Aswath Damodaran 0

RISK MEASUREMENT AND HURDLE

RATES IN PRACTICE

“The price of purity is purists…”

Anonymous
 First Principles
1

M a xim ize th e va lu e o f th e b u sin ess (firm )

The Investment Decision The Financing Decision The Dividend Decision

In vest in a ssets th a t ea rn a F in d th e rig h t kin d o f d eb t If yo u ca n n o t fin d in vestm en ts
retu rn g rea ter th a n th e fo r yo u r firm a n d th e rig h t th a t m a ke yo u r m in im u m
m in im u m a ccep ta b le h u rd le m ix o f d eb t a n d eq u ity to a ccep ta b le ra te,retu rn th e ca sh
ra te fu n d yo u r o p era tio n s to o w n ers o f yo u r b u sin ess

T h e hurdle rate T h e return H o w m u ch H o w yo u ch o o se

sh o u ld reflect th e T h e o p tim a l T h e rig h t kin d
sh o u ld reflect th e ca sh yo u ca n to retu rn ca sh to
riskin ess o f th e m ix o f d eb t o f d eb t
m a g n itu d e an d th e retu rn d ep en d s th e o w n ers w ill
in vestm en t a n d a n d eq u ity m a tch es th e u p o n cu rren t &
tim in g o f th e d ep en d o n
th e m ix o f d eb t m a xim izes firm ten o r o f yo u r
ca sh flo w s a s w elll p o ten tial w h eth er th ey
a n d eq u ity u sed va lu e a ssets
a s all sid e effects. in vestm en t p refer d ivid en d s
to fu n d it. o p p o rtu n ities o r b u yb a cks

Aswath Damodaran
1
 Inputs required to use the CAPM -­‐

 The capital asset pricing model yields the following

expected return:
Expected Return = Riskfree Rate+ Beta * (Expected Return on
the Market Portfolio Riskfree Rate)
-­‐

 To use the model we need three inputs:

a. The current riskfree rate
-­‐

b. The expected market risk premium, the premium expected

for investing in risky assets, i.e. the market portfolio, over the
riskless asset.
c. The beta of the asset being analyzed.

Aswath Damodaran
2
 I. The Risk-Free Rate
3

 On a riskfree asset, the actual return is equal to the

expected return. Therefore, there is no variance around the
expected return.
 For an investment to be riskfree, i.e., to have an actual
return be equal to the expected return, two conditions have
to be met –
There has to be no default risk, which generally implies that the
security has to be issued by the government. Note, however, that
not all governments can be viewed as default free.
There can be no uncertainty about reinvestment rates, which
implies that it is a zero coupon security with the same maturity as
the cash flow being analyzed.

Aswath Damodaran
3
 Riskfree Rate in Practice
4

 The riskfree rate is the rate on a zero coupon

government bond matching the time horizon of the cash
flow being analyzed.
 Theoretically, this translates into using different riskfree
rates for each cash flow the 1 year zero coupon rate for
-­‐

the cash flow in year 1, the 2-­‐year zero

coupon rate for the cash flow in year 2 ...
 Practically speaking, if there is substantial uncertainty
about expected cash flows, the present value effect of
using time varying riskfree rates is small enough that it
may not be worth it.
Aswath Damodaran
4
The Bottom Line on Riskfree Rates

 Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value. For short term analysis, it is entirely
appropriate to use a short term government security rate as the riskfree
rate.
 The riskfree rate that you use in an analysis should be in the same currency
that your cashflows are estimated in.
In other words, if your cashflows are in U.S. dollars, your riskfree rate
has to be in
U.S. dollars as well.
If your cash flows are in Euros, your riskfree rate should be a Euro
riskfree rate.
 The conventional practice of estimating riskfree rates is to use the
government bond rate, with the government being the one that is in
control of issuing that currency. In November 2013, for instance, the rate
on a ten-­‐year US treasury bond (2.75%) is used as the risk free rate in US
dollars.
Aswath Damodaran
5
What is the Euro riskfree rate? An exercise
in November 2013
Rate on 10-­‐year Euro Government Bonds: November 2013

9.00%
8.30%

8.00%

7.00% 6.42%
5.90%
6.00%

5.00%
3.90% 3.95%
4.00%
3.30%

3.00% 2.35%
2.10% 2.15%
1.75%
2.00%

1.00%

0.00%
Germany Austria France Belgium Ireland Italy Spain Portugal Slovenia Greece

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When the government is default free: Risk
free rates – in November 2013

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What if there is no default-­‐free entity?
Risk free rates in November 2013
 Adjust the local currency government borrowing rate for default risk to get a
riskless local currency rate.
In November 2013, the Indian government rupee bond rate was 8.82%. the local currency
rating from Moody’s was Baa3 and the default spread for a Baa3 rated country bond was
2.25%.
Riskfree rate in Rupees = 8.82% 2.25% = 6.57%
-­‐

In November 2013, the Chinese Renmimbi government bond rate was 4.30% and the local
currency rating was Aa3, with a default spread of 0.8%.
Riskfree rate in Chinese Renmimbi = 4.30% 0.8% = 3.5%
-­‐

 Do the analysis in an alternate currency, where getting the riskfree rate is

easier. With Vale in 2013, we could chose to do the analysis in US dollars
(rather than estimate a riskfree rate in R$). The riskfree rate is then the US
treasury bond rate.
 Do your analysis in real terms, in which case the riskfree rate has to be a real
riskfree rate. The inflation-­‐indexed treasury rate is a measure of a real riskfree
rate.

Aswath Damodaran
8
 Three paths to estimating sovereign
default spreads
9

Sovereign dollar or euro denominated bonds: The difference

between the interest rate on a sovereign US $ bond, issued by
the country, and the US treasury bond rate can be used as the
default spread. For example, in November 2013, the 10-­‐year Brazil
US $ bond, denominated in US dollars had a yield of 4.25% and
the US 10year [Link] rate traded at 2.75%.
-­‐

Default spread = 4.25% 2.75% = 1.50%

-­‐

 CDS spreads: Obtain the default spreads for sovereigns in the CDS
market. The CDS spread for Brazil in November 2013 was 2.50%.
 Average spread: If you know the sovereign rating for a country,
you can estimate the default spread based on the rating. In
November 2013, Brazil’s rating was Baa2, yielding a default
spread of 2%.

Aswath Damodaran
9
 Risk free rates in currencies: Sovereigns
with default risk
10

Figure 4.2: Risk free rates in Currencies where Governments not Aaa
rated
16.00%

14.00%

12.00%

10.00%

8.00%

Default Spread
6.00%
Risk free rate
4.00%

2.00%

0.00%

Aswath Damodaran
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 II. Risk Premium
11

 The risk premium is the premium that investors demand for

investing in an average risk investment, relative to the riskfree
rate.
 As a general proposition, this premium should be:
greater than zero
increase with the risk aversion of the investors in that
market: As investors become more risk-averse, they should
demand a larger premium for shifting from the riskless asset.
Although some of this risk aversion may be inherent, some of it
is also a function of economic prosperity (when the economy is
doing well, investors tend to be much more willing to take risk)
and recent experiences in the market (risk premiums tend to
surge after large market drops). 11

Aswath Damodaran
 II. Risk Premium
11

increase with the riskiness of the “average”

risk investment: As the riskiness of the average
risk investment increases, so should the
premium. This will depend on what firms are
actually traded in the market, their economic
fundamentals, and how involved they are in
managing risk.

11
Aswath Damodaran
What is your risk premium?

 Assume that stocks are the only risky assets and that you are
offered two investment options:
a riskless investment (say a Government Security), on which you can make
3%
a mutual fund of all stocks, on which the returns are uncertain
 How much of an expected return would you demand to shift your
money from the riskless asset to the mutual fund?
a. Less than 3%
b. Between 3% 5% -­‐

c. Between 5% 7% -­‐

d. Between 7% -­‐9%
e. Between 9% 11%
-­‐

f. More than 11%

Aswath Damodaran
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 Risk Aversion and Risk Premiums
13

 If this were the entire market, the risk premium

would be a weighted average of the risk
premiums demanded by each and every investor.
 The weights will be determined by the wealth
that each investor brings to the market. Thus,
Warren Buffett’s risk aversion counts more
towards determining the “equilibrium” premium
than yours’and mine.
 As investors become more risk averse, you would
expect the “equilibrium” premium to increase.

13
Aswath Damodaran
 Risk Premiums do change..
14

 Go back to the previous example. Assume now that you

are making the same choice but that you are making it
in the aftermath of a stock market crash (it has dropped
25% in the last month). Would you change your
answer?
a. I would demand a larger premium
b. I would demand a smaller premium
c. I would demand the same premium

Aswath Damodaran
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 Estimating Risk Premiums in Practice
15

 Survey investors on their desired risk

premiums and use the average premium from
these surveys.
 Assume that the actual premium delivered
over long time periods is equal to the
expected premium -­‐i.e., use historical data.
 Estimate the implied premium in today’s
asset prices.

