ls
enurely approprlaLe Lo use a shorL Lerm governmenL securlLy raLe as Lhe
rlskfree raLe.
! 1he rlskfree raLe LhaL you use ln an analysls should be ln Lhe same
currency LhaL your cashows are esumaLed ln.
! ln oLher words, lf your cashows are ln u.S. dollars, your rlskfree raLe has Lo be ln
u.S. dollars as well.
! lf your cash ows are ln Luros, your rlskfree raLe should be a Luro rlskfree raLe.
! 1he convenuonal pracuce of esumaung rlskfree raLes ls Lo use Lhe
governmenL bond raLe, wlLh Lhe governmenL belng Lhe one LhaL ls ln
conLrol of lssulng LhaL currency. In November 2013, for lnsLance, Lhe raLe
on a Len-year uS Lreasury bond (2.73) ls used as Lhe rlsk free raLe ln uS
dollars.
Aswath Damodaran
93
WhaL ls Lhe Luro rlskfree raLe? An exerclse
ln november 2013
Aswath Damodaran
0.00
1.00
2.00
3.00
4.00
3.00
6.00
7.00
8.00
9.00
Cermany AusLrla lrance 8elglum lreland lLaly Spaln orLugal Slovenla Creece
1.73
2.10
2.13
2.33
3.30
3.90
3.93
3.90
6.42
8.30
kate on 10-year Luro Government 8onds: November 2013
94
When Lhe governmenL ls defaulL free: 8lsk
free raLes - ln november 2013

Aswath Damodaran
95
WhaL lf Lhere ls no defaulL-free enuLy?
8lsk free raLes ln november 2013
! Ad[usL Lhe local currency governmenL borrowlng raLe for defaulL rlsk Lo
geL a rlskless local currency raLe.
! ln november 2013, Lhe lndlan governmenL rupee bond raLe was 8.82. Lhe local
currency raung from Moodys was 8aa3 and Lhe defaulL spread for a 8aa3 raLed
counLry bond was 2.23.
8lskfree raLe ln 8upees = 8.82 - 2.23 = 6.37
! ln november 2013, Lhe Chlnese 8enmlmbl governmenL bond raLe was 4.30 and
Lhe local currency raung was Aa3, wlLh a defaulL spread of 0.8.
8lskfree raLe ln Chlnese 8enmlmbl = 4.30 - 0.8 = 3.3
! uo Lhe analysls ln an alLernaLe currency, where gemng Lhe rlskfree raLe ls
easler. WlLh vale ln 2013, we could chose Lo do Lhe analysls ln uS dollars
(raLher Lhan esumaLe a rlskfree raLe ln 8$). 1he rlskfree raLe ls Lhen Lhe
uS Lreasury bond raLe.
! uo your analysls ln real Lerms, ln whlch case Lhe rlskfree raLe has Lo be a
real rlskfree raLe. 1he lnauon-lndexed Lreasury raLe ls a measure of a
real rlskfree raLe.
Aswath Damodaran
96
1hree paLhs Lo esumaung soverelgn
defaulL spreads
! Soverelgn dollar or euro denomlnaLed bonds: 1he dlerence
beLween Lhe lnLeresL raLe on a soverelgn uS $ bond, lssued
by Lhe counLry, and Lhe uS Lreasury bond raLe can be used as
Lhe defaulL spread. lor example, ln november 2013, Lhe 10-
year 8razll uS $ bond, denomlnaLed ln uS dollars had a yleld
of 4.23 and Lhe uS 10-year 1.8ond raLe Lraded aL 2.73.
uefaulL spread = 4.23 - 2.73 = 1.30
! CuS spreads: CbLaln Lhe defaulL spreads for soverelgns ln Lhe
CuS markeL. 1he CuS spread for 8razll ln november 2013 was
2.30.
! Average spread: lf you know Lhe soverelgn raung for a
counLry, you can esumaLe Lhe defaulL spread based on Lhe
raung. ln november 2013, 8razll's raung was 8aa2, yleldlng a
defaulL spread of 2.
Aswotb uomoJotoo
96
97
8lsk free raLes ln currencles: Soverelgns
wlLh defaulL rlsk
Aswotb uomoJotoo
97
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
llqote 4.2. klsk ftee totes lo cotteocles wbete Covetomeots oot Aoo
toteJ
uefaulL Spread
8lsk free raLe
98
MeasuremenL of Lhe rlsk premlum
Aswotb uomoJotoo
98
! 1he rlsk premlum ls Lhe premlum LhaL lnvesLors
demand for lnvesung ln an average rlsk lnvesLmenL,
relauve Lo Lhe rlskfree raLe.
! As a general proposluon, Lhls premlum should be
! greaLer Lhan zero
! lncrease wlLh Lhe rlsk averslon of Lhe lnvesLors ln LhaL
markeL
! lncrease wlLh Lhe rlsklness of Lhe average rlsk
lnvesLmenL
99
WhaL ls your rlsk premlum?
! Assume LhaL sLocks are Lhe only rlsky asseLs and LhaL you are
oered Lwo lnvesLmenL opuons:
! a rlskless lnvesLmenL (say a CovernmenL SecurlLy), on whlch you can
make 3
! a muLual fund of all sLocks, on whlch Lhe reLurns are uncerLaln
! Pow much of an expecLed reLurn would you demand Lo shl
your money from Lhe rlskless asseL Lo Lhe muLual fund?
a. Less Lhan 3
b. 8eLween 3 - 3
c. 8eLween 3 - 7
d. 8eLween 7 -9
e. 8eLween 9- 11
f. More Lhan 9
Aswath Damodaran
100
8lsk Averslon and 8lsk remlums
Aswotb uomoJotoo
100
! lf Lhls were Lhe enure markeL, Lhe rlsk premlum
would be a welghLed average of Lhe rlsk premlums
demanded by each and every lnvesLor.
! 1he welghLs wlll be deLermlned by Lhe wealLh LhaL
each lnvesLor brlngs Lo Lhe markeL. 1hus, Warren
8ueus rlsk averslon counLs more Lowards
deLermlnlng Lhe equlllbrlum premlum Lhan yours
and mlne.
! As lnvesLors become more rlsk averse, you would
expecL Lhe equlllbrlum premlum Lo lncrease.
101
8lsk remlums do change..
Aswotb uomoJotoo
101
! Co back Lo Lhe prevlous example. Assume now LhaL
you are maklng Lhe same cholce buL LhaL you are
maklng lL ln Lhe aermaLh of a sLock markeL crash (lL
has dropped 23 ln Lhe lasL monLh). Would you
change your answer?
a. l would demand a larger premlum
b. l would demand a smaller premlum
c. l would demand Lhe same premlum
102
Lsumaung 8lsk remlums ln racuce
Aswotb uomoJotoo
102
! Survey lnvesLors on Lhelr deslred rlsk premlums and
use Lhe average premlum from Lhese surveys.
! Assume LhaL Lhe acLual premlum dellvered over long
ume perlods ls equal Lo Lhe expecLed premlum - l.e.,
use hlsLorlcal daLa
! LsumaLe Lhe lmplled premlum ln Lodays asseL
prlces.
103
1he Survey Approach
Aswotb uomoJotoo
103
! Surveylng all lnvesLors ln a markeL place ls lmpracucal.
! Powever, you can survey a few lndlvlduals and use Lhese resulLs. ln
pracuce, Lhls LranslaLes lnLo surveys of Lhe followlng:
! 1he llmlLauons of Lhls approach are:
! Lhere are no consLralnLs on reasonablllLy (Lhe survey could produce
negauve rlsk premlums or rlsk premlums of 30)
! 1he survey resulLs are more reecuve of Lhe pasL Lhan Lhe fuLure.
! Lhey Lend Lo be shorL Lerm, even Lhe longesL surveys do noL go beyond
one year.
104
1he PlsLorlcal remlum Approach
Aswotb uomoJotoo
104
! 1hls ls Lhe defaulL approach used by mosL Lo arrlve aL Lhe
premlum Lo use ln Lhe model
! ln mosL cases, Lhls approach does Lhe followlng
! uenes a ume perlod for Lhe esumauon (1928-resenL, lasL 30 years...)
! CalculaLes average reLurns on a sLock lndex durlng Lhe perlod
! CalculaLes average reLurns on a rlskless securlLy over Lhe perlod
! CalculaLes Lhe dlerence beLween Lhe Lwo averages and uses lL as a
premlum looklng forward.
! 1he llmlLauons of Lhls approach are:
! lL assumes LhaL Lhe rlsk averslon of lnvesLors has noL changed ln a
sysLemauc way across ume. (1he rlsk averslon may change from year
Lo year, buL lL reverLs back Lo hlsLorlcal averages)
! lL assumes LhaL Lhe rlsklness of Lhe rlsky poruollo (sLock lndex) has
noL changed ln a sysLemauc way across ume.
105
8. 1he PlsLorlcal 8lsk remlum
Lvldence from Lhe unlLed SLaLes
Aswotb uomoJotoo
105
WhaL ls Lhe rlghL premlum?
! Co back as far as you can. CLherwlse, Lhe sLandard error ln Lhe esumaLe wlll be
large.
! 8e conslsLenL ln your use of a rlskfree raLe.
! use arlLhmeuc premlums for one-year esumaLes of cosLs of equlLy and geomeLrlc
premlums for esumaLes of long Lerm cosLs of equlLy.
Std Error in estimate =
Annualized Std deviation in Stock prices
Number of years of historical data
)
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2013 7.93% 6.29% 6.02% 4.62%
Std Error 2.19% 2.34%
1964-2013 6.18% 4.32% 4.83% 3.33%
Std Error 2.42% 2.75%
2004-2013 7.55% 4.41% 5.80% 3.07%
Std Error 6.02% 8.66%
106
WhaL abouL hlsLorlcal premlums for oLher
markeLs?
Aswotb uomoJotoo
106
! PlsLorlcal daLa for markeLs ouLslde Lhe unlLed SLaLes
ls avallable for much shorLer ume perlods. 1he
problem ls even greaLer ln emerglng markeLs.
! 1he hlsLorlcal premlums LhaL emerge from Lhls daLa
reecLs Lhls daLa problem and Lhere ls much greaLer
error assoclaLed wlLh Lhe esumaLes of Lhe
premlums.
107
Cne soluuon: 8ond defaulL spreads as C8
- november 2013
! ln november 2013, Lhe hlsLorlcal rlsk premlum for Lhe uS was 4.20
(geomeLrlc average, sLocks over 1.8onds, 1928-2012)
! uslng Lhe defaulL spread on Lhe soverelgn bond or based upon Lhe
soverelgn raung and addlng LhaL spread Lo Lhe maLure markeL premlum
(4.20 for Lhe uS) glves you a LoLal L8 for a counLry.


! lf you prefer CuS spreads:

Aswath Damodaran
CounLry 8aung uefaulL Spread (CounLry 8lsk remlum) uS L8 1oLal L8 for counLry
lndla 8aa3 2.23 4.20 6.43
Chlna Aa3 0.80 4.20 3.00
8razll 8aa2 2.00 4.20 6.20
coootty 5ovetelqo cu5 5pteoJ u5 kl 1otol kl fot coootty
lndla 4.20 4.20 8.40
Chlna 1.20 4.20 3.40
8razll 2.39 4.20 6.79
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2012 7.65% 5.88% 5.74% 4.20%
2.20% 2.33%
108
8eyond Lhe defaulL spread? Lqulues are
rlskler Lhan bonds
! Whlle defaulL rlsk spreads and equlLy rlsk premlums are hlghly correlaLed,
one would expecL equlLy spreads Lo be hlgher Lhan debL spreads. Cne
approach Lo scallng up Lhe premlum ls Lo look aL Lhe relauve volaullLy of
equlues Lo bonds and Lo scale up Lhe defaulL spread Lo reecL Lhls:
! 8razll: 1he annuallzed sLandard devlauon ln Lhe 8razlllan equlLy lndex
over Lhe prevlous year ls 21 percenL, whereas Lhe annuallzed sLandard
devlauon ln Lhe 8razlllan C-bond ls 14 percenL.

! uslng Lhe same approach for Chlna and lndla:
Aswath Damodaran
Brazil's Total Risk Premium = 4.20% + 2.00%
21%
14%
!
"
#
$
%
& = 7.20%
Equity Risk Premium
India
= 4.20% + 2.25%
24%
17%
!
"
#
$
%
& = 7.80%
Equity Risk Premium
China
= 4.20% + 0.80%
18%
10%
!
"
#
$
%
& = 5.64%
109
lmplled L8 ln november 2013: WaLch
whaL l pay, noL whaL l say..
Aswath Damodaran
! lf you can observe whaL lnvesLors are wllllng Lo pay
for sLocks, you can back ouL an expecLed reLurn from
LhaL prlce and an lmplled equlLy rlsk premlum.
Base year cash ow (last 12 mths)
Dividends (TTM): 33.22
+ Buybacks (TTM): 49.02
= Cash to investors (TTM): 82.35
Earnings in TTM:
Expected growth in next 5 years
Top down analyst estimate of
earnings growth for S&P 500 with
stable payout: 5.59%
86.96 91.82 96.95
102.38 108.10
Beyond year 5
Expected growth rate =
Riskfree rate = 2.55%
Expected CF in year 6 =
108.1(1.0255)
Risk free rate = T.Bond rate on 1/1/14=2.55%
r = Implied Expected Return on Stocks = 8.04%
S&P 500 on 11/1/13=
1756.54
E(Cash to investors)
Minus
Implied Equity Risk Premium (1/1/14) = 8.04% - 2.55% = 5.49%
Equals
1756.54 =
86.96
(1+r)
+
91.82
(1+r)
2
+
96.95
(1+r)
3
+
102.38
(1+r)
4
+
108.10
(1+r)
5
+
110.86
(r !.0255)(1+r)
5
110
1he bouom llne on LqulLy 8lsk remlums
ln november 2013
! MaLure MarkeLs: ln november 2013, Lhe number LhaL we chose Lo use as Lhe
equlLy rlsk premlum for all maLure markeLs was 3.3. 1hls was seL equal Lo Lhe
lmplled premlum aL LhaL polnL ln ume and lL was much hlgher Lhan Lhe hlsLorlcal
rlsk premlum of 4.20 prevalllng Lhen (1928-2012 perlod).
! lor emerglng markeLs, we wlll use Lhe melded defaulL spread approach (where
defaulL spreads are scaled up Lo reecL addluonal equlLy rlsk) Lo come up wlLh Lhe
addluonal rlsk premlum LhaL we wlll add Lo Lhe maLure markeL premlum. 1hus,
markeLs ln counLrles wlLh lower soverelgn raungs wlll have hlgher rlsk premlums
LhaL 3.3.
Lmerglng MarkeL L8 = 3.3 +
Aswath Damodaran
Country Default Spread*
!
Equity
!
Country Bond
!
"
#
#
$
%
&
&

Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2012 7.65% 5.88% 5.74% 4.20%
2.20% 2.33%
1962-2012 5.93% 3.91% 4.60% 2.93%
2.38% 2.66%
2002-2012 7.06% 3.08% 5.38% 1.71%
5.82% 8.11%
111
A ComposlLe way of esumaung L8 for
counLrles
SLep 1: LsumaLe an equlLy rlsk premlum for a maLure markeL. lf your
preference ls for a forward looklng, updaLed number, you can
esumaLe an lmplled equlLy rlsk premlum for Lhe uS (assumlng LhaL
you buy lnLo Lhe conLenuon LhaL lL ls a maLure markeL)
! My esumaLe: ln !anuary 2014, my esumaLe for Lhe lmplled premlum ln Lhe
uS was 3. 1haL wlll also be my esumaLe for a maLure markeL L8.
SLep 2: Come up wlLh a generlc and measurable denluon of a maLure
markeL.
! My esumaLe: Any AAA raLed counLry ls maLure.
SLep 3: LsumaLe Lhe addluonal rlsk premlum LhaL you wlll charge for
markeLs LhaL are noL maLure. ?ou have Lwo cholces:
! 1he defaulL spread for Lhe counLry, esumaLed based elLher on soverelgn
raungs or Lhe CuS markeL.
! A scaled up defaulL spread, where you ad[usL Lhe defaulL spread upwards
for Lhe addluonal rlsk ln equlLy markeLs.
Aswath Damodaran
Black #: Total ERP
Red #: Country risk premium
AVG: GDP weighted average
E
R
P

:

N
o
v

2
0
1
3

Canada 5.50% 0.00%
United States of America 5.50% 0.00%
North America 5.50% 0.00%
Aswath Damodaran
!"#$%&' )*+ !*+
Angola 10.90 3.40
8enln 13.73 8.23
8oLswana 7.13 1.63
8urklna laso 13.73 8.23
Cameroon 13.73 8.23
Cape verde 12.23 6.73
LgypL 17.30 12.00
Cabon 10.90 3.40
Chana 12.23 6.73
kenya 12.23 6.73
Morocco 9.63 4.13
Mozamblque 12.23 6.73
namlbla 8.88 3.38
nlgerla 10.90 3.40
8wanda 13.73 8.23
Senegal 12.23 6.73
SouLh Afrlca 8.03 2.33
1unlsla 10.23 4.73
uganda 12.23 6.73
Zambla 12.23 6.73
Afr|ca 11.22 S.82
8angladesh 10.90 3.40
Cambodla 13.73 8.23
Chlna 6.94 1.44
ll[l 12.23 6.73
Pong kong 3.93 0.43
lndla 9.10 3.60
lndonesla 8.88 3.38
!apan 6.70 1.20
korea 6.70 1.20
Macao 6.70 1.20
Malaysla 7.43 1.93
Maurluus 8.03 2.33
Mongolla 12.23 6.73
aklsLan 17.30 12.00
apua nC 12.23 6.73
hlllpplnes 9.63 4.13
Slngapore 3.30 0.00
Srl Lanka 12.23 6.73
1alwan 6.70 1.20
1halland 8.03 2.33
vleLnam 13.73 8.23
As|a 7.27 1.77
Argenuna 13.63 10.13
8ellze 19.73 14.23
8ollvla 10.90 3.40
8razll 8.30 3.00
Chlle 6.70 1.20
Colombla 8.88 3.38
CosLa 8lca 8.88 3.38
Lcuador 17.30 12.00
Ll Salvador 10.90 3.40
CuaLemala 9.63 4.13
Ponduras 13.73 8.23
Mexlco 8.03 2.33
nlcaragua 13.63 10.13
anama 8.30 3.00
araguay 10.90 3.40
eru 8.30 3.00
Surlname 10.90 3.40
uruguay 8.88 3.38
venezuela 12.23 6.73
Lann Amer|ca 9.44 3.94
Albanla 12.23 6.73
Armenla 10.23 4.73
Azerbal[an 8.88 3.38
8elarus 13.63 10.13
8osnla 13.63 10.13
8ulgarla 8.30 3.00
Croaua 9.63 4.13
Czech 8epubllc 6.93 1.43
LsLonla 6.93 1.43
Ceorgla 10.90 3.40
Pungary 9.63 4.13
kazakhsLan 8.30 3.00
LaLvla 8.30 3.00
LlLhuanla 8.03 2.33
Macedonla 10.90 3.40
Moldova 13.63 10.13
MonLenegro 10.90 3.40
oland 7.13 1.63
8omanla 8.88 3.38
8ussla 8.03 2.33
Serbla 10.90 3.40
Slovakla 7.13 1.63
Slovenla 9.63 4.13
ukralne 13.63 10.13
L. Lurope & kuss|a 8.60 3.10
8ahraln 8.03 2.33
lsrael 6.93 1.43
!ordan 12.23 6.73
kuwalL 6.40 0.90
Lebanon 12.23 6.73
Cman 6.93 1.43
CaLar 6.40 0.90
Saudl Arabla 6.70 1.20
unlLed Arab LmlraLes 6.40 0.90
M|dd|e Last 6.88 1.38
Andorra 7.43 1.93 LlechLensLeln 3.30 0.00
AusLrla 3.30 0.00 Luxembourg 3.30 0.00
8elglum 6.70 1.20 MalLa 7.43 1.93
Cyprus 22.00 16.30 neLherlands 3.30 0.00
uenmark 3.30 0.00 norway 3.30 0.00
llnland 3.30 0.00 orLugal 10.90 3.40
lrance 3.93 0.43 Spaln 8.88 3.38
Cermany 3.30 0.00 Sweden 3.30 0.00
Creece 13.63 10.13 SwlLzerland 3.30 0.00
lceland 8.88 3.38 1urkey 8.88 3.38
lreland 9.63 4.13 unlLed klngdom 3.93 0.43
lLaly 8.30 3.00 Western Lurope 6.72 1.22
AusLralla 3.30 0.00
Cook lslands 12.23 6.73
new Zealand 3.30 0.00
Austra||a & N2 S.00 0.00
113
Lsumaung L8 for ulsney: november 2013
! lncorporauon: 1he convenuonal pracuce on equlLy rlsk premlums ls Lo
esumaLe an L8 based upon where a company ls lncorporaLed. 1hus, Lhe
cosL of equlLy for ulsney would be compuLed based on Lhe uS equlLy rlsk
premlum, because lL ls a uS company, and Lhe 8razlllan L8 would be
used for vale, because lL ls a 8razlllan company.
! Cperauons: 1he more senslble pracuce on equlLy rlsk premlum ls Lo
esumaLe an L8 based upon where a company operaLes. lor ulsney ln
2013:
Aswath Damodaran
Region/ Country
Proportion of Disneys
Revenues
ERP
US& Canada
82.01
5.50%
Lurope 11.64
6.72%
Asla-aclc 6.02
7.27%
Laun Amerlca 0.33
9.44%
Disney 100.00% 5.76%
114
L8 for Companles: november 2013
Aswath Damodaran
Company Region/ Country Weight ERP
Bookscape United States 100% 5.50%
Vale
US & Canada 4.90% 5.50%
Brazil 16.90% 8.50%
Rest of Latin
America
1.70% 10.09%
China 37.00% 6.94%
Japan 10.30% 6.70%
Rest of Asia 8.50% 8.61%
Europe 17.20% 6.72%
Rest of World 3.50% 10.06%
Company 100.00% 7.38%
Tata Motors
India 23.90% 9.10%
China 23.60% 6.94%
UK 11.90% 5.95%
United States 10.00% 5.50%
Mainland Europe 11.70% 6.85%
Rest of World 18.90% 6.98%
Company 100.00% 7.19%
Baidu China 100% 6.94%
Deutsche Bank
Germany 35.93% 5.50%
North America 24.72% 3.30
Rest of Europe 28.67% 7.02
Asia-Pacic 10.68% 7.27
South America 0.00%
9.44
Company
100.00 6.12
In November 2013,
the mature market
premium used was
5.5%
115
1he AnaLomy of a Crlsls: lmplled L8 from
SepLember 12, 2008 Lo !anuary 1, 2009
Aswotb uomoJotoo
115
116
An updaLed LqulLy 8lsk remlum: !anuary
2014
Base year cash ow
Dividends (TTM): 34.32
+ Buybacks (TTM): 49.85
= Cash to investors (TTM): 84.16
Earnings in TTM:
Expected growth in next 5 years
Top down analyst estimate of
earnings growth for S&P 500 with
stable payout: 4.28%
87.77 91.53 95.45
99.54 103.80
Beyond year 5
Expected growth rate =
Riskfree rate = 3.04%
Terminal value =
103.8(1.0304)/(,08 - .0304)
Risk free rate = T.Bond rate on 1/1/14=3.04%
r = Implied Expected Return on Stocks = 8.00%
S&P 500 on 1/1/14 =
1848.36
E(Cash to investors)
Minus
!"!!!
!! !!!
!
!
!"!!"
!! !!!
!
!
!"!!"
!! !!!
!
!
!!!!"
!! !!!
!
!
!"#!!"
!! !!!
!
!
!"#!!"!!!!"!#!
!! !!!"!#!!! !!!
!
! !"#"!!"
Implied Equity Risk Premium (1/1/14) = 8% - 3.04% = 4.96%
Equals
Aswath Damodaran
117
lmplled remlums ln Lhe uS: 1960-2013
Aswotb uomoJotoo
117
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
1
9
6
0

