ACF601: Advanced Corporate Finance

Lecture Notes: Weeks 15 and 16

Damodaran – Applied Corporate Finance
Capital Structure: Chapters 7, 8 and 9
An Overview of the Financing Decisions
Model and Applications
The Financing Details
 The Choices in Financing
• There are only two ways in which a business can raise financing.
– The first is debt. The essence of debt is that you promise to make fixed payments
in the future (interest payments and repaying principal). If you fail to make those
payments, you lose control of your business.
– The other is equity. With equity, you do get whatever cash flows are left over after
you have made debt payments.

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Assessing the existing financing choices
Tata
Disney Vale Baidu
Motors
BV of Interest bearing 535,914₹
$14,288 $48,469 ¥17,844
Debt
MV of Interest bearing 477,268₹
$13,028 $41,143 ¥15,403
Debt
Lease Debt $2,933 $1,248 0.00₹ ¥3,051
Type of Debt
Bank Debt 7.93% 59.97% 62.26% 100.00%
Bonds/Notes 92.07% 40.03% 37.74% 0.00%
Debt Maturity
<1 year 13.04% 6.08% 0.78% 1.98%
1- 5 years 48.93% 23.12% 30.24% 68.62%
5-10 years 20.31% 29.44% 57.90% 29.41%
10-20 years 4.49% 3.00% 10.18% 0.00%
> 20 years 13.24% 38.37% 0.90% 0.00%
Currency for debt
Debt in domestic currency 94.51% 34.52% 70.56% 17.90%
Debt in foreign currency 5.49% 65.48% 29.44% 82.10%
Fixed versus Floating rate debt
Fixed rate debt 94.33% 100.00% 100.00% 94.63%
Floating rate debt 5.67% 0.00% 0.00% 5.37%

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 Financing Choices across the life cycle

Revenues
$ Revenues/
Earnings

Earnings

Time

External funding High, but High, relative Moderate, relative Declining, as a

Low, as projects dry
needs constrained by to firm value. to firm value. percent of firm
up.
infrastructure value

Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs
low low funding needs funding needs

External Owner’s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock
Convertibles

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expansion High Growth Mature Growth Decline

Financing
Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues
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 Transitional Phases: Expansion of a Start-up
• The transitions that we see at firms – from fully owned private businesses to
venture capital, from private to public and subsequent seasoned offerings are
all motivated primarily by the need for capital.
• In each transition, though, there are costs incurred by the existing owners:
– When venture capitalists (VCs) enter the firm, they will demand their ‘fair’ share
and more of the ownership of the firm to provide equity.
– Demand for VCs is high - supply is limited. Investment is risky.
– Firms are valued using: Estimated future cash flows and Estimated IPO value (the
exit value).
• VCs participate in post-deal management. Bring their experience, contacts.
• They design contract so that they have a say on management.
• VCs don’t want to get involved forever – they prefer to cash out when the firm becomes
public.

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 The Initial Public Offering (IPO) decision
When a firm decides to go public , it has to trade off the greater access to capital
markets against the increased disclosure requirements, possible loss of control
and the transactions costs of going public.
– Underwriters takes responsibility of selling. First they value the firm, get
feedback from potential investors and finalize the issue price.
• IPOs are often underpriced to attract enough investors. IPO firms have lower
transparency (in the past).
• Many investors undervalue these firms, forcing firms to issue equity at a discount to
their actual valuation.
When making seasoned equity offerings (SEO), firms have to consider issuance
costs while managing their relations with equity research analysts and rating
agencies.

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 The Financing Mix Question

In deciding to raise financing for a business, is there an optimal mix

of debt and equity?
– If yes, what is the trade off that lets us determine this optimal mix?
• What are the costs benefits of using debt instead of equity?
• Measuring the financial mix - the debt to capital ratio:
• Debt to Capital Ratio = Debt / (Debt + Equity)
• Debt includes all interest bearing liabilities, short term as well as long term.
• Equity can be defined either in accounting terms (as book value of equity) or in
market value terms (based upon the current price). The resulting debt ratios can be
very different.

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 Costs and Benefits of Debt
• Benefits of Debt
– Tax Benefits
– Adds discipline to management
• Costs of Debt
– Bankruptcy Costs
– Agency Costs
– Loss of Future Flexibility

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 Tax Benefits of Debt
• When you borrow money, you are allowed to deduct interest expenses
from your income to arrive at taxable income. This reduces your taxes.
When you use equity, you are not allowed to deduct payments to equity
(such as dividends) to arrive at taxable income.

• The dollar tax benefit from the interest payment in any year is a function
of your tax rate and the interest payment:
Tax benefit = Tax Rate * Interest Payment
• Proposition 1: Other things being equal, the higher the marginal tax rate
of a business, the more debt it will have in its capital structure.

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 Debt adds discipline to management
• If you are managers of a firm with no debt, and you generate high
income and cash flows each year, you tend to become complacent.
The complacency can lead to inefficiency and investing in poor
projects. There is little or no cost borne by the managers.
• Forcing such a firm to borrow money can be an antidote to the
complacency. The managers now have to ensure that the investments
they make will earn at least enough return to cover the interest
expenses. The cost of not doing so is bankruptcy and the loss of such
a job.

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 Bankruptcy Cost
• The expected bankruptcy cost is a function of two variables--
– the probability of bankruptcy, which will depend upon how uncertain you
are about future cash flows
– the cost of going bankrupt
• direct costs: Legal and other Deadweight Costs
• indirect costs: Costs arising because people perceive you to be in financial trouble
Proposition 2: Firms with more volatile earnings and cash flows will have higher
probabilities of bankruptcy at any given level of debt and for any given level
of earnings.
Proposition 3: Other things being equal, the greater the indirect bankruptcy
cost, the less debt the firm can afford to use.

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 Agency Cost: Debtholder vs Stockholder
• An agency cost arises whenever you hire someone else to do
something for you. (The principal-agent problem)
• When you lend money to a business, you are allowing the
stockholders to use that money in the course of running that
business. Stockholders interests are different from your interests,
because
– You (as lender) are interested in getting your money back
– Stockholders are interested in maximizing their wealth
• In some cases, the clash of interests can lead to stockholders
– Investing in riskier projects than you would want them to
– Paying themselves large dividends when you would rather have them
keep the cash in the business.
•Proposition 4: Other things being equal, the greater the agency
problems associated with lending to a firm, the less debt.
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 Loss of future financing flexibility

• When a firm borrows up to its capacity, it loses the

flexibility of financing future projects with debt.