Aswath Damodaran
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 The Survey Approach
16

 Surveying all investors in a market place is impractical.

 However, you can survey a few individuals and use these results. In
practice, this translates into surveys of the following:

 The limitations of this approach are:

There are no constraints on reasonability (the survey could produce
negative risk premiums or risk premiums of 50%)
The survey results are more reflective of the past than the future.
They tend to be short term; even the longest surveys do not go beyond
one year.

Aswath Damodaran
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 The Historical Premium Approach
17

 This is the default approach used by most to arrive at the

premium to use in the model
 In most cases, this approach does the following
Defines a time period for the estimation (1928-­‐Present, last 50 years...)
Calculates average returns on a stock index during the period
Calculates average returns on a riskless security over the period
Calculates the difference between the two averages and uses it as a
premium looking forward.
 The limitations of this approach are:
it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from year to
year, but it reverts back to historical averages)
it assumes that the riskiness of the “risky” portfolio (stock index) has not
changed in a systematic way across time.

Aswath Damodaran
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 The Historical Risk Premium
Evidence from the United States
18

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%

What is the right premium?

 Go back as far as you can. Otherwise, the standard error in the estimate will be
large.
Std Error in estimate = Annualized Std deviation in Stock
prices)
Number of years of historical data
 Be consistent in your use of a riskfree rate.
 Use arithmetic premiums for one-­‐year estimates of costs of equity and geometric
premiums for estimates of long term costs of equity.

Aswath Damodaran
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 What about historical premiums for other
markets?
19

 Historical data for markets outside the United

States is available for much shorter time
periods. The problem is even greater in
emerging markets.
 The historical premiums that emerge from this
data reflects this data problem and there is
much greater error associated with the
estimates of the premiums.

Aswath Damodaran
19
One solution: Bond default spreads as CRP
– November 2013
 In November 2013, the historical risk premium for the US was 4.20%
(geometric average, stocks over [Link], 1928-­‐2012)
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%
 Using the default spread on the sovereign bond or based upon the
sovereign rating and adding that spread to the mature market premium
(4.20% for the US) gives you a total ERP for a country.
Country Rating Default Spread (Country Risk Premium) US ERP Total ERP for country
India Baa3 2.25% 4.20% 6.45%
China Aa3 0.80% 4.20% 5.00%
Brazil Baa2 2.00% 4.20% 6.20%

 If you prefer CDS spreads:

Country Sovereign CDS Spread US ERP Total ERP for country
India 4.20% 4.20% 8.40%
China 1.20% 4.20% 5.40%
Brazil 2.59% 4.20% 6.79%

Aswath Damodaran
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Beyond the default spread? Equities are
riskier than bonds
 While default risk spreads and equity risk premiums are highly correlated,
one would expect equity spreads to be higher than debt spreads. One
approach to scaling up the premium is to look at the relative volatility of
equities to bonds and to scale up the default spread to reflect this:

 Brazil: The annualized standard deviation in the Brazilian equity index

over the previous year is 21 percent, whereas the annualized standard
deviation in the Brazilian C-­‐bond is 14 percent.

Brazil's Total Risk Premium4.20% + 2.00%21%7.20%
 
14% 

 Using the same approach for China and India:


24%
Equity Risk PremiumIndia = 4.20% + 2.25%
 7.80%
17% 


18%
Equity Risk Premium China = 4.20% + 0.80%
 5.64%
10% 

Aswath Damodaran
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 Implied ERP in November 2013: Watch
what I pay, not what I say..
 If you can observe what investors are willing to pay
for stocks, you can back out an expected return from
that price and an implied equity risk premium.
Base year cash flow (last 12 mths)
D ivid en d s (T T M ): 3 3 .2 2 Expected growth in next 5 years
+ B uyb acks (T T M ): 4 9 .0 2 T o p d o w n an alyst estim ate o f
= C ash to in vesto rs (T T M ): 8 2 .3 5 ea rn in g s g ro w th fo r S & P 5 0 0 w ith
E arn in g s in T T M : sta b le p a yo u t: 5 .5 9 %
Beyond year 5 E xp ected
E (C a sh to in vesto rs) 8 6 .9 6 9 1 .8 2 9 6 .9 5 1 0 2 .3 8 1 0 8 .1 0 g ro w th rate = R iskfree ra te =
2 .5 5 % E xp ected C F in year 6
S & P 5 0 0 o n 1 1 /1 /1 3 = = 1 0 8 .1 (1 .0 2 5 5 )
1 7 5 6 .5 4 86.96 91.82 96.95 102.38 108.10 110.86
1756.54   2  3  4  5 
(1r) (1r) (1r) (1r) (1r) (r .0255)(1r) 5

r = Im p lied E xp ected R etu rn o n S to cks = 8 .0 4 %

Minus

R isk free rate = T .B o n d rate o n 1 /1 /1 4 = 2 .5 5 %

Equals
Aswath Damodaran Im p lied E q u ity R isk P rem iu m (1 /1 /1 4 ) = 8 .0 4 % - 2 .5 5 % = 5 .4 9 %
22
The bottom line on Equity Risk Premiums
in November 2013
 Mature Markets: In November 2013, the number that we chose to use as the
equity risk premium for all mature markets was 5.5%. This was set equal to the
implied premium at that point in time and it was much higher than the historical
risk premium of 4.20% prevailing then (1928-­‐2012 period).
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%
 For emerging markets, we will use the melded default spread approach (where
default spreads are scaled up to reflect additional equity risk) to come up with the
additional risk premium that we will add to the mature market premium. Thus,
markets in countries with lower sovereign ratings will have higher risk premiums
that 5.5%.  
Emerging Market ERP = 5.5% + Country Default Spread*
Equity
 Country Bond
 

Aswath Damodaran
23
A Composite way of estimating ERP for
countries
Step 1: Estimate an equity risk premium for a mature market. If your
preference is for a forward looking, updated number, you can estimate an
implied equity risk premium for the US (assuming that you buy into the
contention that it is a mature market)
My estimate: In January 2014, my estimate for the implied premium in the US
was 5%. That will also be my estimate for a mature market ERP.
Step 2: Come up with a generic and measurable definition of a mature
market.
My estimate: Any AAA rated country is mature.
Step 3: Estimate the additional risk premium that you will charge for
markets that are not mature. You have two choices:
The default spread for the country, estimated based either on sovereign ratings
or the CDS market.
A scaled up default spread, where you adjust the default spread upwards for the
additional risk in equity markets.

Aswath Damodaran
24
 Andorra 7.45% 1.95% Liechtenstein 5.50% 0.00%Albania 12.25% 6.75%
Austria 5.50% 0.00% Luxembourg 5.50%
10.23% 4.73% Bangladesh 10.90% 5.40%
3102

0.00%ArmeniaAzerbaijan
Belgium 6.70% 1.20% Malta 7.45% 1.95% 8.88% 3.38% Cambodia 13.75% 8.25%
Cyprus 22.00% 16.50% Netherlands 5.50% 0.00%Belarus 15.63% 10.13% China 6.94% 1.44%
Denmark 5.50% 0.00% Norway 5.50% 0.00%Bosnia 15.63% 10.13% Fiji 12.25% 6.75%
10.90% 5.40%Bulgaria 8.50% 3.00%
voN

Finland 5.50% 0.00% Portugal Hong Kong 5.95% 0.45%

France 5.95% 0.45% Spain 8.88% 3.38%Croatia 9.63% 4.13%
India 9.10% 3.60%
5.50% 0.00%Czech 6.93% 1.43%
Germany 5.50% 0.00% Sweden Indonesia 8.88% 3.38%
Republic 6.93% 1.43%
Greece 15.63% 10.13% Switzerland 5.50% 0.00%Estonia
:

Georgia 10.90% 5.40% Japan 6.70% 1.20%

P

Iceland 8.88% 3.38% Turkey 8.88% 3.38%Hungary 6.70% 1.20%

9.63% 4.13% Korea
R

Ireland 9.63% 4.13% United Kingdom 5.95% 0.45%Kazakhstan 8.50% 3.00% Macao 6.70% 1.20%
E