1
9
6
1

1
9
6
2

1
9
6
3

1
9
6
4

1
9
6
5

1
9
6
6

1
9
6
7

1
9
6
8

1
9
6
9

1
9
7
0

1
9
7
1

1
9
7
2

1
9
7
3

1
9
7
4

1
9
7
5

1
9
7
6

1
9
7
7

1
9
7
8

1
9
7
9

1
9
8
0

1
9
8
1

1
9
8
2

1
9
8
3

1
9
8
4

1
9
8
5

1
9
8
6

1
9
8
7

1
9
8
8

1
9
8
9

1
9
9
0

1
9
9
1

1
9
9
2

1
9
9
3

1
9
9
4

1
9
9
5

1
9
9
6

1
9
9
7

1
9
9
8

1
9
9
9

2
0
0
0

2
0
0
1

2
0
0
2

2
0
0
3

2
0
0
4

2
0
0
5

2
0
0
6

2
0
0
7

2
0
0
8

2
0
0
9

2
0
1
0

2
0
1
1

2
0
1
2

2
0
1
3

I
m
p
l
i
e
d

P
r
e
m
i
u
m

Year
Black #: Total ERP
Red #: Country risk premium
AVG: GDP weighted average
E
R
P

:

J
a
n

2
0
1
4

Angola 10.40% 5.40%
Benin 13.25% 8.25%
Botswana 6.28% 1.28%
Burkina Faso 13.25% 8.25%
Cameroon 13.25% 8.25%
Cape Verde 13.25% 8.25%
DR Congo 14.75% 9.75%
Egypt 16.25% 11.25%
Gabon 10.40% 5.40%
Ghana 11.75% 6.75%
Kenya 11.75% 6.75%
Morocco 8.75% 3.75%
Mozambique 11.75% 6.75%
Namibia 8.30% 3.30%
Nigeria 10.40% 5.40%
Rep Congo 10.40% 5.40%
Rwanda 13.25% 8.25%
Senegal 11.75% 6.75%
South Africa 7.40% 2.40%
Tunisia 10.40% 5.40%
Uganda 11.75% 6.75%
Zambia 11.75% 6.75%
Africa 10.04% 5.04%
Bangladesh 10.40% 5.40%
Cambodia 13.25% 8.25%
China 5.90% 0.90%
Fiji 11.75% 6.75%
Hong Kong 5.60% 0.60%
India 8.30% 3.30%
Indonesia 8.30% 3.30%
Japan 5.90% 0.90%
Korea 5.90% 0.90%
Macao 5.90% 0.90%
Malaysia 6.80% 1.80%
Mauritius 7.40% 2.40%
Mongolia 11.75% 6.75%
Pakistan 16.25% 11.25%
Papua New Guinea 11.75% 6.75%
Philippines 8.30% 3.30%
Singapore 5.00% 0.00%
Sri Lanka 11.75% 6.75%
Taiwan 5.90% 0.90%
Thailand 7.40% 2.40%
Vietnam 13.25% 8.25%
Asia 6.51% 1.51%
Australia 5.00% 0.00%
Cook Islands 11.75% 6.75%
New Zealand 5.00% 0.00%
Australia & New
Zealand 5.00% 0.00%
Argentina 14.75% 9.75%
Belize 18.50% 13.50%
Bolivia 10.40% 5.40%
Brazil 7.85% 2.85%
Chile 5.90% 0.90%
Colombia 8.30% 3.30%
Costa Rica 8.30% 3.30%
Ecuador 16.25% 11.25%
El Salvador 10.40% 5.40%
Guatemala 8.75% 3.75%
Honduras 13.25% 8.25%
Mexico 7.40% 2.40%
Nicaragua 14.75% 9.75%
Panama 7.85% 2.85%
Paraguay 10.40% 5.40%
Peru 7.85% 2.85%
Suriname 10.40% 5.40%
Uruguay 8.30% 3.30%
Venezuela 16.25% 11.25%
Latin America 8.62% 3.62%
Albania 11.75% 6.75%
Armenia 9.50% 4.50%
Azerbaijan 8.30% 3.30%
Belarus 14.75% 9.75%
Bosnia and Herzegovina 14.75% 9.75%
Bulgaria 7.85% 2.85%
Croatia 8.75% 3.75%
Czech Republic 6.05% 1.05%
Estonia 6.05% 1.05%
Georgia 10.40% 5.40%
Hungary 8.75% 3.75%
Kazakhstan 7.85% 2.85%
Latvia 7.85% 2.85%
Lithuania 7.40% 2.40%
Macedonia 10.40% 5.40%
Moldova 14.75% 9.75%
Montenegro 10.40% 5.40%
Poland 6.28% 1.28%
Romania 8.30% 3.30%
Russia 7.40% 2.40%
Serbia 11.75% 6.75%
Slovakia 6.28% 1.28%
Slovenia 8.75% 3.75%
Ukraine 16.25% 11.25%
E. Europe & Russia 7.96% 2.96%
Abu Dhabi 5.75% 0.75%
Bahrain 7.85% 2.85%
Israel 6.05% 1.05%
Jordan 11.75% 6.75%
Kuwait 5.75% 0.75%
Lebanon 11.75% 6.75%
Oman 6.05% 1.05%
Qatar 5.75% 0.75%
Saudi Arabia 5.90% 0.90%
United Arab Emirates 5.75% 0.75%
Middle East 6.14% 1.14%
Canada 5.00% 0.00%
United States of America 5.00% 0.00%
North America 5.00% 0.00%
Andorra 6.80% 1.80% Liechtenstein 5.00% 0.00%
Austria 5.00% 0.00% Luxembourg 5.00% 0.00%
Belgium 5.90% 0.90% Malta 6.80% 1.80%
Cyprus 20.00% 15.00% Netherlands 5.00% 0.00%
Denmark 5.00% 0.00% Norway 5.00% 0.00%
Finland 5.00% 0.00% Portugal 10.40% 5.40%
France 5.60% 0.60% Spain 8.30% 3.30%
Germany 5.00% 0.00% Sweden 5.00% 0.00%
Greece 20.00% 15.00% Switzerland 5.00% 0.00%
Iceland 8.30% 3.30% Turkey 8.30% 3.30%
Ireland 8.75% 3.75% United Kingdom 5.60% 0.60%
Italy 7.85% 2.85% Western Europe 6.29% 1.29%
Aswath Damodaran
119
Appllcauon 1esL: Lsumaung a MarkeL 8lsk
remlum
Aswotb uomoJotoo
119
! lor your company, geL Lhe geographlcal breakdown of revenues ln
Lhe mosL recenL year. 8ased upon Lhls revenue breakdown and Lhe
mosL recenL counLry rlsk premlums, esumaLe Lhe equlLy rlsk
premlum LhaL you would use for your company.
! 1hls compuLauon was based enurely on revenues. WlLh your
company, whaL concerns would you have abouL your esumaLe
belng Loo hlgh or Loo low?
120
Lsumaung 8eLa
Aswotb uomoJotoo
120
! 1he sLandard procedure for esumaung beLas ls Lo
regress sLock reLurns (8
[
) agalnsL markeL reLurns (8
m
):
8
[
= a + b 8
m
where a ls Lhe lnLercepL and b ls Lhe slope of Lhe regresslon.
! 1he slope of Lhe regresslon corresponds Lo Lhe beLa of
Lhe sLock, and measures Lhe rlsklness of Lhe sLock.
! 1he 8 squared (8
2
) of Lhe regresslon provldes an
esumaLe of Lhe proporuon of Lhe rlsk (varlance) of a rm
LhaL can be aurlbuLed Lo markeL rlsk. 1he balance (1 -
8
2
) can be aurlbuLed Lo rm speclc rlsk.

121
Lsumaung erformance
Aswotb uomoJotoo
121
! 1he lnLercepL of Lhe regresslon provldes a slmple measure of
performance durlng Lhe perlod of Lhe regresslon, relauve Lo
Lhe caplLal asseL prlclng model.
8
[
= 8
f
+ b (8
m
- 8
f
)
= 8
f
(1-b) + b 8
m
........... CaplLal AsseL rlclng Model
8
[
= a + b 8
m
........... 8egresslon Lquauon
! lf
a 8
f
(1-b) .... SLock dld beuer Lhan expecLed durlng regresslon perlod
a = 8
f
(1-b) .... SLock dld as well as expecLed durlng regresslon perlod
a 8
f
(1-b) .... SLock dld worse Lhan expecLed durlng regresslon perlod
! 1he dlerence beLween Lhe lnLercepL and 8f (1-b) ls !ensen's
alpha. lf lL ls posluve, your sLock dld perform beuer Lhan
expecLed durlng Lhe perlod of Lhe regresslon.
122
Semng up for Lhe Lsumauon
Aswotb uomoJotoo
122
! ueclde on an esumauon perlod
! Servlces use perlods ranglng from 2 Lo 3 years for Lhe regresslon
! Longer esumauon perlod provldes more daLa, buL rms change.
! ShorLer perlods can be aecLed more easlly by slgnlcanL rm-speclc
evenL LhaL occurred durlng Lhe perlod
! ueclde on a reLurn lnLerval - dally, weekly, monLhly
! ShorLer lnLervals yleld more observauons, buL suer from more nolse.
! nolse ls creaLed by sLocks noL Lradlng and blases all beLas Lowards one.
! LsumaLe reLurns (lncludlng dlvldends) on sLock
! 8eLurn = (rlce
Lnd
- rlce
8eglnnlng
+ ulvldends
erlod
)/ rlce
8eglnnlng
! lncluded dlvldends only ln ex-dlvldend monLh
! Choose a markeL lndex, and esumaLe reLurns (lncluslve of
dlvldends) on Lhe lndex for each lnLerval for Lhe perlod.
123
Chooslng Lhe arameLers: ulsney
! erlod used: 3 years
! 8eLurn lnLerval = MonLhly
! MarkeL lndex: S& 300 lndex.
! lor lnsLance, Lo calculaLe reLurns on ulsney ln uecember 2009,
! rlce for ulsney aL end of november 2009 = $ 30.22
! rlce for ulsney aL end of uecember 2009 = $ 32.23
! ulvldends durlng monLh = $0.33 (lL was an ex-dlvldend monLh)
! 8eLurn =($32.23 - $30.22 + $ 0.33)/$30.22= 7.88
! 1o esumaLe reLurns on Lhe lndex ln Lhe same monLh
! lndex level aL end of november 2009 = 1093.63
! lndex level aL end of uecember 2009 = 1113.10
! ulvldends on lndex ln uecember 2009 = 1.683
! 8eLurn =(1113.1 - 1093.63+1.683)/ 1093.63 = 1.78
Aswath Damodaran
ulsneys PlsLorlcal 8eLa

ketoto oo ulsoey = .0071 + 1.2317 ketoto oo Motket 8 = 0.73386
(0.10)
125
Analyzlng ulsneys erformance
! lnLercepL = 0.712
! 1hls ls an lnLercepL based on monLhly reLurns. 1hus, lL has Lo be
compared Lo a monLhly rlskfree raLe.
! 8eLween 2008 and 2013
" Average Annuallzed 1.8lll raLe = 0.30
" MonLhly 8lskfree 8aLe = 0.3/12 = 0.042
" 8lskfree 8aLe (1-8eLa) = 0.042 (1-1.232) = -.0103
! 1he Comparlson ls Lhen beLween
! lnLercepL versus 8lskfree 8aLe (1 - 8eLa)
! 0.712 versus 0.0103
! !ensens Alpha = 0.7122 - (-0.0103) = 0.723
! ulsney dld 0.723 beuer Lhan expecLed, per monLh, beLween
CcLober 2008 and SepLember 2013
! Annuallzed, ulsneys annual excess reLurn = (1.00723)
12
-1= 9.02
Aswath Damodaran
126
More on !ensens Alpha
Aswotb uomoJotoo
126
! lf you dld Lhls analysls on every sLock llsLed on an exchange, whaL would Lhe
average !ensens alpha be across all sLocks?
a. uepend upon wheLher Lhe markeL wenL up or down durlng Lhe perlod
b. Should be zero
c. Should be greaLer Lhan zero, because sLocks Lend Lo go up more oen Lhan down.
! ulsney has a posluve !ensens alpha of 9.02 a year beLween 2008 and 2013. 1hls
can be vlewed as a slgn LhaL managemenL ln Lhe rm dld a good [ob, managlng
Lhe rm durlng Lhe perlod.
a. 1rue
b. lalse
! ulsney has had a posluve !ensen's alpha beLween 2008 and 2013. lf you were an
lnvesLor ln early 2014, looklng aL Lhe sLock, you would vlew Lhls as a slgn LhaL Lhe
sLock wlll be a:
a. Cood lnvesLmenL for Lhe fuLure
b. 8ad lnvesLmenL for Lhe fuLure
c. no lnformauon abouL Lhe fuLure
127
Lsumaung ulsneys 8eLa
! Slope of Lhe 8egresslon of 1.23 ls Lhe beLa
! 8egresslon parameLers are always esumaLed wlLh error.
1he error ls capLured ln Lhe sLandard error of Lhe beLa
esumaLe, whlch ln Lhe case of ulsney ls 0.10.
! Assume LhaL l asked you whaL ulsneys Lrue beLa ls,
aer Lhls regresslon.
! WhaL ls your besL polnL esumaLe?
! WhaL range would you glve me, wlLh 67 condence?
! WhaL range would you glve me, wlLh 93 condence?
Aswath Damodaran
128
1he ulrLy SecreL of SLandard Lrror
Distribution of Standard Errors: Beta Estimates for U.S. stocks
0
200
400
600
800
1000
1200
1400
1600
<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75
Standard Error in Beta Estimate
N
u
m
b
e
r

o
f

F
i
r
m
s

Aswath Damodaran
129
8reaklng down ulsneys 8lsk
! 8 Squared = 73
! 1hls lmplles LhaL
! 73 of Lhe rlsk aL ulsney comes from markeL sources
! 27, Lherefore, comes from rm-speclc sources
! 1he rm-speclc rlsk ls dlverslable and wlll noL be
rewarded.
! 1he 8-squared for companles, globally, has lncreased
slgnlcanLly slnce 2008. Why mlghL Lhls be happenlng?

! WhaL are Lhe lmpllcauons for lnvesLors?
Aswath Damodaran
130
1he 8elevance of 8 Squared
Aswotb uomoJotoo
130
! ?ou are a dlversled lnvesLor Lrylng Lo declde
wheLher you should lnvesL ln ulsney or Amgen. 1hey
boLh have beLas of 1.23, buL ulsney has an 8
Squared of 73 whlle Amgens 8 squared of only
23. Whlch one would you lnvesL ln?
! Amgen, because lL has Lhe lower 8 squared
! ulsney, because lL has Lhe hlgher 8 squared
! ?ou would be lndlerenL
! Would your answer be dlerenL lf you were an
undlversled lnvesLor?
131
8eLa Lsumauon: uslng a Servlce
(8loomberg)
Aswath Damodaran
132
Lsumaung LxpecLed 8eLurns for ulsney ln
november 2013
! lnpuLs Lo Lhe expecLed reLurn calculauon
! ulsneys 8eLa = 1.23
! 8lskfree 8aLe = 2.73 (u.S. Len-year 1.8ond raLe ln
november 2013)
! 8lsk remlum = 3.76 (8ased on ulsney's operaung
exposure)
LxpecLed 8eLurn = 8lskfree 8aLe + 8eLa (8lsk remlum)
= 2.73 + 1.23 (3.76) = 9.93
Aswath Damodaran
133
use Lo a oLenual lnvesLor ln ulsney
! As a poLenual lnvesLor ln ulsney, whaL does Lhls expecLed
reLurn of 9.93 Lell you?
! 1hls ls Lhe reLurn LhaL l can expecL Lo make ln Lhe long Lerm on ulsney,
lf Lhe sLock ls correcLly prlced and Lhe CAM ls Lhe rlghL model for rlsk,
! 1hls ls Lhe reLurn LhaL l need Lo make on ulsney ln Lhe long Lerm Lo
break even on my lnvesLmenL ln Lhe sLock
! 8oLh
! Assume now LhaL you are an acuve lnvesLor and LhaL your
research suggesLs LhaL an lnvesLmenL ln ulsney wlll yleld
12.3 a year for Lhe nexL 3 years. 8ased upon Lhe expecLed
reLurn of 9.93, you would
! 8uy Lhe sLock
! Sell Lhe sLock
Aswath Damodaran
134
Pow managers use Lhls expecLed reLurn
! Managers aL ulsney
! need Lo make aL leasL 9.93 as a reLurn for Lhelr equlLy
lnvesLors Lo break even.
! Lhls ls Lhe hurdle raLe for pro[ecLs, when Lhe lnvesLmenL ls
analyzed from an equlLy sLandpolnL
! ln oLher words, ulsneys cosL of equlLy ls 9.93.
! WhaL ls Lhe cosL of noL dellverlng Lhls cosL of equlLy?
Aswath Damodaran
135
Appllcauon 1esL: Analyzlng Lhe 8lsk 8egresslon
Aswotb uomoJotoo
135
! uslng your 8loomberg rlsk and reLurn prlnL ouL, answer Lhe
followlng quesuons:
! Pow well or badly dld your sLock do, relauve Lo Lhe markeL, durlng Lhe
perlod of Lhe regresslon?
! lnLercepL - (8lskfree 8aLe/n) (1- 8eLa) = !ensens Alpha
" where n ls Lhe number of reLurn perlods ln a year (12 lf monLhly, 32
lf weekly)
! WhaL proporuon of Lhe rlsk ln your sLock ls aurlbuLable Lo Lhe markeL?
WhaL proporuon ls rm-speclc?
! WhaL ls Lhe hlsLorlcal esumaLe of beLa for your sLock? WhaL ls Lhe
range on Lhls esumaLe wlLh 67 probablllLy? WlLh 93 probablllLy?
! 8ased upon Lhls beLa, whaL ls your esumaLe of Lhe requlred reLurn on
Lhls sLock?
! 8lskless 8aLe + 8eLa * 8lsk remlum
136
A Culck 1esL
Aswotb uomoJotoo
136
! ?ou are advlslng a very rlsky soware rm on Lhe rlghL cosL of
equlLy Lo use ln pro[ecL analysls. ?ou esumaLe a beLa of 3.0
for Lhe rm and come up wlLh a cosL of equlLy of 20. 1he
ClC of Lhe rm ls concerned abouL Lhe hlgh cosL of equlLy
and wanLs Lo know wheLher Lhere ls anyLhlng he can do Lo
lower hls beLa.
! Pow do you brlng your beLa down?
! Should you focus your auenuon on brlnglng your beLa down?
! ?es
! no
137
8egresslon ulagnosucs for 1aLa MoLors
Beta = 1.83
67% range
1.67-1.99
Jensens !
= 2.28% - 4%/12 (1-1.83) = 2.56%
Annualized = (1-.0256)
12
-1= 35.42%
Average monthly riskfree rate (2008-13) = 4%
69% market risk
31% rm specic
Expected Return (in Rupees)
= Riskfree Rate+ Beta*Risk premium
= 6.57%+ 1.83 (7.19%) = 19.73%
Aswath Damodaran
138
A beuer beLa? vale
Aswath Damodaran
139
ueuLsche 8ank and 8aldu: lndex LecLs on
8lsk arameLers
Aswath Damodaran
! lor ueuLsche 8ank, a wldely held Luropean sLock,
we Lrled boLh Lhe uA (Cerman lndex) and Lhe l1SL
Luropean lndex.
! lor 8aldu, a nASuAC llsLed sLock, we ran regresslons
agalnsL boLh Lhe S& 300 and Lhe nASuAC.
140
8eLa: Lxplorlng lundamenLals
Aswotb uomoJotoo
140
Beta > 2
Beta
between 1
and 2
Beta <1
Beta <0
GE: 1.15
Microsoft: 1.25
Exxon Mobil: 0.70
Altria (Philip Morris): 0.60
Bulgari: 2.45
Qwest Communications: 1.85
Harmony Gold Mining: -0.15
141
ueLermlnanL 1: roducL 1ype
Aswotb uomoJotoo
141
! lndusLry LecLs: 1he beLa value for a rm depends
upon Lhe sensluvlLy of Lhe demand for lLs producLs
and servlces and of lLs cosLs Lo macroeconomlc
facLors LhaL aecL Lhe overall markeL.
! Cycllcal companles have hlgher beLas Lhan non-cycllcal
rms
! llrms whlch sell more dlscreuonary producLs wlll have
hlgher beLas Lhan rms LhaL sell less dlscreuonary producLs
142
A Slmple 1esL
Aswotb uomoJotoo
142
! hone servlce ls close Lo belng non-dlscreuonary ln Lhe
unlLed SLaLes and WesLern Lurope. Powever, ln much of
Asla and Laun Amerlca, Lhere are large segmenLs of Lhe
populauon for whlch phone servlce ls a luxury.
! Clven our dlscusslon of dlscreuonary and non-
dlscreuonary producLs, whlch of Lhe followlng
concluslons would you be wllllng Lo draw:
! Lmerglng markeL Lelecom companles should have hlgher beLas
Lhan developed markeL Lelecom companles.
! ueveloped markeL Lelecom companles should have hlgher beLas
Lhan emerglng markeL Lelecom companles
! 1he Lwo groups of companles should have slmllar beLas
143
ueLermlnanL 2: Cperaung Leverage LecLs
Aswotb uomoJotoo
143
! Cperaung leverage refers Lo Lhe proporuon of Lhe
LoLal cosLs of Lhe rm LhaL are xed.
! CLher Lhlngs remalnlng equal, hlgher operaung
leverage resulLs ln greaLer earnlngs varlablllLy whlch
ln Lurn resulLs ln hlgher beLas.
144
Measures of Cperaung Leverage
Aswotb uomoJotoo
144
! llxed CosLs Measure = llxed CosLs / varlable CosLs
! 1hls measures Lhe relauonshlp beLween xed and varlable
cosLs. 1he hlgher Lhe proporuon, Lhe hlgher Lhe operaung
leverage.
! L8l1 varlablllLy Measure = Change ln L8l1 /
Change ln 8evenues
! 1hls measures how qulckly Lhe earnlngs before lnLeresL
and Laxes changes as revenue changes. 1he hlgher Lhls
number, Lhe greaLer Lhe operaung leverage.
145
ulsneys Cperaung Leverage: 1987- 2013