• Proposition 5: Other things remaining equal, the more

uncertain a firm is about its future financing
requirements and projects, the less debt the firm will
use for financing current projects.

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 A Hypothetical Scenario
Assume that you live in a world where
(a) There are no taxes
(b) Managers do what’s best for stockholders.
(c) No firm ever goes bankrupt
(d) Equity investors are honest with lenders;
(e) Firms know their future financing needs with certainty
•In an environment, where there are no taxes, default risk or agency costs, capital
structure is irrelevant.
•In this environment, capital structure is irrelevant. - Modigliani Miller theorem. If this holds:
– A firm's value will be determined by the quality of its investments and not by its
financing mix. The cost of capital of the firm will not change with leverage. As a firm
increases its leverage, the cost of equity will increase just enough to offset any gains to
the leverage.

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 The Modigliani-Miller propositions
Weighted Average Cost of Capital (R0) with corporate taxes
𝐸 𝐷
𝑅0 = 𝑅𝐸 + 𝑅 (1 − 𝑡𝑐 )
𝐸+𝐷 𝐸+𝐷 𝐷

Modigliani-Miller Proposition I with corporate taxes

𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐 𝐷
(Debt is risk free; 𝑡𝑐 𝐷 is the PV of all tax savings from debt)

Modigliani-Miller Proposition II with corporate taxes and bankruptcy costs

𝐷
𝑅𝐸 = 𝑅0 + ∗ 𝑅0 − 𝑅𝐷 ∗ (1 − 𝑡𝑐 )
𝐸

(The intermediate step: Modigliani-Miller Proposition II without corporate taxes:

𝐸 𝐷
Start from 𝑅0 = 𝐸+𝐷 𝑅𝐸 + 𝐸+𝐷 𝑅𝐷
𝐷
So, 𝑅𝐸 = 𝑅0 + ∗ 𝑅0 − 𝑅𝐷
𝐸

Beta and leverage

𝐷
𝛽𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 × 1 + 1 − 𝑡𝐶 ×
𝐸
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 First Principles
Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

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 Pathways to the Optimal
1. The Cost of Capital Approach: The optimal debt ratio is the one
that minimizes the cost of capital for a firm.
2. The Enhanced Cost of Capital approach: The optimal debt ratio is
the one that generates the best combination of (low) cost of
capital and (high) operating income.
3. The Adjusted Present Value Approach: The optimal debt ratio is
the one that maximizes the overall value of the firm.
4. The Sector Approach: The optimal debt ratio is the one that
brings the firm closes to its peer group in terms of financing mix.

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 I. The Cost of Capital Approach
• Value of a Firm = Present Value of Cash Flows to the Firm, discounted back
at the cost of capital.
• If the cash flows to the firm are held constant, and the cost of capital is
minimized, the value of the firm will be maximized.
• Measurement: The cost of capital is the cost of each component weighted
by its relative market value.
Cost of capital = Cost of equity (E/(D+E)) + After-tax cost of debt (D/(D+E))
• An article in an Asian business magazine argued that equity was cheaper
than debt, because dividend yields are much lower than interest rates on
debt. Do you agree with this statement?
a. Yes; b. No

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 Applying Cost of Capital Approach: The Textbook Example

Assume the firm has $200 million in cash flows, expected to grow 3% a year forever.

Simple
example:
The cost
of debt
and
equity are
given

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The U-shaped Cost of Capital Graph…

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 Current Cost of Capital: Disney
•The beta for Disney’s stock in November 2013 was 1.0013. The T. bond rate at that
time was 2.75%. Using an estimated equity risk premium of 5.76%, we estimated the
cost of equity for Disney to be 8.52%:
Cost of Equity = 2.75% + 1.0013(5.76%) = 8.52%
•Disney’s bond rating in May 2009 was A, and based on this rating, the estimated
pretax cost of debt for Disney is 3.75%. Using a marginal tax rate of 36.1%, the after-
tax cost of debt for Disney is 2.40%.
After-Tax Cost of Debt = 3.75% (1 – 0.361) = 2.40%
•The cost of capital was calculated using these costs and the weights based on
market values of equity (121,878) and debt (15.961):
121,878 15,961
Cost of Capital = 8.52% + 2.40% = 7.81%
(15,961+121,878) (15,961+121,878)
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 Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
– Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
– Estimation will use levered beta calculation.
2. Estimate the Cost of Debt at different levels of debt:
– Default risk will go up and bond ratings will go down as debt goes up -> Cost
of Debt will increase.
– To estimating bond ratings, we will use the interest coverage ratio
(EBIT/Interest expense) for Synthetic ratings. And then default spread.
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.

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The groundwork: 1. Estimate the unlevered beta for the firm
• The Regression Beta: One approach is to use the regression beta (1.25)
and then unlever, using the average debt to equity ratio (19.44%) during
the period of the regression to arrive at an unlevered beta.
Unlevered beta = = 1.25 / (1 + (1 - 0.361)(0.1944))= 1.1119
• The Bottom up Beta: Alternatively, we can back to the source and
estimate it from the betas of the businesses.
Value of Proportion Unlevered
Business Revenues EV/Sales Business of 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 $135,132.11 100.00%
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 Cost of Equity

Levered Beta = 0.9239 (1 + (1- .361) (D/E))

Cost of equity = 2.75% + Levered beta * 5.76%

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2. Cost of Debt: Get Disney’s Current Financials…