Italy 8.50% 3.00% Western Europe 6.72% 1.22%Latvia 8.50% 3.00% Malaysia 7.45% 1.95%
Canada 5.50% 0.00% Lithuania 8.05% 2.55% Mauritius 8.05% 2.55%
United States of America
5.50% 0.00% Country TRP CRP Macedonia 10.90% 5.40% Mongolia 12.25% 6.75%
North America 5.50% 0.00% Angola 10.90% 5.40% Moldova 15.63% 10.13% Pakistan 17.50% 12.00%
Argentina 15.63% 10.13% Benin 13.75% 8.25% Montenegro 10.90% 5.40% Papua NG 12.25% 6.75%
Belize 19.75% 14.25% Botswana 7.15% 1.65% Poland 7.15% 1.65% Philippines 9.63% 4.13%
Bolivia 10.90% 5.40% Burkina Faso 13.75% 8.25% Romania 8.88% 3.38%
Singapore 5.50% 0.00%
Cameroon 13.75% 8.25% Russia 8.05% 2.55%
Brazil 8.50% 3.00% Sri Lanka 12.25% 6.75%
Cape Verde 12.25% 6.75% Serbia 10.90% 5.40%
Chile 6.70% 1.20% Taiwan 6.70% 1.20%
Egypt 17.50% 12.00% Slovakia 7.15% 1.65%
Colombia 8.88% 3.38% Thailand 8.05% 2.55%
Slovenia 9.63% 4.13%
Costa Rica 8.88% 3.38% Gabon 10.90% 5.40% 13.75% 8.25%
Ukraine 15.63% 10.13% Vietnam
Ecuador 17.50% 12.00% Ghana 12.25% 6.75% 7.27% 1.77%
E. Europe & Russia 8.60% 3.10% Asia
El Salvador 10.90% 5.40% Kenya 12.25% 6.75%
Morocco 9.63% 4.13% Bahrain 8.05% 2.55%
Guatemala 9.63% 4.13%
Moza m bique 12.25% 6.75% Israel 6.93% 1.43% Australia 5.50% 0.00%
Honduras 13.75% 8.25%
Namibia 8.88% 3.38% Jordan 12.25% 6.75% Cook Islands 12.25% 6.75%
Mexico 8.05% 2.55%
Nigeria 10.90% 5.40% Kuwait 6.40% 0.90% New Zealand 5.50% 0.00%
Nicaragua 15.63% 10.13%
Rwanda 13.75% 8.25% Lebanon 12.25% 6.75% Australia & NZ 5.00% 0.00%
Panama 8.50% 3.00%
Paraguay 10.90% 5.40% Senegal 12.25% 6.75% Oman 6.93% 1.43%
Peru 8.50% 3.00% South Africa 8.05% 2.55% Qatar 6.40% 0.90%
10.23% 4.73% Saudi Arabia 6.70% 1.20%
Suriname 10.90% 5.40% Tunisia
Uganda 12.25% 6.75% United Arab Emirates 6.40% 0.90% Black #: Total ERP
UruguayAswath D8a.8m8o%dar3a.3n8%
Zambia 12.25% 6.75% Middle East 6.88% 1.38% Red #: Country risk premium
Venezuela 12.25% 6.75%
Latin America 9.44% 3.94% Africa 11.22% 5.82% AVG: GDP weighted average
 Estimating ERP for Disney: November 2013

 Incorporation: The conventional practice on equity risk premiums is to

estimate an ERP based upon where a company is incorporated. Thus, the
cost of equity for Disney would be computed based on the US equity risk
premium, because it is a US company, and the Brazilian ERP would be
used for Vale, because it is a Brazilian company.
 Operations: The more sensible practice on equity risk premium is to
estimate an ERP based upon where a company operates. For Disney in
2013:
Proportion of Disney’s
Region/ Country ERP
Revenues
US& Canada 82.01% 5.50%
Europe 11.64% 6.72%
Asia-­‐Pacific 6.02% 7.27%
Latin America 0.33% 9.44%
Disney 100.00% 5.76%

Aswath Damodaran
26
ERP for Companies: November 2013

Company Region/ Country Weight ERP

Bookscape United States 100% 5.50%
US & Canada 4.90% 5.50%
Brazil 16.90% 8.50%
Rest of Latin
1.70% 10.09%
America
China 37.00% 6.94%
Vale Japan 10.30% 6.70%
In November 2013, Rest of Asia 8.50% 8.61%
Europe 17.20% 6.72%
the mature market
Rest of World 3.50% 10.06%
premium used was Company 100.00% 7.38%
5.5% India 23.90% 9.10%
China 23.60% 6.94%
UK 11.90% 5.95%
Tata Motors 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%
Germany 35.93% 5.50%
North America 24.72% 5.50%
Rest of Europe 28.67% 7.02%
Deutsche Bank
Asia-Pacific 10.68% 7.27%
South America 0.00% 9.44%
Company 100.00% 6.12%

Aswath Damodaran
27
 The Anatomy of a Crisis: Implied ERP from
September 12, 2008 to January 1, 2009
28

Aswath Damodaran
28
An Updated Equity Risk Premium: January
2014

Base year cash flow

D ivid en d s (T T M ): 3 4 .3 2 Expected growth in next 5 years
+ B u yb a cks (T T M ): 4 9 .8 5 T o p d o w n a n a lyst estim a te o f
= C a sh to in vesto rs (T T M ): 8 4 .1 6 e a rn in g s g ro w th fo r S & P 5 0 0 w ith
E a rn in g s in T T M : sta b le p a yo u t: 4 .2 8 %
Beyond year 5 E xp ected
E (C a sh to in ve sto rs) 8 7 .7 7 9 1 .5 3 9 5 .4 5 9 9 .5 4 1 0 3 .8 0 g ro w th ra te = R iskfree ra te =
3 .0 4 % T e rm in a l va lu e =
S & P 5 0 0 o n 1 /1 /1 4 = 1 0 3 .8 (1 .0 3 0 4 )/(,0 8 - .0 3 0 4 )
1 8 4 8 .3 6 87.77 91.53 95.45 99.54 103.80 103.80(1.0304)
(1 + )1 + (1 + )2 + (1 + )3 + (1 + )4 + (1 + )5 + ( − .0304)(1 + )5 = 1848.36

r = Im p lied E xp ected R etu rn o n S to cks = 8 .0 0 %

Minus

R isk free ra te = T .B o n d ra te o n 1 /1 /1 4 = 3 .0 4 %

Equals
Im p lie d E q u ity R isk P re m iu m (1 /1 /1 4 ) = 8 % - 3 .0 4 % = 4 .9 6 %

Aswath Damodaran
29
 30

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02 1 1
012
902
Implied Premiums in the US: 1960-­‐2013

802
702
602
502
402
302
20
102
02
91
891
791
691
591
491
391
291
19
091
981
891
7891

Y ear
6891
5891
4891
3891
2891
189
0891
971
8791
791
6791
5791
4791
3791
2791
179
0791
961
8691
7691
691

Aswath Damodaran
5691
4691
3691
2691
169
0691

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
muimerP deilpmI

30
 Andorra 6.80% 1.80% Liechtenstein 5.00% 0.00%
Albania 11.75% 6.75%
Austria 5.00% 0.00% Luxembourg 5.00% 0.00% Bangladesh 10.40% 5.40%
Armenia 9.50% 4.50%
Belgium 5.90% 0.90% Malta 6.80% 1.80% Cambodia 13.25% 8.25%
4102

Azerbaijan 8.30% 3.30%

Cyprus 20.00% 15.00% Netherlands 5.00% 0.00% China 5.90% 0.90%
Belarus 14.75% 9.75%
Denmark 5.00% 0.00% Norway 5.00% 0.00% Fiji 11.75% 6.75%
Bosnia and Herzegovina 14.75% 9.75%
Finland 5.00% 0.00% Portugal 10.40% 5.40% Bulgaria 7.85% 2.85% Hong Kong 5.60% 0.60%
n

France 5.60% 0.60% Spain 8.30% 3.30% Croatia 8.75% 3.75% India 8.30% 3.30%
a

Germany 5.00% 0.00% Sweden 5.00% 0.00% Czech Republic 6.05% 1.05% Indonesia 8.30% 3.30%
J

Greece 20.00% 15.00% Switzerland 5.00% 0.00% Estonia 6.05% 1.05% Japan 5.90% 0.90%
:

Georgia 10.40% 5.40% Korea 5.90% 0.90%

P

Iceland 8.30% 3.30% Turkey 8.30% 3.30%

8.75% 3.75% Macao 5.90% 0.90%
R

Ireland 8.75% 3.75% United Kingdom 5.60% 0.60% Hungary

Kazakhstan 7.85% 2.85% Malaysia 6.80% 1.80%
E

Italy 7.85% 2.85% Western Europe 6.29% 1.29%

Latvia 7.85% 2.85% Mauritius 7.40% 2.40%
Canada 5.00% 0.00% Lithuania 7.40% 2.40%
Angola 10.40% 5.40% Mongolia 11.75% 6.75%
United States of America 5.00% 0.00% Macedonia 10.40% 5.40%
Benin 13.25% 8.25% Pakistan 16.25% 11.25%
North America 5.00% 0.00% Moldova 14.75% 9.75%
Botswana 6.28% 1.28% Papua New Guinea 11.75% 6.75%
Montenegro 10.40% 5.40% Philippines 8.30% 3.30%
Argentina 14.75% 9.75% Burkina Faso 13.25% 8.25%
Poland 6.28% 1.28% Singapore 5.00% 0.00%
Belize 18.50% 13.50% Cameroon 13.25% 8.25%
Romania 8.30% 3.30%
Bolivia 10.40% 5.40% Cape Verde 13.25% 8.25% Sri Lanka 11.75% 6.75%
Russia 7.40% 2.40%
Brazil 7.85% 2.85% DR Congo 14.75% 9.75% Taiwan 5.90% 0.90%
Serbia 11.75% 6.75%
Chile 5.90% 0.90% Egypt 16.25% 11.25% Thailand 7.40% 2.40%
Slovakia 6.28% 1.28%
Colombia 8.30% 3.30% Gabon 10.40% 5.40% Vietnam 13.25% 8.25%
Slovenia 8.75% 3.75%
Costa Rica 8.30% 3.30% Ghana 11.75% 6.75% Asia 6.51% 1.51%
Ukraine 16.25% 11.25%
Ecuador 16.25% 11.25% Kenya 11.75% 6.75% E. Europe & Russia 7.96% 2.96%
El Salvador 10.40% 5.40% Morocco 8.75% 3.75%
Guatemala 8.75% 3.75% Mozambique 11.75% 6.75% Abu Dhabi 5.75% 0.75% Australia 5.00% 0.00%

Honduras 13.25% 8.25% Namibia 8.30% 3.30% Bahrain 7.85% 2.85% Cook Islands 11.75% 6.75%

Mexico 7.40% 2.40% Nigeria 10.40% 5.40% Israel 6.05% 1.05% New Zealand 5.00% 0.00%

Nicaragua 14.75% 9.75% Rep Congo 10.40% 5.40% Jordan 11.75% 6.75% Australia & New
Zealand 5.00% 0.00%
Panama 7.85% 2.85% Rwanda 13.25% 8.25% Kuwait 5.75% 0.75%

Paraguay 10.40% 5.40% Senegal 11.75% 6.75% Lebanon 11.75% 6.75%

Peru 7.85% 2.85% South Africa 7.40% 2.40% Oman 6.05% 1.05%

Suriname 10.40% 5.40% Tunisia 10.40% 5.40% Qatar 5.75% 0.75%

Saudi Arabia 5.90% 0.90% Black #: Total ERP
Uruguy
a AswatD 8.m
a
30%o d3a3
.r0a%n Uganda 11.75% 6.75%
h Zambia 11.75% 6.75% United Arab Emirates 5.75% 0.75% Red #: Country risk premium
Venezuela 16.25% 11.25% Africa 10.04% 5.04% Middle East 6.14% 1.14% AVG: GDP weighted average
Latin America 8.62% 3.62%
 III. Risk Parameters

19

 The final set of inputs we need to put risk and return

models into practice are the risk parameters for
individual assets and projects. In the CAPM, the beta of
the asset has to be estimated relative to the market
portfolio. In the APM and multifactor model, the betas
of the asset relative to each factor have to be measured.
There are three approaches available for estimating
these parameters; one is to use historical data on
market prices for individual assets; the second is to
estimate the betas from fundamentals; and the third is
to use accounting data.
19
Aswath Damodaran
 IV. Estimating the Cost of Equity

19

 Having estimated the risk-free rate, the risk premium(s),

and the beta(s), we can now estimate the expected
return from investing in equity at any firm. In the CAPM,
this expected return can be written as:
Expected Return = Risk-Free Rate + Beta * Expected Risk
Premium
 In the APM and multifactor model, the expected return
would be written as follows:
=

Expected Return = Risk-free Rate + ∑ β ∗Risk Premiumj

j
=1
19
Aswath Damodaran
 Application Test: Estimating a Market Risk
Premium
32

 For your company, get the geographical breakdown of revenues in

the most recent year. Based upon this revenue breakdown and the
most recent country risk premiums, estimate the equity risk
premium that you would use for your company.

 This computation was based entirely on revenues. With your

company, what concerns would you have about your estimate
being too high or too low?

Aswath Damodaran
32
 Estimating Beta
33

 The standard procedure for estimating betas is to regress

stock returns (Rj) against market returns (Rm):
Rj = a + b R m
where a is the intercept and b is the slope of the regression.
 The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.
 The R squared (R2) of the regression provides an
estimate of the proportion of the risk (variance) of a firm
that can be attributed to market risk. The balance (1 R2) -­‐
can be attributed to firm specific risk.

Aswath Damodaran
33
 Estimating Performance
34

 The intercept of the regression provides a simple measure of

performance during the period of the regression, relative to
the capital asset pricing model.
Rj = Rf + b (Rm Rf)
-­‐

= Rf (1b) + b Rm
-­‐ ........... Capital Asset Pricing Model
Rj =a + b Rm ........... Regression Equation
 If
a > Rf (1-­‐b) .... Stock did better than expected during regression period a =
Rf (1-­‐b) .... Stock did as well as expected during regression period
a < Rf (1-­‐b) .... Stock did worse than expected during regression period
 The difference between the intercept and Rf (1-­‐b) is Jensen's
alpha. If it is positive, your stock did perform better than
expected during the period of the regression.

Aswath Damodaran
34
 Setting up for the Estimation
35

 Decide on an estimation period

Services use periods ranging from 2 to 5 years for the regression
Longer estimation period provides more data, but firms change.
Shorter periods can be affected more easily by significant firm-­‐specific
event that occurred during the period
Decide on a return interval daily, weekly, monthly
-­‐

Shorter intervals yield more observations, but suffer from more noise.
Noise is created by stocks not trading and biases all betas towards one.
 Estimate returns (including dividends) on stock
Return = (PriceEnd PriceBeginning + DividendsPeriod)/ PriceBeginning
-­‐

Included dividends only in ex-­‐dividend month

 Choose a market index, and estimate returns (inclusive of
dividends) on the index for each interval for the period.

Aswath Damodaran
35
Choosing the Parameters: Disney

 Period used: 5 years

 Return Interval = Monthly
 Market Index: S&P 500 Index.
 For instance, to calculate returns on Disney in December 2009,
Price for Disney at end of November 2009 = $ 30.22
Price for Disney at end of December 2009 = $ 32.25
Dividends during month = $0.35 (It was an ex-­‐dividend month)
Return =($32.25 $30.22 + $ 0.35)/$30.22= 7.88%
-­‐

 To estimate returns on the index in the same month

Index level at end of November 2009 = 1095.63
Index level at end of December 2009 = 1115.10
Dividends on index in December 2009 = 1.683
Return =(1115.1 – 1095.63+1.683)/ 1095.63 = 1.78%

Aswath Damodaran
36
Disney’s Historical Beta

Return on Disney = .0071 + 1.2517 Return on Market R² = 0.73386

(0.10)
Analyzing Disney’s Performance

 Intercept = 0.712%
This is an intercept based on monthly returns. Thus, it has to be
compared to a monthly riskfree rate.
Between 2008 and 2013
 Average Annualized [Link] rate = 0.50%
 Monthly Riskfree Rate = 0.5%/12 = 0.042%
 Riskfree Rate (1Beta) = 0.042% (11.252) = .0105%
-­‐ -­‐ -­‐

 The Comparison is then between

Intercept versus Riskfree Rate (1 Beta) -­‐

0.712% versus 0.0105%

Jensen’s Alpha = 0.712% (0.0105)% = 0.723%
-­‐ -­‐

 Disney did 0.723% better than expected, per month, between

October 2008 and September 2013
Annualized, Disney’s annual excess return = (1.00723)12 -­‐1= 9.02%

Aswath Damodaran
38
 More on Jensen’s Alpha
39

 If you did this analysis on every stock listed on an exchange, what would the
average Jensen’s alpha be across all stocks?
a. Depend upon whether the market went up or down during the period Should be
b. zero
c. Should be greater than zero, because stocks tend to go up more often than down.

 Disney has a positive Jensen’s alpha of 9.02% a year between 2008 and 2013. This
can be viewed as a sign that management in the firm did a good job, managing
the firm during the period.
a. True
b. False

 Disney has had a positive Jensen’s alpha between 2008 and 2013. If you were an
investor in early 2014, looking at the stock, you would view this as a sign that the
stock will be a:
a. Good investment for the future
b. Bad investment for the future
c. No information about the future

Aswath Damodaran
39
Estimating Disney’s Beta

 Slope of the Regression of 1.25 is the beta

 Regression parameters are always estimated with error.
The error is captured in the standard error of the beta
estimate, which in the case of Disney is 0.10.
 Assume that I asked you what Disney’s true beta is, after
this regression.
What is your best point estimate?

