The Investment Principle: Estimating

Hurdle Rates

You cannot swing upon a rope that is attached only to

your own belt.

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.

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

Chooseafinancingmixthatminimizesthehurdlerateandmatches
theassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.

Aswath Damodaran

Inputs required to use the CAPM

Thecapitalassetpricingmodelyieldsthefollowingexpectedreturn:
ExpectedReturn=RiskfreeRate+Beta*(ExpectedReturnontheMarket
PortfolioRiskfreeRate)

Tousethemodelweneedthreeinputs:
(a) Thecurrentriskfreerate
(b)Theexpectedmarketriskpremium(thepremiumexpectedforinvesting
inriskyassets(marketportfolio)overtherisklessasset)
(c)Thebetaoftheassetbeinganalyzed.

Aswath Damodaran

The Riskfree Rate and Time Horizon

Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.
Therefore,thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,i.e.,tohaveanactualreturnbeequal
totheexpectedreturn,twoconditionshavetobemet
Therehastobenodefaultrisk,whichgenerallyimpliesthatthesecurity
hastobeissuedbythegovernment.Note,however,thatnotall
governmentscanbeviewedasdefaultfree.
Therecanbenouncertaintyaboutreinvestmentrates,whichimpliesthat
itisazerocouponsecuritywiththesamematurityasthecashflowbeing
analyzed.

Aswath Damodaran

Riskfree Rate in Practice

Theriskfreerateistherateonazerocoupongovernmentbond
matchingthetimehorizonofthecashflowbeinganalyzed.
Theoretically,thistranslatesintousingdifferentriskfreeratesforeach
cashflowthe1yearzerocouponrateforthecashflowinyear1,the
2yearzerocouponrateforthecashflowinyear2...
Practicallyspeaking,ifthereissubstantialuncertaintyaboutexpected
cashflows,thepresentvalueeffectofusingtimevaryingriskfreerates
issmallenoughthatitmaynotbeworthit.

Aswath Damodaran

The Bottom Line on Riskfree Rates

Usingalongtermgovernmentrate(evenonacouponbond)asthe
riskfreerateonallofthecashflowsinalongtermanalysiswillyield
acloseapproximationofthetruevalue.
Forshorttermanalysis,itisentirelyappropriatetouseashortterm
governmentsecurityrateastheriskfreerate.
Theriskfreeratethatyouuseinananalysisshouldbeinthesame
currencythatyourcashflowsareestimatedin.
Inotherwords,ifyourcashflowsareinU.S.dollars,yourriskfreeratehas
tobeinU.S.dollarsaswell.
IfyourcashflowsareinEuros,yourriskfreerateshouldbeaEuro
riskfreerate.

Aswath Damodaran

What if there is no default-free entity?

Youcouldadjustthelocalcurrencygovernmentborrowingratebythe
estimated default spread on the bond to arrive at a riskless local
currencyrate.
The default spread on the government bond can be estimated using the
localcurrencyratingsthatareavailableformanycountries.
Forinstance,assumethattheMexican10yearpesobondhasaninterest
rateof8.85%andthatthelocalcurrencyratingassignedtotheMexican
governmentisAA.IfthedefaultspreadforAAratedbondsis0.7%,the
risklessnominalpesorateis8.15%.

Alternatively,youcananalyzeMexicancompaniesinU.S.dollarsand
use the U.S. treasury bond rate as your riskfree rate or in real terms
anddoallanalysiswithoutaninflationcomponent.

Aswath Damodaran

Measurement of the risk premium

Theriskpremiumisthepremiumthatinvestorsdemandforinvesting
inanaverageriskinvestment,relativetotheriskfreerate.
Asageneralproposition,thispremiumshouldbe
greaterthanzero
increasewiththeriskaversionoftheinvestorsinthatmarket
increasewiththeriskinessoftheaverageriskinvestment

Aswath Damodaran

What is your risk premium?

Assumethatstocksaretheonlyriskyassetsandthatyouareofferedtwoinvestment
options:
arisklessinvestment(sayaGovernmentSecurity),onwhichyoucanmake5%
amutualfundofallstocks,onwhichthereturnsareuncertain
Howmuchofanexpectedreturnwouldyoudemandtoshiftyourmoneyfromtheriskless
assettothemutualfund?
a) Lessthan5%
b) Between57%
c) Between79%
d) Between911%
e) Between1113%
f) Morethan13%
Checkyourpremiumagainstthesurveypremiumonmywebsite.

Aswath Damodaran

Risk Aversion and Risk Premiums

Ifthisweretheentiremarket,theriskpremiumwouldbeaweighted
averageoftheriskpremiumsdemandedbyeachandeveryinvestor.
Theweightswillbedeterminedbythemagnitudeofwealththateach
investorhas.Thus,WarrenBuffetsriskaversioncountsmoretowards
determiningtheequilibriumpremiumthanyoursandmine.
Asinvestorsbecomemoreriskaverse,youwouldexpectthe
equilibriumpremiumtoincrease.

Aswath Damodaran

10

Risk Premiums do change..

Gobacktothepreviousexample.Assumenowthatyouaremakingthe
samechoicebutthatyouaremakingitintheaftermathofastock
marketcrash(ithasdropped25%inthelastmonth).Wouldyou
changeyouranswer?
a) Iwoulddemandalargerpremium
b) Iwoulddemandasmallerpremium
c) Iwoulddemandthesamepremium

Aswath Damodaran

11

Estimating Risk Premiums in Practice

Surveyinvestorsontheirdesiredriskpremiumsandusetheaverage
premiumfromthesesurveys.
Assumethattheactualpremiumdeliveredoverlongtimeperiodsis
equaltotheexpectedpremiumi.e.,usehistoricaldata
Estimatetheimpliedpremiumintodaysassetprices.

Aswath Damodaran

12

The Survey Approach

Surveyingallinvestorsinamarketplaceisimpractical.
However,youcansurveyafewinvestors(especiallythelarger
investors)andusetheseresults.Inpractice,thistranslatesintosurveys
ofmoneymanagersexpectationsofexpectedreturnsonstocksover
thenextyear.
Thelimitationsofthisapproachare:
therearenoconstraintsonreasonability(thesurveycouldproduce
negativeriskpremiumsorriskpremiumsof50%)
theyareextremelyvolatile
theytendtobeshortterm;eventhelongestsurveysdonotgobeyondone
year

Aswath Damodaran

13

The Historical Premium Approach

Thisisthedefaultapproachusedbymosttoarriveatthepremiumto
useinthemodel
Inmostcases,thisapproachdoesthefollowing
itdefinesatimeperiodfortheestimation(1926Present,1962Present....)
itcalculatesaveragereturnsonastockindexduringtheperiod
itcalculatesaveragereturnsonarisklesssecurityovertheperiod
itcalculatesthedifferencebetweenthetwo
andusesitasapremiumlookingforward

Thelimitationsofthisapproachare:
itassumesthattheriskaversionofinvestorshasnotchangedina
systematicwayacrosstime.(Theriskaversionmaychangefromyearto
year,butitrevertsbacktohistoricalaverages)
itassumesthattheriskinessoftheriskyportfolio(stockindex)hasnot
changedinasystematicwayacrosstime.