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 The Ratings Table
Interest coverage ratio is Rating is Spread is Interest rate
> 8.50 Aaa/AAA 0.40% 3.15%
6.5 – 8.5 Aa2/AA 0.70% 3.45%
5.5 – 6.5 A1/A+ 0.85% 3.60%
4.25 – 5.5 A2/A 1.00% 3.75%
3 – 4.25 A3/A- 1.30% 4.05%
2.5 -3 Baa2/BBB 2.00% 4.75%
2.25 –2.5 Ba1/BB+ 3.00% 5.75% [Link] rate =2.75%
2 – 2.25 Ba2/BB 4.00% 6.75%
1.75 -2 B1/B+ 5.50% 8.25%
1.5 – 1.75 B2/B 6.50% 9.25%
1.25 -1.5 B3/B- 7.25% 10.00%
0.8 -1.25 Caa/CCC 8.75% 11.50%
0.65 – 0.8 Ca2/CC 9.50% 12.25%
0.2 – 0.65 C2/C 10.50% 13.25%
<0.2 D2/D 12.00% 14.75%

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 Estimating Cost of Debt
Start with the market value of the firm = = 121,878 + $15,961 = $137,839 million
D/(D+E) 0.00% 10.00% Debt to capital
D/E 0.00% 11.11% D/E = 10/90 = .1111
$ Debt $0 $13,784 10% of $137,839

EBITDA $12,517 $12,517 Same as 0% debt

Depreciation $ 2,485 $ 2,485 Same as 0% debt
EBIT $10,032 $10,032 Same as 0% debt
Interest $0 $434 Pre-tax cost of debt * $ Debt

Pre-tax Int. cov ∞ 23.10 EBIT/ Interest Expenses

Likely Rating AAA AAA From Ratings table
Pre-tax cost of debt 3.15% 3.15% Riskless Rate + Spread

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 A Test: Can you do the 30% level?
Iteration 1 Iteration 2
(Debt @AAA rate) (Debt @AA rate)
D/(D + E) 20.00% 30.00% 30.00%
D/E 25.00%
$ Debt $27,568
EBITDA $12,517
Depreciation $2,485
EBIT $10,032
Interest expense $868
Interest coverage ratio 11.55
Likely rating AAA
Pretax cost of debt 3.15%
• You have to start by assuming the AAA rate but you will end up with a rating that is
different (AA).
• You can redo the analysis using the AA rate and you can stop because you end up
with the same rating at the end. (Sometimes you will need a third iteration).

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 Debt at 30% level
Before Iteration 1 Iteration 2
Change (Debt @AAA rate) (Debt @AA rate)
D/(D + E) 20.00% 30.00% 30.00%
D/E 25.00% 42.86% 42.86%
$ Debt $27,568 $41,352 $41,352
EBITDA $12,517 $12,517 $12,517
Depreciation $2,485 $2,485 $2,485
EBIT $10,032 $10,032 $10,032
Interest expense $868 $1,302.59 $1,426.64
Int. coverage ratio 11.55 7.7 7.03
Likely rating AAA AA AA
Pretax cost of debt 3.15% 3.45% 3.45%

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Bond Ratings, Cost of Debt and Debt Ratios

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 Effect on Marginal Tax Rates
• You need taxable income for interest to provide a tax savings. Note that
the EBIT at Disney is $10,032 million. As long as interest expenses are less
than $10,032 million, interest expenses remain fully tax-deductible and
earn the 36.1% tax benefit. At an 60% debt ratio, the interest expenses
are $9,511 million and the tax benefit is therefore 36.1% of this amount.
• At a 70% debt ratio, however, the interest expenses (I) balloon to $11,096
million, which is greater than the EBIT of $10,032 million. We consider
the tax benefit on the interest expenses up to this amount:
– Maximum Tax Benefit = Imax, tax benefit>0 * Marginal Tax Rate
= EBIT * Marginal Tax Rate
= $10,032 million * 0.361 = $ 3,622 million
– Adjusted Marginal Tax Rate = (Maximum) Tax Benefit/I
= $3,622/$11,096 = 32.64%

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Disney’s cost of capital schedule…

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Disney: Cost of Capital Chart

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The cost of capital approach suggests that Disney should do
the following…
• Disney currently has $15.96 billion in debt. The optimal dollar debt (at
40%) is roughly $55.1 billion. Disney has excess debt capacity of 39.14
billion.
• To move to its optimal and gain the increase in value, Disney should
borrow $ 39.14 billion and buy back stock.
• Given the magnitude of this decision, you should expect to answer three
questions:
A. Why should we do it?
B. What if something goes wrong?
C. What if we don’t want (or cannot ) buy back stock and want to make
investments with the additional debt capacity?

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 A. Why should we do it? Effect on Firm Value – Full Valuation
Step 1: Estimate the cash flows to Disney as a firm
EBIT (1 – Tax Rate) = 10,032 (1 – 0.361) = $6,410
+ Depreciation and amortization = $2,485
– Capital expenditures = $5,239
– Change in noncash working capital $0
Free cash flow to the firm = $3,657
•Step 2: Back out the implied growth rate in the current market value
Current enterprise value = $121,878 + 15,961 - 3,931 = 133,908
$ 133,908 = FCFF0 (1+ g) 3, 657(1+g)
=
(Cost of Capital -g) (.0781 -g)
Growth rate = (Firm Value * Cost of Capital – CF to Firm)/(Firm Value + CF to Firm)
= (133,908* 0.0781 – 3,657)/(133,908+ 3,657) = 0.0494 or 4.94%
•Step 3: Revalue the firm with the new cost of capital
–Enterprise value = FCFF0 (1+ g) 3, 657(1.0494)
= = $172, 935 million
(Cost of Capital -g) (.0716 -0.0484)
Increase in value = $172,935 - $133,908 = $39,027 million

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 Effect on Value: Incremental approach
• In this approach, we start with the current market value and isolate the
effect of changing the capital structure on the cash flow and the resulting
value.
Enterprise Value before the change = $133,908 million
Cost of financing Disney at existing debt ratio = $ 133,908 * 7.81% = $10,458 million
Cost of financing Disney at optimal debt ratio = $ 133,908 * 7.16% = $ 9,592 million
Annual savings in cost of financing = $10,458 million – $9,592 million = $866 million
Annual Savings next year $866
Increase in Value= = = $19, 623 million
(Cost of Capital - g) (0.0716 - 0.0275)

Enterprise value after recapitalization

= Existing enterprise value + PV of Savings = $133,908 + $19,623 = $153,531 million

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 From firm value to value per share: The Rational
Investor Solution
• Because the increase in value accrues entirely to stockholders, we can
estimate the increase in value per share by dividing by the total number
of shares outstanding (1,800 million).
– Increase in Value per Share = $19,623/1800 = $ 10.90
– New Stock Price = $67.71 + $10.90= $78.61
• Implicit in this computation is the assumption that the increase in firm
value will be spread evenly across both the stockholders who sell their
stock back to the firm and those who do not and that is why we term this
the “rational” solution, since it leaves investors indifferent between
selling back their shares and holding on to them.