Aswath Damodaran
Year Net Sales % Change in
Sales
EBIT % Change in
EBIT
1987 $2,877 $756
1988 $3,438 19.50% $848 12.17%
1989 $4,594 33.62% $1,177 38.80%
1990 $5,844 27.21% $1,368 16.23%
1991 $6,182 5.78% $1,124 -17.84%
1992 $7,504 21.38% $1,287 14.50%
1993 $8,529 13.66% $1,560 21.21%
1994 $10,055 17.89% $1,804 15.64%
1995 $12,112 20.46% $2,262 25.39%
1996 $18,739 54.71% $3,024 33.69%
1997 $22,473 19.93% $3,945 30.46%
1998 $22,976 2.24% $3,843 -2.59%
1999 $23,435 2.00% $3,580 -6.84%
2000 $25,418 8.46% $2,525 -29.47%
2001 $25,172 -0.97% $2,832 12.16%
2002 $25,329 0.62% $2,384 -15.82%
2003 $27,061 6.84% $2,713 13.80%
2004 $30,752 13.64% $4,048 49.21%
2005 $31,944 3.88% $4,107 1.46%
2006 $33,747 5.64% $5,355 30.39%
2007 $35,510 5.22% $6,829 27.53%
2008 $37,843 6.57% $7,404 8.42%
2009 $36,149 -4.48% $5,697 -23.06%
2010 $38,063 5.29% $6,726 18.06%
2011 $40,893 7.44% $7,781 15.69%
2012 $42,278 3.39% $8,863 13.91%
2013 $45,041 6.54% $9,450 6.62%
Operating Leverage
Average:
87-13 11.79% 11.91% 11.91/11.79 =1.01
Average:
96-13 8.16% 10.20% 10.20/8.16 =1.25
Average across entertainment companies = 1.35

Given Disneys operating leverage measures (1.01
or 1.25), would you expect Disney to have a higher
or a lower beta than other entertainment
companies?
a. Higher
b. Lower
c. No effect
146
ueLermlnanL 3: llnanclal Leverage
Aswotb uomoJotoo
146
! As rms borrow, Lhey creaLe xed cosLs (lnLeresL
paymenLs) LhaL make Lhelr earnlngs Lo equlLy
lnvesLors more volaule.
! 1hls lncreased earnlngs volaullLy whlch lncreases Lhe
equlLy beLa.
147
LecLs of leverage on beLas: ulsney
! 1he regresslon beLa for ulsney ls 1.23. 1hls beLa ls a
levered beLa (because lL ls based on sLock prlces, whlch
reecL leverage) and Lhe leverage lmpllclL ln Lhe beLa
esumaLe ls Lhe average markeL debL equlLy rauo durlng
Lhe perlod of Lhe regresslon (2008 Lo 2013)
! 1he average debL equlLy rauo durlng Lhls perlod was
19.44.
! 1he unlevered beLa for ulsney can Lhen be esumaLed
(uslng a marglnal Lax raLe of 36.1)
= CurrenL 8eLa / (1 + (1 - Lax raLe) (Average uebL/LqulLy))
= 1.23 / (1 + (1 - 0.361)(0.1944))= 1.1119
Aswath Damodaran
148
ulsney : 8eLa and llnanclal Leverage
Aswath Damodaran
Debt to Capital Debt/Equity Ratio Beta Effect of Leverage
0.00% 0.00% 1.11 0.00
10.00% 11.11% 1.1908 0.08
20.00% 25.00% 1.29 0.18
30.00% 42.86% 1.42 0.30
40.00% 66.67% 1.59 0.47
50.00% 100.00% 1.82 0.71
60.00% 150.00% 2.18 1.07
70.00% 233.33% 2.77 1.66
80.00% 400.00% 3.95 2.84
90.00% 900.00% 7.51 6.39

149
8eLas are welghLed Averages
Aswotb uomoJotoo
149
! 1he beLa of a poruollo ls always Lhe markeL-value
welghLed average of Lhe beLas of Lhe lndlvldual
lnvesLmenLs ln LhaL poruollo.
! 1hus,
! Lhe beLa of a muLual fund ls Lhe welghLed average of Lhe
beLas of Lhe sLocks and oLher lnvesLmenL ln LhaL poruollo
! Lhe beLa of a rm aer a merger ls Lhe markeL-value
welghLed average of Lhe beLas of Lhe companles lnvolved
ln Lhe merger.
150
1he ulsney/Cap Clues Merger (1996): re-
Merger
Aswotb uomoJotoo
150
Disney: The Acquirer
Equity Beta
1.15
Debt = $3,186 million
Market value of equity = $31,100 million
Debt + Equity = Firm value = $31,100
+ $3186 = $34,286 million
D/E Ratio = 3186/31100 = 0.10
Capital Cities: The Target
Equity Beta
0.95
Debt = $ 615 million
Market value of equity = $18, 500 million
Debt + Equity = Firm value = $18,500 +
$615 = $19,115 million
D/E Ratio = 615/18500 = 0.03
+
151
ulsney Cap Clues 8eLa Lsumauon: SLep 1
Aswotb uomoJotoo
151
! CalculaLe Lhe unlevered beLas for boLh rms
! ulsneys unlevered beLa = 1.13/(1+0.64*0.10) = 1.08
! Cap Clues unlevered beLa = 0.93/(1+0.64*0.03) = 0.93
! CalculaLe Lhe unlevered beLa for Lhe comblned rm
! unlevered 8eLa for comblned rm
= 1.08 (34286/33401) + 0.93 (19113/33401)
= 1.026
! 1he welghLs used are Lhe rm values (and noL [usL Lhe
equlLy values) of Lhe Lwo rms, slnce Lhese are unlevered
beLas and Lhus reecLs Lhe rlsks of Lhe enure buslnesses
and noL [usL Lhe equlLy
152
ulsney Cap Clues 8eLa Lsumauon: SLep 2
Aswotb uomoJotoo
152
! lf ulsney had used all equlLy Lo buy Cap Clues equlLy, whlle assumlng Cap
Clues debL, Lhe consolldaLed numbers would have looked as follows:
! uebL = $ 3,186+ $613 = $ 3,801 mllllon
! LqulLy = $ 31,100 + $18,300 = $ 49,600 m (ulsney lssues $18.3 bllllon ln equlLy)
! u/L 8auo = 3,801/49600 = 7.66
! new 8eLa = 1.026 (1 + 0.64 (.0766)) = 1.08
! Slnce ulsney borrowed $ 10 bllllon Lo buy Cap Clues/A8C, funded Lhe resL
wlLh new equlLy and assumed Cap Clues debL:
! 1he markeL value of Cap Clues equlLy ls $18.3 bllllon. lf $ 10 bllllon comes from
debL, Lhe balance ($8.3 bllllon) has Lo come from new equlLy.
! uebL = $ 3,186 + $613 mllllon + $ 10,000 = $ 13,801 mllllon
! LqulLy = $ 31,100 + $8,300 = $39,600 mllllon
! u/L 8auo = 13,801/39600 = 34.82
! new 8eLa = 1.026 (1 + 0.64 (.3482)) = 1.23
153
llrm 8eLas versus dlvlslonal 8eLas
Aswotb uomoJotoo
153
! llrm 8eLas as welghLed averages: 1he beLa of a rm
ls Lhe welghLed average of Lhe beLas of lLs lndlvldual
pro[ecLs.
! llrm 8eLas and 8uslness beLas: AL a broader level of
aggregauon, Lhe beLa of a rm ls Lhe welghLed
average of Lhe beLas of lLs lndlvldual dlvlslon.
154
8ouom-up versus 1op-down 8eLa
Aswotb uomoJotoo
154
! 1he Lop-down beLa for a rm comes from a regresslon
! 1he bouom up beLa can be esumaLed by dolng Lhe followlng:
! llnd ouL Lhe buslnesses LhaL a rm operaLes ln
! llnd Lhe unlevered beLas of oLher rms ln Lhese buslnesses
! 1ake a welghLed (by sales or operaung lncome) average of Lhese
unlevered beLas
! Lever up uslng Lhe rms debL/equlLy rauo
! 1he bouom up beLa ls a beuer esumaLe Lhan Lhe Lop down
beLa for Lhe followlng reasons
! 1he sLandard error of Lhe beLa esumaLe wlll be much lower
! 1he beLas can reecL Lhe currenL (and even expecLed fuLure) mlx of
buslnesses LhaL Lhe rm ls ln raLher Lhan Lhe hlsLorlcal mlx
155
ulsney's buslnesses: 1he nanclal
breakdown (from 2013 annual reporL)
Aswath Damodaran
156
unlevered 8eLas for buslnesses
Aswath Damodaran
!
Unlevered Beta
(1 - Cash/ Firm Value)
8osloess compotoble ftms
5omple
slze
MeJloo
8eto
MeJloo
u/
MeJloo
1ox tote
compooy
uoleveteJ
8eto
MeJloo
cosb/
lltm
voloe
8osloess
uoleveteJ
8eto
Medla neLworks
uS rms ln
broadcasung
buslness 26 1.43 71.09 40.00 1.0024 2.80 1.0313
arks & 8esorLs
Clobal rms ln
amusemenL park
buslness 20 0.87 46.76 33.67 0.6677 4.93 0.7024
SLudlo
LnLerLalnmenL uS movle rms 10 1.24 27.06 40.00 1.0668 2.96 1.0993
Consumer
roducLs
Clobal rms ln
Loys/games
producuon & reLall 44 0.74 29.33 23.00 0.6034 10.64 0.6732
lnLeracuve
Clobal compuLer
gamlng rms 33 1.03 3.26 34.33 1.0083 17.23 1.2187
157
A closer look aL Lhe process.
SLudlo LnLerLalnmenL 8eLas
Aswath Damodaran
158
8acklng lnLo a pure play beLa: SLudlo
LnLerLalnmenL
Aswotb uomoJotoo
158
1. Start with the median regression beta (equity beta) of 1.24
2. Unlever the beta, using the median gross D/E ratio of 27.06%
Gross D/E ratio = 21.30/78.70 = 27.06%
Unlevered beta = 1.24/ (1+ (1-.4) (.2706)) = 1.0668
3. Take out the cash effect, using the median cash/value of 2.96%
(.0296) (0) + (1-.0296) (Beta of movie business) = 1.0668
Beta of movie business = 1.0668/(1-.0296) = 1.0993
Alternatively, you could have used the net debt to equity ratio
Net D/E ratio = (21.30-2.96)/78.70 = 23.30%
Unlevered beta for movies = 1.24/ (1+(1-.4)(.233)) = 1.0879
The Median Movie Company
Movie Business 97.04 Beta (movies) = 1.0093
Cash Businesss 2.96 Beta (cash) = 0.0000
Movie Company 100.0 Beta (company) = 1.0668
Debt 21.30 Beta (debt) = 0
Equity 78.70 Beta (equity) = 1.24
159
ulsney's unlevered beLa: Cperauons &
Lnure Company
Aswath Damodaran
Disney has $3.93 billion in cash, invested in close to riskless assets (with a beta of zero). You
can compute an unlevered beta for Disney as a company (inclusive of cash):
8osloess keveooes v/5oles
voloe of
8osloess
ltopotuoo of
ulsoey
uoleveteJ
beto voloe ltopotuoo
Medla neLworks $20,336 3.27 $66,380 49.27 1.03 $66,379.81 49.27
arks & 8esorLs $14,087 3.24 $43,683 33.81 0.70 $43,682.80 33.81
SLudlo LnLerLalnmenL $3,979 3.03 $18,234 13.49 1.10 $18,234.27 13.49
Consumer roducLs $3,333 0.83 $2,932 2.18 0.68 $2,931.30 2.18
lnLeracuve $1,064 1.38 $1,684 1.23 1.22 $1,683.72 1.23
ulsney Cperauons $43,041 $133,132 100.00 0.9239 $133,132.11
160
1he levered beLa: ulsney and lLs dlvlslons
! 1o esumaLe Lhe debL rauos for dlvlslon, we allocaLe ulsney's LoLal debL
($13,961 mllllon) Lo lLs dlvlslons based on ldenuable asseLs.


! We use Lhe allocaLed debL Lo compuLe u/L rauos and levered beLas.
Aswath Damodaran
8osloess uoleveteJ beto voloe of bosloess u/ touo leveteJ beto cost of polty
Medla neLworks 1.0313 $66,380 10.03 1.0973 9.07
arks & 8esorLs 0.7024 $43,683 11.41 0.7337 7.09
SLudlo LnLerLalnmenL 1.0993 $18,234 20.71 1.2448 9.92
Consumer roducLs 0.6732 $2,932 117.11 1.1803 9.33
lnLeracuve 1.2187 $1,684 41.07 1.3383 11.61
ulsney Cperauons 0.9239 $133,132 13.10 1.0012 8.32
161
ulscusslon lssue
Aswotb uomoJotoo
161
! Assume now LhaL you are Lhe ClC of ulsney. 1he
head of Lhe movle buslness has come Lo you wlLh a
new blg budgeL movle LhaL he would llke you Lo
fund. Pe clalms LhaL hls analysls of Lhe movle
lndlcaLes LhaL lL wlll generaLe a reLurn on equlLy of
9.3. Would you fund lL?
! ?es. lL ls hlgher Lhan Lhe cosL of equlLy for ulsney as a
company
! no. lL ls lower Lhan Lhe cosL of equlLy for Lhe movle
buslness.
! WhaL are Lhe broader lmpllcauons of your cholce?
162
Lsumaung 8ouom up 8eLas & CosLs of
LqulLy: vale
Aswath Damodaran
!"#$%&## ()*+,&
()*+,&
#$-&
.%,&/&0&1 2&3)
45 2"#$%&## 6&/&%"&#
7&&0 804"+
9:;(),&#
:),"& 45
!"#$%&##
704+403$4% 45
:),&
!"#$%& (
!)*)*+
,%-.$% /)01& )* 1"#$%& (
1)*)*+2 !$03"# 4$5678
.)%%)-* 9: ;<:= 7>2;8? 8<>@ 78@2@?> 8=<=AB
C0-* D0" ,%-.$% /)01& )* )0-* -0" @: ;<:? 7?E2@8@ E<9: 7:828:: @=<E;B
F"0#)%)G"0&
,%-.$% &5"4)$%#H
4I"1)4$% /)01& =>? ;<>> 7?2@@@ 8<AE 7A2@98 A<?>B
J-+)&#)4&
,%-.$% #0$*&5-0#$#)-*
/)01& EE? ;<@A 782=99 8<89 782:@9 8<@=B
:),&
<+&0)3$4%# =>?@@= A@BCDED AD=FCE@G D==>==H

163
vale: CosL of LqulLy Calculauon - ln
nomlnal $8
! 1o converL a dlscounL raLe ln one currency Lo anoLher, all you need are
expecLed lnauon raLes ln Lhe Lwo currencles.

! lrom uS $ Lo 8$: lf we use 2 as Lhe lnauon raLe ln uS dollars and 9 as
Lhe lnauon rauo ln 8razll, we can converL vale's uS dollar cosL of equlLy
of 11.23 Lo a $8 cosL of equlLy:
! AlLernauvely, you can compuLe a cosL of equlLy, sLarung wlLh Lhe $8
rlskfree raLe of 10.18.
CosL of LqulLy ln $8 = = 10.18 + 1.13 (7.38) = 18.67

Aswath Damodaran
!
(1+$ Cost of Equity)
(1+ Inflation Rate
Brazil
)
(1+ Inflation Rate
US
)
"1
164
8ouom up beLas & CosLs of LqulLy: 1aLa
MoLors & 8aldu
! 1aLa MoLors: We esumaLed an unlevered beLa of 0.8601
across 76 publlcly Lraded auLomouve companles (globally)
and esumaLed a levered beLa based on 1aLa MoLor's u/L
rauo of 41.41 and a marglnal Lax raLe of 32.43 for lndla:
Levered 8eLa for 1aLa MoLors = 0.8601 (1 + (1-.3243) (.4141)) = 1.1007
CosL of equlLy for 1aLa MoLors (8s) = 6.37 + 1.1007 (7.19) = 14.49
! 8aldu: 1o esumaLe lLs beLa, we looked aL 42 global companles
LhaL derlve all or mosL of Lhelr revenues from onllne
adveruslng and esumaLed an unlevered beLa of 1.30 for Lhe
buslness. lncorporaung 8aldu's currenL markeL debL Lo equlLy
rauo of 3.23 and Lhe marglnal Lax raLe for Chlna of 23, we
esumaLe 8aldu's currenL levered beLa Lo be 1.3360.
Levered 8eLa for 8aldu = 1.30 (1 + (1-.23) (.0323)) = 1.336
CosL of LqulLy for 8aldu (8enmlmbl) = 3.30 + 1.336 (6.94) = 12.91
Aswath Damodaran
165
8ouom up 8eLas and CosLs of LqulLy:
ueuLsche 8ank
! We break ueuLsche 8ank down lnLo Lwo buslnesses - commerclal and
lnvesLmenL banklng.

! We do noL unlever or relever beLas, because esumaung debL and equlLy
for banks ls an exerclse ln fuullLy. uslng a rlskfree raLe of 1.73 (Luro rlsk
free raLe) and ueuLsche's L8 of 6.12:
Aswath Damodaran
166
Lsumaung 8eLas for non-1raded AsseLs
Aswotb uomoJotoo
166
! 1he convenuonal approaches of esumaung beLas
from regresslons do noL work for asseLs LhaL are noL
Lraded. 1here are no sLock prlces or hlsLorlcal
reLurns LhaL can be used Lo compuLe regresslon
beLas.
! 1here are Lwo ways ln whlch beLas can be esumaLed
for non-Lraded asseLs
! uslng comparable rms
! uslng accounung earnlngs
167
uslng comparable rms Lo esumaLe beLa
for 8ookscape
Aswath Damodaran
Unlevered beta for book company = 0.8130/ (1+ (1-.4) (.2141)) = 0.7205
Unlevered beta for book business = 0.7205/(1-.05) = 0.7584
168
Lsumaung 8ookscape Levered 8eLa and
CosL of LqulLy
! 8ecause Lhe debL/equlLy rauos used ln compuung
levered beLas are markeL debL equlLy rauos, and Lhe only
debL equlLy rauo we can compuLe for 8ookscape ls a
book value debL equlLy rauo, we have assumed LhaL
8ookscape ls close Lo Lhe book lndusLry medlan markeL
debL Lo equlLy rauo of 21.41 percenL.
! uslng a marglnal Lax raLe of 40 percenL for 8ookscape,
we geL a levered beLa of 0.8338.
Levered beLa for 8ookscape = 0.73841 + (1 - 0.40) (0.2141) = 0.8338
! uslng a rlskfree raLe of 2.73 (uS Lreasury bond raLe)
and an equlLy rlsk premlum of 3.3:
CosL of LqulLy = 2.73+ 0.8338 (3.3) = 7.46
Aswath Damodaran
169
ls 8eLa an AdequaLe Measure of 8lsk for a
rlvaLe llrm?
! 8eLa measures Lhe rlsk added on Lo a dlversled
poruollo. 1he owners of mosL prlvaLe rms are noL
dlversled. 1herefore, uslng beLa Lo arrlve aL a cosL
of equlLy for a prlvaLe rm wlll
a. under esumaLe Lhe cosL of equlLy for Lhe prlvaLe rm
b. Cver esumaLe Lhe cosL of equlLy for Lhe prlvaLe rm
c. Could under or over esumaLe Lhe cosL of equlLy for Lhe
prlvaLe rm
Aswath Damodaran
170
1oLal 8lsk versus MarkeL 8lsk
! Ad[usL Lhe beLa Lo reecL LoLal rlsk raLher Lhan markeL rlsk.
1hls ad[usLmenL ls a relauvely slmple one, slnce Lhe 8
squared of Lhe regresslon measures Lhe proporuon of Lhe rlsk
LhaL ls markeL rlsk.
! 1oLal 8eLa = MarkeL 8eLa / Correlauon of Lhe secLor wlLh Lhe markeL
! ln Lhe 8ookscape example, where Lhe markeL beLa ls 0.8338
and Lhe medlan 8-squared of Lhe comparable publlcly Lraded
rms ls 26.00, Lhe correlauon wlLh Lhe markeL ls 30.99.