What range would you give me, with 67% confidence?

What range would you give me, with 95% confidence?

Aswath Damodaran
40
The Dirty Secret of “Standard Error”

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

1600

1400

1200

1000
smriF

800
f
ro
ebm

600
uN

400

200

0
<. 10 .1 0 - .2 0 .2 0 - .3 0 .3 0 - .4 0 .4 0 -. 5 0 .5 0 - .7 5 > . 75

Standard Error in Beta Estimate

Aswath Damodaran
41
Breaking down Disney’s Risk

 R Squared = 73%
 This implies that
73% of the risk at Disney comes from market sources
27%, therefore, comes from firm-­‐specific sources
 The firm-­‐specific risk is diversifiable and will not be
rewarded.
 The R-­‐squared for companies, globally, has increased
significantly since 2008. Why might this be happening?

 What are the implications for investors?

Aswath Damodaran
42
 The Relevance of R Squared
43

 You are a diversified investor trying to decide

whether you should invest in Disney or Amgen. They
both have betas of 1.25, but Disney has an R
Squared of 73% while Amgen’s R squared is only
25%. Which one would you invest in?
Amgen, because it has the lower R squared
Disney, because it has the higher R squared
You would be indifferent
 Would your answer be different if you were an
undiversified investor?
Aswath Damodaran
43
Beta Estimation: Using a Service
(Bloomberg)

Aswath Damodaran
44
Estimating Expected Returns for Disney in
November 2013
 Inputs to the expected return calculation
Disney’s Beta = 1.25
Riskfree Rate = 2.75% (U.S. tenyear [Link] rate in
-­‐

November 2013)
Risk Premium = 5.76% (Based on Disney’s operating
exposure)
Expected Return = Riskfree Rate + Beta (Risk Premium)
= 2.75% + 1.25 (5.76%) = 9.95%

Aswath Damodaran
45
Use to a Potential Investor in Disney

 As a potential investor in Disney, what does this expected

return of 9.95% tell you?
This is the return that I can expect to make in the long term on Disney,
if the stock is correctly priced and the CAPM is the right model for risk,
This is the return that I need to make on Disney in the long term to
break even on my investment in the stock
Both
 Assume now that you are an active investor and that your
research suggests that an investment in Disney will yield
12.5% a year for the next 5 years. Based upon the expected
return of 9.95%, you would
Buy the stock
Sell the stock

Aswath Damodaran
46
How managers use this expected return

 Managers at Disney
need to make at least 9.95% as a return for their equity
investors to break even.
this is the hurdle rate for projects, when the investment is
analyzed from an equity standpoint
 In other words, Disney’s cost of equity is 9.95%.
 What is the cost of not delivering this cost of equity?

Aswath Damodaran
47
 Application Test: Analyzing the Risk Regression
48

 Using your Bloomberg risk and return print out, answer the
following questions:
How well or badly did your stock do, relative to the market, during the
period of the regression?
Intercept (Riskfree Rate/n) (1-­‐ Beta) = Jensen’s Alpha
-­‐

 where n is the number of return periods in a year (12 if monthly; 52

if weekly)
What proportion of the risk in your stock is attributable to the market?
What proportion is firm-­‐specific?
What is the historical estimate of beta for your stock? What is the
range on this estimate with 67% probability? With 95% probability?
Based upon this beta, what is your estimate of the required return on
this stock?
Riskless Rate + Beta * Risk Premium

Aswath Damodaran
48
 A Quick Test
49

 You are advising a very risky software firm on the right cost of
equity to use in project analysis. You estimate a beta of 3.0
for the firm and come up with a cost of equity of 20%. The
CFO of the firm is concerned about the high cost of equity
and wants to know whether there is anything he can do to
lower his beta.
 How do you bring your beta down?

 Should you focus your attention on bringing your beta down?

Yes
No

Aswath Damodaran
49
Regression Diagnostics for Tata Motors

Beta = 1.83
67% range
1.67-1.99

69% market risk

31% firm specific

Jensen’s 
= 2.28% - 4%/12 (1-1.83) = 2.56% Expected Return (in Rupees)
Annualized = (1+.0256)12-1= 35.42% = Riskfree Rate+ Beta*Risk premium
Average monthly riskfree rate (2008-13) = 4% = 6.57%+ 1.83 (7.19%) = 19.73%
Aswath Damodaran
50
A better beta? Vale

Aswath Damodaran
51
Deutsche Bank and Baidu: Index Effects
on Risk Parameters
 For Deutsche Bank, a widely held European stock,
we tried both the DAX (German index) and the FTSE
European index.

 For Baidu, a NASDAQ listed stock, we ran regressions

against both the S&P 500 and the NASDAQ.

Aswath Damodaran
52
 Beta: Exploring Fundamentals
53

B eta > 2 B u lg a ri:2 .4 5

Q w est C o m m u n ica tio n s:1 .8 5

B eta
b etw een 1 M icro so ft: 1 .2 5
and 2
G E :1 .1 5

E xxo n M o b
il:0 .7 0
B eta <1
A ltria (P h ilip
M o rris): 0 .6 0

H a rm o n y G o ld M in in g : -0 .1 5
B eta <0

Aswath Damodaran
53
 Determinant 1: Product Type
54

 Industry Effects: The beta value for a firm depends

upon the sensitivity of the demand for its products
and services and of its costs to macroeconomic
factors that affect the overall market.
Cyclical companies have higher betas than non-­‐cyclical
firms
Firms which sell more discretionary products will have
higher betas than firms that sell less discretionary products

Aswath Damodaran
54
 A Simple Test
55

 Phone service is close to being non-­‐discretionary in the

United States and Western Europe. However, in much of
Asia and Latin America, there are large segments of the
population for which phone service is a luxury.
 Given our discussion of discretionary and non-­‐
discretionary products, which of the following
conclusions would you be willing to draw:
Emerging market telecom companies should have higher betas
than developed market telecom companies.
Developed market telecom companies should have higher betas
than emerging market telecom companies
The two groups of companies should have similar betas

Aswath Damodaran
55
 Determinant 2: Operating Leverage
56 Effects
 Operating leverage refers to the proportion of the
total costs of the firm that are fixed.
 Other things remaining equal, higher operating
leverage results in greater earnings variability which
in turn results in higher betas.

Aswath Damodaran
56
 Measures of Operating Leverage
57

 Fixed Costs Measure = Fixed Costs / Variable Costs

This measures the relationship between fixed and variable
costs. The higher the proportion, the higher the operating
leverage.
 EBIT Variability Measure = % Change in EBIT / %
Change in Revenues
This measures how quickly the earnings before interest
and taxes changes as revenue changes. The higher this
number, the greater the operating leverage.

Aswath Damodaran
57
 Disney’s Operating Leverage: 1987 2013 -­‐

Year Net Sales % Change in EBIT % Change in

Sales 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%
Average across entertainment companies = 1.35
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% Given Disney’s operating leverage measures (1.01
1998
1999
$22,976
$23,435
2.24%
2.00%
$3,843
$3,580
-2.59%
-6.84%
or 1.25), would you expect Disney to have a higher
2000 $25,418 8.46% $2,525 -29.47% or a lower beta than other entertainment
2001 $25,172 -0.97% $2,832 12.16%
2002 $25,329 0.62% $2,384 -15.82% companies?
2003
2004
$27,061
$30,752
6.84%
13.64%
$2,713
$4,048
13.80%
49.21%
a. Higher
2005 $31,944 3.88% $4,107 1.46% b. Lower
2006 $33,747 5.64% $5,355 30.39%
2007 $35,510 5.22% $6,829 27.53% c. No effect
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
Aswath Damodaran
58
 Determinant 3: Financial Leverage
59

 As firms borrow, they create fixed costs (interest payments) that

make their earnings to equity investors more volatile. This
increased earnings volatility which increases the equity beta.
 The beta of equity alone can be written as a function of the
unlevered beta and the debt-­‐equity ratio
 L =  u (1+ ((1-­‐t)D/E))
where
 L = Levered or Equity Beta D/E = Market value Debt to equity ratio
 u = Unlevered or Asset Beta t = Marginal tax rate
 Earlier, we estimated the beta for Disney from a regression. Was
that beta a levered or unlevered beta?
a. Levered
b. Unlevered

Aswath Damodaran
59
Effects of leverage on betas:
Disney
 The regression beta for Disney is 1.25. This beta is a
levered beta (because it is based on stock prices, which
reflect leverage) and the leverage implicit in the beta
estimate is the average market debt equity ratio during
the period of the regression (2008 to 2013)
 The average debt equity ratio during this period was
19.44%.
 The unlevered beta for Disney can then be estimated
(using a marginal tax rate of 36.1%)
= Current Beta / (1 + (1 tax rate) (Average Debt/Equity))
-­‐

= 1.25 / (1 + (1 0.361)(0.1944))= 1.1119

-­‐

Aswath Damodaran
60
Disney : Beta and Financial Leverage

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

Aswath Damodaran
61
 Betas are weighted Averages
62

 The beta of a portfolio is always the market-­‐value

weighted average of the betas of the individual
investments in that portfolio.
 Thus,
the beta of a mutual fund is the weighted average of the
betas of the stocks and other investment in that portfolio
the beta of a firm after a merger is the market-­‐value
weighted average of the betas of the companies involved
in the merger.