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 The more general solution, given a buyback price
• Start with the buyback price and compute the number of shares outstanding
after the buyback:
– Increase in Debt = Debt at optimal – Current Debt
Increase in Debt
– # Shares after buyback = # Shares before –
Share Price

• Then compute the equity value after the recapitalization, starting with the
enterprise value at the optimal, adding back cash and subtracting out the
debt at the optimal:
– Equity value after buyback = Optimal Enterprise value + Cash – Debt
• Divide the equity value after the buyback by the post-buyback number of
shares.
– Value per share after buyback = Equity value after buyback/ Number of shares after
buyback

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 B. ‘What if’ something goes wrong?
• Consider realistic ‘worst case’ scenario:

Recession: Decline in Operating Income

2009 Drop of 23.06%
2002 Drop of 15.82%
1991 Drop of 22.00%
Worst Year Drop of 29.47%

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 Disney: Safety Buffers? Constraint on ratings?
Management often specifies a 'desired
rating' below which they do not want to
fall.
• Caveat: The cost of this artificial constraint
is the difference between the
unconstrained value and the value of the
firm with the constraint.

At its optimal debt ratio of 40%, Disney has an estimated rating of A.

If managers insisted on an AA rating, the optimal debt ratio for Disney is
then 30% and the cost of the ratings constraint is
Cost of AA Rating Constraint = Value at 40% Debt – Value at 30% Debt = $153,531 m –
$147,835 m = $ 5,696 million
 C. What if you do not buy back stock.
• The optimal debt ratio is ultimately a function of the
underlying riskiness of the business in which you operate and
your tax rate.
• Will the optimal be different if you invested in projects
instead of buying back stock?
– No. As long as the projects financed are in the same business mix
that the company has always been in and your tax rate does not
change significantly.
– Yes, if the projects are in entirely different types of businesses or if
the tax rate is significantly different.

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 Limitations of the Cost of Capital approach
• It is static: The most critical number in the entire analysis is
the operating income. If that changes, the optimal debt ratio
will change.
• It ignores indirect bankruptcy costs: The operating income is
assumed to stay fixed as the debt ratio and the rating
changes.
• Beta and Ratings: It is based upon rigid assumptions of how
market risk and default risk get borne as the firm borrows
more money and the resulting costs.

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 II. Enhanced Cost of Capital Approach
• Distress cost affected operating income: In the enhanced cost
of capital approach, the indirect costs of bankruptcy are built
into the expected operating income. As the rating of the firm
declines, the operating income is adjusted to reflect the loss
in operating income that will occur when customers,
suppliers and investors react.
• Dynamic analysis: Rather than look at a single number for
operating income, you can draw from a distribution of
operating income (thus allowing for different outcomes).

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 Estimating the Distress Effect- Disney
Rating Drop in EBITDA Drop in EBITDA Drop in EBITDA
(Low) (Medium) (High)
To A No effect No effect 2.00%
To A- No effect 2.00% 5.00%
To BBB 5.00% 10.00% 15.00%
To BB+ 10.00% 20.00% 25.00%
To B- 15.00% 25.00% 30.00%
To C 25.00% 40.00% 50.00%
To D 30.00% 50.00% 100.00%

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The Optimal Debt Ratio with Indirect Bankruptcy Costs
Debt Cost of Bond Interest rate Cost of Debt Enterprise
Ratio Beta Equity Rating on debt Tax Rate (after-tax) WACC Value
0% 0.9239 8.07% Aaa/AAA 3.15% 36.10% 2.01% 8.07% $122,633
10% 0.9895 8.45% Aaa/AAA 3.15% 36.10% 2.01% 7.81% $134,020
20% 1.0715 8.92% Aaa/AAA 3.15% 36.10% 2.01% 7.54% $147,739
30% 1.1769 9.53% Aa2/AA 3.45% 36.10% 2.20% 7.33% $160,625
40% 1.3175 10.34% A2/A 3.75% 36.10% 2.40% 7.16% $172,933
50% 1.5573 11.72% Caa/CCC 11.50% 31.44% 7.88% 9.80% $35,782
60% 1.9946 14.24% C2/C 13.25% 22.74% 10.24% 11.84% $25,219
70% 2.6594 18.07% C2/C 13.25% 19.49% 10.67% 12.89% $21,886
80% 3.9892 25.73% C2/C 13.25% 17.05% 10.99% 13.94% $19,331
90% 7.9783 48.72% C2/C 13.25% 15.16% 11.24% 14.99% $17,311

The optimal debt ratio stays at 40% but the cliff becomes much steeper.
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III. The APV Approach to Optimal Capital Structure

• In the adjusted present value approach, the value of the firm

is written as the sum of the value of the firm without debt
(the unlevered firm) and the effect of debt on firm value
Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected
Bankruptcy Cost from the Debt)
• The optimal dollar debt level is the one that maximizes firm
value

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 Implementing the APV Approach
• Step 1: Estimate the unlevered firm value. This can be done in one of two ways:
– Estimating the unlevered beta, a cost of equity based upon the unlevered beta and
valuing the firm using this cost of equity (which will also be the cost of capital, with
an unlevered firm)
– Alternatively, Unlevered Firm Value = Current Market Value of Firm - Tax Benefits of
Debt (Current) + Expected Bankruptcy cost from Debt
• Step 2: Estimate the tax benefits at different levels of debt. The simplest
assumption to make is that the savings are perpetual, in which case
Tax benefits = Dollar Debt * Tax Rate
• Step 3: Estimate the expected bankruptcy cost: Estimate a probability of
bankruptcy at each debt level, and multiply by the cost of bankruptcy
(including both direct and indirect costs).