! 1oLal CosL of LqulLy = 2.73 + 1.6783 (3.3) = 11.98
Market Beta
R squared
=
0.8558
.5099
=1.6783
Aswath Damodaran
171
Appllcauon 1esL: Lsumaung a 8ouom-up 8eLa
Aswotb uomoJotoo
171
! 8ased upon Lhe buslness or buslnesses LhaL your
rm ls ln rlghL now, and lLs currenL nanclal
leverage, esumaLe Lhe bouom-up unlevered beLa for
your rm.
! uaLa Source: ?ou can geL a llsung of unlevered beLas
by lndusLry on my web slLe by golng Lo updaLed
daLa.
172
lrom CosL of LqulLy Lo CosL of CaplLal
Aswotb uomoJotoo
172
! 1he cosL of caplLal ls a composlLe cosL Lo Lhe rm of
ralslng nanclng Lo fund lLs pro[ecLs.
! ln addluon Lo equlLy, rms can ralse caplLal from
debL
173
WhaL ls debL?
Aswotb uomoJotoo
173
! Ceneral 8ule: uebL generally has Lhe followlng
characLerlsucs:
! CommlLmenL Lo make xed paymenLs ln Lhe fuLure
! 1he xed paymenLs are Lax deducuble
! lallure Lo make Lhe paymenLs can lead Lo elLher defaulL or
loss of conLrol of Lhe rm Lo Lhe parLy Lo whom paymenLs
are due.
! As a consequence, debL should lnclude
! Any lnLeresL-bearlng llablllLy, wheLher shorL Lerm or long
Lerm.
! Any lease obllgauon, wheLher operaung or caplLal.
174
Lsumaung Lhe CosL of uebL
Aswotb uomoJotoo
174
! lf Lhe rm has bonds ouLsLandlng, and Lhe bonds are Lraded,
Lhe yleld Lo maLurlLy on a long-Lerm, sLralghL (no speclal
feaLures) bond can be used as Lhe lnLeresL raLe.
! lf Lhe rm ls raLed, use Lhe raung and a Lyplcal defaulL spread
on bonds wlLh LhaL raung Lo esumaLe Lhe cosL of debL.
! lf Lhe rm ls noL raLed,
! and lL has recenLly borrowed long Lerm from a bank, use Lhe lnLeresL
raLe on Lhe borrowlng or
! esumaLe a synLheuc raung for Lhe company, and use Lhe synLheuc
raung Lo arrlve aL a defaulL spread and a cosL of debL
! 1he cosL of debL has Lo be esumaLed ln Lhe same currency as
Lhe cosL of equlLy and Lhe cash ows ln Lhe valuauon.
175
1he easy rouLe: CuLsourclng Lhe
measuremenL of defaulL rlsk
! lor Lhose rms LhaL have bond raungs from global
raungs agencles, l used Lhose raungs:

! lf you wanL Lo esumaLe vale's cosL of debL ln $8
Lerms, we can agaln use Lhe dlerenual lnauon
approach we used for Lhe cosL of equlLy:
Aswath Damodaran
Company S&P Rating Risk-Free Rate Default Spread Cost of Debt
Disney A 2.75% (US $) 1.00% 3.75%
Deutsche Bank A 1.75% (Euros) 1.00% 2.75%
Vale A- 2.75% (US $) 1.30% 4.05%

176
A more general rouLe: Lsumaung
SynLheuc 8aungs
! 1he raung for a rm can be esumaLed uslng Lhe
nanclal characLerlsucs of Lhe rm. ln lLs slmplesL
form, we can use [usL Lhe lnLeresL coverage rauo:
lnLeresL Coverage 8auo = L8l1 / lnLeresL Lxpenses
! lor Lhe non-nanclal servlce companles, we obLaln
Lhe followlng:
Aswath Damodaran
Company Operating income Interest Expense Interest coverage ratio
Disney $10.023 $444 22.57
Vale $15,667 $1,342 11.67
Tata Motors Rs 166,605 Rs 36,972 4.51
Baidu CY 11,193 CY 472 23.72
Bookscape $2,536 $492 5.16

177
lnLeresL Coverage 8auos, 8aungs and
uefaulL Spreads- november 2013
Disney: Large cap, developed 22.57 # AAA
Vale: Large cap, emerging 11.67 # AA
Tata Motors: Large cap, Emerging 4.51 # A-
Baidu: Small cap, Emerging 23.72 # AAA
Bookscape: Small cap, private 5.16 # A-
Aswath Damodaran
178
SynLheuc versus AcLual 8aungs: 8aLed
llrms
! ulsneys synLheuc raung ls AAA, whereas lLs acLual raung ls
A. 1he dlerence can be aurlbuLed Lo any of Lhe followlng:
! SynLheuc raungs reecL only Lhe lnLeresL coverage rauo whereas
acLual raungs lncorporaLe all of Lhe oLher rauos and quallLauve facLors
! SynLheuc raungs do noL allow for secLor-wlde blases ln raungs
! SynLheuc raung was based on 2013 operaung lncome whereas acLual
raung reecLs normallzed earnlngs
! vales synLheuc raung ls AA, buL Lhe acLual raung for dollar
debL ls A-. 1he blggesL facLor behlnd Lhe dlerence ls Lhe
presence of counLry rlsk, slnce vale ls probably belng raLed
lower for belng a 8razll-based corporauon.
! ueuLsche 8ank had an A raung. We wlll noL Lry Lo esumaLe a
synLheuc raung for Lhe bank. uenlng lnLeresL expenses on
debL for a bank ls dlmculL.
Aswath Damodaran
179
Lsumaung CosL of uebL
! lor 8ookscape, we wlll use Lhe synLheuc raung (A-) Lo esumaLe Lhe cosL
of debL:
! uefaulL Spread based upon A- raung = 1.30
! re-Lax cosL of debL = 8lskfree 8aLe + uefaulL Spread = 2.73 + 1.30 = 4.03
! Aer-Lax cosL of debL = re-Lax cosL of debL (1- Lax raLe) = 4.03 (1-.40) = 2.43
! lor Lhe Lhree publlcly Lraded rms LhaL are raLed ln our sample, we wlll
use Lhe acLual bond raungs Lo esumaLe Lhe cosLs of debL.
! lor 1aLa MoLors, we have a raung of AA- from C8lSlL, an lndlan bond-
raung rm, LhaL measures only company rlsk. uslng LhaL raung:
CosL of debL
1M1
= 8lsk free raLe
8upees
+ uefaulL spread
lndla
+ uefaulL spread
1M1

= 6.37 + 2.23 + 0.70 = 9.62
Aer-Lax cosL of debL = 9.62 (1-.3243) = 6.30

Aswath Damodaran
Company S&P Rating Risk-Free Rate Default Spread Cost of Debt Tax Rate After-Tax Cost of Debt
Disney A 2.75% (US $) 1.00% 3.75% 36.1% 2.40%
Deutsche Bank A 1.75% (Euros) 1.00% 2.75% 29.48% 1.94%
Vale A- 2.75% (US $) 1.30% 4.05% 34% 2.67%

180
updaLed uefaulL Spreads - !anuary 2014
8aung 1 year 3 year 10 ?ear 30 year
Aaa/AAA 0.03 0.18 0.42 0.63
Aa1/AA+ 0.11 0.37 0.37 0.82
Aa2/AA 0.16 0.33 0.71 0.98
Aa3/AA- 0.22 0.60 0.73 0.99
A1/A+ 0.26 0.63 0.78 1.00
A2/A 0.33 0.67 0.84 1.12
A3/A- 0.46 0.84 1.00 1.26
8aa1/888+ 0.38 1.09 1.32 1.67
8aa2/888 0.47 1.27 1.32 1.91
8aa3/888- 0.93 1.33 1.78 2.18
8a1/88+ 1.68 2.29 2.39 2.97
8a2/88 2.40 3.04 3.39 3.77
8a3/88- 3.12 3.80 4.20 4.37
81/8+ 3.84 4.36 3.01 3.36
82/8 4.36 3.31 3.81 6.16
83/8- 3.28 6.06 6.62 6.96
Caa/CCC+ 6.00 6.82 7.43 7.73
Aswath Damodaran
181
Appllcauon 1esL: Lsumaung a CosL of uebL
Aswotb uomoJotoo
181
! 8ased upon your rms currenL earnlngs before
lnLeresL and Laxes, lLs lnLeresL expenses, esumaLe
! An lnLeresL coverage rauo for your rm
! A synLheuc raung for your rm (use Lhe Lables from prlor
pages)
! A pre-Lax cosL of debL for your rm
! An aer-Lax cosL of debL for your rm
182
CosLs of Pybrlds
Aswotb uomoJotoo
182
! referred sLock shares some of Lhe characLerlsucs of
debL - Lhe preferred dlvldend ls pre-specled aL Lhe ume
of Lhe lssue and ls pald ouL before common dlvldend --
and some of Lhe characLerlsucs of equlLy - Lhe paymenLs
of preferred dlvldend are noL Lax deducuble. lf preferred
sLock ls vlewed as perpeLual, Lhe cosL of preferred sLock
can be wrluen as follows:
! kps = referred ulvldend per share/ MarkeL rlce per
preferred share
! Converuble debL ls parL debL (Lhe bond parL) and parL
equlLy (Lhe converslon opuon). lL ls besL Lo break lL up
lnLo lLs componenL parLs and ellmlnaLe lL from Lhe mlx
alLogeLher.
183
WelghLs for CosL of CaplLal Calculauon
Aswotb uomoJotoo
183
! 1he welghLs used ln Lhe cosL of caplLal compuLauon should
be markeL values.
! 1here are Lhree speclous argumenLs used agalnsL markeL
value
! 8ook value ls more rellable Lhan markeL value because lL ls noL as
volaule: Whlle lL ls Lrue LhaL book value does noL change as much as
markeL value, Lhls ls more a reecuon of weakness Lhan sLrengLh
! uslng book value raLher Lhan markeL value ls a more conservauve
approach Lo esumaung debL rauos: lor mosL companles, uslng book
values wlll yleld a lower cosL of caplLal Lhan uslng markeL value
welghLs.
! Slnce accounung reLurns are compuLed based upon book value,
conslsLency requlres Lhe use of book value ln compuung cosL of
caplLal: Whlle lL may seem conslsLenL Lo use book values for boLh
accounung reLurn and cosL of caplLal calculauons, lL does noL make
economlc sense.
184
ulsney: lrom book value Lo markeL value
for lnLeresL bearlng debL.
! ln ulsneys 2013 nanclal sLaLemenLs, Lhe debL due over ume was fooLnoLed.
! ulsneys LoLal debL due, ln book value Lerms, on Lhe balance sheeL ls $14,288
mllllon and Lhe LoLal lnLeresL expense for Lhe year was $349 mllllon. uslng 3.73
as Lhe pre-Lax cosL of debL:
! LsumaLed Mv of ulsney uebL =
Aswath Damodaran
Time due Amount due Weight
Weight
*Maturity
0.5 $1,452 11.96% 0.06
2 $1,300 10.71% 0.21
3 $1,500 12.36% 0.37
4 $2,650 21.83% 0.87
6 $500 4.12% 0.25
8 $1,362 11.22% 0.9
9 $1,400 11.53% 1.04
19 $500 4.12% 0.78
26 $25 0.21% 0.05
28 $950 7.83% 2.19
29 $500 4.12% 1.19
$12,139 7.92
349
(1!
1
(1.0375)
7.92
.0375
"
#
$
$
$
$
%
&
'
'
'
'
+
14, 288
(1.0375)
7.92
= $13, 028 million
The debt in this table does
not add up to the book value
of debt, because Disney
does not break down the
maturity of all of its debt.
185
Cperaung Leases aL ulsney
! 1he debL value of operaung leases ls Lhe presenL
value of Lhe lease paymenLs, aL a raLe LhaL reecLs
Lhelr rlsk, usually Lhe pre-Lax cosL of debL.
! 1he pre-Lax cosL of debL aL ulsney ls 3.73.

! uebL ouLsLandlng aL ulsney = $13,028 + $ 2,933= $13,961 mllllon

Disney reported $1,784 million
in commitments after year 5.
Given that their average
commitment over the rst 5
years, we assumed 5 years @
$356.8 million each.
Aswath Damodaran
Year Commitment Present Value @3.75%
1 $507.00 $488.67
2 $422.00 $392.05
3 $342.00 $306.24
4 $272.00 $234.76
5 $217.00 $180.52
6-10 $356.80 $1,330.69
Debt value of leases $2,932.93

186
Appllcauon 1esL: Lsumaung MarkeL value
Aswotb uomoJotoo
186
! LsumaLe Lhe
! MarkeL value of equlLy aL your rm and 8ook value of
equlLy
! MarkeL value of debL and book value of debL (lf you cannoL
nd Lhe average maLurlLy of your debL, use 3 years):
8emember Lo caplLallze Lhe value of operaung leases and
add Lhem on Lo boLh Lhe book value and Lhe markeL value
of debL.
! LsumaLe Lhe
! WelghLs for equlLy and debL based upon markeL value
! WelghLs for equlLy and debL based upon book value
187
CurrenL CosL of CaplLal: ulsney
! LqulLy
! CosL of LqulLy = 8lskfree raLe + 8eLa * 8lsk remlum
= 2.73 + 1.0013 (3.76) = 8.32
! MarkeL value of LqulLy = $121,878 mllllon
! LqulLy/(uebL+LqulLy ) = 88.42
! uebL
! Aer-Lax CosL of debL =(8lskfree raLe + uefaulL Spread) (1-L)
= (2.73+1) (1-.361) = 2.40
! MarkeL value of uebL = $13,028+ $2933 = $ 13,961 mllllon
! uebL/(uebL +LqulLy) = 11.38
! CosL of CaplLal = 8.32(.8842)+ 2.40(.1138) = 7.81
121,878/ (121,878+15,961)
Aswath Damodaran
188
ulvlslonal CosLs of CaplLal: ulsney and vale
ulsney




vale
Aswath Damodaran

CosL of
equlLy
CosL of
debL
Marglnal Lax
raLe
AfLer-Lax cosL of
debL
uebL
raLlo
CosL of
caplLal
Medla neLworks 9.07 3.73 36.10 2.40 9.12 8.46
arks & 8esorLs 7.09 3.73 36.10 2.40 10.24 6.61
SLudlo
LnLerLalnmenL 9.92 3.73 36.10 2.40 17.16 8.63
Consumer roducLs 9.33 3.73 36.10 2.40 33.94 3.69
lnLeracLlve 11.63 3.73 36.10 2.40 29.11 8.96
ulsney CperaLlons 8.32 3.73 36.10 2.40 11.38 7.81

Business
Cost of
equity
After-tax cost of
debt
Debt
ratio
Cost of capital (in
US$)
Cost of capital (in
$R)
Metals &
Mining 11.35% 2.67% 35.48% 8.27% 15.70%
Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%

189
CosLs of CaplLal: 1aLa MoLors, 8aldu and
8ookscape
! 1o esumaLe Lhe cosLs of caplLal for 1aLa MoLors ln lndlan
rupees:
CosL of caplLal= 14.49 (1-.2928) + 6.30 (.2928) = 12.13
! lor 8aldu, we follow Lhe same paLh Lo esumaLe a cosL of
equlLy ln Chlnese 8M8:
CosL of caplLal = 12.91 (1-.0323) + 3.43 (.0323) = 12.42
! lor 8ookscape, Lhe cosL of caplLal ls dlerenL dependlng on
wheLher you look aL markeL or LoLal beLa:

Aswath Damodaran

Cost of
equity Pre-tax Cost of debt
After-tax cost of
debt D/(D+E) Cost of capital
Market Beta 7.46% 4.05% 2.43% 17.63% 6.57%
Total Beta 11.98% 4.05% 2.43% 17.63% 10.30%

190
Appllcauon 1esL: Lsumaung CosL of CaplLal
Aswotb uomoJotoo
190
! uslng Lhe bouom-up unlevered beLa LhaL you compuLed for
your rm, and Lhe values of debL and equlLy you have
esumaLed for your rm, esumaLe a bouom-up levered beLa
and cosL of equlLy for your rm.
! 8ased upon Lhe cosLs of equlLy and debL LhaL you have
esumaLed, and Lhe welghLs for each, esumaLe Lhe cosL of
caplLal for your rm.
! Pow dlerenL would your cosL of caplLal have been, lf you
used book value welghLs?
191
Chooslng a Purdle 8aLe
Aswotb uomoJotoo
191
! LlLher Lhe cosL of equlLy or Lhe cosL of caplLal can be
used as a hurdle raLe, dependlng upon wheLher Lhe
reLurns measured are Lo equlLy lnvesLors or Lo all
clalmholders on Lhe rm (caplLal)
! lf reLurns are measured Lo equlLy lnvesLors, Lhe
approprlaLe hurdle raLe ls Lhe cosL of equlLy.
! lf reLurns are measured Lo caplLal (or Lhe rm), Lhe
approprlaLe hurdle raLe ls Lhe cosL of caplLal.
192
8ack Lo llrsL rlnclples
Aswotb uomoJotoo
192
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should relfect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend whether
they prefer
dividends or
buybacks
Maximize the value of the business (rm)
MLASu8lnC lnvLS1MLn1 8L1u8nS
l: 1PL MLCPAnlCS Cl lnvLS1MLn1
AnAL?SlS


Show me Lhe money
from !erry Magulre
Aswotb uomoJotoo 193
194
llrsL rlnclples
Aswotb uomoJotoo
194
195
Measures of reLurn: earnlngs versus cash ows
Aswotb uomoJotoo
195
! rlnclples Covernlng Accounung Larnlngs MeasuremenL
! Accrual Accounung: Show revenues when producLs and servlces are
sold or provlded, noL when Lhey are pald for. Show expenses
assoclaLed wlLh Lhese revenues raLher Lhan cash expenses.
! Cperaung versus CaplLal LxpendlLures: Cnly expenses assoclaLed wlLh
creaung revenues ln Lhe currenL perlod should be LreaLed as operaung
expenses. Lxpenses LhaL creaLe beneLs over several perlods are
wrluen o over muluple perlods (as depreclauon or amoruzauon)
! 1o geL from accounung earnlngs Lo cash ows:
! you have Lo add back non-cash expenses (llke depreclauon)
! you have Lo subLracL ouL cash ouulows whlch are noL expensed (such
as caplLal expendlLures)
! you have Lo make accrual revenues and expenses lnLo cash revenues
and expenses (by conslderlng changes ln worklng caplLal).
196
Measurlng 8eLurns 8lghL: 1he 8aslc rlnclples
Aswotb uomoJotoo
196
! use cash ows raLher Lhan earnlngs. ?ou cannoL spend
earnlngs.
! use lncremenLal cash ows relaung Lo Lhe lnvesLmenL
declslon, l.e., cashows LhaL occur as a consequence of
Lhe declslon, raLher Lhan LoLal cash ows.
! use ume welghLed reLurns, l.e., value cash ows LhaL
occur earller more Lhan cash ows LhaL occur laLer.
1he keturn Mantra: 1|me-we|ghted, Incrementa| Cash
I|ow keturn
197
Semng Lhe Lable: WhaL ls an lnvesLmenL/
pro[ecL?
Aswotb uomoJotoo
197
! An lnvesLmenL/pro[ecL can range Lhe specLrum from blg
Lo small, money maklng Lo cosL savlng:
! Ma[or sLraLeglc declslons Lo enLer new areas of buslness or new
markeLs.
! Acqulsluons of oLher rms are pro[ecLs as well, noLwlLhsLandlng
auempLs Lo creaLe separaLe seLs of rules for Lhem.
! ueclslons on new venLures wlLhln exlsung buslnesses or
markeLs.
! ueclslons LhaL may change Lhe way exlsung venLures and
pro[ecLs are run.
! ueclslons on how besL Lo dellver a servlce LhaL ls necessary for
Lhe buslness Lo run smooLhly.
! uL ln broader Lerms, every cholce made by a rm can
be framed as an lnvesLmenL.
198
Pere are four examples.
Aswotb uomoJotoo
198
! 8lo ulsney: We wlll conslder wheLher ulsney should lnvesL ln lLs rsL
Lheme parks ln SouLh Amerlca. 1hese parks, whlle slmllar Lo Lhose LhaL
ulsney has ln oLher parLs of Lhe world, wlll requlre us Lo conslder Lhe
eecLs of counLry rlsk and currency lssues ln pro[ecL analysls.
! new lron ore mlne for vale: 1hls ls an lron ore mlne LhaL vale ls
conslderlng ln WesLern Labrador, Canada.
! An Cnllne SLore for 8ookscape: 8ookscape ls evaluaung wheLher lL should
creaLe an onllne sLore Lo sell books. Whlle lL ls an exLenslon of Lhelr basls
buslness, lL wlll requlre dlerenL lnvesLmenLs (and poLenually expose
Lhem Lo dlerenL Lypes of rlsk).
! Acqulsluon of Parman by 1aLa MoLors: A cross-border bld by 1aLa for
Parman lnLernauonal, a publlcly Lraded uS rm LhaL manufacLures hlgh-
end audlo equlpmenL, wlLh Lhe lnLenL of upgradlng Lhe audlo upgrades on
1aLa MoLors' auLomoblles. 1hls lnvesLmenL wlll allow us Lo examlne
currency and rlsk lssues ln such a Lransacuon.
199
Larnlngs versus Cash llows: A ulsney 1heme
ark
Aswotb uomoJotoo
199
! 1he Lheme parks Lo be bullL near 8lo, modeled on
Luro ulsney ln arls and ulsney World ln Crlando.
! 1he complex wlll lnclude a Maglc klngdom Lo be
consLrucLed, beglnnlng lmmedlaLely, and becomlng
operauonal aL Lhe beglnnlng of Lhe second year, and
a second Lheme park modeled on LpcoL CenLer aL
Crlando Lo be consLrucLed ln Lhe second and Lhlrd
year and becomlng operauonal aL Lhe beglnnlng of
Lhe fourLh year.
! 1he earnlngs and cash ows are esumaLed ln
nomlnal u.S. uollars.
200
key Assumpuons on SLarL up and ConsLrucuon
Aswotb uomoJotoo
200
! ulsney has already spenL $0.3 8llllon researchlng Lhe proposal and
gemng Lhe necessary llcenses for Lhe park, none of Lhls lnvesLmenL
can be recovered lf Lhe park ls noL bullL. 1hls expendlLure has been
caplLallzed and wlll be depreclaLed sLralghL llne over Len years Lo a
salvage value of zero.
! ulsney wlll face subsLanual consLrucuon cosLs, lf lL chooses Lo bulld
Lhe Lheme parks.
! 1he cosL of consLrucung Maglc klngdom wlll be $3 bllllon, wlLh $ 2 bllllon
Lo be spenL rlghL now, and $1 8llllon Lo be spenL one year from now.
! 1he cosL of consLrucung LpcoL ll wlll be $ 1.3 bllllon, wlLh $ 1 bllllon Lo be
spenL aL Lhe end of Lhe second year and $0.3 bllllon aL Lhe end of Lhe Lhlrd
year.
! 1hese lnvesLmenLs wlll be depreclaLed based upon a depreclauon
schedule ln Lhe Lax code, where depreclauon wlll be dlerenL each year.
201
key 8evenue Assumpuons
Aswotb uomoJotoo
201
! 8evenue esumaLes for Lhe parks and resorL properues (ln mllllons)
?ear Maglc klngdom LpcoL ll 8esorL roperues 1oLal
1 $0 $0 $0 $0
2 $1,000 $0 $230 $1,230
3 $1,400 $0 $330 $1.730
4 $1,700 $300 $300 $2.300
3 $2,000 $300 $623 $3.123
6 $2,200 $330 $688 $3,438
7 $2,420 $603 $736 $3,781
8 $2,662 $666 $832 $4,139
9 $2,928 $732 $913 $4,373
10 $2,987 $747 $933 $4,667
!
202
key Lxpense Assumpuons
Aswotb uomoJotoo
202
! 1he operaung expenses are assumed Lo be 60 of
Lhe revenues aL Lhe parks, and 73 of revenues aL
Lhe resorL properues.
! ulsney wlll also allocaLe corporaLe general and
admlnlsLrauve cosLs Lo Lhls pro[ecL, based upon
revenues, Lhe C&A allocauon wlll be 13 of Lhe
revenues each year. lL ls worLh noung LhaL a recenL
analysls of Lhese expenses found LhaL only one-Lhlrd
of Lhese expenses are varlable (and a funcuon of
LoLal revenue) and LhaL Lwo-Lhlrds are xed.
203
uepreclauon and CaplLal MalnLenance
Aswotb uomoJotoo
203