Aswath Damodaran

14

Historical Average Premiums for the United

States
Arithmeticaverage
GeometricAverage
Stocks
Stocks
Stocks
Stocks
HistoricalPeriod
T.Bills
T.Bonds
T.Bills
T.Bonds
19282005
7.83%
5.95%
6.47%
4.80%
19642005
5.52%
4.29%
4.08%
3.21%
19942005
8.80%
7.07%
5.15%
3.76%
Whatistherightpremium?
Gobackasfarasyoucan.Otherwise,thestandarderrorintheestimatewillbelarge.(
StdErrorinestimate =

AnnualizedStddeviationinStockprices
)
Numberofyearsofhistoricaldata

Beconsistentinyouruseofariskfreerate.

Usearithmeticpremiumsforoneyearestimatesofcostsofequityandgeometric
premiumsforestimatesoflongtermcostsofequity.
DataSource:Checkoutthereturnsbyyearandestimateyourownhistoricalpremiumsby
goingtoupdateddataonmywebsite.

Aswath Damodaran

15

What about historical premiums for other

markets?

HistoricaldataformarketsoutsidetheUnitedStatesisavailablefor
muchshortertimeperiods.Theproblemisevengreaterinemerging
markets.
Thehistoricalpremiumsthatemergefromthisdatareflectsthisand
thereismuchgreatererrorassociatedwiththeestimatesofthe
premiums.

Aswath Damodaran

16

One solution: Look at a countrys bond rating

and default spreads as a start

RatingsagenciessuchasS&PandMoodysassignratingstocountries
thatreflecttheirassessmentofthedefaultriskofthesecountries.
Theseratingsreflectthepoliticalandeconomicstabilityofthese
countriesandthusprovideausefulmeasureofcountryrisk.In
September2004,forinstance,BrazilhadacountryratingofB2.
Ifacountryissuesbondsdenominatedinadifferentcurrency(say
dollarsoreuros),youcanalsoseehowthebondmarketviewstherisk
inthatcountry.InSeptember2004,BrazilhaddollardenominatedC
Bonds,tradingataninterestrateof10.01%.TheUStreasurybond
ratethatdaywas4%,yieldingadefaultspreadof6.01%forBrazil.
ManyanalystsaddthisdefaultspreadtotheUSriskpremiumtocome
upwithariskpremiumforacountry.Usingthisapproachwouldyield
ariskpremiumof10.83%forBrazil,ifweuse4.82%asthepremium
fortheUS.

Aswath Damodaran

17

Beyond the default spread

Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsand
equityriskpremiumsarehighlycorrelated,onewouldexpectequity
spreadstobehigherthandebtspreads.Ifwecancomputehowmuch
moreriskytheequitymarketis,relativetothebondmarket,wecould
usethisinformation.Forexample,

StandardDeviationinBovespa(Equity)=36%
StandardDeviationinBrazilCBond=28.2%
DefaultspreadonCBond=6.01%
CountryRiskPremiumforBrazil=6.01%(36%/28.2%)=7.67%

Notethatthisisontopofthepremiumyouestimateforamature
market.Thus,ifyouassumethattheriskpremiumintheUSis4.82%
(19982003average),theriskpremiumforBrazilwouldbe12.49%.

Aswath Damodaran

18

An alternate view of ERP: Watch what I pay, not

what I say..
Afteryear5,wewillassumethat
AnalystestimateofgrowthinnetincomeforS&P500overnext5
years=8%
earningsontheindexwillgrowat
4.39%,thesamerateastheentire
economy

QuickTimeanda
TIFF(Uncompressed)decompressor
areneededtoseethispicture.

Aswath Damodaran

19

Solving for the implied premium

Ifweknowwhatinvestorspaidforequitiesatthebeginningof2006
andwecanestimatetheexpectedcashflowsfromequities,wecan
solvefortherateofreturnthattheyexpecttomake(IRR):
1248.29 =

44.96
48.56
52.44
56.64
61.17
61.17(1.0439)
+
+
+
+
+
(1 + r) (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) 5 (r .0439)(1 + r) 5

ExpectedReturnonStocks=8.47%

ImpliedEquityRiskPremium=ExpectedReturnonStocksT.Bond
Rate=8.47%4.39%=4.08%

Aswath Damodaran

20

Implied Premiums in the US

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Aswath Damodaran

21

Application Test: A Market Risk Premium

Baseduponourdiscussionofhistoricalriskpremiumssofar,therisk
premiumlookingforwardshouldbe:
a) About7.8%,whichiswhatthearithmeticaveragepremiumhasbeen
since1928,forstocksoverT.Bills
b) About4.8%,whichisthegeometricaveragepremiumsince1928,for
stocksoverT.Bonds
c) About4%,whichistheimpliedpremiuminthestockmarkettoday

Aswath Damodaran

22

Estimating Beta

Thestandardprocedureforestimatingbetasistoregressstockreturns
(Rj)againstmarketreturns(Rm)
Rj=a+bRm
whereaistheinterceptandbistheslopeoftheregression.

Theslopeoftheregressioncorrespondstothebetaofthestock,and
measurestheriskinessofthestock.

Aswath Damodaran

23

Estimating Performance

Theinterceptoftheregressionprovidesasimplemeasureof
performanceduringtheperiodoftheregression,relativetothecapital
assetpricingmodel.
Rj =Rf+b(RmRf)
=Rf(1b) +bRm
Rj =a
+bRm

...........
...........

CapitalAssetPricingModel
RegressionEquation

If
a>Rf(1b).... Stockdidbetterthanexpectedduringregressionperiod
a=Rf(1b).... Stockdidaswellasexpectedduringregressionperiod
a<Rf(1b).... Stockdidworsethanexpectedduringregressionperiod

ThedifferencebetweentheinterceptandRf(1b)isJensen'salpha.If
itispositive,yourstockdidperformbetterthanexpectedduringthe
periodoftheregression.

Aswath Damodaran

24

Firm Specific and Market Risk

TheRsquared(R2)oftheregressionprovidesanestimateofthe
proportionoftherisk(variance)ofafirmthatcanbeattributedto
marketrisk;
Thebalance(1R2)canbeattributedtofirmspecificrisk.