47
 Estimating Expected Bankruptcy Cost
• Probability of Bankruptcy
– Estimate the synthetic rating that the firm will have at each level of debt
– Estimate the probability that the firm will go bankrupt over time, at that
level of debt (Use studies that have estimated the empirical probabilities
of this occurring over time - Altman does an update every year)
• Cost of Bankruptcy
– The direct bankruptcy cost is the easier component. It is generally
between 5-10% of firm value, based upon empirical studies
– The indirect bankruptcy cost is much tougher. It should be higher for
sectors where operating income is affected significantly by default risk
(like airlines) and lower for sectors where it is not (like groceries)

48
 Ratings and Default Probabilities: Results from Altman
study of bonds
Rating Likelihood of Default
AAA 0.07%
AA 0.51%
A+ 0.60%
A 0.66%
A- 2.50% Altman estimated these probabilities by
BBB 7.54% looking at bonds in each ratings class ten
BB 16.63%
B+ 25.00% years prior and then examining the
B 36.80% proportion of these bonds that defaulted
B- 45.00%
CCC 59.01%
over the ten years.
CC 70.00%
C 85.00%
D 100.00%

49
 Disney: Estimating Unlevered Firm Value
Current Value of firm = $121,878+ $15,961 = $ 137,839
- Tax Benefit on Current Debt = $15,961 * 0.361 = $ 5,762
+ Expected Bankruptcy Cost = 0.66% * (0.25 * 137,839) = $ 227
Unlevered Value of Firm = = $ 132,304
– Cost of Bankruptcy for Disney = 25% of firm value
– Probability of Bankruptcy = 0.66%, based on firm’s
current rating of A
– Tax Rate = 36.1%

50
 Disney: APV at Debt Ratios
Expected Value of
Unlevered Probability Bankruptcy Levered
Debt Ratio $ Debt Tax Rate Firm Value Tax Benefits Bond Rating of Default Cost Firm
0% $0 36.10% $132,304 $0 AAA 0.07% $23 $132,281
10% $13,784 36.10% $132,304 $4,976 Aaa/AAA 0.07% $24 $137,256
20% $27,568 36.10% $132,304 $9,952 Aaa/AAA 0.07% $25 $142,231
30% $41,352 36.10% $132,304 $14,928 Aa2/AA 0.51% $188 $147,045
40% $55,136 36.10% $132,304 $19,904 A2/A 0.66% $251 $151,957
50% $68,919 36.10% $132,304 $24,880 B3/B- 45.00% $17,683 $139,501
60% $82,703 36.10% $132,304 $29,856 Caa/CCC 59.01% $23,923 $138,238
70% $96,487 32.64% $132,304 $31,491 Caa/CCC 59.01% $24,164 $139,631
80% $110,271 26.81% $132,304 $29,563 Ca2/CC 70.00% $28,327 $133,540
90% $124,055 22.03% $132,304 $27,332 C2/C 85.00% $33,923 $125,713

The optimal debt ratio is 40%,

which is the point at which firm
value is maximized.

51
 Determinants of the Optimal Debt Ratio:
1. The marginal tax rate
– The higher the marginal tax rate, the greater the benefit to borrowing.
2. Pre-tax Cash flow
– Higher cash flows, as a percent of value, give you a higher debt capacity.
3. Operating Risk
– Firms that face more risk or uncertainty in their operations will have lower
optimal debt ratios than firms that have more predictable operations.
– Operating risk enters the cost of capital approach in two places:
• Unlevered beta: Firms that face more operating risk will tend to have higher unlevered
betas. Higher debt will magnify this
• Bond ratings: For any given level of operating income, firms that face more risk in
operations will have lower ratings. The ratings are based upon normalized income.

52
 Determinant 4. The only macro determinant:
Equity vs Debt Risk Premiums
Figure 16: Equity Risk Premiums and Bond Default Spreads
7.00% 9.00

8.00
6.00%
7.00
5.00%

ERP / Baa Spread

6.00
Premium (Spread)

4.00% 5.00

3.00% 4.00

3.00
2.00%
2.00
1.00%
1.00

0.00% 0.00

ERP/Baa Spread Baa - [Link] Rate ERP

53
 IV. Relative Analysis
• The “safest” place for any firm to be is close to the industry
average
• Subjective adjustments can be made to these averages to arrive at
the right debt ratio.
– Higher tax rates -> Higher debt ratios (Tax benefits)
– Lower insider ownership -> Higher debt ratios (Greater discipline)
– More stable income -> Higher debt ratios (Lower bankruptcy costs)
– More intangible assets -> Lower debt ratios (More agency problems)

54
 Comparing to industry averages
Debt to Capital Net Debt to Capital Debt to Capital Net Debt to Capital
Ratio Ratio Ratio Ratio
Book Market Book Market Comparable Book Market Book Market
Company
value value value value group value value value value
US
Disney 22.88% 11.58% 17.70% 8.98% 39.03% 15.44% 24.92% 9.93%
Entertainment
Global
Diversified
Vale 39.02% 35.48% 34.90% 31.38% Mining & Iron 34.43% 26.03% 26.01% 17.90%
Ore (Market
cap> $1 b)

Global Autos
Tata
58.51% 29.28% 22.44% 19.25% (Market Cap> $1 35.96% 18.72% 3.53% 0.17%
Motors
b)
Baidu 32.93% 5.23% 20.12% 2.32% Global Online 6.37% 1.83% -27.13% -2.76%
Advertising

55
 Getting past simple averages: Regression in Sector
Step 1: Run a regression of debt ratios on the variables that you believe
determine debt ratios in the sector. For example,
Debt Ratio = a + b (Tax rate) + c (Earnings Variability) + d (EBITDA/Firm Value)
Check this regression for statistical significance (t statistics) and predictive
ability (R squared)
Step 2: Estimate the values of the proxies for the firm under consideration.
Plugging into the cross sectional regression, we can obtain an estimate of
predicted debt ratio.
Step 3: Compare the actual debt ratio to the predicted debt ratio.