Aswath Damodaran
62
 The Disney/Cap Cities Merger (1996): Pre-­‐
Merger
63

Disney: The Acquirer

D eb t = $ 3 ,1 8 6 m illio n
E q u ity B eta M arket value o f eq uity = $ 3 1 ,1 0 0 m illio n
1 .1 5 D eb t + E q u ity = F irm valu e = $ 3 1 ,1 0 0
+ $ 3 1 8 6 = $ 3 4 ,2 8 6 m illio n
D /E R a tio = 3 1 8 6 /3 1 1 0 0 = 0 .1 0

+
Capital Cities: The Target
D eb t = $ 6 1 5 m illio n
E q u ity B eta M arket value o f eq uity = $ 1 8 ,5 0 0 m illio n
0 .9 5 D eb t + E q u ity = F irm valu e = $ 1 8 ,5 0 0 +
$ 6 1 5 = $ 1 9 ,1 1 5 m illio n
D /E R a tio = 6 1 5 /1 8 5 0 0 = 0 .0 3

Aswath Damodaran
63
 Disney Cap Cities Beta Estimation: Step 1
64

 Calculate the unlevered betas for both firms

Disney’s unlevered beta = 1.15/(1+0.64*0.10) = 1.08
Cap Cities unlevered beta = 0.95/(1+0.64*0.03) = 0.93
 Calculate the unlevered beta for the combined firm
Unlevered Beta for combined firm
= 1.08 (34286/53401) + 0.93 (19115/53401)
= 1.026
The weights used are the firm values (and not just the
equity values) of the two firms, since these are unlevered
betas and thus reflects the risks of the entire businesses
and not just the equity]

Aswath Damodaran
64
 Disney Cap Cities Beta Estimation: Step 2
65

 If Disney had used all equity to buy Cap Cities equity, while assuming Cap
Cities debt, the consolidated numbers would have looked as follows:
Debt = $ 3,186+ $615 = $ 3,801 million
Equity = $ 31,100 + $18,500 = $ 49,600 m (Disney issues $18.5 billion in equity)
D/E Ratio = 3,801/49600 = 7.66%
New Beta = 1.026 (1 + 0.64 (.0766)) = 1.08
 Since Disney borrowed $ 10 billion to buy Cap Cities/ABC, funded the rest
with new equity and assumed Cap Cities debt:
The market value of Cap Cities equity is $18.5 billion. If $ 10 billion comes from
debt, the balance ($8.5 billion) has to come from new equity.
Debt = $ 3,186 + $615 million + $ 10,000 = $ 13,801 million
Equity = $ 31,100 + $8,500 = $39,600 million
D/E Ratio = 13,801/39600 = 34.82%
New Beta = 1.026 (1 + 0.64 (.3482)) = 1.25

Aswath Damodaran
65
 Firm Betas versus divisional Betas
66

 Firm Betas as weighted averages: The beta of a firm

is the weighted average of the betas of its individual
projects.
 Firm Betas and Business betas: At a broader level of
aggregation, the beta of a firm is the weighted
average of the betas of its individual division.

Aswath Damodaran
66
 Bottomup versus Topdown Beta
-­‐ -­‐

67

 The top-­‐down beta for a firm comes from a regression

 The bottom up beta can be estimated by doing the following:
Find out the businesses that a firm operates in
Find the unlevered betas of other firms in these businesses
Take a weighted (by sales or operating income) average of these
unlevered betas
Lever up using the firm’s debt/equity ratio
 The bottom up beta is a better estimate than the top down
beta for the following reasons
The standard error of the beta estimate will be much lower
The betas can reflect the current (and even expected future) mix of
businesses that the firm is in rather than the historical mix

Aswath Damodaran
67
Disney’s businesses: The financial
breakdown (from 2013 annual report)

Aswath Damodaran
68
 Unlevered Betas for businesses Unlevered Beta
(1 - Cash/ Firm Value)

Median
Company Cash/ Business
Sample Median Median Median Unlevered Firm Unlevered
Business Comparable firms size Beta D/E Tax rate Beta Value Beta
US firms in
broadcasting
Media Networks business 26 1.43 71.09% 40.00% 1.0024 2.80% 1.0313
Global firms in
amusement park
Parks & Resorts business 20 0.87 46.76% 35.67% 0.6677 4.95% 0.7024
Studio
Entertainment US movie firms 10 1.24 27.06% 40.00% 1.0668 2.96% 1.0993

Global firms in
Consumer toys/games
Products production & retail 44 0.74 29.53% 25.00% 0.6034 10.64% 0.6752
Global computer
Interactive gaming firms 33 1.03 3.26% 34.55% 1.0085 17.25% 1.2187

Aswath Damodaran
69
A closer look at the process…
Studio Entertainment Betas

Aswath Damodaran
70
 Backing into a pure play beta: Studio
Entertainment
71

The Median Movie Company

M o vie B u sin e ss 9 7 .0 4 B eta (m o vies) = 1 .0 0 9 3 D ebt 2 1 .3 0 B eta (d eb t) = 0

E q u ity 7 8 .7 0 B eta (eq u ity) = 1 .2 4

C a sh B u sin e sss 2 .9 6 B eta (ca sh ) = 0 .0 0 0 0

M o vie C o m p a n y 1 0 0 .0 B eta (co m p a n y) = 1 .0 6 6 8

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%
Aswath DamodaranUnlevered beta for movies = 1.24/ (1+(1-.4)(.233)) = 1.0879
71
 Disney’s unlevered beta: Operations &
Entire Company

Value of Proportion of Unlevered

Business Revenues EV/Sales Business Disney beta Value Proportion
Media Networks $20,356 3.27 $66,580 49.27% 1.03 $66,579.81 49.27%
Parks & Resorts $14,087 3.24 $45,683 33.81% 0.70 $45,682.80 33.81%
Studio Entertainment $5,979 3.05 $18,234 13.49% 1.10 $18,234.27 13.49%
Consumer Products $3,555 0.83 $2,952 2.18% 0.68 $2,951.50 2.18%
Interactive $1,064 1.58 $1,684 1.25% 1.22 $1,683.72 1.25%
Disney Operations $45,041 $135,132 100.00% 0.9239 $135,132.11

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):

Aswath Damodaran
72
 The levered beta: Disney and its divisions

 To estimate the debt ratios for division, we allocate Disney’s total debt
($15,961 million) to its divisions based on identifiable assets.

 We use the allocated debt to compute D/E ratios and levered betas.
Business Unlevered beta Value of business D/E ratio Levered beta Cost of Equity
Media Networks 1.0313 $66,580 10.03% 1.0975 9.07%
Parks & Resorts 0.7024 $45,683 11.41% 0.7537 7.09%
Studio Entertainment 1.0993 $18,234 20.71% 1.2448 9.92%
Consumer Products 0.6752 $2,952 117.11% 1.1805 9.55%
Interactive 1.2187 $1,684 41.07% 1.5385 11.61%
Disney Operations 0.9239 $135,132 13.10% 1.0012 8.52%
Aswath Damodaran
73
 Discussion Issue
74

 Assume now that you are the CFO of Disney. The

head of the movie business has come to you with a
new big budget movie that he would like you to
fund. He claims that his analysis of the movie
indicates that it will generate a return on equity of
9.5%. Would you fund it?
Yes. It is higher than the cost of equity for Disney as a
company
No. It is lower than the cost of equity for the movie
business.
What are the broader implications of your choice?