! 1he caplLal malnLenance expendlLures are low ln Lhe
early years, when Lhe parks are sull new buL lncrease as
Lhe parks age.
204
CLher Assumpuons
Aswotb uomoJotoo
204
! ulsney wlll have Lo malnLaln non-cash worklng
caplLal (prlmarlly conslsung of lnvenLory aL Lhe
Lheme parks and Lhe resorL properues, neued
agalnsL accounLs payable) of 3 of revenues, wlLh
Lhe lnvesLmenLs belng made aL Lhe end of each year.
! 1he lncome from Lhe lnvesLmenL wlll be Laxed aL
ulsneys marglnal Lax raLe of 38.
205
Laylng Lhe groundwork:
8ook CaplLal, Worklng CaplLal and uepreclauon
Aswotb uomoJotoo
205
12.5% of book
value at end of
prior year
($3,000)
206
SLep 1: LsumaLe Accounung Larnlngs on ro[ecL
Aswotb uomoJotoo
206
207
And Lhe Accounung vlew of 8eLurn
Aswotb uomoJotoo
207
(a) Based upon book capital at the start of each year
(b) Based upon average book capital over the year
208
WhaL should Lhls reLurn be compared Lo?
! 1he compuLed reLurn on caplLal on Lhls lnvesLmenL
ls abouL 4.18. 1o make a [udgmenL on wheLher Lhls
ls a sumclenL reLurn, we need Lo compare Lhls reLurn
Lo a hurdle raLe. Whlch of Lhe followlng ls Lhe
rlghL hurdle raLe? Why or why noL?
a. 1he rlskfree raLe of 2.73 (1. 8ond raLe)
b. 1he cosL of equlLy for ulsney as a company (8.32)
c. 1he cosL of equlLy for ulsney Lheme parks (7.09)
d. 1he cosL of caplLal for ulsney as a company (7.81)
e. 1he cosL of caplLal for ulsney Lheme parks (6.61)
f. none of Lhe above
Aswath Damodaran
209
Should Lhere be a rlsk premlum for forelgn
pro[ecLs?
Aswotb uomoJotoo
209
! 1he exchange raLe rlsk should be dlverslable rlsk (and hence
should noL command a premlum) lf
! Lhe company has pro[ecLs ls a large number of counLrles (or)
! Lhe lnvesLors ln Lhe company are globally dlversled.
! lor ulsney, Lhls rlsk should noL aecL Lhe cosL of caplLal used.
ConsequenLly, we would noL ad[usL Lhe cosL of caplLal for ulsneys
lnvesLmenLs ln oLher maLure markeLs (Cermany, uk, lrance)
! 1he same dlverslcauon argumenL can also be applled agalnsL
some pollucal rlsk, whlch would mean LhaL lL Loo should noL aecL
Lhe dlscounL raLe. Powever, Lhere are aspecLs of pollucal rlsk
especlally ln emerglng markeLs LhaL wlll be dlmculL Lo dlverslfy and
may aecL Lhe cash ows, by reduclng Lhe expecLed llfe or cash
ows on Lhe pro[ecL.
! lor ulsney, Lhls ls Lhe rlsk LhaL we are lncorporaung lnLo Lhe cosL of
caplLal when lL lnvesLs ln 8razll (or any oLher emerglng markeL)
210
Should Lhere be a rlsk premlum for forelgn
pro[ecLs?
! 1he exchange raLe rlsk should be dlverslable rlsk (and hence
should noL command a premlum) lf
! Lhe company has pro[ecLs ls a large number of counLrles (or)
! Lhe lnvesLors ln Lhe company are globally dlversled.
! lor ulsney, Lhls rlsk should noL aecL Lhe cosL of caplLal used.
ConsequenLly, we would noL ad[usL Lhe cosL of caplLal for ulsneys
lnvesLmenLs ln oLher maLure markeLs (Cermany, uk, lrance)
! 1he same dlverslcauon argumenL can also be applled agalnsL
some pollucal rlsk, whlch would mean LhaL lL Loo should noL aecL
Lhe dlscounL raLe. Powever, Lhere are aspecLs of pollucal rlsk
especlally ln emerglng markeLs LhaL wlll be dlmculL Lo dlverslfy and
may aecL Lhe cash ows, by reduclng Lhe expecLed llfe or cash
ows on Lhe pro[ecL.
! lor ulsney, Lhls ls Lhe rlsk LhaL we are lncorporaung lnLo Lhe cosL of
caplLal when lL lnvesLs ln 8razll (or any oLher emerglng markeL)
Aswath Damodaran
211
Lsumaung a hurdle raLe for 8lo ulsney
! We dld esumaLe a cosL of caplLal of 6.61 for Lhe ulsney Lheme park
buslness, uslng a bouom-up levered beLa of 0.7337 for Lhe buslness.
! 1hls cosL of equlLy may noL adequaLely reecL Lhe addluonal rlsk
assoclaLed wlLh Lhe Lheme park belng ln an emerglng markeL.
! 1he only concern we would have wlLh uslng Lhls cosL of equlLy for Lhls
pro[ecL ls LhaL lL may noL adequaLely reecL Lhe addluonal rlsk assoclaLed
wlLh Lhe Lheme park belng ln an emerglng markeL (8razll). We rsL
compuLed Lhe 8razll counLry rlsk premlum (by muluplylng Lhe defaulL
spread for 8razll by Lhe relauve equlLy markeL volaullLy) and Lhen re-
esumaLed Lhe cosL of equlLy:
! CounLry rlsk premlum for 8razll = 3.3+ 3 = 8.3
! CosL of LqulLy ln uS$= 2.73 + 0.7337 (8.3) = 9.16
! uslng Lhls esumaLe of Lhe cosL of equlLy, ulsneys Lheme park debL rauo
of 10.24 and lLs aer-Lax cosL of debL of 2.40 (see chapLer 4), we can
esumaLe Lhe cosL of caplLal for Lhe pro[ecL:
! CosL of CaplLal ln uS$ = 9.16 (0.8976) + 2.40 (0.1024) = 8.46
Aswath Damodaran
212
Would lead us Lo conclude LhaL...
! uo noL lnvesL ln Lhls park. 1he reLurn on caplLal of
4.18 ls lower Lhan Lhe cosL of caplLal for Lheme
parks of 8.46, 1hls would suggesL LhaL Lhe pro[ecL
should noL be Laken.
! Clven LhaL we have compuLed Lhe average over an
arblLrary perlod of 10 years, whlle Lhe Lheme park
lLself would have a llfe greaLer Lhan 10 years, would
you feel comforLable wlLh Lhls concluslon?
! ?es
! no
Aswath Damodaran
213
A 1angenL: lrom new Lo Lxlsung
lnvesLmenLs: 8CC for Lhe enure rm
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
How good are the
existing investments
of the rm?
Measuring ROC for existing investments..
Aswath Damodaran
214
Cld wlne ln a new boule.. AnoLher way of
presenung Lhe same resulLs.
! 1he key Lo value ls earnlng excess reLurns. Cver ume, Lhere have been
auempLs Lo resLaLe Lhls obvlous facL ln new and dlerenL ways. lor
lnsLance, Lconomlc value Added (LvA) developed a wlde followlng ln Lhe
Lhe 1990s:
! LvA = (8CC - CosL of CaplLal ) (8ook value of CaplLal lnvesLed)
! 1he excess reLurns for Lhe four rms can be resLaLed as follows:
Aswath Damodaran
215
8eLurn Spreads Clobally..
0.00
10.00
20.00
30.00
40.00
30.00
60.00
70.00
80.00
AusLralla,
nZ &
Canada
Lurope Lmerglng
MarkeLs
!apan uS Clobal

o
f

h
r
m
s

|
n

t
h
e

g
r
o
u
p

kOlc vetsos cost of copltol. A Clobol Assessmeot fot 201J
8CC more Lhan 3 below cosL of caplLal
8CC beLween 2 and 3 below cosL of caplLal
8CC beLween 2 and 0 below cosL of caplLal
8CC beLween 0 and 2 more Lhan cosL of caplLal
8CC beLween 2 and 3 above cosL of caplLal
8CC more Lhan 3 above cosL of caplLal
215
216
$ Appllcauon 1esL: Assesslng lnvesLmenL
CuallLy
! lor Lhe mosL recenL perlod for whlch you have daLa,
compuLe Lhe aer-Lax reLurn on caplLal earned by your
rm, where aer-Lax reLurn on caplLal ls compuLed Lo be
! Aer-Lax 8CC = L8l1 (1-Lax raLe)/ (8v of debL + 8v of
LqulLy-Cash)prevlous year
! lor Lhe mosL recenL perlod for whlch you have daLa,
compuLe Lhe reLurn spread earned by your rm:
! 8eLurn Spread = Aer-Lax 8CC - CosL of CaplLal
! lor Lhe mosL recenL perlod, compuLe Lhe LvA earned by
your rm
LvA = 8eLurn Spread * ((8v of debL + 8v of LqulLy-
Cash)prevlous year
Aswath Damodaran
217
1he cash ow vlew of Lhls pro[ecL..
To get from income to cash ow, we
I. added back all non-cash charges such as depreciation. Tax
benets:
II. subtracted out the capital expenditures
III. subtracted out the change in non-cash working capital
Aswath Damodaran
0 1 2 3 4 5 6 7 8 9 10
After-tax Operating Income
-$32 -$96 -$34 $68 $202 $249 $299 $332 $410 $421
+ Depreciation & Amortization
$0 $30 $423 $469 $444 $372 $367 $364 $364 $366 $368
- Capital Expenditures
$2,300 $1,000 $1,188 $732 $276 $238 $283 $314 $330 $347 $330
- Change in non-cash Work Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashow to rm ($2,500) ($982) ($921) ($361) $198 $285 $314 $332 $367 $407 $434
218
1he uepreclauon 1ax 8eneL
Aswotb uomoJotoo
218
! Whlle depreclauon reduces Laxable lncome and Laxes, lL does noL reduce
Lhe cash ows.
! 1he beneL of depreclauon ls Lherefore Lhe Lax beneL. ln general, Lhe Lax
beneL from depreclauon can be wrluen as:
! 1ax 8eneL = uepreclauon * 1ax 8aLe
! ulsney 1heme ark: uepreclauon Lax savlngs (1ax raLe = 36.1)
! roposluon 1: 1he Lax beneL from depreclauon and oLher non-cash
charges ls greaLer, Lhe hlgher your Lax raLe.
! roposluon 2: non-cash charges LhaL are noL Lax deducuble (such as
amoruzauon of goodwlll) and Lhus provlde no Lax beneLs have no eecL
on cash ows.
1 2 3 4 3 6 7 8 9 10
Depreciation
$30 $423 $469 $444 $372 $367 $364 $364 $366 $368
Tax Bendts from Depreciation
$18 $133 $169 $160 $134 $132 $132 $132 $132 $133
219
uepreclauon MeLhods
Aswotb uomoJotoo
219
! 8roadly caLegorlzlng, depreclauon meLhods can be classled
as sLralghL llne or acceleraLed meLhods. ln sLralghL llne
depreclauon, Lhe caplLal expense ls spread evenly over ume,
ln acceleraLed depreclauon, Lhe caplLal expense ls
depreclaLed more ln earller years and less ln laLer years.
Assume LhaL you made a large lnvesLmenL Lhls year, and LhaL
you are chooslng beLween sLralghL llne and acceleraLed
depreclauon meLhods. Whlch wlll resulL ln hlgher neL lncome
Lhls year?
! SLralghL Llne uepreclauon
! AcceleraLed uepreclauon
! Whlch wlll resulL ln hlgher cash ows Lhls year?
! SLralghL Llne uepreclauon
! AcceleraLed uepreclauon
220
1he CaplLal LxpendlLures LecL
Aswotb uomoJotoo
220
! CaplLal expendlLures are noL LreaLed as accounung expenses
buL Lhey do cause cash ouulows.
! CaplLal expendlLures can generally be caLegorlzed lnLo Lwo
groups
! new (or CrowLh) caplLal expendlLures are caplLal expendlLures
deslgned Lo creaLe new asseLs and fuLure growLh
! MalnLenance caplLal expendlLures refer Lo caplLal expendlLures
deslgned Lo keep exlsung asseLs.
! 8oLh lnlual and malnLenance caplLal expendlLures reduce
cash ows
! 1he need for malnLenance caplLal expendlLures wlll lncrease
wlLh Lhe llfe of Lhe pro[ecL. ln oLher words, a 23-year pro[ecL
wlll requlre more malnLenance caplLal expendlLures Lhan a 2-
year pro[ecL.
221
1o cap ex or noL Lo cap ex?
Aswotb uomoJotoo
221
! Assume LhaL you run your own soware buslness, and
LhaL you have an expense Lhls year of $ 100 mllllon from
produclng and dlsLrlbuuon promouonal Cus ln soware
magazlnes. ?our accounLanL Lells you LhaL you can
expense Lhls lLem or caplLallze and depreclaLe lL over
Lhree years. Whlch wlll have a more posluve eecL on
lncome?
! Lxpense lL
! CaplLallze and uepreclaLe lL
! Whlch wlll have a more posluve eecL on cash ows?
! Lxpense lL
! CaplLallze and uepreclaLe lL
222
1he Worklng CaplLal LecL
Aswotb uomoJotoo
222
! lnLuluvely, money lnvesLed ln lnvenLory or ln accounLs recelvable cannoL
be used elsewhere. lL, Lhus, represenLs a draln on cash ows
! 1o Lhe degree LhaL some of Lhese lnvesLmenLs can be nanced uslng
suppller credlL (accounLs payable), Lhe cash ow draln ls reduced.
! lnvesLmenLs ln worklng caplLal are Lhus cash ouulows
! Any lncrease ln worklng caplLal reduces cash ows ln LhaL year
! Any decrease ln worklng caplLal lncreases cash ows ln LhaL year
! 1o provlde closure, worklng caplLal lnvesLmenLs need Lo be salvaged aL
Lhe end of Lhe pro[ecL llfe.
! roposluon 1: 1he fallure Lo conslder worklng caplLal ln a caplLal
budgeung pro[ecL wlll oversLaLe cash ows on LhaL pro[ecL and make lL
look more auracuve Lhan lL really ls.
! roposluon 2: CLher Lhlngs held equal, a reducuon ln worklng caplLal
requlremenLs wlll lncrease Lhe cash ows on all pro[ecLs for a rm.
223
1he lncremenLal cash ows on Lhe pro[ecL
$ 500 million has
already been spent & $
50 million in
depreciation will exist
anyway
2/3rd of allocated G&A is xed.
Add back this amount (1-t)
Tax rate = 36.1%
Aswath Damodaran
224
A more dlrecL way of gemng Lo
lncremenLal cash ows
0 1 2 3 4 5 6 7 8 9 10
Revenues $0 $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,159 $4,575 $4,667
Direct Expenses $0 $788 $1,103 $1,575 $1,969 $2,166 $2,382 $2,620 $2,882 $2,940
Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
Incremental G&A $0 $63 $88 $125 $156 $172 $189 $208 $229 $233
Incremental Operating Income $0 $25 $141 $406 $678 $783 $896 $1,017 $1,148 $1,175
- Taxes $0 $9 $51 $147 $245 $283 $323 $367 $415 $424
Incremental after-tax Operating income $0 $16 $90 $260 $433 $500 $572 $650 $734 $751
+ Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
- Capital Expenditures $2,000 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
- Change in non-cash Working Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashow to rm ($2,000) ($1,000) ($859) ($267) $340 $466 $516 $555 $615 $681 $715
Aswotb uomoJotoo
224
225
Sunk CosLs
Aswotb uomoJotoo
225
! WhaL ls a sunk cosL? Any expendlLure LhaL has already
been lncurred, and cannoL be recovered (even lf a
pro[ecL ls re[ecLed) ls called a sunk cosL. A LesL markeL
for a consumer producL and 8&u expenses for a drug
(for a pharmaceuucal company) would be good
examples.
! 1he sunk cosL rule: When analyzlng a pro[ecL, sunk cosLs
should noL be consldered slnce Lhey are noL lncremenLal.
! A 8ebovlotol AslJe. lt ls o well estobllsbeJ foJloq lo
psycboloqlcol ooJ bebovlotol teseotcb tbot moooqets
foJ lt olmost lmposslble to lqoote sook costs.
226
1esL Markeung and 8&u: 1he Cuandary of Sunk
CosLs
Aswotb uomoJotoo
226
! A consumer producL company has spenL $ 100 mllllon on
LesL markeung. Looklng aL only Lhe lncremenLal cash
ows (and lgnorlng Lhe LesL markeung), Lhe pro[ecL looks
llke lL wlll creaLe $23 mllllon ln value for Lhe company.
Should lL Lake Lhe lnvesLmenL?
! ?es
! no
! now assume LhaL every lnvesLmenL LhaL Lhls company
has shares Lhe same characLerlsucs (Sunk cosLs value
Added). 1he rm wlll clearly noL be able Lo survlve. WhaL
ls Lhe soluuon Lo Lhls problem?
227
AllocaLed CosLs
Aswotb uomoJotoo
227
! llrms allocaLe cosLs Lo lndlvldual pro[ecLs from a
cenLrallzed pool (such as general and admlnlsLrauve
expenses) based upon some characLerlsuc of Lhe
pro[ecL (sales ls a common cholce, as ls earnlngs)
! lor large rms, Lhese allocaLed cosLs can be
slgnlcanL and resulL ln Lhe re[ecuon of pro[ecLs
! 1o Lhe degree LhaL Lhese cosLs are noL lncremenLal
(and would exlsL anyway), Lhls makes Lhe rm worse
o. 1hus, lL ls only Lhe lncremenLal componenL of
allocaLed cosLs LhaL should show up ln pro[ecL
analysls.
228
8reaklng ouL C&A CosLs lnLo xed and varlable
componenLs: A slmple example
Aswotb uomoJotoo
228
! Assume LhaL you have a ume serles of revenues and
C&A cosLs for a company.
! WhaL percenLage of Lhe C&A cosL ls varlable?
229
1o 1lme-WelghLed Cash llows
Aswotb uomoJotoo
229
! lncremenLal cash ows ln Lhe earller years are worLh
more Lhan lncremenLal cash ows ln laLer years.
! ln facL, cash ows across ume cannoL be added up.
1hey have Lo be broughL Lo Lhe same polnL ln ume
before aggregauon.
! 1hls process of movlng cash ows Lhrough ume ls
! dlscounung, when fuLure cash ows are broughL Lo Lhe
presenL
! compoundlng, when presenL cash ows are Laken Lo Lhe
fuLure
230
resenL value Mechanlcs
Aswotb uomoJotoo
230
! Cash llow 1ype ulscounung lormula Compoundlng lormula
1. Slmple Cl Cl
n
/ (1+r)
n
Cl
0
(1+r)
n