Aswath Damodaran

25

Setting up for the Estimation

Decideonanestimationperiod
Servicesuseperiodsrangingfrom2to5yearsfortheregression
Longerestimationperiodprovidesmoredata,butfirmschange.
Shorterperiodscanbeaffectedmoreeasilybysignificantfirmspecific
eventthatoccurredduringtheperiod(Example:ITTfor19951997)

Decideonareturnintervaldaily,weekly,monthly
Shorterintervalsyieldmoreobservations,butsufferfrommorenoise.
Noiseiscreatedbystocksnottradingandbiasesallbetastowardsone.

Estimatereturns(includingdividends)onstock
Return=(PriceEndPriceBeginning+DividendsPeriod)/PriceBeginning
Includeddividendsonlyinexdividendmonth

Chooseamarketindex,andestimatereturns(inclusiveofdividends)
ontheindexforeachintervalfortheperiod.

Aswath Damodaran

26

Choosing the Parameters: Disney

Periodused:5years
ReturnInterval=Monthly
MarketIndex:S&P500Index.
Forinstance,tocalculatereturnsonDisneyinDecember1999,

PriceforDisneyatendofNovember1999=$27.88
PriceforDisneyatendofDecember1999=$29.25
Dividendsduringmonth=$0.21(Itwasanexdividendmonth)
Return=($29.25$27.88+$0.21)/$27.88=5.69%

Toestimatereturnsontheindexinthesamemonth
Indexlevel(includingdividends)atendofNovember1999=1388.91
Indexlevel(includingdividends)atendofDecember1999=1469.25
Return=(1469.251388.91)/1388.91=5.78%

Aswath Damodaran

27

Disneys Historical Beta

DisneyversusS&P500:19992003
30.00%

20.00%

Regressionline

10.00%

Disney
15.00%

0.00%
10.00%

5.00%

0.00%

5.00%

10.00%

15.00%

10.00%

20.00%

30.00%
S&P500

Aswath Damodaran

28

The Regression Output

Usingmonthlyreturnsfrom1999to2003,weranaregressionof
returnsonDisneystockagainsttheS*P500.Theoutputisbelow:
ReturnsDisney=0.0467%+1.01ReturnsS&P500(Rsquared=29%)

(0.20)

Aswath Damodaran

29

Analyzing Disneys Performance

Intercept=0.0467%
Thisisaninterceptbasedonmonthlyreturns.Thus,ithastobecompared
toamonthlyriskfreerate.
Between1999and2003,
MonthlyRiskfreeRate=0.313%(baseduponaverageT.Billrate:9903)
RiskfreeRate(1Beta)=0.313%(11.01)=..0032%

TheComparisonisthenbetween
Intercept
versus RiskfreeRate(1Beta)
0.0467%
versus 0.313%(11.01)=0.0032%
JensensAlpha=0.0467%(0.0032%)=0.05%

Disneydid0.05%betterthanexpected,permonth,between1999and
2003.
Annualized,Disneysannualexcessreturn=(1.0005)121=0.60%

Aswath Damodaran

30

More on Jensens Alpha

Ifyoudidthisanalysisoneverystocklistedonanexchange,whatwould
theaverageJensensalphabeacrossallstocks?
a) Dependuponwhetherthemarketwentupordownduringtheperiod
b) Shouldbezero
c) Shouldbegreaterthanzero,becausestockstendtogoupmoreoftenthan
down

Aswath Damodaran

31

A positive Jensens alpha Who is

responsible?

DisneyhasapositiveJensensalphaof0.60%ayearbetween1999
and2003.Thiscanbeviewedasasignthatmanagementinthefirm
didagoodjob,managingthefirmduringtheperiod.
a) True
b) False

Aswath Damodaran

32

Estimating Disneys Beta

SlopeoftheRegressionof1.01isthebeta
Regressionparametersarealwaysestimatedwitherror.Theerroris
capturedinthestandarderrorofthebetaestimate,whichinthecaseof
Disneyis0.20.
AssumethatIaskedyouwhatDisneystruebetais,afterthis
regression.
Whatisyourbestpointestimate?
Whatrangewouldyougiveme,with67%confidence?
Whatrangewouldyougiveme,with95%confidence?

Aswath Damodaran

33

The Dirty Secret of Standard Error

Distribution of Standard Errors: Beta Estimates for U.S. stocks
1600
1400

Number of Firms

1200
1000
800
600
400
200
0

<.10

.10 - .20

.20 - .30

.30 - .40

.40 -.50

.50 - .75

> .75

Standard Error in Beta Estimate

Aswath Damodaran

34

Breaking down Disneys Risk

RSquared=29%
Thisimpliesthat
29%oftheriskatDisneycomesfrommarketsources
71%,therefore,comesfromfirmspecificsources

Thefirmspecificriskisdiversifiableandwillnotberewarded

Aswath Damodaran

35

The Relevance of R Squared

Youareadiversifiedinvestortryingtodecidewhetheryoushouldinvest
inDisneyorAmgen.Theybothhavebetasof1.01,butDisneyhasan
RSquaredof29%whileAmgensRsquaredofonly14.5%.Which
onewouldyouinvestin?
a) Amgen,becauseithasthelowerRsquared
b) Disney,becauseithasthehigherRsquared
c) Youwouldbeindifferent

Wouldyouranswerbedifferentifyouwereanundiversifiedinvestor?

Aswath Damodaran

36

Beta Estimation: Using a Service (Bloomberg)

QuickTime and a
TIFF (LZW) decompressor
are needed to see this picture.

Aswath Damodaran

37

Estimating Expected Returns for Disney in

September 2004

Inputstotheexpectedreturncalculation
DisneysBeta=1.01
RiskfreeRate=4.00%(U.S.tenyearT.Bondrate)
RiskPremium=4.82%(Approximatehistoricalpremium:19282003)

ExpectedReturn

Aswath Damodaran

=RiskfreeRate+Beta(RiskPremium)
=4.00%+1.01(4.82%)=8.87%

38

Use to a Potential Investor in Disney

AsapotentialinvestorinDisney,whatdoesthisexpectedreturnof
8.87%tellyou?
a) ThisisthereturnthatIcanexpecttomakeinthelongtermonDisney,if
thestockiscorrectlypricedandtheCAPMistherightmodelforrisk,
b) ThisisthereturnthatIneedtomakeonDisneyinthelongtermtobreak
evenonmyinvestmentinthestock
c) Both

Assumenowthatyouareanactiveinvestorandthatyourresearch
suggeststhataninvestmentinDisneywillyield12.5%ayearforthe
next5years.Basedupontheexpectedreturnof8.87%,youwould
a) Buythestock
b) Sellthestock

Aswath Damodaran

39

How managers use this expected return

ManagersatDisney
needtomakeatleast8.87%asareturnfortheirequityinvestorstobreak
even.
thisisthehurdlerateforprojects,whentheinvestmentisanalyzedfrom
anequitystandpoint

Inotherwords,Disneyscostofequityis8.87%.
Whatisthecostofnotdeliveringthiscostofequity?