56
 Applying the Regression Methodology: Global Auto Firms
• Using a sample of 56 global auto firms, we arrived at the following
regression:
Debt to capital = 0.09 + 0.63 (Effective Tax Rate) + 1.01 (EBITDA/
Enterprise Value) - 0.93 (Cap Ex/ Enterprise Value)
• The R squared of the regression is 21%. This regression can be used
to arrive at a predicted value for Tata Motors’ Predicted Debt Ratio
0.09 + 0.63 (0.252) +1.01 (0.1167) - 0.93 (0.1949) = .1854 or 18.54%
• Based upon the capital structure of other firms in the automobile
industry, Tata Motors should have a market value debt ratio of
18.54%. It is over levered at its existing debt ratio of 29.28%.

57
 Extending to the entire market
• Using 2014 data for US listed firms, we looked at the determinants of the
market debt to capital ratio. The regression provides the following results:
DFR = 0.27 – 0.24 ETR – 0.10 g – 0.065 INST – 0.338 CVOI + 0.59 E/V
(15.79) (9.00) (2.71) (3.55) (3.10) (6.85)
DFR = Debt / (Debt + Market Value of Equity)
ETR = Effective tax rate in most recent twelve months; g for growth
INST = % of Shares held by institutions
CVOI = Std dev in OI in last 10 years/ Average OI in last 10 years
E/V = EBITDA/ (Market Value of Equity + Debt- Cash)
The regression has an R-squared of 8%. (t-statistics in brackets)

58
 Applying the Regression
• Disney had the following values for these inputs in 2013. Estimate the optimal debt ratio
using the debt regression.
ETR = 31.02%
Expected Revenue Growth = 6.45%
INST = 70.2%
CVOI = 0.0296
E/V = 9.35%
Optimal Debt Ratio:
0.27 - 0.24 (.3102) -0.10 (.0645)– 0.065 (.702) -0.338 (.0296)+ 0.59 (.0935)= 0.1886 or 18.86%
• What does this optimal debt ratio tell you? (under levered: actual Debt-to-capital ratio
11.58%)
• Why might it be different from the optimal calculated using the weighted average cost of
capital? (implicit assumption: on average firms get their debt ratio optimal)

59
 First Principles
Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

60
 Now that we have an optimal.. And an actual..
What next?
• At the end of the analysis of financing mix (using whatever tool or tools
you choose to use), you can come to one of three conclusions:
1. The firm has the right financing mix
2. It has too little debt (it is under levered)
3. It has too much debt (it is over levered)
• The next step in the process is
– Deciding how much quickly or gradually the firm should move to its
optimal
– Assuming that it does, the right kind of financing to use in making this
adjustment
•The following slides are based on Chapter 9 (of Damodaran – Applied Corporate Finance)

61
A Framework for Getting to the Optimal

62
 The mechanics of changing debt ratios
• Quickly: It changing debt ratio is urgent, firms can:
– Sell assets to pay down (decrease) debt or buy back stocks (increase
the D/E ratio)
– Issue new stock to pay down debt; If D/E ratio needs a quick
increase, issue new debt and buy back stock.
• Gradually: To change debt ratios over time, you use the same mix
of tools that you used to change debt ratios gradually:
– Dividends and stock buybacks: Dividends and stock buybacks will
reduce the value of equity.
– Debt repayments: will reduce the value of debt.

63
 Disney: Applying the Framework

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

Actual > Optimal Actual < Optimal

Overlevered Actual (11.58%) < Optimal (40%)

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No Yes No. Large mkt cap & positive

Jensen’s a
Reduce Debt quickly Increase leverage
1. Equity for Debt swap Does the firm have good quickly Does the firm have good
2. Sell Assets; use cash projects? 1. Debt/Equity swaps projects?
to pay off debt ROE > Cost of Equity 2. Borrow money& ROE > Cost of Equity
3. Renegotiate with lenders ROC > Cost of Capital buy shares. ROC > Cost of Capital

Yes No Yes. ROC > Cost of capital

Take good projects with 1. Pay off debt with retained No
new equity or with retained earnings. Take good projects
earnings. 2. Reduce or eliminate dividends. With debt.
3. Issue new equity and pay off Do your stockholders like
debt. dividends?

Yes
Pay Dividends No
Buy back stock

64
 Designing Debt: The Fundamental Principle

• The objective in designing debt is to make the cash flows

on debt match up as closely as possible with the cash
flows that the firm makes on its assets.
• By doing so, we reduce our risk of default, increase debt
capacity and increase firm value.

65
Firm with (mis)matched debt
Mismatch between
value and debt: firm
goes bankrupt in the two
periods

The same firm never goes

bankrupt, even though it
has borrowed a lot more.

66
 Design the perfect financing instrument
• The perfect financing instrument will
– Have all of the tax advantages of debt
– While preserving the flexibility offered by equity
Start with the
Cash Flows Cyclicality &
Growth Patterns Other Effects
on Assets/ Duration Currency Effect of Inflation
Projects Uncertainty about Future

Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds
Duration/ Currency * More floating rate Convertible on Debt Catastrophe Notes
Define Debt Maturity Mix - if CF move with - Convertible if - Options to make
Characteristics inflation cash flows low cash flows on debt
- with greater uncertainty now but high match cash flows
on future exp. growth on assets

Design debt to have cash flows that match up to cash flows on the assets financed
67
 Soothe bondholder fears, information asymmetry
• There are some firms that face skepticism from bondholders when they
go out to raise debt, because
– Of their past history of defaults or other actions
– They are small firms without any borrowing history
• Bondholders tend to demand much higher interest rates from these firms
to reflect these concerns.
• Convertible bonds
• Puttable bonds
• Rating sensitive notes
• If firm is undervalued and/or underrated (information asymmetry):
– Go for short term (bridge) financing.