2. AnnulLy



3. Crowlng AnnulLy



4. erpeLulLy A/r
3. Crowlng erpeLulLy LxpecLed Cashow nexL year/(r-g)
A
1 -
1
(1+r)
n
r
!
"
#
#
#
#
$
%
&
&
&
&
!
A
(1+r)
n
- 1
r
"
#
$
%
&
'
A(1+g)
1 -
(1+g)
n
(1+r)
n
r-g
!
"
#
#
#
#
$
%
&
&
&
&
231
ulscounLed cash ow measures of reLurn
Aswotb uomoJotoo
231
! neL resenL value (nv): 1he neL presenL value ls Lhe
sum of Lhe presenL values of all cash ows from Lhe
pro[ecL (lncludlng lnlual lnvesLmenL).
! nv = Sum of Lhe presenL values of all cash ows on Lhe pro[ecL,
lncludlng Lhe lnlual lnvesLmenL, wlLh Lhe cash ows belng
dlscounLed aL Lhe approprlaLe hurdle raLe (cosL of caplLal, lf cash
ow ls cash ow Lo Lhe rm, and cosL of equlLy, lf cash ow ls Lo
equlLy lnvesLors)
! ueclslon 8ule: AccepL lf nv 0
! lnLernal 8aLe of 8eLurn (l88): 1he lnLernal raLe of reLurn
ls Lhe dlscounL raLe LhaL seLs Lhe neL presenL value equal
Lo zero. lL ls Lhe percenLage raLe of reLurn, based upon
lncremenLal ume-welghLed cash ows.
! ueclslon 8ule: AccepL lf l88 hurdle raLe
232
Closure on Cash llows
! ln a pro[ecL wlLh a nlLe and shorL llfe, you would need Lo compuLe
a salvage value, whlch ls Lhe expecLed proceeds from selllng all of
Lhe lnvesLmenL ln Lhe pro[ecL aL Lhe end of Lhe pro[ecL llfe. lL ls
usually seL equal Lo book value of xed asseLs and worklng caplLal
! ln a pro[ecL wlLh an lnnlLe or very long llfe, we compuLe cash
ows for a reasonable perlod, and Lhen compuLe a Lermlnal value
for Lhls pro[ecL, whlch ls Lhe presenL value of all cash ows LhaL
occur aer Lhe esumauon perlod ends..
! Assumlng Lhe pro[ecL lasLs forever, and LhaL cash ows aer year
10 grow 2 (Lhe lnauon raLe) forever, Lhe presenL value aL Lhe
end of year 10 of cash ows aer LhaL can be wrluen as:
! 1ermlnal value ln year 10= Cl ln year 11/(CosL of CaplLal - CrowLh 8aLe)
=713 (1.02) /(.0846-.02) = $ 11,273 mllllon
Aswath Damodaran
233
Whlch ylelds a nv of..
Discounted at Rio Disney cost
of capital of 8.46%
Aswath Damodaran
234
Whlch makes Lhe argumenL LhaL..
! 1he pro[ecL should be accepLed. 1he posluve neL
presenL value suggesLs LhaL Lhe pro[ecL wlll add
value Lo Lhe rm, and earn a reLurn ln excess of Lhe
cosL of caplLal.
! 8y Laklng Lhe pro[ecL, ulsney wlll lncrease lLs value
as a rm by $3,296 mllllon.
Aswath Damodaran
235
1he l88 of Lhls pro[ecL
Aswath Damodaran
-$3,000.00
-$2,000.00
-$1,000.00
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
$5,000.00
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
N
P
V

Discount Rate
Internal Rate of Return=12.60%
236
1he l88 suggesLs..
! 1he pro[ecL ls a good one. uslng ume-welghLed, lncremenLal cash
ows, Lhls pro[ecL provldes a reLurn of 12.60. 1hls ls greaLer Lhan
Lhe cosL of caplLal of 8.46.
! 1he l88 and Lhe nv wlll yleld slmllar resulLs mosL of Lhe ume,
Lhough Lhere are dlerences beLween Lhe Lwo approaches LhaL
may cause pro[ecL ranklngs Lo vary dependlng upon Lhe approach
used. 1hey can yleld dlerenL resulLs, especlally why comparlng
across pro[ecLs because
! A pro[ecL can have only one nv, whereas lL can have more Lhan one l88.
! 1he nv ls a dollar surplus value, whereas Lhe l88 ls a percenLage measure
of reLurn. 1he nv ls Lherefore llkely Lo be larger for large scale
pro[ecLs, whlle Lhe l88 ls hlgher for small-scale pro[ecLs.
! 1he nv assumes LhaL lnLermedlaLe cash ows geL relnvesLed aL Lhe
hurdle raLe, whlch ls based upon whaL you can make on lnvesLmenLs of
comparable rlsk, whlle Lhe l88 assumes LhaL lnLermedlaLe cash ows geL
relnvesLed aL Lhe l88.
Aswath Damodaran
237
uoes Lhe currency mauer?
! 1he analysls was done ln dollars. Would Lhe
concluslons have been any dlerenL lf we had done
Lhe analysls ln 8razlllan 8eals?
a. ?es
b. no
Aswath Damodaran
238
1he ConslsLency 8ule for Cash llows
Aswotb uomoJotoo
238
! 1he cash ows on a pro[ecL and Lhe dlscounL raLe
used should be dened ln Lhe same Lerms.
! lf cash ows are ln dollars ($8), Lhe dlscounL raLe has Lo be
a dollar ($8) dlscounL raLe
! lf Lhe cash ows are nomlnal (real), Lhe dlscounL raLe has
Lo be nomlnal (real).
! lf conslsLency ls malnLalned, Lhe pro[ecL concluslons
should be ldenucal, no mauer whaL cash ows are
used.
239
ulsney 1heme ark: ro[ecL Analysls ln $8
Aswotb uomoJotoo
239
! 1he lnauon raLes were assumed Lo be 9 ln 8razll and 2 ln Lhe
unlLed SLaLes. 1he $8/dollar raLe aL Lhe ume of Lhe analysls was
2.33 $8/dollar.
! 1he expecLed exchange raLe was derlved assumlng purchaslng
power parlLy.
! LxpecLed Lxchange 8aLe
L
= Lxchange 8aLe Loday * (1.09/1.02)
L
! 1he expecLed growLh raLe aer year 10 ls sull expecLed Lo be Lhe
lnauon raLe, buL lL ls Lhe 9 $8 lnauon raLe.
! 1he cosL of caplLal ln $8 was derlved from Lhe cosL of caplLal ln
dollars and Lhe dlerences ln lnauon raLes:
$8 CosL of CaplLal =
= (1.0846) (1.09/1.02) - 1 = 13.91
!
(1+US $ Cost of Capital)
(1+Exp Inflation
Brazil
)
(1+Exp Inflation
US
)
"1
240
ulsney 1heme ark: $8 nv
nv = 8$ 7,743/2.33= $ 3,296 Mllllon
nv ls equal Lo nv ln dollar Lerms
Discount at $R cost of capital
= (1.0846) (1.09/1.02) 1 = 15.91%
Expected Exchange Rate
t

= Exchange Rate today * (1.09/1.02)
t

Aswath Damodaran
241
uncerLalnLy ln ro[ecL Analysls: WhaL can we
do?
Aswotb uomoJotoo
241
! 8ased on our expecLed cash ows and Lhe esumaLed cosL of caplLal, Lhe
proposed Lheme park looks llke a very good lnvesLmenL for ulsney. Whlch
of Lhe followlng may aecL your assessmenL of value?
! 8evenues may be over esumaLed (crowds may be smaller and spend less)
! AcLual cosLs may be hlgher Lhan esumaLed cosLs
! 1ax raLes may go up
! lnLeresL raLes may rlse
! 8lsk premlums and defaulL spreads may lncrease
! All of Lhe above
! Pow would you respond Lo Lhls uncerLalnLy?
! Wlll walL for Lhe uncerLalnLy Lo be resolved
! Wlll noL Lake Lhe lnvesLmenL
! Ask someone else (consulLanL, boss, colleague) Lo make Lhe declslon
! lgnore lL.
! CLher
242
Cne slmpllsuc soluuon: See how qulckly
you can geL your money back.
! lf your blggesL fear ls loslng Lhe bllllons LhaL you lnvesLed ln Lhe pro[ecL,
one slmple measure LhaL you can compuLe ls Lhe number of years lL wlll
Lake you Lo geL your money back.
Payback = 10.3 years
Discounted Payback
= 16.8 years
Aswath Damodaran
Year Cash Flow Cumulated CF PV of Cash Flow Cumulated DCF
0 -$2,000 -$2,000 -$2,000 -$2,000
1 -$1,000 -$3,000 -$922 -$2,922
2 -$859 -$3,859 -$730 -$3,652
3 -$267 -$4,126 -$210 -$3,862
4 $340 -$3,786 $246 -$3,616
5 $466 -$3,320 $311 -$3,305
6 $516 -$2,803 $317 -$2,988
7 $555 -$2,248 $314 -$2,674
8 $615 -$1,633 $321 -$2,353
9 $681 -$952 $328 -$2,025
10 $715 -$237 $317 -$1,708
11 $729 $491 $298 -$1,409
12 $743 $1,235 $280 -$1,129
13 $758 $1,993 $264 -$865
14 $773 $2,766 $248 -$617
15 $789 $3,555 $233 -$384
16 $805 $4,360 $219 -$165
17 $821 $5,181 $206 $41
243
A sllghLly more sophlsucaLed approach:
SensluvlLy Analysls & WhaL-lf Cuesuons.
! 1he nv, l88 and accounung reLurns for an lnvesLmenL wlll change
as we change Lhe values LhaL we use for dlerenL varlables.
! Cne way of analyzlng uncerLalnLy ls Lo check Lo see how sensluve
Lhe declslon measure (nv, l88..) ls Lo changes ln key assumpuons.
Whlle Lhls has become easler and easler Lo do over ume, Lhere are
caveaLs LhaL we would oer.
! CaveaL 1: When analyzlng Lhe eecLs of changlng a varlable, we
oen hold all else consLanL. ln Lhe real world, varlables move
LogeLher.
! CaveaL 2: 1he ob[ecuve ln sensluvlLy analysls ls LhaL we make
beuer declslons, noL churn ouL more Lables and numbers.
! Corollary 1: Less ls more. noL everyLhlng ls worLh varylng.
! Corollary 2: A plcLure ls worLh a Lhousand numbers (and Lables).
Aswath Damodaran
244
And here ls a really good plcLure.
Aswath Damodaran
245
1he nal sLep up: lncorporaLe probablllsuc
esumaLes.. 8aLher Lhan expecLed values..
Actual Revenues as % of Forecasted Revenues (Base case = 100%)
Operating Expenses at Parks as % of
Revenues (Base Case = 60%)
Country Risk Premium (Base Case = 3%
(Brazil))
Aswath Damodaran



246
1he resulung slmulauon.
Average = $3.40 billion
Median = $3.28 billion

NPV ranges from -$1 billion to +$8.5 billion. NPV is negative 12% of the
time.
Aswath Damodaran

247
?ou are Lhe declslon maker.
Aswotb uomoJotoo
247
! Assume LhaL you are Lhe person aL ulsney who ls glven
Lhe resulLs of Lhe slmulauon. 1he average and medlan
nv are close Lo your base case values of $3.29 bllllon.
Powever, Lhere ls a 10 probablllLy LhaL Lhe pro[ecL
could have a negauve nv and LhaL Lhe nv could be a
large negauve value? Pow would you use Lhls
lnformauon?
! l would accepL Lhe lnvesLmenL and prlnL Lhe resulLs of Lhls
slmulauon and le Lhem away Lo show LhaL l exerclsed due
dlllgence.
! l would re[ecL Lhe lnvesLmenL, because lL ls Loo rlsky (Lhere ls a
10 chance LhaL lL could be a bad pro[ecL)
! CLher
248
LqulLy Analysls: 1he arallels
Aswotb uomoJotoo
248
! 1he lnvesLmenL analysls can be done enurely ln equlLy
Lerms, as well. 1he reLurns, cashows and hurdle raLes
wlll all be dened from Lhe perspecuve of equlLy
lnvesLors.
! lf uslng accounung reLurns,
! 8eLurn wlll be 8eLurn on LqulLy (8CL) = neL lncome/8v of
LqulLy
! 8CL has Lo be greaLer Lhan cosL of equlLy
! lf uslng dlscounLed cashow models,
! Cashows wlll be cashows aer debL paymenLs Lo equlLy
lnvesLors
! Purdle raLe wlll be cosL of equlLy
249
A vale lron Cre Mlne ln Canada lnvesLmenL
Cperaung Assumpuons
Aswotb uomoJotoo
249
1. 1he mlne wlll requlre an lnlual lnvesLmenL of $1.23 bllllon and ls expecLed Lo have a producuon
capaclLy of 8 mllllon Lons of lron ore, once esLabllshed. 1he lnlual lnvesLmenL of $1.23 bllllon wlll
be depreclaLed over Len years, uslng double decllnlng balance depreclauon, down Lo a salvage
value of $230 mllllon aL Lhe end of Len years.
2. 1he mlne wlll sLarL producuon mldway Lhrough Lhe nexL year, produclng 4 mllllon Lons of lron
ore for year 1, wlLh producuon lncreaslng Lo 6 mllllon Lons ln year 2 and levellng o aL 8 mllllon
Lons Lhereaer (unul year 10). 1he prlce, ln uS dollars per Lon of lron ore ls currenLly $100 and ls
expecLed Lo keep pace wlLh lnauon for Lhe llfe of Lhe planL.
3. 1he varlable cosL of producuon, lncludlng labor, maLerlal and operaung expenses, ls expecLed Lo
be $43/Lon of lron ore produced and Lhere ls a xed cosL of $123 mllllon ln year 1. 8oLh cosLs,
whlch wlll grow aL Lhe lnauon raLe of 2 Lhereaer. 1he cosLs wlll be ln Canadlan dollars, buL
Lhe expecLed values are converLed lnLo uS dollars, assumlng LhaL Lhe currenL parlLy beLween Lhe
currencles (1 Canadlan $ = 1 uS dollar) wlll conunue, slnce lnLeresL and lnauon raLes are slmllar
ln Lhe Lwo currencles.
4. 1he worklng caplLal requlremenLs are esumaLed Lo be 20 of LoLal revenues, and Lhe
lnvesLmenLs have Lo be made aL Lhe beglnnlng of each year. AL Lhe end of Lhe LenLh year, lL ls
anuclpaLed LhaL Lhe enure worklng caplLal wlll be salvaged.
3. vale's corporaLe Lax raLe of 34 wlll apply Lo Lhls pro[ecL as well.
250
llnanclng Assumpuons
Aswotb uomoJotoo
250
vale plans Lo borrow $0.3 bllllon aL lLs currenL cosL of debL of 4.03 (based
upon lLs raung of A-), uslng a Len-year Lerm loan (where Lhe loan wlll be pald
o ln equal annual lncremenLs). 1he breakdown of Lhe paymenLs each year
lnLo lnLeresL and prlnclpal are provlded below:
251
1he Purdle 8aLe
Aswotb uomoJotoo
251
! 1he analysls ls done uS dollar Lerms and Lo equlLy
lnvesLors. 1hus, Lhe hurdle raLe has Lo be a uS $ cosL
of equlLy.
! ln Lhe earller secuon, we esumaLed cosLs of equlLy,
debL and caplLal ln uS dollars and $8 for vale's lron
ore buslness.
Business
Cost of
equity
After-tax cost of
debt
Debt
ratio
Cost of capital (in
US$)
Cost of capital (in
$R)
Metals &
Mining 11.35% 2.67% 35.48% 8.27% 15.70%
Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%

252
neL lncome: vale lron Cre Mlne
Aswotb uomoJotoo
252
1 2 3 4 5 6 7 8 9 10
Production (millions of tons) 4.00 6.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
* Price per ton 102 104.04 106.12 108.24 110.41 112.62 114.87 117.17 119.51 121.9
= Revenues (millions US$) $408.00 $624.24 $848.97 $865.95 $883.26 $900.93 $918.95 $937.33 $956.07 $975.20
- Variable Costs $180.00 $275.40 $374.54 $382.03 $389.68 $397.47 $405.42 $413.53 $421.80 $430.23
- Fixed Costs $125.00 $127.50 $130.05 $132.65 $135.30 $138.01 $140.77 $143.59 $146.46 $149.39
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
EBIT -$97.00 $61.34 $216.37 $248.86 $276.37 $299.91 $307.22 $314.68 $322.28 $330.04
- Interest Expenses $20.25 $18.57 $16.82 $14.99 $13.10 $11.13 $9.07 $6.94 $4.72 $2.41
Taxable Income -$117.25 $42.77 $199.56 $233.87 $263.27 $288.79 $298.15 $307.74 $317.57 $327.63
- Taxes ($39.87) $14.54 $67.85 $79.51 $89.51 $98.19 $101.37 $104.63 $107.97 $111.40
= Net Income (millions US$) -$77.39 $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
Book Value and Depreciation
Beg. Book Value $1,250.00 $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
+ Capital Exp. $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
End Book Value $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54 $250.00
- Debt Outstanding $458.45 $415.22 $370.24 $323.43 $274.73 $224.06 $171.34 $116.48 $59.39 $0.00
End Book Value of Equity $591.55 $474.78 $391.76 $336.17 $302.95 $288.08 $275.27 $264.60 $256.14 $250.00
253
A 8CL Analysls
Aswotb uomoJotoo
253
Year Net Income
Beg. BV:
Assets
Depreciation
Capital
Expense
Ending BV:
Assets
BV of
Working
Capital
Debt BV: Equity
Average BV:
Equity
ROE
0 $0.00 $0.00 $1,250.00 $1,250.00 $81.60 $500.00 $831.60
1 ($77.39) $1,250.00 $200.00 $0.00 $1,050.00 $124.85 $458.45 $716.40 $774.00 -10.00%
2 $28.23 $1,050.00 $160.00 $0.00 $890.00 $169.79 $415.22 $644.57 $680.49 4.15%
3 $131.71 $890.00 $128.00 $0.00 $762.00 $173.19 $370.24 $564.95 $604.76 21.78%
4 $154.35 $762.00 $102.40 $0.00 $659.60 $176.65 $323.43 $512.82 $538.89 28.64%
5 $173.76 $659.60 $81.92 $0.00 $577.68 $180.19 $274.73 $483.13 $497.98 34.89%
6 $190.60 $577.68 $65.54 $0.00 $512.14 $183.79 $224.06 $471.87 $477.50 39.92%
7 $196.78 $512.14 $65.54 $0.00 $446.61 $187.47 $171.34 $462.74 $467.31 42.11%
8 $203.11 $446.61 $65.54 $0.00 $381.07 $191.21 $116.48 $455.81 $459.27 44.22%
9 $209.59 $381.07 $65.54 $0.00 $315.54 $195.04 $59.39 $451.18 $453.50 46.22%
10 $216.24 $315.54 $65.54 $0.00 $250.00 $0.00 $0.00 $250.00 $350.59 61.68%
Average ROE over the ten-year period = 31.36%
US $ ROE of 31.36% is greater than
Vale Iron Ore US$ Cost of Equity of 11.13%
254
lrom ro[ecL 8CL Lo llrm 8CL
Aswotb uomoJotoo
254
! As wlLh Lhe earller analysls, where we used reLurn on caplLal and cosL of
caplLal Lo measure Lhe overall quallLy of pro[ecLs aL rms, we can
compuLe reLurn on equlLy and cosL of equlLy Lo pass [udgmenL on
wheLher rms are creaung value Lo lLs equlLy lnvesLors.
! Speclcally, we can compuLe Lhe reLurn on equlLy (neL lncome as a
percenLage of book equlLy) and compare Lo Lhe cosL of equlLy. 1he reLurn
spread ls Lhen:
! LqulLy 8eLurn Spread = 8eLurn on LqulLy - CosL of equlLy
! 1hls measure ls parucularly useful for nanclal servlce rms, where
caplLal, reLurn on caplLal and cosL of caplLal are dlmculL measures Lo nall
down.
! lor non-nanclal servlce rms, lL provldes a secondary (albelL a more
volaule measure of performance). Whlle lL usually provldes Lhe same
general resulL LhaL Lhe excess reLurn compuLed from reLurn on caplLal,
Lhere can be cases where Lhe Lwo measures dlverge.
255
An lncremenLal Cl Analysls
Aswotb uomoJotoo
255
0 1 2 3 4 5 6 7 8 9 10
Net Income ($77.39) $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
+ Depreciation & Amortization $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
- Capital Expenditures $750.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
- Change in Working Capital $81.60 $43.25 $44.95 $3.40 $3.46 $3.53 $3.60 $3.68 $3.75 $3.82 ($195.04)
- Principal Repayments $41.55 $43.23 $44.98 $46.80 $48.70 $50.67 $52.72 $54.86 $57.08 $59.39
+ Salvage Value of mine $250.00
Cashow to Equity ($831.60) $37.82 $100.05 $211.33 $206.48 $203.44 $201.86 $205.91 $210.04 $214.22 $667.42
256
An LqulLy nv
Aswotb uomoJotoo
256
Discounted at US$ cost of
equity of 11.13% for Vales
iron ore business
257
An LqulLy l88
Aswotb uomoJotoo
257
258
8eal versus nomlnal Analysls
Aswotb uomoJotoo
258
ln compuung Lhe nv of Lhe planL, we esumaLed uS $
cash ows and dlscounLed Lhem aL Lhe uS $ cosL of
equlLy. We could have esumaLed Lhe cash ows ln real
Lerms (wlLh no lnauon) and dlscounLed Lhem aL a real
cosL of equlLy. Would Lhe answer be dlerenL?
! ?es
! no
! Lxplaln
259
ueallng wlLh Macro uncerLalnLy: 1he LecL of
lron Cre rlce
Aswotb uomoJotoo
259
! Llke Lhe ulsney 1heme ark, Lhe vale lron Cre Mlne's acLual value wlll be
bueLed as Lhe varlables change. 1he blggesL source of varlablllLy ls an
exLernal facLor -Lhe prlce of lron ore.
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
-$1,500
-$1,000
-$500
$0
$500
$1,000
$1,500
$50 $60 $70 $80 $90 $100 $110 $120 $130
N
P
V