Aswath Damodaran
74
Estimating Bottom Up Betas & Costs of
Equity: Vale
Sample Unlevered beta Peer Group Value of Proportion of
Business Sample size of business Revenues EV/Sales Business Vale

Global firms in metals &

Metals & mining, Market cap>$1
Mining billion 48 0.86 $9,013 1.97 $17,739 16.65%

Iron Ore Global firms in iron ore 78 0.83 $32,717 2.48 $81,188 76.20%

Global specialty
Fertilizers chemical firms 693 0.99 $3,777 1.52 $5,741 5.39%

Global transportation
Logistics firms 223 0.75 $1,644 1.14 $1,874 1.76%
Vale
Operations 0.8440 $47,151 $106,543 100.00%

Aswath Damodaran
75
Vale: Cost of Equity Calculation – in
nominal $R
 To convert a discount rate in one currency to another, all you need are
expected inflation rates in the two currencies.
(1 $ Cost of Equity) (1 Inflation R ateBrazi l) 
1
(1 Inflation RateU S )
 From US $ to R$: If we use 2% as the inflation rate in US dollars and 9% as
the inflation ratio in Brazil, we can convert Vale’s US dollar cost of equity
of 11.23% to a $R cost of equity:

 Alternatively, you can compute a cost of equity, starting with the $R

riskfree rate of 10.18%.
Cost of Equity in $R = = 10.18% + 1.15 (7.38%) = 18.67%

Aswath Damodaran
76
Bottom up betas & Costs of Equity: Tata
Motors & Baidu
 Tata Motors: We estimated an unlevered beta of 0.8601
across 76 publicly traded automotive companies (globally)
and estimated a levered beta based on Tata Motor’s D/E ratio
of 41.41% and a marginal tax rate of 32.45% for India:
Levered Beta for Tata Motors = 0.8601 (1 + (1-­‐.3245) (.4141)) = 1.1007 Cost
of equity for Tata Motors (Rs) = 6.57% + 1.1007 (7.19%) = 14.49%
 Baidu: To estimate its beta, we looked at 42 global companies
that derive all or most of their revenues from online
advertising and estimated an unlevered beta of 1.30 for the
business. Incorporating Baidu’s current market debt to equity
ratio of 5.23% and the marginal tax rate for China of 25%, we
estimate Baidu’s current levered beta to be 1.3560.
Levered Beta for Baidu = 1.30 (1 + (1-­‐.25) (.0523)) = 1.356
Cost of Equity for Baidu (Renmimbi) = 3.50% + 1.356 (6.94%) = 12.91%

Aswath Damodaran
77
Bottom up Betas and Costs of Equity:
Deutsche Bank
 We break Deutsche Bank down into two businesses – commercial and
investment banking.

 We do not unlever or relever betas, because estimating debt and equity

for banks is an exercise in futility. Using a riskfree rate of 1.75% (Euro risk
free rate) and Deutsche’s ERP of 6.12%:

Aswath Damodaran
78
 Estimating Betas for Non-­‐Traded Assets
79

 The conventional approaches of estimating betas

from regressions do not work for assets that are not
traded. There are no stock prices or historical
returns that can be used to compute regression
betas.
 There are two ways in which betas can be estimated
for non-­‐traded assets
Using comparable firms
Using accounting earnings

Aswath Damodaran
79
Using comparable firms to estimate beta
for Bookscape

Unlevered beta for book company = 0.8130/ (1+ (1-.4) (.2141)) = 0.7205
Aswath Damodaran
Unlevered beta for book business = 0.7205/(1-.05) = 0.7584 80
Estimating Bookscape Levered Beta and
Cost of Equity
 Because the debt/equity ratios used in computing
levered betas are market debt equity ratios, and the only
debt equity ratio we can compute for Bookscape is a
book value debt equity ratio, we have assumed that
Bookscape is close to the book industry median market
debt to equity ratio of 21.41 percent.
 Using a marginal tax rate of 40 percent for Bookscape,
we get a levered beta of 0.8558.
Levered beta for Bookscape = 0.7584[1 + (1 – 0.40) (0.2141)] = 0.8558
 Using a riskfree rate of 2.75% (US treasury bond rate)
and an equity risk premium of 5.5%:
Cost of Equity = 2.75%+ 0.8558 (5.5%) = 7.46%

Aswath Damodaran
81
Is Beta an Adequate Measure of Risk for a
Private Firm?
 Beta measures the risk added on to a diversified
portfolio. The owners of most private firms are not
diversified. Therefore, using beta to arrive at a cost
of equity for a private firm will
a. Under estimate the cost of equity for the private firm
b. Over estimate the cost of equity for the private firm
c. Could under or over estimate the cost of equity for the
private firm

Aswath Damodaran
82
Total Risk versus Market Risk

 Adjust the beta to reflect total risk rather than market risk.
This adjustment is a relatively simple one, since the R
squared of the regression measures the proportion of the risk
that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
 In the Bookscape example, where the market beta is 0.8558
and the median R-­‐squared of the comparable publicly traded
firms is 26.00%; the correlation with the market is 50.99%.
Market Beta 0.8558 1.6783
R squared .5099

Total Cost of Equity = 2.75 + 1.6783 (5.5%) = 11.98%

Aswath Damodaran
83
 Application Test: Estimating a Bottom-­‐up Beta
84

 Based upon the business or businesses that your

firm is in right now, and its current financial
leverage, estimate the bottom-­‐up unlevered beta for
your firm.

 Data Source: You can get a listing of unlevered betas

by industry on my web site by going to updated
data.

Aswath Damodaran
84
 From Cost of Equity to Cost of Capital
85

 The cost of capital is a composite cost to the firm of

raising financing to fund its projects.
 In addition to equity, firms can raise capital from
debt

Aswath Damodaran
85
 What is debt?
86

 General Rule: Debt generally has the following

characteristics:
Commitment to make fixed payments in the future
The fixed payments are tax deductible
Failure to make the payments can lead to either default or
loss of control of the firm to the party to whom payments
are due.
 As a consequence, debt should include
Any interest-­‐bearing liability, whether short term or long
term.
Any lease obligation, whether operating or capital.

Aswath Damodaran
86
 Estimating the Cost of Debt
87

 If the firm has bonds outstanding, and the bonds are traded,
the yield to maturity on a long-­‐term, straight (no special
features) bond can be used as the interest rate.
 If the firm is rated, use the rating and a typical default spread
on bonds with that rating to estimate the cost of debt.
 If the firm is not rated,
and it has recently borrowed long term from a bank, use the interest
rate on the borrowing or
estimate a synthetic rating for the company, and use the synthetic
rating to arrive at a default spread and a cost of debt
 The cost of debt has to be estimated in the same currency as
the cost of equity and the cash flows in the valuation.

Aswath Damodaran
87
The easy route: Outsourcing the
measurement of default risk
 For those firms that have bond ratings from global
ratings agencies, I used those ratings:
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%

 If you want to estimate Vale’s cost of debt in $R

terms, we can again use the differential
inflation approach we used for the cost of
equity:

Aswath Damodaran
88
A more general route: Estimating
Synthetic Ratings
 The rating for a firm can be estimated using the
financial characteristics of the firm. In its simplest
form, we can use just the interest coverage ratio:
Interest Coverage Ratio = EBIT / Interest Expenses
 For the non-­‐financial service companies, we obtain
the following:
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

Aswath Damodaran
89
Interest Coverage Ratios, Ratings and
Default 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
90
Synthetic versus Actual Ratings: Rated
Firms
 Disney’s synthetic rating is AAA, whereas its actual rating is
A. The difference can be attributed to any of the following:
Synthetic ratings reflect only the interest coverage ratio whereas
actual ratings incorporate all of the other ratios and qualitative factors
Synthetic ratings do not allow for sector-­‐wide biases in ratings
Synthetic rating was based on 2013 operating income whereas actual
rating reflects normalized earnings
 Vale’s synthetic rating is AA, but the actual rating for dollar
debt is A. The biggest factor behind the difference is the
-­‐

presence of country risk, since Vale is probably being rated

lower for being a Brazil-­‐based corporation.
 Deutsche Bank had an A rating. We will not try to estimate a
synthetic rating for the bank. Defining interest expenses on
debt for a bank is difficult…

Aswath Damodaran
91
 Estimating Cost of Debt

 For Bookscape, we will use the synthetic rating (A-­‐) to estimate the cost
of debt:
Default Spread based upon A-­‐ rating = 1.30%
Pre-­‐tax cost of debt = Riskfree Rate + Default Spread = 2.75% + 1.30% = 4.05%
After-­‐tax cost of debt = Pre-­‐tax cost of debt (1-­‐ tax rate) = 4.05% (1-­‐.40) = 2.43%
 For the three publicly traded firms that are rated in our sample, we will
use the actual bond ratings to estimate the costs of debt.
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%

 For Tata Motors, we have a rating of AA-­‐ from CRISIL, an Indian bond-­‐
rating firm, that measures only company risk. Using that rating:
Cost of debtTMT = Risk free rateRupees + Default spreadIndia + Default spreadTMT
= 6.57% + 2.25% + 0.70% = 9.62%
Aftertax cost of debt = 9.62% (1.3245) = 6.50%
-­‐ -­‐