68
69

Pleasing ratings agencies, equity research analysts, and regulators

• Tax authorities must count the payments as debt.
• Ratings agencies want companies to issue equity, since it makes them safer.
• Equity research analysts want them not to issue equity because it dilutes
earnings per share.
• Regulatory authorities want to ensure that you meet their requirements in
terms of capital ratios (usually book value).
• Financing that leaves all groups happy is nirvana.
Consider Analyst Concerns Ratings Agency Regulatory Concerns
ratings agency - Effect on EPS - Effect on Ratios - Measures used Operating Leases
& analyst concerns - Value relative to comparables - Ratios relative to comparables MIPs
Surplus Notes

Can securities be designed that can make these different entities happy?
70

Debt or Equity: The Strange Case of Trust Preferred

• Trust preferred stock has
– A fixed dividend payment, specified at the time of the issue
– That is tax deductible
– And failing to make the payment can give these shareholders voting
rights
• When trust preferred was first created, ratings agencies treated
it as equity.
• They have become more savvy and have started giving firms
only partial equity credit for trust preferred.
– So have the designs of debt; it is game of catching up with
innovations.
 Approaches for evaluating Asset Cash Flows
I. Intuitive Approach
– Are the projects typically long term or short term? What is the cash flow
pattern on projects?
– How much growth potential does the firm have relative to current
projects?
– How cyclical are the cash flows? What specific factors determine the cash
flows on projects?
II. Project Cash Flow Approach
– Estimate expected cash flows on a typical project for the firm
– Do scenario analyses on these cash flows, based upon different macro
economic scenarios
III. Firm level Cash Flow analysis
– Operating Cash Flows
– Firm Value

71
 I. Intuitive Approach - Disney
Business Project Cash Flow Characteristics Type of Financing
Movie projects are likely to Debt should be
Studio
• Be short-term 1. Short-term
entertainment • Have cash outflows primarily in dollars, but cash inflows could have 2. Mixed currency debt,
a substantial foreign currency component . reflecting audience
• Have net cash flows that are heavily driven by whether the movie is make-up.
a hit, which is often difficult to predict 3. If possible, tied to the
success of movies.
Media Projects are likely to be Debt should be
networks 1. Short-term 1. Short-term
2. Primarily in dollars, though foreign component is growing, 2. Primarily dollar debt
especially for ESPN. 3. If possible, linked to
3. Driven by advertising revenues and show success (Nielsen ratings) network ratings
Park resorts Projects are likely to be Debt should be
1. Very long-term 1. Long-term
2. Currency will be a function of the region where park is located. 2. Mix of currencies,
3. Affected by success of media networks divisions. based on tourist
makeup at the park.
Consumer Projects are likely to be short- to medium-term and linked to the Debt should be
products success of the movie division; most of Disney’s product offerings and 1. Medium-term
licensing revenues are derived from their movie productions 2. Dollar debt

72
 II. Project Specific Financing
• With project specific financing, you match the financing
choices to the project being funded. The benefit is that the
the debt is truly customized to the project.
• Project specific financing makes the most sense when you
have a few large, independent projects to be financed. It
becomes both impractical and costly when firms have
portfolios of projects with interdependent cashflows.

73
 Duration of Disney Theme Park

Duration of the Project =

62,355/3296 = 18.92 years

• The perfect debt for this theme park would have a duration of roughly 19 years and be in a mix of
Latin American currencies (since it is located in Brazil), reflecting where the visitors to the park are
coming from.
• If possible, you would tie the interest payments on the debt to the number of visitors at the park.

74
 Duration of a bond: a Refresher
• A measure of the effective maturity of a bond
• The weighted average of the times until each payment is received, with the
weights proportional to the present value of the payment
• Duration is shorter than maturity for all bonds except zero coupon bonds.
Duration is equal to maturity for zero coupon bonds.
• Duration can be calculated by regressing change in firm value on change in
interest rates. Or:
T

Duration, D=  t w
t =1
t
CFt=cash flow at time t
r= interest rate/y-t-m

wt = CF t (1 + r ) PV
t
 dP, dr: change in price, interest rate

Price change is proportional to duration and not to maturity:

dP d (1 + r )
= −D 
P (1 + r )
75
 III. Firm-wide financing
• Rather than look at individual projects, you could consider the firm to be a portfolio of
projects. The firm’s past history should then provide clues as to what type of debt makes
the most sense.
• Operating Cash Flows
• The question of how sensitive a firm’s asset cash flows are to a variety of factors,
such as interest rates, inflation, currency rates and the economy, can be directly
tested by regressing changes in the operating income against changes in these
variables.
• This analysis is useful in determining the coupon/interest payment structure of the
debt.
• Firm Value
• The firm value is clearly a function of the level of operating income, but it also
incorporates other factors such as expected growth & cost of capital.
• The firm value analysis is useful in determining the overall structure of the debt,
particularly maturity.

76
 I. Sensitivity to Interest Rate Changes

• How sensitive is the firm’s value and operating income

to changes in the level of interest rates?
• The answer to this question is important because it
– it provides a measure of the duration of the firm’s
projects
– it provides insight into whether the firm should be using
fixed or floating rate debt.

77
 Firm Value versus Interest Rate Changes
• Regressing changes in firm value against changes in interest rates over
this period yields the following regression –
Change in Firm Value = 0.1790 – 2.3251 (Change in Interest Rates)
(2.74) (0.39) t-statistics are in brackets.
–The coefficient on the regression (-2.33) measures how much the value
of Disney as a firm changes for a unit change in interest rates.
Operating Income versus Interest Rates
• Regressing changes in operating cash flow against changes in interest
rates over this period yields the following regression –
Change in Operating Income = 0.1698 – 7.9339 (Change in Interest Rates)
(2.69a) (1.40)
Conclusion: Disney’s operating income has been affected a lot more than
its firm value has by changes in interest rates.
78
 Why the coefficient on the regression is duration..
• The duration of a straight bond or loan issued by a company can be written
in terms of the coupons (interest payments) on the bond (loan) and the
face value of the bond to be (Macaulay duration)
𝑡 ⋅ Coupon𝑡 𝑇 ⋅ Face value
σ𝑇𝑡=1 +
1+𝑟 𝑡 1+𝑟 𝑇
Coupon𝑡 Face value
σ𝑇𝑡=1 +
1+𝑟 𝑡 1+𝑟 𝑇
• The duration of a bond measures how much the price of the bond changes
for a unit change in interest rates.
• Holding other factors constant, the duration of a bond will increase with the
maturity of the bond, and decrease with the coupon rate on the bond.