Price per ton of iron ore
Vale Paper Plant: Effect of Changing Iron Ore Prices
NP
260
And Lxchange 8aLes.
Aswotb uomoJotoo
260
0.00
3.00
10.00
13.00
20.00
23.00
-$100
$0
$100
$200
$300
$400
$300
$600
$700
I
n
t
e
r
n
a
|

k
a
t
e

o
f

k
e
t
u
r
n

N
e
t

r
e
s
e
n
t

V
a
|
u
e

Canad|an 5 versus US 5
xcbooqe kote e[ects oo ltoo Ote lloot
nv
l88
261
Should you hedge?
Aswotb uomoJotoo
261
! 1he value of Lhls mlne ls very much a funcuon lron ore prlces. 1here are fuLures,
forward and opuon markeLs lron ore LhaL vale can use Lo hedge agalnsL prlce
movemenLs. Should lL?
! ?es
! no
Lxplaln.
! 1he value of Lhe planL ls also a funcuon of exchange raLes. 1here are forward,
fuLures and opuons markeLs on currency. Should vale hedge agalnsL exchange
raLe rlsk?
! ?es
! no
Lxplaln.
! Cn Lhe lasL quesuon, would your answer have been dlerenL lf Lhe mlne were ln
8razll.
! ?es
! no
Will the benets persist if investors hedge
the risk instead of the rm?
No Yes
No Yes
Can marginal investors
hedge this risk cheaper
than the rm can?
No Yes
Is there a signicant benet in
terms of higher expected cash
ows or a lower discount rate?
No Yes
Is there a signicant benet in
terms of higher cash ows or
a lower discount rate?
What is the cost to the rm of hedging this risk?
Negligible High
Do not hedge this risk.
The benets are small
relative to costs
Hedge this risk. The
benets to the rm will
exceed the costs
Hedge this risk. The
benets to the rm will
exceed the costs
Let the risk pass
through to investors
and let them hedge
the risk.
Hedge this risk. The
benets to the rm will
exceed the costs
Indifferent to
hedging risk
Cash ow benets
- Tax benets
- Better project choices
Discount rate benets
- Hedge "macro" risks (cost of equity)
- Reduce default risk (cost of debt or debt ratio)
Survival benets (truncation risk)
- Protect against catastrophic risk
- Reduce default risk
Value Trade Off
Earnings Multiple
- Effect on multiple
Earnings
- Level
- Volatility
X
Pricing Trade
Aswotb uomoJotoo 262
263
Acqulsluons and ro[ecLs
Aswotb uomoJotoo
263
! An acqulsluon ls an lnvesLmenL/pro[ecL llke any oLher and all of Lhe
rules LhaL apply Lo Lradluonal lnvesLmenLs should apply Lo
acqulsluons as well. ln oLher words, for an acqulsluon Lo make
sense:
! lL should have posluve nv. 1he presenL value of Lhe expecLed cash ows
from Lhe acqulsluon should exceed Lhe prlce pald on Lhe acqulsluon.
! 1he l88 of Lhe cash ows Lo Lhe rm (equlLy) from Lhe acqulsluon CosL of
caplLal (equlLy) on Lhe acqulsluon
! ln esumaung Lhe cash ows on Lhe acqulsluon, we should counL ln
any posslble cash ows from synergy.
! 1he dlscounL raLe Lo assess Lhe presenL value should be based
upon Lhe rlsk of Lhe lnvesLmenL (LargeL company) and noL Lhe
enuLy conslderlng Lhe lnvesLmenL (acqulrlng company).
264
1aLa MoLors and Parman lnLernauonal
Aswotb uomoJotoo
264
! Parman lnLernauonal ls a publlcly Lraded uS rm
LhaL manufacLures hlgh end audlo equlpmenL. 1aLa
MoLors ls an auLomoblle company, based ln lndla.
! 1aLa MoLors ls conslderlng an acqulsluon of Parman,
wlLh an eye on uslng lLs audlo equlpmenL ln lLs
lndlan auLomoblles, as opuonal upgrades on new
cars.
265
Lsumaung Lhe CosL of CaplLal for Lhe
Acqulsluon (no synergy)
Aswotb uomoJotoo
265
1. Currency: LsumaLed ln uS $, slnce cash ows wlll be esumaLed ln uS $.
2. 8eLa: Parman lnLernauonal ls an elecLronlc company and we use Lhe unlevered beLa
(1.17) of elecLronlcs companles ln Lhe uS.
3. LqulLy 8lsk remlum: CompuLed based on Parman's operaung exposure:
4. uebL rauo & cosL of debL: 1aLa MoLors plans Lo assume Lhe exlsung debL of Parman
lnLernauonal and Lo preserve Parman's exlsung debL rauo. Parman currenLly has a debL
(lncludlng lease commlLmenLs) Lo caplLal rauo of 7.39 (Lranslaung lnLo a debL Lo equlLy
rauo of 7.98) and faces a pre-Lax cosL of debL of 4.73 (based on lLs 888- raung).
Levered 8eLa = 1.17 (1+ (1-.40) (.0798)) = 1.226
CosL of LqulLy= 2.73 + 1.226 (6.13) = 10.26
CosL of CaplLal = 10.26 (1-.0739) + 4.73 (1-.40) (.0739) = 9.67
266
Lsumaung Cashows- llrsL SLeps
Aswotb uomoJotoo
266
! Cperaung lncome: 1he rm reporLed operaung lncome of
$201.23 mllllon on revenues of $4.30 bllllon for Lhe year.
Addlng back non-recurrlng expenses (resLrucLurlng charge of
$83.2 mllllon ln 2013) and ad[usung lncome for Lhe
converslon of operaung lease commlLmenLs Lo debL, we
esumaLed an ad[usLed operaung lncome of $313.2 mllllon.
1he rm pald 18.21 of lLs lncome as Laxes ln 2013 and we
wlll use Lhls as Lhe eecuve Lax raLe for Lhe cash ows.
! 8elnvesLmenL: uepreclauon ln 2013 amounLed Lo $128.2
mllllon, whereas caplLal expendlLures and acqulsluons for Lhe
year were $206.4 mllllon. non-cash worklng caplLal lncreased
by $272.6 mllllon durlng 2013 buL was 13.34 of revenues ln
2013.
267
8rlnglng ln growLh
! We wlll assume LhaL Parman lnLernauonal ls a maLure rm, growlng
2.73 ln perpeLulLy.
! We assume LhaL revenues, operaung lncome, caplLal expendlLures and
depreclauon wlll all grow 2.73 for Lhe year and LhaL Lhe non-cash
worklng caplLal remaln 13.34 of revenues ln fuLure perlods.
Aswotb uomoJotoo
267
268
value of Parman lnLernauonal: 8efore Synergy
Aswotb uomoJotoo
268
! Larller, we esumaLed Lhe cosL of caplLal of 9.67 as Lhe rlghL dlscounL raLe Lo apply ln
valulng Parman lnLernauonal and Lhe cash ow Lo Lhe rm of $166.83 mllllon for 2014 (nexL
year), assumlng a 2.73 growLh raLe ln revenues, operaung lncome, depreclauon, caplLal
expendlLures and LoLal non-cash worklng caplLal. We also assumed LhaL Lhese cash ows
would conunue Lo grow 2.73 a year ln perpeLulLy.

! Addlng Lhe cash balance of Lhe rm ($313 mllllon) and subLracung ouL Lhe exlsung debL
($313 mllllon, lncludlng Lhe debL value of leases) ylelds Lhe value of equlLy ln Lhe rm:
! value of LqulLy = value of Cperaung AsseLs + Cash - uebL
= $2,476 + $ 313 - $313 mllllon = $2,678 mllllon
! 1he markeL value of equlLy ln Parman ln november 2013 was $3,428 mllllon.
! 1o Lhe exLenL LhaL 1aLa MoLors pays Lhe markeL prlce, lL wlll have Lo generaLe beneLs from
synergy LhaL exceed $2730 mllllon.
MLASu8lnC lnvLS1MLn1 8L1u8nS
ll. lnvLS1MLn1 ln1L8AC1lCnS,
C1lCnS Anu 8LMC8SL.
Llfe ls Loo shorL for regreLs, rlghL?
Aswotb uomoJotoo 269
270
lndependenL lnvesLmenLs are Lhe excepuon.
Aswotb uomoJotoo
270
! ln all of Lhe examples we have used so far, Lhe
lnvesLmenLs LhaL we have analyzed have sLood alone.
1hus, our [ob was a slmple one. Assess Lhe expecLed
cash ows on Lhe lnvesLmenL and dlscounL Lhem aL Lhe
rlghL dlscounL raLe.
! ln Lhe real world, mosL lnvesLmenLs are noL
lndependenL. 1aklng an lnvesLmenL can oen mean
re[ecung anoLher lnvesLmenL aL one exLreme (muLually
excluslve) Lo belng locked ln Lo Lake an lnvesLmenL ln Lhe
fuLure (pre-requlslLe).
! More generally, accepung an lnvesLmenL can creaLe slde
cosLs for a rms exlsung lnvesLmenLs ln some cases and
beneLs for oLhers.
271
l. MuLually Lxcluslve lnvesLmenLs
Aswotb uomoJotoo
271
! We have looked aL how besL Lo assess a sLand-alone
lnvesLmenL and concluded LhaL a good lnvesLmenL wlll have
posluve nv and generaLe accounung reLurns (8CC and 8CL)
and l88 LhaL exceed your cosLs (caplLal and equlLy).
! ln some cases, Lhough, rms may have Lo choose beLween
lnvesLmenLs because
! 1hey are muLually excluslve: 1aklng one lnvesLmenL makes Lhe oLher
one redundanL because Lhey boLh serve Lhe same purpose
! 1he rm has llmlLed caplLal and cannoL Lake every good lnvesLmenL
(l.e., lnvesLmenLs wlLh posluve nv or hlgh l88).
! uslng Lhe Lwo sLandard dlscounLed cash ow measures, nv
and l88, can yleld dlerenL cholces when chooslng beLween
lnvesLmenLs.
272
Comparlng ro[ecLs wlLh Lhe same (or slmllar)
llves..
Aswotb uomoJotoo
272
! When comparlng and chooslng beLween lnvesLmenLs
wlLh Lhe same llves, we can
! CompuLe Lhe accounung reLurns (8CC, 8CL) of Lhe lnvesLmenLs
and plck Lhe one wlLh Lhe hlgher reLurns
! CompuLe Lhe nv of Lhe lnvesLmenLs and plck Lhe one wlLh Lhe
hlgher nv
! CompuLe Lhe l88 of Lhe lnvesLmenLs and plck Lhe one wlLh Lhe
hlgher l88
! Whlle lL ls easy Lo see why accounung reLurn measures
can glve dlerenL ranklngs (and cholces) Lhan Lhe
dlscounLed cash ow approaches, you would expecL nv
and l88 Lo yleld conslsLenL resulLs slnce Lhey are boLh
ume-welghLed, lncremenLal cash ow reLurn measures.
273
Case 1: l88 versus nv
Aswotb uomoJotoo
273
! Conslder Lwo pro[ecLs wlLh Lhe followlng cash ows:
?ear ro[ecL 1 Cl ro[ecL 2 Cl
0 -1000 -1000
1 800 200
2 1000 300
3 1300 400
4 -2200 300
274
ro[ecLs nv role
Aswotb uomoJotoo
274
275
WhaL do we do now?
Aswotb uomoJotoo
275
! ro[ecL 1 has Lwo lnLernal raLes of reLurn. 1he rsL ls
6.60, whereas Lhe second ls 36.33. ro[ecL 2 has one
lnLernal raLe of reLurn, abouL 12.8.
! Why are Lhere Lwo lnLernal raLes of reLurn on pro[ecL 1?
! lf your cosL of caplLal ls 12, whlch lnvesLmenL would
you accepL?
a. ro[ecL 1
b. ro[ecL 2
! Lxplaln.
276
Case 2: nv versus l88
Aswotb uomoJotoo
276
Cash Flow
Investment
$ 350,000
$ 1,000,000
Project A
Cash Flow
Investment
Project B
NPV = $467,937
IRR= 33.66%
$ 450,000 $ 600,000 $ 750,000
NPV = $1,358,664
IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000
$ 5,500,000
277
Whlch one would you plck?
Aswotb uomoJotoo
277
! Assume LhaL you can plck only one of Lhese Lwo pro[ecLs.
?our cholce wlll clearly vary dependlng upon wheLher
you look aL nv or l88. ?ou have enough money
currenLly on hand Lo Lake elLher. Whlch one would you
plck?
a. ro[ecL A. lL glves me Lhe blgger bang for Lhe buck and more
margln for error.
b. ro[ecL 8. lL creaLes more dollar value ln my buslness.
! lf you plck A, whaL would your blggesL concern be?
! lf you plck 8, whaL would your blggesL concern be?
278
CaplLal 8auonlng, uncerLalnLy and Chooslng a
8ule
Aswotb uomoJotoo
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! lf a buslness has llmlLed access Lo caplLal, has a sLream
of surplus value pro[ecLs and faces more uncerLalnLy ln
lLs pro[ecL cash ows, lL ls much more llkely Lo use l88 as
lLs declslon rule.
! Small, hlgh-growLh companles and prlvaLe buslnesses are much
more llkely Lo use l88.
! lf a buslness has subsLanual funds on hand, access Lo
caplLal, llmlLed surplus value pro[ecLs, and more
cerLalnLy on lLs pro[ecL cash ows, lL ls much more llkely
Lo use nv as lLs declslon rule.
! As rms go publlc and grow, Lhey are much more llkely
Lo galn from uslng nv.
279
1he sources of caplLal rauonlng.
Aswotb uomoJotoo
279
Cause Number of firms Percent of total
Debt limit imposed by outside agreement 10 10.7
Debt limit placed by management external
to firm
3 3.2
Limit placed on borrowing by internal
management
65 69.1
Restrictive policy imposed on retained
earnings
2 2.1
Maintenance of target EPS or PE ratio 14 14.9

280
An AlLernauve Lo l88 wlLh CaplLal 8auonlng
Aswotb uomoJotoo
280
! 1he problem wlLh Lhe nv rule, when Lhere ls caplLal
rauonlng, ls LhaL lL ls a dollar value. lL measures success
ln absoluLe Lerms.
! 1he nv can be converLed lnLo a relauve measure by
dlvldlng by Lhe lnlual lnvesLmenL. 1hls ls called Lhe
proLablllLy lndex.
! roLablllLy lndex (l) = nv/lnlual lnvesLmenL
! ln Lhe example descrlbed, Lhe l of Lhe Lwo pro[ecLs
would have been:
! l of ro[ecL A = $467,937/1,000,000 = 46.79
! l of ro[ecL 8 = $1,338,664/10,000,000 = 13.39
! ro[ecL A would have scored hlgher.
281
Case 3: nv versus l88
Aswotb uomoJotoo
281
Cash Flow
Investment
$ 5,000,000
$ 10,000,000
Project A
Cash Flow
Investment
Project B
NPV = $1,191,712
IRR=21.41%
$ 4,000,000 $ 3,200,000 $ 3,000,000
NPV = $1,358,664
IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000
$ 5,500,000
282
Why Lhe dlerence?
Aswotb uomoJotoo
282
! 1hese pro[ecLs are of Lhe same scale. 8oLh Lhe nv
and l88 use ume-welghLed cash ows. ?eL, Lhe
ranklngs are dlerenL. Why?
! Whlch one would you plck?
a. ro[ecL A. lL glves me Lhe blgger bang for Lhe buck and
more margln for error.
b. ro[ecL 8. lL creaLes more dollar value ln my buslness.
283
nv, l88 and Lhe 8elnvesLmenL 8aLe
Assumpuon
Aswotb uomoJotoo
283
! 1he nv rule assumes LhaL lnLermedlaLe cash ows on
Lhe pro[ecL geL relnvesLed aL Lhe hurdle raLe (whlch ls
based upon whaL pro[ecLs of comparable rlsk should
earn).
! 1he l88 rule assumes LhaL lnLermedlaLe cash ows on
Lhe pro[ecL geL relnvesLed aL Lhe l88. lmpllclL ls Lhe
assumpuon LhaL Lhe rm has an lnnlLe sLream of
pro[ecLs yleldlng slmllar l88s.
! Concluslon: wbeo tbe lkk ls blqb (tbe ptoject ls cteouoq
slqolfcoot sotplos voloe) ooJ tbe ptoject llfe ls looq, tbe
lkk wlll ovetstote tbe ttoe tetoto oo tbe ptoject.
284
Soluuon Lo 8elnvesLmenL 8aLe roblem
Aswotb uomoJotoo
284
285
Why nv and l88 may dler.. Lven lf pro[ecLs
have Lhe same llves
Aswotb uomoJotoo
285
! A pro[ecL can have only one nv, whereas lL can have
more Lhan one l88.
! 1he nv ls a dollar surplus value, whereas Lhe l88 ls a
percenLage measure of reLurn. 1he nv ls Lherefore
llkely Lo be larger for large scale pro[ecLs, whlle Lhe
l88 ls hlgher for small-scale pro[ecLs.
! 1he nv assumes LhaL lnLermedlaLe cash ows geL
relnvesLed aL Lhe hurdle raLe, whlch ls based upon
whaL you can make on lnvesLmenLs of comparable rlsk,
whlle Lhe l88 assumes LhaL lnLermedlaLe cash ows geL
relnvesLed aL Lhe l88.
286
Comparlng pro[ecLs wlLh dlerenL llves..
Aswotb uomoJotoo
286
Project A
-$1500
$350 $350 $350 $350 $350
-$1000
$400 $400 $400 $400 $400
$350 $350 $350 $350 $350
Project B
NPV of Project A = $ 442
IRR of Project A = 28.7%
NPV of Project B = $ 478
IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%
287
Why nvs cannoL be compared.. When pro[ecLs
have dlerenL llves.
Aswotb uomoJotoo
287
! 1he neL presenL values of muLually excluslve pro[ecLs
wlLh dlerenL llves cannoL be compared, slnce Lhere
ls a blas Lowards longer-llfe pro[ecLs. 1o compare
Lhe nv, we have Lo
! repllcaLe Lhe pro[ecLs ull Lhey have Lhe same llfe (or)
! converL Lhe neL presenL values lnLo annulues
! 1he l88 ls unaecLed by pro[ecL llfe. We can choose
Lhe pro[ecL wlLh Lhe hlgher l88.
288
Soluuon 1: ro[ecL 8epllcauon
Aswotb uomoJotoo
288
Project A: Replicated
-$1500
$350 $350 $350 $350 $350
$350 $350 $350 $350 $350
Project B
-$1000
$400 $400 $400 $400 $400 $400 $400 $400
$400
$400
-$1000 (Replication)
NPV of Project A replicated = $ 693
NPV of Project B= $ 478
289
Soluuon 2: LqulvalenL Annulues
Aswotb uomoJotoo
289
! LqulvalenL AnnulLy for 3-year pro[ecL
! = $442 * v(A,12,3 years)
! = $ 122.62
! LqulvalenL AnnulLy for 10-year pro[ecL
! = $478 * v(A,12,10 years)
! = $ 84.60
290
WhaL would you choose as your lnvesLmenL
Lool?
Aswotb uomoJotoo
290
! Clven Lhe advanLages/dlsadvanLages ouLllned for
each of Lhe dlerenL declslon rules, whlch one
would you choose Lo adopL?
a. 8eLurn on lnvesLmenL (8CL, 8CC)
b. ayback or ulscounLed ayback
c. neL resenL value
d. lnLernal 8aLe of 8eLurn
e. roLablllLy lndex
! uo you Lhlnk your cholce has been aecLed by Lhe
evenLs of Lhe lasL quarLer of 2008? lf so, why? lf noL,
why noL?
291
WhaL rms acLually use ..
Aswotb uomoJotoo
291
ueclslon 8ule of llrms uslng as prlmary declslon rule ln
1976 1986 1998
l88 33.6 49.0 42.0
Accounung 8eLurn 23.0 8.0 7.0
nv 9.8 21.0 34.0
ayback erlod 8.9 19.0 14.0
roLablllLy lndex 2.7 3.0 3.0
292
ll. Slde CosLs and 8eneLs
Aswotb uomoJotoo
292
! MosL pro[ecLs consldered by any buslness creaLe slde
cosLs and beneLs for LhaL buslness.
! 1he slde cosLs lnclude Lhe cosLs creaLed by Lhe use of resources
LhaL Lhe buslness already owns (opporLunlLy cosLs) and losL
revenues for oLher pro[ecLs LhaL Lhe rm may have.
! 1he beneLs LhaL may noL be capLured ln Lhe Lradluonal caplLal
budgeung analysls lnclude pro[ecL synergles (where cash ow
beneLs may accrue Lo oLher pro[ecLs) and opuons embedded ln
pro[ecLs (lncludlng Lhe opuons Lo delay, expand or abandon a
pro[ecL).
! 1he reLurns on a pro[ecL should lncorporaLe Lhese cosLs
and beneLs.
293
A. CpporLunlLy CosL
Aswotb uomoJotoo
293
! An opporLunlLy cosL arlses when a pro[ecL uses a
resource LhaL may already have been pald for by Lhe
rm.
! When a resource LhaL ls already owned by a rm ls belng
consldered for use ln a pro[ecL, Lhls resource has Lo be
prlced on lLs nexL besL alLernauve use, whlch may be
! a sale of Lhe asseL, ln whlch case Lhe opporLunlLy cosL ls Lhe
expecLed proceeds from Lhe sale, neL of any caplLal galns Laxes
! renung or leaslng Lhe asseL ouL, ln whlch case Lhe opporLunlLy
cosL ls Lhe expecLed presenL value of Lhe aer-Lax renLal or
lease revenues.
! use elsewhere ln Lhe buslness, ln whlch case Lhe opporLunlLy
cosL ls Lhe cosL of replaclng lL.
294
Case 1: loregone Sale?
Aswotb uomoJotoo
294
! Assume LhaL ulsney owns land ln 8lo already. 1hls land ls
undeveloped and was acqulred several years ago for $ 3
mllllon for a hoLel LhaL was never bullL. lL ls anuclpaLed,
lf Lhls Lheme park ls bullL, LhaL Lhls land wlll be used Lo
bulld Lhe omces for ulsney 8lo. 1he land currenLly can be
sold for $ 40 mllllon, Lhough LhaL would creaLe a caplLal
galn (whlch wlll be Laxed aL 20). ln assesslng Lhe Lheme
park, whlch of Lhe followlng would you do:
! lgnore Lhe cosL of Lhe land, slnce ulsney owns lLs already
! use Lhe book value of Lhe land, whlch ls $ 3 mllllon
! use Lhe markeL value of Lhe land, whlch ls $ 40 mllllon
! CLher:
295
Case 2: lncremenLal CosL?
An Cnllne 8eLalllng venLure for 8ookscape
Aswotb uomoJotoo
295
! 1he lnlual lnvesLmenL needed Lo sLarL Lhe servlce, lncludlng Lhe
lnsLallauon of addluonal phone llnes and compuLer equlpmenL, wlll be $1
mllllon. 1hese lnvesLmenLs are expecLed Lo have a llfe of four years, aL
whlch polnL Lhey wlll have no salvage value. 1he lnvesLmenLs wlll be
depreclaLed sLralghL llne over Lhe four-year llfe.
! 1he revenues ln Lhe rsL year are expecLed Lo be $1.3 mllllon, growlng
20 ln year Lwo, and 10 ln Lhe Lwo years followlng. 1he cosL of Lhe
books wlll be 60 of Lhe revenues ln each of Lhe four years.
! 1he salarles and oLher beneLs for Lhe employees are esumaLed Lo be
$130,000 ln year one, and grow 10 a year for Lhe followlng Lhree years.
! 1he worklng caplLal, whlch lncludes Lhe lnvenLory of books needed for Lhe
servlce and Lhe accounLs recelvable wlll be10 of Lhe revenues, Lhe
lnvesLmenLs ln worklng caplLal have Lo be made aL Lhe beglnnlng of each
year. AL Lhe end of year 4, Lhe enure worklng caplLal ls assumed Lo be
salvaged.
! 1he Lax raLe on lncome ls expecLed Lo be 40.
296
CosL of caplLal for lnvesLmenL
Aswotb uomoJotoo
296
! We wlll re-esumaLe Lhe beLa for Lhls onllne pro[ecL by looklng aL
publlcly Lraded onllne reLallers. 1he unlevered LoLal beLa of onllne
reLallers ls 3.02, and we assume LhaL Lhls pro[ecL wlll be funded
wlLh Lhe same mlx of debL and equlLy (u/L = 21.41, uebL/CaplLal
= 17.63) LhaL 8ookscape uses ln Lhe resL of Lhe buslness. We wlll
assume LhaL 8ookscape's Lax raLe (40) and preLax cosL of debL
(4.03) apply Lo Lhls pro[ecL.
Levered 8eLa
Cnllne Servlce
= 3.02 1 + (1 - 0.4) (0.2141) = 3.41
CosL of LqulLy
Cnllne Servlce
= 2.73 + 3.41 (3.3) = 21.48
CosL of CaplLal
Cnllne Servlce
= 21.48 (0.8237) + 4.03 (1 - 0.4) (0.1763) =
18.12
! 1hls ls much hlgher Lhan Lhe cosL of caplLal (10.30) we compuLed
for 8ookscape earller, buL lL reecLs Lhe hlgher rlsk of Lhe onllne
reLall venLure.
297
lncremenLal Cash ows on lnvesLmenL
Aswotb uomoJotoo
297
NPV of investment = -$76,375
0 1 2 3 4
Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000