Aswath Damodaran

40

Application Test: Analyzing the Risk

Regression

UsingyourBloombergriskandreturnprintout,answerthefollowing
questions:
Howwellorbadlydidyourstockdo,relativetothemarket,duringthe
periodoftheregression?
Intercept(RiskfreeRate/n)(1Beta)=JensensAlpha
Wherenisthenumberofreturnperiodsinayear(12ifmonthly;52ifweekly)

Whatproportionoftheriskinyourstockisattributabletothemarket?
Whatproportionisfirmspecific?
Whatisthehistoricalestimateofbetaforyourstock?Whatistherange
onthisestimatewith67%probability?With95%probability?
Baseduponthisbeta,whatisyourestimateoftherequiredreturnonthis
stock?
RisklessRate+Beta*RiskPremium

Aswath Damodaran

41

A Quick Test
Youareadvisingaveryriskysoftwarefirmontherightcostofequityto
useinprojectanalysis.Youestimateabetaof3.0forthefirmand
comeupwithacostofequityof18.46%.TheCFOofthefirmis
concernedaboutthehighcostofequityandwantstoknowwhether
thereisanythinghecandotolowerhisbeta.
Howdoyoubringyourbetadown?

Shouldyoufocusyourattentiononbringingyourbetadown?
a) Yes
b) No

Aswath Damodaran

42

Disneys Beta Calculation: A look back at 19972002

Jensensalpha=0.39%
0.30(10.94)=0.41%
Annualized=
(1.0041)^121=4.79%

Aswath Damodaran

43

Beta Estimation and Index Choice: Deutsche

Bank

Aswath Damodaran

44

A Few Questions

TheRsquaredforDeutscheBankisveryhigh(62%),atleastrelative
toU.S.firms.Whyisthat?
ThebetaforDeutscheBankis1.04.
Isthisanappropriatemeasureofrisk?
Ifnot,whynot?

IfyouwereaninvestorinprimarilyU.S.stocks,wouldthisbean
appropriatemeasureofrisk?

Aswath Damodaran

45

Deutsche Bank: Alternate views of Risk

DAX
Intercept
Beta
StdEr r or o f
Beta
RSqua r ed

Aswath Damodaran

1.24%

FTSE Euro
300
1.54%

MSCI
1.37%

1.05
0.11

1.52
0.19

1.23
0.25

62%

52%

30%

46

Aracruzs Beta?

A
8

r a c r u z

A D

v s

S &

5 0 0

A
1

r a c r u z

v s

B o v e

s p

R
D
A

z
u
r
c
a
r

z
u
r
c
a
r
A

A
0

S &

Aracruz ADR = 2.80% + 1.00 S&P

Aswath Damodaran

B O

E S P

Aracruz = 2.62% + 0.22 Bovespa

47

Beta: Exploring Fundamentals

Enron:
Beta
Real
Qwest
General
Microsoft:
Philip
Exxon
Harmony
>Morris:
=
<
Networks:
Mobil:
Communications:
0
1
0.95
Electric:
Gold
1..25
0.40
0.65
Mining:
3.24
1.10 - 0.10
2.60

Aswath Damodaran

48

Determinant 1: Product Type

IndustryEffects:Thebetavalueforafirmdependsuponthe
sensitivityofthedemandforitsproductsandservicesandofitscosts
tomacroeconomicfactorsthataffecttheoverallmarket.
Cyclicalcompanieshavehigherbetasthannoncyclicalfirms
Firmswhichsellmorediscretionaryproductswillhavehigherbetasthan
firmsthatselllessdiscretionaryproducts

Aswath Damodaran

49

A Simple Test
PhoneserviceisclosetobeingnondiscretionaryintheUnitedStatesand
WesternEurope.However,inmuchofAsiaandLatinAmerica,there
arelargesegmentsofthepopulationforwhichphoneserviceisa
luxur.Givenourdiscussionofdiscretionaryandnondiscretionary
products,whichofthefollowingconclusionswouldyoubewillingto
draw:
a) Emergingmarkettelecomcompaniesshouldhavehigherbetasthan
developedmarkettelecomcompanies.
b) Developedmarkettelecomcompaniesshouldhavehigherbetasthan
emergingmarkettelecomcompanies
c) Thetwogroupsofcompaniesshouldhavesimilarbetas

Aswath Damodaran

50

Determinant 2: Operating Leverage Effects

Operatingleveragereferstotheproportionofthetotalcostsofthe
firmthatarefixed.
Otherthingsremainingequal,higheroperatingleverageresultsin
greaterearningsvariabilitywhichinturnresultsinhigherbetas.

Aswath Damodaran

51

Measures of Operating Leverage

FixedCostsMeasure=FixedCosts/VariableCosts
Thismeasurestherelationshipbetweenfixedandvariablecosts.The
highertheproportion,thehighertheoperatingleverage.
EBITVariabilityMeasure=%ChangeinEBIT/%ChangeinRevenues
Thismeasureshowquicklytheearningsbeforeinterestandtaxes
changesasrevenuechanges.Thehigherthisnumber,thegreaterthe
operatingleverage.

Aswath Damodaran

52

Disneys Operating Leverage: 1987- 2003

Aswath Damodaran

Year

Net Sales

1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
1987 -2003
1996 -2003

2877
3438
4594
5844
6182
7504
8529
10055
12112
18739
22473
22976
23435
25418
25172
25329
27061

% Change
in Sales
19.50%
33.62%
27.21%
5.78%
21.38%
13.66%
17.89%
20.46%
54.71%
19.93%
2.24%
2.00%
8.46%
-0.97%
0.62%
6.84%
15.83%
11.73%

EBIT
756
848
1177
1368
1124
1287
1560
1804
2262
3024
3945
3843
3580
2525
2832
2384
2713

% Change
in EBIT
12.17%
38.80%
16.23%
-17.84%
14.50%
21.21%
15.64%
25.39%
33.69%
30.46%
-2.59%
-6.84%
-29.47%
12.16%
-15.82%
13.80%
10.09%
4.42%

53

Reading Disneys Operating Leverage

OperatingLeverage

=%ChangeinEBIT/%ChangeinSales
=10.09%/15.83%=0.64
Thisislowerthantheoperatingleverageforotherentertainment
firms,whichwecomputedtobe1.12.ThiswouldsuggestthatDisney
haslowerfixedcoststhanitscompetitors.
TheacquisitionofCapitalCitiesbyDisneyin1996maybeskewing
theoperatingleverage.Lookingatthechangessincethen:
OperatingLeverage199603=4.42%/11.73%=0.38
LookslikeDisneysoperatingleveragehasdecreasedsince1996.