79
 II. Sensitivity to Changes in GDP/ GNP
• How sensitive is the firm’s value and operating income to changes in the
GNP/GDP?
• The answer to this question is important because
– it provides insight into whether the firm’s cash flows are cyclical and
– whether the cash flows on the firm’s debt should be designed to protect
against cyclical factors.
• If the cash flows and firm value are sensitive to movements in the
economy, the firm will either have to issue less debt overall, or add
special features to the debt to tie cash flows on the debt to the firm’s
cash flows.

80
 Regression Results
• Regressing changes in firm value against changes in the GDP over this
period yields the following regression –
Change in Firm Value = 0.0067 + 6.7000 (GDP Growth)
(0.06) (2.03a)
Conclusion: Disney is sensitive to economic growth
• Regressing changes in operating cash flow against changes in GDP over
this period yields the following regression –
Change in Operating Income = 0.0142 + 6.6443 ( GDP Growth)
(0.13) (2.05a)
Conclusion: Disney’s operating income is sensitive to economic growth as
well.

81
 III. Sensitivity to Currency Changes
• How sensitive is the firm’s value and operating income to changes
in exchange rates?
• The answer to this question is important, because
– it provides a measure of how sensitive cash flows and firm value are
to changes in the currency
– it provides guidance on whether the firm should issue debt in another
currency that it may be exposed to.
• If cash flows and firm value are sensitive to changes in the dollar,
the firm should
– figure out which currency its cash flows are in;
– and issued some debt in that currency

82
 Regression Results
• Regressing changes in firm value against changes in the dollar over this period
yields the following regression –
Change in Firm Value = 0.1774 – 0.5705 (Change in Dollar)
(2.76) (0.67)
Conclusion: Disney’s value is sensitive to exchange rate changes, decreasing as
the dollar strengthens. However, the effect is statistically insignificant.

• Regressing changes in operating cash flow against changes in the dollar over
this period yields the following regression –
Change in Operating Income = 0.1680 – 1.6773 (Change in Dollar)
(2.82a) (2.13a )
Conclusion: Disney’s operating income is more strongly impacted by the dollar
than its value is. A stronger dollar seems to hurt operating income.

83
 IV. Sensitivity to Inflation
• How sensitive is the firm’s value and operating income to changes
in the inflation rate?
• The answer to this question is important, because
– it provides a measure of whether cash flows are positively or
negatively impacted by inflation.
– it then helps in the design of debt; whether the debt should be fixed
or floating rate debt.
• If cash flows move with inflation, increasing (decreasing) as
inflation increases (decreases), the debt should have a larger
floating rate component.

84
 Regression Results
• Regressing changes in firm value against changes in inflation over this
period yields the following regression –
Change in Firm Value = 0.1855 + 2.9966 (Change in Inflation Rate)
(2.96) (0.90)
Conclusion: Disney’s firm value does seem to increase with inflation, but not
by much (statistical significance is low)
• Regressing changes in operating cash flow against changes in inflation
over this period yields the following regression –
Change in Operating Income = 0.1919 + 8.1867 (Change in Inflation Rate)
(3.43a) (2.76a )
Conclusion: Disney’s operating income increases in periods when inflation
increases, suggesting that Disney does have pricing power.

85
 Summarizing…
• Looking at the four macroeconomic regressions, we would
conclude that
– Disney’s assets collectively have a duration of about 2.33 years
– Disney is increasingly affected by economic cycles
– Disney is hurt by a stronger dollar
– Disney’s operating income tends to move with inflation
• All of the regression coefficients have substantial standard errors
associated with them. One way to reduce the error (a la bottom up
betas) is to use sector-wide averages for each of the coefficients.

86
 Bottom-up Estimates
The sensitivity of firm value to these factors can be estimated by regressing value (industry
aggregation) on these factors (rather than firm level due to data restriction).
Interest GDP
Business rates Growth Inflation Currency Weights
Media Networks -3.70 0.56 1.41 -1.23 49.27%
Parks & Resorts -4.50 0.70 -3.05 -1.58 33.81%
Studio
-6.47 0.22 -1.45 -3.21
Entertainment 13.49%
Consumer Products -4.88 0.13 -5.51 -3.01 2.18%
Interactive -1.01 0.25 -3.55 -2.86 1.25%
Disney Operations -4.34 0.55 -0.70 -1.67 100.00%

These weights reflect the recent

estimated values of the businesses
87
 Overall Recommendations for Disney
• The debt issued should be long term and should have
duration of about 4.3 years.
• A significant portion of the debt should be floating rate debt,
reflecting Disney’s capacity to pass inflation through to its
customers.
• Given Disney’s sensitivity to a stronger dollar, a portion of the
debt should be in foreign currencies. The specific currency
used and the magnitude of the foreign currency debt should
reflect where Disney makes its revenues (e.g. in 2013, 12% in
Europe and 6% in Asia).

88
 Analyzing Disney’s Current Debt
• Disney has $14.3 billion in interest-bearing debt with a face-value weighted average
maturity of 7.92 years. Allowing for the fact that the maturity of debt is higher than
the duration, this would indicate that Disney’s debt may be a little longer than would
be optimal, but not by much.
• Of the debt, about 5.49% of the debt is in non-US dollar currencies (Indian rupees and
Hong Kong dollars), but the rest is in US dollars and the company has no Euro debt.
Based on our analysis, we would suggest that Disney increase its proportion of Euro
debt to about 12% and tie the choice of currency on future debt issues to its expansion
plans.
• Disney has no convertible debt and about 5.67% of its debt is floating rate debt, which
looks low, given the company’s pricing power. While the mix of debt in 2013 may be
reflective of a desire to lock in low long-term interest rates on debt, as rates rise, the
company should consider expanding its use of foreign currency debt.

89
 Adjusting Debt at Disney

• It can swap some of its existing fixed rate, dollar debt for floating
rate, foreign currency debt. Given Disney’s standing in financial
markets and its large market capitalization, this should not be
difficult to do.
• If Disney is planning new debt issues, either to get to a higher debt
ratio or to fund new investments, it can use primarily floating rate,
foreign currency debt to fund these new investments. Although it
may be mismatching the funding on these investments, its debt
matching will become better at the company level.

90