Operating Expenses
Labor $150,000 $165,000 $181,500 $199,650
Materials $900,000 $1,080,000 $1,188,000 $1,306,800
Depreciation $250,000 $250,000 $250,000 $250,000

Operating Income $200,000 $305,000 $360,500 $421,550
Taxes $80,000 $122,000 $144,200 $168,620
After-tax Operating
Income $120,000 $183,000 $216,300 $252,930
+ Depreciation $250,000 $250,000 $250,000 $250,000
- Change in Working
Capital $150,000 $30,000 $18,000 $19,800 -$217,800
+ Salvage Value of
Investment $0
Cash ow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730
Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
298
1he slde cosLs.
Aswotb uomoJotoo
298
! lL ls esumaLed LhaL Lhe addluonal buslness assoclaLed wlLh
onllne orderlng and Lhe admlnlsLrauon of Lhe servlce lLself
wlll add Lo Lhe workload for Lhe currenL general manager of
Lhe booksLore. As a consequence, Lhe salary of Lhe general
manager wlll be lncreased from $100,000 Lo $120,000 nexL
year, lL ls expecLed Lo grow 3 percenL a year aer LhaL for Lhe
remalnlng Lhree years of Lhe onllne venLure. Aer Lhe onllne
venLure ls ended ln Lhe fourLh year, Lhe managers salary wlll
reverL back Lo lLs old levels.
! lL ls also esumaLed LhaL 8ookscape Cnllne wlll uullze an omce
LhaL ls currenLly used Lo sLore nanclal records. 1he records
wlll be moved Lo a bank vaulL, whlch wlll cosL $1000 a year Lo
renL.
299
nv wlLh slde cosLs.
Aswotb uomoJotoo
299
! Addluonal salary cosLs = v of $34,332
! Cmce CosLs
! Aer-1ax Addluonal SLorage LxpendlLure per ?ear = $1,000 (1 - 0.40) = $600
! v of expendlLures = $600 (v of annulLy, 18.12,4 yrs) = $1,610
! nv wlLh CpporLunlLy CosLs = $76,373 - $34,332 - $1,610= $ 40,413
! CpporLunlLy cosLs aggregaLed lnLo cash ows
Year Cashows Opportunity costs Cashow with opportunity costs Present Value
0 ($1,150,000) ($1,150,000) ($1,150,000)
1 $340,000 $12,600 $327,400 $277,170
2 $415,000 $13,200 $401,800 $287,968
3 $446,500 $13,830 $432,670 $262,517
4 $720,730 $14,492 $706,238 $362,759
Adjusted NPV $40,413
300
Case 3: Lxcess CapaclLy
Aswotb uomoJotoo
300
! ln Lhe vale example, assume LhaL Lhe rm wlll use lLs
exlsung dlsLrlbuuon sysLem Lo servlce Lhe
producuon ouL of Lhe new lron ore mlne. 1he mlne
manager argues LhaL Lhere ls no cosL assoclaLed wlLh
uslng Lhls sysLem, slnce lL has been pald for already
and cannoL be sold or leased Lo a compeuLor (and
Lhus has no compeung currenL use). uo you agree?
a. ?es
b. no
301
A lramework for Assesslng 1he CosL of uslng
Lxcess CapaclLy
Aswotb uomoJotoo
301
! lf l do noL add Lhe new producL, when wlll l run ouL
of capaclLy?
! lf l add Lhe new producL, when wlll l run ouL of
capaclLy?
! When l run ouL of capaclLy, whaL wlll l do?
! CuL back on producuon: cosL ls v of aer-Lax cash ows
from losL sales
! 8uy new capaclLy: cosL ls dlerence ln v beLween earller
& laLer lnvesLmenL
302
roducL and ro[ecL Cannlballzauon: A 8eal
CosL?
Aswotb uomoJotoo
302
! Assume LhaL ln Lhe ulsney Lheme park example, 20 of Lhe
revenues aL Lhe 8lo ulsney park are expecLed Lo come from
people who would have gone Lo ulsney Lheme parks ln Lhe
uS. ln dolng Lhe analysls of Lhe park, you would
a. Look aL only lncremenLal revenues (l.e. 80 of Lhe LoLal revenue)
b. Look aL LoLal revenues aL Lhe park
c. Choose an lnLermedlaLe number
! Would your answer be dlerenL lf you were analyzlng
wheLher Lo lnLroduce a new show on Lhe ulsney cable
channel on SaLurday mornlngs LhaL ls expecLed Lo auracL 20
of lLs vlewers from A8C (whlch ls also owned by ulsney)?
a. ?es
b. no
303
8. ro[ecL Synergles
Aswotb uomoJotoo
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! A pro[ecL may provlde beneLs for oLher pro[ecLs wlLhln Lhe rm.
Conslder, for lnsLance, a Lyplcal ulsney anlmaLed movle. Assume
LhaL lL cosLs $ 30 mllllon Lo produce and promoLe. 1hls movle, ln
addluon Lo LheaLrlcal revenues, also produces revenues from
! Lhe sale of merchandlse (sLued Loys, plasuc gures, cloLhes ..)
! lncreased auendance aL Lhe Lheme parks
! sLage shows (see 8eauLy and Lhe 8easL and Lhe Llon klng)
! Lelevlslon serles based upon Lhe movle
! ln lnvesLmenL analysls, however, Lhese synergles are elLher le
unquanued and used Lo [usufy overrldlng Lhe resulLs of
lnvesLmenL analysls, l.e,, used as [usucauon for lnvesung ln
negauve nv pro[ecLs.
! lf synergles exlsL and Lhey oen do, Lhese beneLs have Lo be
valued and shown ln Lhe lnlual pro[ecL analysls.
304
Case 1: Addlng a Caf Lo a booksLore:
8ookscape
Aswotb uomoJotoo
304
! Assume LhaL you are conslderlng addlng a caf Lo Lhe booksLore. Assume
also LhaL based upon Lhe expecLed revenues and expenses, Lhe caf
sLandlng alone ls expecLed Lo have a neL presenL value of -$87,371.
! 1he cafe wlll lncrease revenues aL Lhe book sLore by $300,000 ln year 1,
growlng aL 10 a year for Lhe followlng 4 years. ln addluon, assume LhaL
Lhe pre-Lax operaung margln on Lhese sales ls 10.


! 1he neL presenL value of Lhe added beneLs ls $130,739. Added Lo Lhe
nv of Lhe sLandalone Caf of -$87,371 ylelds a neL presenL value of
$43,188.
305
Case 2: Synergy ln a merger..
Aswotb uomoJotoo
305
! We valued Parman lnLernauonal for an acqulsluon by 1aLa MoLors and
esumaLed a value of $ 2,476 mllllon for Lhe operaung asseLs and $ 2,678
mllllon for Lhe equlLy ln Lhe rm, concludlng LhaL lL would noL be a value-
creaung acqulsluon aL lLs currenL markeL caplLallzauon of $3,248 mllllon.
ln esumaung Lhls value, Lhough, we LreaLed Parman lnLernauonal as a
sLand-alone rm.
! Assume LhaL 1aLa MoLors foresees poLenual synergles ln Lhe comblnauon
of Lhe Lwo rms, prlmarlly from uslng lLs uslng Parman's hlgh-end audlo
Lechnology (speakers, Luners) as opuonal upgrades for cusLomers buylng
new 1aLa MoLors cars ln lndla. 1o value Lhls synergy, leL us assume Lhe
followlng:
! lL wlll Lake 1aLa MoLors approxlmaLely 3 years Lo adapL Parman's producLs Lo 1aLa
MoLors cars.
! 1aLa MoLors wlll be able Lo generaLe 8s 10 bllllon ln aer-Lax operaung lncome ln
year 4 from selllng Parman audlo upgrades Lo lLs lndlan cusLomers, growlng aL a
raLe of 4 a year aer LhaL ln perpeLulLy (buL only ln lndla).
306
Lsumaung Lhe cosL of caplLal Lo use ln valulng
synergy..
Aswotb uomoJotoo
306
! 8uslness rlsk: 1he percelved synergles ow from opuonal add-ons
ln auLo sales. We wlll begln wlLh Lhe levered beLa of 1.10, LhaL we
esumaLed for 1aLa MoLors ln chapLer 4, ln esumaung Lhe cosL of
equlLy.
! Ceographlc rlsk: 1he second ls LhaL Lhe synergles are expecLed Lo
come from lndla, consequenLly, we wlll add Lhe counLry rlsk
premlum of 3.60 for lndla, esumaLed ln chapLer 4 (for 1aLa
MoLors) Lo Lhe maLure markeL premlum of 3.3.
! uebL rauo: llnally, we wlll assume LhaL Lhe expanslon wlll be
enurely ln lndla, wlLh 1aLa MoLors malnLaln lLs exlsung debL Lo
caplLal rauo of 29.28 and lLs currenL rupee cosL of debL of 9.6
and lLs marglnal Lax raLe of 32.43.
! CosL of equlLy ln 8upees = 6.37 + 1.10 (3.3+3.60) = 16.39
! CosL of debL ln 8upees = 9.6 (1-.3243) = 6.30
! CosL of caplLal ln 8upees = 16.39 (1-.2928) + 6.30 (.2928) = 13.63
307
Lsumaung Lhe value of synergy. and whaL 1aLa
can pay for Parman
Aswotb uomoJotoo
307
! value of synergy
?ear 3
=
! value of synergy Loday =
! Converung Lhe synergy value lnLo dollar Lerms aL Lhe prevalllng
exchange raLe of 8s 60/$, we can esumaLe a dollar value for Lhe
synergy from Lhe poLenual acqulsluon:
! value of synergy ln uS $ = 8s 70,733/60 = $ 1,179 mllllon
! Addlng Lhls value Lo Lhe lnLrlnslc value of $2,678 mllllon LhaL we
esumaLed for Parman's equlLy ln chapLer 3, we geL a LoLal value for
Lhe equlLy of $3,837 mllllon.
! value of Parman = $2,678 mllllon + $1,179 mllllon = $3,837 mllllon
! Slnce Parman's equlLy Lrades aL $3,248 mllllon, Lhe acqulsluon sull
does noL make sense, even wlLh Lhe synergy lncorporaLed lnLo
value.
!
Expected Cash Flow
Year 4
(Cost of Capital - g)
=
1500
(.1067 -.04)
= Rs 22,476 million
!
Value of Synergy
year 3
(1 + Cost of Capital)
3
=
22,476
(1.1067)
3
= Rs 16,580 million
308
lll. ro[ecL Cpuons
Aswotb uomoJotoo
308
! Cne of Lhe llmlLauons of Lradluonal lnvesLmenL analysls
ls LhaL lL ls sLauc and does noL do a good [ob of capLurlng
Lhe opuons embedded ln lnvesLmenL.
! 1he rsL of Lhese opuons ls Lhe opuon Lo delay Laklng a pro[ecL,
when a rm has excluslve rlghLs Lo lL, unul a laLer daLe.
! 1he second of Lhese opuons ls Laklng one pro[ecL may allow us
Lo Lake advanLage of oLher opporLunlues (pro[ecLs) ln Lhe fuLure
! 1he lasL opuon LhaL ls embedded ln pro[ecLs ls Lhe opuon Lo
abandon a pro[ecL, lf Lhe cash ows do noL measure up.
! 1hese opuons all add value Lo pro[ecLs and may make a
bad pro[ecL (from Lradluonal analysls) lnLo a good one.
309
1he Cpuon Lo uelay
Aswotb uomoJotoo
309
! When a rm has excluslve rlghLs Lo a pro[ecL or producL for a speclc
perlod, lL can delay Laklng Lhls pro[ecL or producL unul a laLer daLe. A
Lradluonal lnvesLmenL analysls [usL answers Lhe quesuon of wheLher Lhe
pro[ecL ls a good one lf Laken Loday. 1he rlghLs Lo a bad pro[ecL can
sull have value.
Present Value of Expected
Cash Flows on Product
PV of Cash Flows
Initial Investment in
Project


NPV is positive in this section
310
lnslghLs for lnvesLmenL Analyses
Aswotb uomoJotoo
310
! Pavlng Lhe excluslve rlghLs Lo a producL or pro[ecL ls
valuable, even lf Lhe producL or pro[ecL ls noL vlable
Loday.
! 1he value of Lhese rlghLs lncreases wlLh Lhe volaullLy
of Lhe underlylng buslness.
! 1he cosL of acqulrlng Lhese rlghLs (by buylng Lhem or
spendlng money on developmenL - 8&u, for
lnsLance) has Lo be welghed o agalnsL Lhese
beneLs.
311
1he Cpuon Lo Lxpand/1ake CLher ro[ecLs
Aswotb uomoJotoo
311
! 1aklng a pro[ecL Loday may allow a rm Lo conslder and Lake oLher
valuable pro[ecLs ln Lhe fuLure. 1hus, even Lhough a pro[ecL may have a
negauve nv, lL may be a pro[ecL worLh Laklng lf Lhe opuon lL provldes
Lhe rm (Lo Lake oLher pro[ecLs ln Lhe fuLure) has a more-Lhan-
compensaung value.
Cash Flows on Expansion
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Firm will not expand in

this section
Expansion becomes
attractive in this section
312
1he Cpuon Lo Abandon
Aswotb uomoJotoo
312
! A rm may someumes have Lhe opuon Lo abandon a pro[ecL, lf Lhe cash
ows do noL measure up Lo expecLauons.
! lf abandonlng Lhe pro[ecL allows Lhe rm Lo save lLself from furLher
losses, Lhls opuon can make a pro[ecL more valuable.
Present Value of Expected
Cash Flows on Project
PV of Cash Flows
from Project
Cost of Abandonment
313
lv. Assesslng Lxlsung or asL lnvesLmenLs.
Aswotb uomoJotoo
313
! Whlle much of our dlscusslon has been focused on
analyzlng new lnvesLmenLs, Lhe Lechnlques and
prlnclples enunclaLed apply [usL as sLrongly Lo
exlsung lnvesLmenLs.
! WlLh exlsung lnvesLmenLs, we can Lry Lo address one
of Lwo quesuons:
! osL -morLem: We can look back aL exlsung lnvesLmenLs
and see lf Lhey have creaLed value for Lhe rm.
! WhaL nexL? We can also use Lhe Lools of lnvesLmenL
analysls Lo see wheLher we should keep, expand or
abandon exlsung lnvesLmenLs.
314
Analyzlng an Lxlsung lnvesLmenL
Aswotb uomoJotoo
314
In a post-mortem, you look at the actual cash
ows, relative to forecasts.
You can also reassess your expected cash
ows, based upon what you have learned,
and decide whether you should expand,
continue or divest (abandon) an investment
315
a. osL MorLem Analysls
Aswotb uomoJotoo
315
! 1he acLual cash ows from an lnvesLmenL can be greaLer Lhan or less Lhan
orlglnally forecasL for a number of reasons buL all Lhese reasons can be
caLegorlzed lnLo Lwo groups:
! Chance: 1he naLure of rlsk ls LhaL acLual ouLcomes can be dlerenL from
expecLauons. Lven when forecasLs are based upon Lhe besL of lnformauon, Lhey
wlll lnvarlably be wrong ln hlndslghL because of unexpecLed shls ln boLh macro
(lnauon, lnLeresL raLes, economlc growLh) and mlcro (compeuLors, company)
varlables.
! 8las: lf Lhe orlglnal forecasLs were blased, Lhe acLual numbers wlll be dlerenL from
expecLauons. 1he evldence on caplLal budgeung ls LhaL managers Lend Lo be over-
opumlsuc abouL cash ows and Lhe blas ls worse wlLh over-condenL managers.
! Whlle lL ls lmposslble Lo Lell on an lndlvldual pro[ecL wheLher chance or
blas ls Lo blame, Lhere ls a way Lo Lell across pro[ecLs and across ume. lf
chance ls Lhe culprlL, Lhere should be symmeLry ln Lhe errors - acLuals
should be abouL as llkely Lo beaL forecasLs as Lhey are Lo come under
forecasLs. lf blas ls Lhe reason, Lhe errors wlll Lend Lo be ln one dlrecuon.
316
b. WhaL should we do nexL?
Aswotb uomoJotoo
316
........ LlquldaLe Lhe pro[ecL


........ 1ermlnaLe Lhe pro[ecL


........ ulvesL Lhe pro[ecL


........ Conunue Lhe pro[ecL

!
NF
n
(1 + r)
n
t =0
t =n
"
> 0 > Divestiture Value
!
NF
n
(1 + r)
n
t =0
t =n
"
< Divestiture Value
!
NF
n
(1 + r)
n
t =0
t =n
"
< 0
!
NF
n
(1 + r)
n
t =0
t =n
"
< Salvage Value
317
Lxample: ulsney Callfornla AdvenLure -
1he 2008 [udgmenL call
Aswotb uomoJotoo
317
! ulsney opened Lhe ulsney Callfornla AdvenLure (uCA) ark ln 2001, aL a
cosL of $1.3 bllllon, wlLh a mlx of roller coasLer rldesand movle nosLalgla.
ulsney expecLed abouL 60 of lLs vlslLors Lo ulsneyland Lo come across Lo
uCA and generaLe abouL $ 100 mllllon ln annual aer-cash ows for Lhe
rm.
! 8y 2008, uCA had noL performed up Lo expecLauons. Cf Lhe 13 mllllon
people who came Lo ulsneyland ln 2007, only 6 mllllon vlslLed Callfornla
AdvenLure, and Lhe cash ow averaged ouL Lo only $ 30 mllllon beLween
2001 and 2007.
! ln early 2008, ulsney faced Lhree cholces:
! ShuL down Callfornla AdvenLure and Lry Lo recover whaLever lL can of lLs lnlual
lnvesLmenL. lL ls esumaLed LhaL Lhe rm recover abouL $ 300 mllllon of lLs lnvesLmenL.
! Conunue wlLh Lhe sLaLus quo, recognlzlng LhaL fuLure cash ows wlll be closer Lo Lhe
acLual values ($ 30 mllllon) Lhan Lhe orlglnal pro[ecuons.
! lnvesL abouL $ 600 mllllon Lo expand and modlfy Lhe par, wlLh Lhe lnLenL of lncreaslng
Lhe number of auracuons for famllles wlLh chlldren, ls expecLed Lo lncrease Lhe
percenLage of ulsneyland vlslLors who come Lo uCA from 40 Lo 60 and lncrease Lhe
annual aer Lax cash ow by 60 (from $ 30 mllllon Lo $ 80 mllllon) aL Lhe park.
318
uCA: Lvaluaung Lhe alLernauves.
Aswotb uomoJotoo
318
! Conunulng Cperauon: Assumlng Lhe currenL aer-Lax cash ow of
$ 30 mllllon wlll conunue ln perpeLulLy, growlng aL Lhe lnauon
raLe of 2 and dlscounung back aL Lhe Lheme park cosL of caplLal ln
2008 of 6.62 ylelds a value for conunulng wlLh Lhe sLaLus quo
value of uCA =
! AbandonmenL: Abandonlng Lhls lnvesLmenL currenLly would allow
ulsney Lo recover only $ 300 mllllon of lLs orlglnal lnvesLmenL.
AbandonmenL value of uCA = $ 300 mllllon
! Lxpanslon: 1he up-fronL cosL of $ 600 mllllon wlll lead Lo more
vlslLors ln Lhe park and an lncrease ln Lhe exlsung cash ows from $
30 Lo $ 80 mllllon.
value of Cl from expanslon =
!
Expected Cash Flow next year
(Cost of capital - g)
=
50(1.02)
(.0662 ".02)
= $1.103 billion
!
Increase in CF next year
(Cost of capital - g)
=
30(1.02)
(.0662 ".02)
= $662 million
319
llrsL rlnclples
Aswotb uomoJotoo
319
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should relfect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend whether
they prefer
dividends or
buybacks
Maximize the value of the business (rm)