Aswath Damodaran

54

A Test
AssumethatyouarecomparingaEuropeanautomobilemanufacturing
firmwithaU.S.automobilefirm.Europeanfirmsaregenerallymuch
moreconstrainedintermsoflayingoffemployees,iftheygetinto
financialtrouble.Whatimplicationsdoesthishaveforbetas,ifthey
areestimatedrelativetoacommonindex?
a) EuropeanfirmswillhavemuchhigherbetasthanU.S.firms
b) EuropeanfirmswillhavesimilarbetastoU.S.firms
c) EuropeanfirmswillhavemuchlowerbetasthanU.S.firms

Aswath Damodaran

55

Determinant 3: Financial Leverage

Asfirmsborrow,theycreatefixedcosts(interestpayments)thatmake
theirearningstoequityinvestorsmorevolatile.
Thisincreasedearningsvolatilitywhichincreasestheequitybeta

Aswath Damodaran

56

Equity Betas and Leverage

Thebetaofequityalonecanbewrittenasafunctionoftheunlevered
betaandthedebtequityratio
L=u(1+((1t)D/E))

where
L=LeveredorEquityBeta
u=UnleveredBeta
t=Corporatemarginaltaxrate
D=MarketValueofDebt
E=MarketValueofEquity

Aswath Damodaran

57

Effects of leverage on betas: Disney

TheregressionbetaforDisneyis1.01.Thisbetaisaleveredbeta
(becauseitisbasedonstockprices,whichreflectleverage)andthe
leverageimplicitinthebetaestimateistheaveragemarketdebtequity
ratioduringtheperiodoftheregression(1999to2003)
Theaveragedebtequityratioduringthisperiodwas27.5%.
TheunleveredbetaforDisneycanthenbeestimated(usingamarginal
taxrateof37.3%)
=CurrentBeta/(1+(1taxrate)(AverageDebt/Equity))
=1.01/(1+(10.373))(0.275)=0.8615

Aswath Damodaran

58

Disney : Beta and Leverage

DebttoCapital
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
Aswath Damodaran

Debt/EquityRatio
0.00%
11.11%
25.00%
42.86%
66.67%
100.00%
150.00%
233.33%
400.00%
900.00%

Beta
0.86
0.92
1.00
1.09
1.22
1.40
1.67
2.12
3.02
5.72

EffectofLeverage
0.00
0.06
0.14
0.23
0.36
0.54
0.81
1.26
2.16
4.86
59

Betas are weighted Averages

Thebetaofaportfolioisalwaysthemarketvalueweightedaverageof
thebetasoftheindividualinvestmentsinthatportfolio.
Thus,
thebetaofamutualfundistheweightedaverageofthebetasofthe
stocksandotherinvestmentinthatportfolio
thebetaofafirmafteramergeristhemarketvalueweightedaverageof
thebetasofthecompaniesinvolvedinthemerger.

Aswath Damodaran

60

The Disney/Cap Cities Merger: Pre-Merger

Disney:
Beta=1.15
Debt=$3,186million Equity=$31,100million Firm=$34,286
D/E=0.10
ABC:
Beta=0.95
Debt=$615million Equity=$18,500million Firm=$19,115
D/E=0.03

Aswath Damodaran

61

Disney Cap Cities Beta Estimation: Step 1

Calculatetheunleveredbetasforbothfirms
Disneysunleveredbeta=1.15/(1+0.64*0.10)=1.08
CapCitiesunleveredbeta=0.95/(1+0.64*0.03)=0.93

Calculatetheunleveredbetaforthecombinedfirm
UnleveredBetaforcombinedfirm
=1.08(34286/53401)+0.93(19115/53401)
=1.026
[Remembertocalculatetheweightsusingthefirmvaluesofthetwofirms]

Aswath Damodaran

62

Disney Cap Cities Beta Estimation: Step 2

IfDisneyhadusedallequitytobuyCapCities

Debt=$615+$3,186=$3,801million
Equity=$18,500+$31,100=$49,600
D/ERatio=3,801/49600=7.66%
NewBeta=1.026(1+0.64(.0766))=1.08

SinceDisneyborrowed$10billiontobuyCapCities/ABC

Aswath Damodaran

Debt=$615+$3,186+$10,000=$13,801million
Equity=$39,600
D/ERatio=13,801/39600=34.82%
NewBeta=1.026(1+0.64(.3482))=1.25

63

Firm Betas versus divisional Betas

FirmBetasasweightedaverages:Thebetaofafirmistheweighted
averageofthebetasofitsindividualprojects.
Atabroaderlevelofaggregation,thebetaofafirmistheweighted
averageofthebetasofitsindividualdivision.

Aswath Damodaran

64

Bottom-up versus Top-down Beta

Thetopdownbetaforafirmcomesfromaregression
Thebottomupbetacanbeestimatedbydoingthefollowing:
Findoutthebusinessesthatafirmoperatesin
Findtheunleveredbetasofotherfirmsinthesebusinesses
Takeaweighted(bysalesoroperatingincome)averageofthese
unleveredbetas
Leverupusingthefirmsdebt/equityratio

Thebottomupbetaisabetterestimatethanthetopdownbetaforthe
followingreasons
Thestandarderrorofthebetaestimatewillbemuchlower
Thebetascanreflectthecurrent(andevenexpectedfuture)mixof
businessesthatthefirmisinratherthanthehistoricalmix

Aswath Damodaran

65

Disneys business breakdown

UnleveredBeta
(1 Cash/FirmValue)

Unlevered
Average
beta
correc
ted
Comparable NumberleveredMedianUnlevered
Cash/Firm
Business
firms
of firms beta
D/E
beta
Value for cash
Radio and TV
Media
broadcasting
Networks companies
24
1.22 20.45% 1.0768 0.75% 1.0850
Themepark&
Parks
andEntertainment
firms
Resorts
9
1.58 120.76
% 0.8853 2.77% 0.9105
Studio
Movie
Entertainmen
t companies
11
1.16 27.96% 0.9824 14.08% 1.1435
Toy
and
apparel
retailers;
Consumer Entertainment
software
Products
77
1.06 9.18% 0.9981 12.08% 1.1353

Aswath Damodaran

66

Disneys bottom up beta

(MarketValueofEquity + Debt Cash)
Sales
Estimatedbylookingatcomparablefirms
EV/Sales =

Business

MediaNetworks
ParksandResorts
Studio
Entertainment
ConsumerProducts
Disney

Aswath Damodaran

Disneys
Revenues
$10,941
$6,412
$7,364
$2,344
$27,061

Estimated
EV/Sales
Value
3.41
$37,278.62
2.37
$15,208.37
2.63
1.63

$19,390.14
$3,814.38
$75,691.51

FirmValue
Proportion
49.25%
20.09%

Unlevered
beta
1.0850
0.9105

25.62%
5.04%
100.00%

1.1435
1.1353
1.0674

67

Disneys Cost of Equity

Business
Medi a Networks
Parksan d
Resorts
Studio
Entertainment

Consumer
Products
Disn e y

Aswath Damodaran

D/E
UnleveredBeta Ratio

1.08 5 0
26.6 2 %

RiskfreeRate=4%
RiskPremium=4.82%

Lever e d
Beta
1.26 6 1

Costof
Equit y
10.1 0 %

0.91 0 5

26.6 2 %

1.06 2 5

9.12%

1.14 3 5

26.6 2 %

1.33 4 4

10.4 3 %

1.13 5 3
1.06 7 4

26.6 2 %
26.6 2 %

1.32 4 8
1.24 5 6

10.3 9 %
10.0 0 %

68

Discussion Issue

IfyouwerethechieffinancialofficerofDisney,whatcostofequity
wouldyouuseincapitalbudgetinginthedifferentdivisions?
a) ThecostofequityforDisneyasacompany
b) ThecostofequityforeachofDisneysdivisions?