Aswath Damodaran
92
Updated Default Spreads – January 2014

Rating 1 year 5 year 10 Year 30 year

Aaa/AAA 0.05% 0.18% 0.42% 0.65%
Aa1/AA+ 0.11% 0.37% 0.57% 0.82%
Aa2/AA 0.16% 0.55% 0.71% 0.98%
Aa3/AA-­‐ 0.22% 0.60% 0.75% 0.99%
A1/A+ 0.26% 0.65% 0.78% 1.00%
A2/A 0.33% 0.67% 0.84% 1.12%
A3/A-­‐ 0.46% 0.84% 1.00% 1.26%
Baa1/BBB+ 0.58% 1.09% 1.32% 1.67%
Baa2/BBB 0.47% 1.27% 1.52% 1.91%
Baa3/BBB-­‐ 0.95% 1.53% 1.78% 2.18%
Ba1/BB+ 1.68% 2.29% 2.59% 2.97%
Ba2/BB 2.40% 3.04% 3.39% 3.77%
Ba3/BB-­‐ 3.12% 3.80% 4.20% 4.57%
B1/B+ 3.84% 4.56% 5.01% 5.36%
B2/B 4.56% 5.31% 5.81% 6.16%
B3/B-­‐ 5.28% 6.06% 6.62% 6.96%
Caa/CCC+ 6.00% 6.82% 7.43% 7.75%

Aswath Damodaran
93
 Application Test: Estimating a Cost of Debt
94

 Based upon your firm’s current earnings before

interest and taxes, its interest expenses, estimate
An interest coverage ratio for your firm
A synthetic rating for your firm (use the tables from prior
pages)
A pretax cost of debt for your firm
-­‐

An aftertax cost of debt for your firm

-­‐

Aswath Damodaran
94
 Costs of Hybrids
95

 Preferred stock shares some of the characteristics of

debt the preferred dividend is prespecified at the time
-­‐ -­‐

of the issue and is paid out before common dividend and -­‐-­‐

some of the characteristics of equity the payments of

-­‐

preferred dividend are not tax deductible. If preferred

stock is viewed as perpetual, the cost of preferred stock
can be written as follows:
kps = Preferred Dividend per share/ Market Price per
preferred share
 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 and eliminate it from the mix
altogether.

Aswath Damodaran
95
 Weights for Cost of Capital Calculation
96

 The weights used in the cost of capital computation should

be market values.
 There are three specious arguments used against market
value
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
market value, this is more a reflection of weakness than strength
Using book value rather than market value is a more conservative
approach to estimating debt ratios: For most companies, using book
values will yield a lower cost of capital than using market value
weights.
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 return and cost of capital calculations, it does not make
economic sense.

Aswath Damodaran
96
Disney: From book value to market value
for interest bearing debt…
 In Disney’s 2013 financial statements, the debt due over time was footnoted.
Weight
Time due Amount due Weight
*Maturity
0.5 $1,452 11.96% 0.06 The debt in this table does
2 $1,300 10.71% 0.21
not add up to the book value
3 $1,500 12.36% 0.37
of debt, because Disney
4 $2,650 21.83% 0.87
does not break down the
6 $500 4.12% 0.25
8 $1,362 11.22% 0.9 maturity of all of its debt.
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

 Disney’s total debt due, in book value terms, on the balance sheet is $14,288
million and the total interest expense for the year was $349 million. Using 3.75%
as the pre-­‐tax cost of debt:  1 
 Estimated MV of Disney Debt = 349 ( 1 
 (1.0375) 
14, 288
7.92
$13, 028 million
  (1.0375)
7.92
.0375

 


Aswath Damodaran
97
Operating Leases at Disney

 The “debt value” of operating leases is the present

value of the lease payments, at a rate that reflects
their risk, usually the pretax cost of debt.
-­‐

 The pre-­‐tax cost of debt at Disney is 3.75%.

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

 Debt outstanding at Disney = $13,028 + $ 2,933= $15,961 million

Aswath Damodaran
98
 Application Test: Estimating Market Value
99

 Estimate the
Market value of equity at your firm and Book Value of
equity
Market value of debt and book value of debt (If you cannot
find the average maturity of your debt, use 3 years):
Remember to capitalize the value of operating leases and
add them on to both the book value and the market value
of debt.
 Estimate the
Weights for equity and debt based upon market value
Weights for equity and debt based upon book value

Aswath Damodaran
99
 Current Cost of Capital: Disney

 Equity
Cost of Equity = Riskfree rate + Beta * Risk Premium
= 2.75% + 1.0013 (5.76%) = 8.52%
Market Value of Equity = $121,878 million
Equity/(Debt+Equity ) = 88.42%
 Debt
After-­‐tax Cost of debt =(Riskfree rate + Default Spread) (1-­‐t)
= (2.75%+1%) (1-­‐.361) = 2.40%
Market Value of Debt = $13,028+ $2933 = $ 15,961 million
Debt/(Debt +Equity) = 11.58%
 Cost of Capital = 8.52%(.8842)+ 2.40%(.1158) = 7.81%
Aswath Damodaran
121,878/ (121,878+15,961)
100
Divisional Costs of Capital: Disney and Vale

Disney
Cost of Cost of Marginal tax After6tax cost of Debt Cost of
equity debt rate debt ratio capital
Media Networks 9.07% 3.75% 36.10% 2.40% 9.12% 8.46%
Parks & Resorts 7.09% 3.75% 36.10% 2.40% 10.24% 6.61%
Studio
Entertainment 9.92% 3.75% 36.10% 2.40% 17.16% 8.63%
Consumer Products 9.55% 3.75% 36.10% 2.40% 53.94% 5.69%
Interactive 11.65% 3.75% 36.10% 2.40% 29.11% 8.96%
Disney Operations 8.52% 3.75% 36.10% 2.40% 11.58% 7.81%

Vale
Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
Business equity debt ratio US$) $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%
Aswath Damodaran
101
Costs of Capital: Tata Motors, Baidu and
Bookscape
 To estimate the costs of capital for Tata Motors in Indian
rupees:
Cost of capital= 14.49% (1.2928) + 6.50% (.2928) = 12.15%
-­‐

 For Baidu, we follow the same path to estimate a cost of

equity in Chinese RMB:
Cost of capital = 12.91% (1.0523) + 3.45% (.0523) = 12.42%
-­‐

 For Bookscape, the cost of capital is different depending on

whether you look at market or total beta:
Cost of After-tax cost of
equity Pre-tax Cost of debt 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%

Aswath Damodaran
102
 Application Test: Estimating Cost of Capital
103

 Using the bottom-­‐up unlevered beta that you computed for

your firm, and the values of debt and equity you have
estimated for your firm, estimate a bottom-­‐up levered beta
and cost of equity for your firm.

 Based upon the costs of equity and debt that you have
estimated, and the weights for each, estimate the cost of
capital for your firm.

 How different would your cost of capital have been, if you

used book value weights?
Aswath Damodaran
103
 Choosing a Hurdle Rate
104

 Either the cost of equity or the cost of capital can be

used as a hurdle rate, depending upon whether the
returns measured are to equity investors or to all
claimholders on the firm (capital)
 If returns are measured to equity investors, the
appropriate hurdle rate is the cost of equity.
 If returns are measured to capital (or the firm), the
appropriate hurdle rate is the cost of capital.

Aswath Damodaran
104
 Back to First Principles
105

M axim ize th e va lu e o f th e b u sin ess (firm )

The Investment Decision The Financing Decision The Dividend Decision

In vest in assets th at earn a F in d th e rig h t kin d o f d eb t If yo u can n o t fin d in vestm en ts
retu rn g reater th an th e fo r yo u r firm an d th e rig h t th at m a ke yo u r m in im u m
m in im u m accep tab le h u rd le m ix o f d eb t an d eq u ity to accep tab le ra te,retu rn th e cash
ra te fu n d yo u r o p era tio n s to o w n ers o f yo u r b u sin ess

T h e hurdle rate T h e return How much How you choose

sh o u ld reflect th e T h e optimal T h e right kind cash yo u can
sh o u ld relfect th e to retu rn cash to
riskin ess o f th e mix o f d eb t o f d eb t retu rn d ep en d s
m ag n itu d e an d th e o w n ers w ill
in vestm en t an d an d eq u ity m a tch es th e u p o n cu rren t &
th e tim in g o f th e d ep en d w h eth er
th e m ix o f d eb t m a xim izes firm ten o r o f yo u r p o ten tial
cash flo w s as w elll th ey p refer
an d eq u ity u sed va lu e assets in vestm en t
as all sid e effects. d ivid en d s o r
to fu n d it. o p p o rtu n ities b u yb acks

Aswath Damodaran
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