Aswath Damodaran

69

Estimating Aracruzs Bottom Up Beta

Correct
EmergingMarkets 111 0.6895 38.33% 0.5469 6.58%
0.585
US
34 0.7927 83.57% 0.5137 2.09%
0.525
Global
288 0.6333 38.88% 0.5024 6.54%
0.538
Aracruzhasacashbalancewhichwas7.07%ofthemarketvalue:
Comparables

No

Avg D/E

Unlev Cash/Val

UnleveredBetaforAracruz=(0.9293)(0.585)+(0.0707)(0)=0.5440

UsingAracruzsgrossD/Eratioof44.59%&ataxrateof34%:
LeveredBetaforAracruz=0.5440(1+(1.34)(.4459))=0.7040

Theleveredbetaforjustthepaperbusinesscanalsobecomputed:
LeveredBetaforpaperbusiness=0.585(1+(1.34)(.4459)))=0.7576

Aswath Damodaran

70

Aracruz: Cost of Equity Calculation

Wewilluseariskpremiumof12.49%incomputingthecostofequity,
composedoftheU.S.historicalriskpremium(4.82%from19282003time
period)andtheBrazilcountryriskpremiumof7.67%(estimatedearlierinthe
package)
U.S.$CostofEquity
CostofEquity=10yrT.Bondrate+Beta*RiskPremium
=4%+0.7040(12.49%)=12.79%

RealCostofEquity
CostofEquity=10yrInflationindexedT.Bondrate+Beta*RiskPremium
=2%+0.7040(12.49%)=10.79%

NominalBRCostofEquity
(1+ InflationRate Brazil )
CostofEquity= (1+ $CostofEquity)
1
(1 + InflationRate US )
=1.1279(1.08/1.02)1=.1943or19.43%

Aswath Damodaran

71

Estimating Bottom-up Beta: Deutsche Bank

DeutscheBankisintwodifferentsegmentsofbusinesscommercial
bankingandinvestmentbanking.
Toestimateitscommercialbankingbeta,wewillusetheaveragebetaof
commercialbanksinGermany.
Toestimatetheinvestmentbankingbeta,wewillusetheaveragebetof
investmentbanksintheU.SandU.K.

ToestimatethecostofequityinEuros,wewillusetheGerman10
yearbondrateof4.05%astheriskfreerateandtheUShistoricalrisk
premium(4.82%)asourproxyforamaturemarketpremium.
Business
Beta
CostofEquity Weights
CommercialBanking 0.7345
7.59%
69.03%
InvestmentBanking 1.5167
11.36%
30.97%
DeutscheBank
8.76%

Aswath Damodaran

72

Estimating Betas for Non-Traded Assets

Theconventionalapproachesofestimatingbetasfromregressionsdo
notworkforassetsthatarenottraded.
Therearetwowaysinwhichbetascanbeestimatedfornontraded
assets
usingcomparablefirms
usingaccountingearnings

Aswath Damodaran

73

Using comparable firms to estimate beta for

Bookscape
Assumethatyouaretryingtoestimatethebetaforaindependentbookstorein
NewYorkCity.
Firm
Beta
Debt
Equity
Cash
BooksAMillion 0.532
$45
$45
$5
BordersGroup
0.844
$182
$1,430
$269
Barnes&Noble
0.885
$300
$1,606
$268
CourierCorp
0.815
$1
$285
$6
InfoHoldings
0.883
$2
$371
$54
JohnWiley&Son 0.636
$235
$1,662
$33
ScholasticCorp
0.744
$549
$1,063
$11
Sector
0.7627
$1,314
$6,462
$645
UnleveredBeta=0.7627/(1+(1.35)(1314/6462))=0.6737
CorrectedforCash=0.6737/(1645/(1314+6462))=0.7346

Aswath Damodaran

74

Estimating Bookscape Levered Beta and Cost

of Equity

Sincethedebt/equityratiosusedaremarketdebtequityratios,andthe
onlydebtequityratiowecancomputeforBookscapeisabookvalue
debt equity ratio, we have assumed that Bookscape is close to the
industryaveragedebttoequityratioof20.33%.
Using a marginal tax rate of 40% (based upon personal income tax
rates)forBookscape,wegetaleveredbetaof0.82.
LeveredbetaforBookscape=0.7346(1+(1.40)(.2033))=0.82

Usingariskfreerateof4%(UStreasurybondrate)andahistorical
riskpremiumof4.82%:
CostofEquity=4%+0.82(4.82%)=7.95%

Aswath Damodaran

75

Using Accounting Earnings to Estimate Beta

Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Aswath Damodaran

S&P500
3.01%
1.31%
8.95%
3.84%
26.69%
6.91%
7.93%
11.10%
42.02%
5.52%
9.58%

Bookscape
3.55%
4.05%
14.33%
47.55%
65.00%
5.05%
8.50%
37.00%
45.17%
3.50%
10.50%

Year
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

S&P500
12.08%
5.12%
9.37%
36.45%
30.70%
1.20%
10.57%
3.35%
18.13%
15.13%
14.94%
6.81%

Bookscape
32.00%
55.00%
31.00%
21.06%
11.55%
19.88%
16.55%
7.10%
14.40%
10.50%
8.15%
4.05%

76

The Accounting Beta for Bookscape

RegressingthechangesinprofitsatBookscapeagainstchangesin
profitsfortheS&P500yieldsthefollowing:
BookscapeEarningsChange=0.1003+0.7329(S&P500Earnings
Change)
Baseduponthisregression,thebetaforBookscapesequityis0.73.
UsingoperatingearningsforboththefirmandtheS&P500shouldyield
theequivalentofanunleveredbeta.

Thecostofequitybasedupontheaccountingbetais:
Costofequity=4%+0.73(4.82%)=7.52%

Aswath Damodaran

77

Is Beta an Adequate Measure of Risk for a

Private Firm?

Betameasurestheriskaddedontoadiversifiedportfolio.Theowners
ofmostprivatefirmsarenotdiversified.Therefore,usingbetato
arriveatacostofequityforaprivatefirmwill
a) Underestimatethecostofequityfortheprivatefirm
b) Overestimatethecostofequityfortheprivatefirm
c) Couldunderoroverestimatethecostofequityfortheprivatefirm

Aswath Damodaran

78

Total Risk versus Market Risk

Adjustthebetatoreflecttotalriskratherthanmarketrisk.This
adjustmentisarelativelysimpleone,sincetheRsquaredofthe
regressionmeasurestheproportionoftheriskthatismarketrisk.
TotalBeta=MarketBeta/Correlationofthesectorwiththemarket

IntheBookscapeexample,wherethemarketbetais0.82andthe
averageRsquaredofthecomparablepubliclytradedfirmsis16%,
MarketBeta
Rsquared

0.82
.16

= 2.06

TotalCostofEquity=4%+2.06(4.82%)=13.93%

Aswath Damodaran

79

Application Test: Estimating a Bottom-up Beta

Baseduponthebusinessorbusinessesthatyourfirmisinrightnow,
anditscurrentfinancialleverage,estimatethebottomupunlevered
betaforyourfirm.

DataSource:Youcangetalistingofunleveredbetasbyindustryon
mywebsitebygoingtoupdateddata.

Aswath Damodaran

80

From Cost of Equity to Cost of Capital

Thecostofcapitalisacompositecosttothefirmofraisingfinancing
tofunditsprojects.
Inadditiontoequity,firmscanraisecapitalfromdebt

Aswath Damodaran

81

What is debt?

GeneralRule:Debtgenerallyhasthefollowingcharacteristics:
Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrol
ofthefirmtothepartytowhompaymentsaredue.

Asaconsequence,debtshouldinclude
Anyinterestbearingliability,whethershorttermorlongterm.
Anyleaseobligation,whetheroperatingorcapital.

Aswath Damodaran

82

Estimating the Cost of Debt

Ifthefirmhasbondsoutstanding,andthebondsaretraded,theyield
tomaturityonalongterm,straight(nospecialfeatures)bondcanbe
usedastheinterestrate.
Ifthefirmisrated,usetheratingandatypicaldefaultspreadonbonds
withthatratingtoestimatethecostofdebt.
Ifthefirmisnotrated,
andithasrecentlyborrowedlongtermfromabank,usetheinterestrate
ontheborrowingor
estimateasyntheticratingforthecompany,andusethesyntheticratingto
arriveatadefaultspreadandacostofdebt

Thecostofdebthastobeestimatedinthesamecurrencyasthecost
ofequityandthecashflowsinthevaluation.

Aswath Damodaran

83

Estimating Synthetic Ratings

Theratingforafirmcanbeestimatedusingthefinancial
characteristicsofthefirm.Initssimplestform,theratingcanbe
estimatedfromtheinterestcoverageratio
InterestCoverageRatio=EBIT/InterestExpenses
In2003,Bookscapehadoperatingincomeof$2millionandinterest
expensesof500,000.Theresultinginterestcoverageratiois4.00.
Interestcoverageratio=2,000,000/500,000=4.00

In2003,Disneyhadoperatingincomeof$2,805millionandmodified
interestexpensesof$758million:
Interestcoverageratio=2805/758=3.70

In2003,Aracruzhadoperatingincomeof887millionBRandinterest
expensesof339millionBR
Interestcoverageratio=887/339=2.62

Aswath Damodaran

84

Interest Coverage Ratios, Ratings and Default

Spreads: Small Companies
InterestCoverageRatio
>12.5
9.5012.50
7.509.50
6.007.50
4.506.00
4.004.50
3.504.00
3.003.50
2.503.00
2.002.50
1.502.00
1.251.50
0.801.25
0.500.80
<0.65

Aswath Damodaran

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

Typicaldefaultspread
0.35%
0.50%
0.70%
0.85%
Bookscape
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%

85

Interest Coverage Ratios, Ratings and Default

Spreads: Large Companies
InterestCoverageRatio
>8.5
6.508.50
5.56.5
4.255.5
34.25
2.53
2.252.5
22.25
1.752
1.51.75
1.251.5
0.81.25
0.650.80
0.20.65
<0.2

Aswath Damodaran

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

DefaultSpread
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%

Disney
Aracruz

86

Synthetic versus Actual Ratings: Disney and

Aracruz

DisneyandAracruzareratedcompaniesandtheiractualratingsare
differentfromthesyntheticrating.
DisneyssyntheticratingisA,whereasitsactualratingisBBB+.The
differencecanbeattributedtoanyofthefollowing:
Syntheticratingsreflectonlytheinterestcoverageratiowhereasactual
ratingsincorporatealloftheotherratiosandqualitativefactors
Syntheticratingsdonotallowforsectorwidebiasesinratings
Syntheticratingwasbasedon2003operatingincomewhereasactual
ratingreflectsnormalizedearnings

AracruzssyntheticratingisBBB,butitsactualratingfordollardebt
isB+.Thebiggestfactorbehindthedifferenceisthepresenceof
countryrisk.Infact,AracruzhasalocalcurrencyratingofBBB,
closertothesyntheticrating.

Aswath Damodaran

87

Estimating Cost of Debt

ForBookscape,wewillusethesyntheticratingtoestimatethecostofdebt:

Ratingbasedoninterestcoverageratio=BBB
DefaultSpreadbaseduponrating=1.50%
Pretaxcostofdebt=RiskfreeRate+DefaultSpread=4%+1.50%=5.50%
Aftertaxcostofdebt=Pretaxcostofdebt(1taxrate)=5.50%(1.40)=3.30%

Forthethreepubliclytradedfirmsinoursample,wewillusetheactualbond
ratingstoestimatethecostsofdebt:

Disney
DeutscheBank
Aracruz

Aswath Damodaran

S&PRating

RiskfreeRate

BBB+
AA
B+

4%($)
4.05%(Eu)
4%($)

Default
Spread
1.25%
1.00%
3.25%

Costof
Debt
5.25%
5.05%
7.25%

Tax
Rate
37.3%
38%
34%

Aftertax
CostofDebt
3.29%
3.13%
4.79%

88

Application Test: Estimating a Cost of Debt

Baseduponyourfirmscurrentearningsbeforeinterestandtaxes,its
interestexpenses,estimate

Aswath Damodaran

Aninterestcoverageratioforyourfirm
Asyntheticratingforyourfirm(usethetablesfrompriorpages)
Apretaxcostofdebtforyourfirm
Anaftertaxcostofdebtforyourfirm

89

Costs of Hybrids

Preferred stock shares some of the characteristics of debt the

preferreddividendisprespecifiedatthetimeoftheissueandispaid
out before common dividend and some of the characteristics of
equitythepaymentsofpreferreddividendarenottaxdeductible.If
preferredstockisviewedasperpetual,thecostofpreferredstockcan
bewrittenasfollows:

kps=PreferredDividendpershare/MarketPriceperpreferredshare

Convertible debt is part debt (the bond part) and part equity (the
conversion option). It is best to break it up into its component parts
andeliminateitfromthemixaltogether.

Aswath Damodaran

90

Weights for Cost of Capital Calculation

Theweightsusedinthecostofcapitalcomputationshouldbemarket
values.
Therearethreespeciousargumentsusedagainstmarketvalue
Book value is more reliable than market value because it is not as
volatile: While it is true that book value does not change as much as
marketvalue,thisismoreareflectionofweaknessthanstrength
Using book value rather than market value is a more conservative
approach to estimating debt ratios: For most companies, using book
valueswillyieldalowercostofcapitalthanusingmarketvalueweights.
Since accounting returns are computed based upon book value,
consistency requires the use of book value in computing cost of capital:
While it may seem consistent to use book values for both accounting
returnandcostofcapitalcalculations,itdoesnotmakeeconomicsense.

Aswath Damodaran

91

Estimating Market Value Weights

MarketValueofEquityshouldincludethefollowing
MarketValueofSharesoutstanding
MarketValueofWarrantsoutstanding
MarketValueofConversionOptioninConvertibleBonds

MarketValueofDebtismoredifficulttoestimatebecausefewfirms
haveonlypubliclytradeddebt.Therearetwosolutions:
Assumebookvalueofdebtisequaltomarketvalue
Estimatethemarketvalueofdebtfromthebookvalue
ForDisney,withbookvalueof13,100million,interestexpensesof$666
million,acurrentcostofborrowingof5.25%andanweightedaverage
maturityof11.53years.

(1
(1.0525)11.53
13,100
EstimatedMVofDisneyDebt=
666
= $12,915million
+

11.53

Aswath Damodaran

.0525

(1.0525)

PVofAnnuity,5.25%,11.53yrs

92

Converting Operating Leases to Debt

Thedebtvalueofoperatingleasesisthepresentvalueofthelease
payments,ataratethatreflectstheirrisk.
Ingeneral,thisratewillbeclosetoorequaltotherateatwhichthe
companycanborrow.

Aswath Damodaran

93

Operating Leases at Disney

ThepretaxcostofdebtatDisneyis5.25%
Year
Commitment
PresentValue
1
$271.00
$257.48
2
$242.00
$218.46
3
$221.00
$189.55
4
$208.00
$169.50
5
$275.00
$212.92
69
$258.25
$704.93
DebtValueofleases=
$1,752.85
DebtoutstandingatDisney
=MVofInterestbearingDebt+PVofOperatingLeases
=$12,915+$1,753=$14,668million

Aswath Damodaran

94

Application Test: Estimating Market Value

Estimatethe
MarketvalueofequityatyourfirmandBookValueofequity
Marketvalueofdebtandbookvalueofdebt(Ifyoucannotfindthe
averagematurityofyourdebt,use3years):Remembertocapitalizethe
valueofoperatingleasesandaddthemontoboththebookvalueandthe
marketvalueofdebt.

Estimatethe
Weightsforequityanddebtbaseduponmarketvalue
Weightsforequityanddebtbaseduponbookvalue

Aswath Damodaran

95

Current Cost of Capital: Disney

Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=4%+1.25(4.82%)=10.00%
MarketValueofEquity=
$55.101Billion
Equity/(Debt+Equity)=
79%

Debt
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(4%+1.25%)(1.373)= 3.29%
MarketValueofDebt=
$14.668Billion
Debt/(Debt+Equity)=
21%

CostofCapital=10.00%(.79)+3.29%(.21)=8.59%
55.101(55.101+14.668)

Aswath Damodaran

96

Disneys Divisional Costs of Capital

Business

Costof
Equity
MediaNetworks
10.10%
ParksandResorts
9.12%
StudioEntertainment 10.43%
ConsumerProducts 10.39%
Disney
10.00%

Aswath Damodaran

Aftertax
costofdebt
3.29%
3.29%
3.29%
3.29%
3.29%

E/(D+E)

D/(D+E)

Costofcapital

78.98%
78.98%
78.98%
78.98%
78.98%

21.02%
21.02%
21.02%
21.02%
21.02%

8.67%
7.90%
8.93%
8.89%
8.59%

97

Aracruzs Cost of Capital

LeveredBeta

Costof
After tax
Equity CostofD e bt D/(D+E)
In Real Terms

Costof
Capital

Paper&
Pulp
Cash
Aracruz

0.75 7 6
0
0.70 4 0

11.4 6 %
3.47%
2.00%

10.7 9 %
3.47%
In USDoll a r Terms

30.8 2 %

30.8 2 %

9.00%
2.00%
8.53%

Paper&
Pulp
Cash
Aracruz

0.75 7 6
0
0.70 4 0

1 3.4 6 %
4.00%
12.7 9 %

30.8 2 %

30.8 2 %

10.7 9 %
4.00%
10.3 3 %

Aswath Damodaran

4.79%

4.79%

98

Bookscape Cost of Capital

Beta
MarketBeta
TotalBeta

Aswath Damodaran

0.82
2.06

Costof
Equity
7.97%
13.93%

Aftertax
D/(D+E)
costofdebt
3.30%
16.90%
3.30%
16.90%

Costof
Capital
7.18%
12.14%

99

Application Test: Estimating Cost of Capital

Usingthebottomupunleveredbetathatyoucomputedforyourfirm,
andthevaluesofdebtandequityyouhaveestimatedforyourfirm,
estimateabottomupleveredbetaandcostofequityforyourfirm.

Baseduponthecostsofequityanddebtthatyouhaveestimated,and
theweightsforeach,estimatethecostofcapitalforyourfirm.

Howdifferentwouldyourcostofcapitalhavebeen,ifyouusedbook
valueweights?

Aswath Damodaran

100

Choosing a Hurdle Rate

Eitherthecostofequityorthecostofcapitalcanbeusedasahurdle
rate,dependinguponwhetherthereturnsmeasuredaretoequity
investorsortoallclaimholdersonthefirm(capital)
Ifreturnsaremeasuredtoequityinvestors,theappropriatehurdlerate
isthecostofequity.
Ifreturnsaremeasuredtocapital(orthefirm),theappropriatehurdle
rateisthecostofcapital.

Aswath Damodaran

101

Back to First Principles

Investinprojectsthatyieldareturngreaterthantheminimum
acceptablehurdlerate.

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

Chooseafinancingmixthatminimizesthehurdlerateandmatches
theassetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependupon
thestockholderscharacteristics.

Aswath Damodaran

102