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Stage 2

Rapid Expansion

Stage 1

Start-up

Stage 4

Mature Growth

Stage 5

Decline

Financing Choices across the life cycle

External

Financing

Revenues

Earnings

Owners Equity

Bank Debt

Venture Capital

Common Stock

Debt Retire debt

Repurchase stock

External funding

needs

High, but

constrained by

infrastructure

High, relative

to firm value.

Moderate, relative

to firm value.

Declining, as a

percent of firm

value

Internal financing

Low, as projects dry

up.

Common stock

Warrants

Convertibles

Stage 3

High Growth

Negative or

low

Negative orlow

Low, relative to

funding needs

High, relative to

funding needs

More than funding needs

Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancing

Transitions

Growth stage

$ Revenues/

Earnings

Time

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$8,422 $8,422

Depreciation $1,593 $1,593EBIT $6,829 $6,829Interest expense $294 $588Pretax int. cov 23.24 11.62Likely rating AAA AAAPretax cost of debt 4.75% 4.75%


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Duration Currency Effect of InflationUncertainty about Future

Growth Patterns Cyclicality &Other Effects

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Start with theCash Flowson Assets/Projects

Overlay taxpreferences Deductibility of cash flowsfor tax purposes Differences in tax ratesacross different locales

Considerratings agency& analyst concerns Analyst Concerns- Effect on EPS- Value relative to comparables Ratings Agency- Effect on Ratios- Ratios relative to comparables Regulatory Concerns- Measures used

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby Lenders- Less observable cash flowslead to more conflicts

Type of Assets financed- Tangible and liquid assetscreate less agency problems Existing Debt covenants- Restrictions on Financing

Consider InformationAsymmetries Uncertainty about Future Cashflows- When there is more uncertainty, it

may be better to use short term debtCredibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

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

If tax advantages are large enough, you might override results of previous step Zero Coupons

Operating LeasesMIPsSurplus Notes

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

Commodity BondsCatastrophe Notes

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CashflowfromOperations

Cashflows to Debt(Principal repaid,InterestExpenses)

Cashflows fromOperations toEquity Investors

Reinvestment backinto the business

Cash availablefor return tostockholders

Cash held backby the company

Cash Paid out

Stock Buybacks

Dividends

How much did you borrow

How good are your investment choices

What is a reasonable cash balanc

What do yourstockholders prefer?

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Issuance Costs for Stocks and Bonds

0.00%

5.00%

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20.00%

25.00%

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Company Premium for cash dividend sharesConsolidated Bathurst + 19.30%Donfasco + 13.30%Dome Petroleum + 0.30%Imperial Oil +12.10%

Newfoundland Light & Power + 1.80%Royal Trustco + 17.30%Stelco + 2.70%TransAlta +1.10%Average across companies + 7.54%

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Chrysler : FCFE Div idends and Cash Balance

($500)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Y e a r

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$3,000

$4,000

$5,000

$6,000

$7,000

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How much did the firm pay out? How much could it have afforded to pay out?What it could have paid out What it actually paid outNet Income Dividends- (Cap Ex - Deprn) (1-DR) + Equity Repurchase- Chg Working Capital (1-DR)= FCFE

Firm pays out too littleFCFE > Dividends Firm pays out too muchFCFE < Dividends

Do you trust managers in the company withyour cash?Look at past project choice:Compare ROE to Cost of Equity

ROC to WACC

What investment opportunities does thefirm have?Look at past project choice:Compare ROE to Cost of Equity

ROC to WACC

Firm has history ofgood project choiceand good projects inthe future

Firm has historyof poor projectchoice

Firm has goodprojects Firm has poorprojects

Give managers theflexibility to keepcash and setdividends

Force managers tojustify holding cashor return cash tostockholders

Firm shouldcut dividendsand reinvestmore

Firm should dealwith its investmentproblem first andthen cut dividends

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Quality of projects taken: ROE versus Cost of EquitPoor projects Good projects

Cash Surplus + GoodProjectsMaximum flexibility insetting dividend policy

Cash Surplus + PoorProjectsSignificant pressure topay out more tostockholders asdividends or stockbuybacks

Cash Deficit + GoodProjectsReduce cash payout, if

any, to stockholders

Cash Deficit + PoorProjectsCut out dividends but

real problem is ininvestment policy.

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Summary of calculationsAverage Standard Deviation Maximum Minimum

Free CF to Equity $571.10 $1,382.29 $3,764.00 ($612.50)Dividends $1,496.30 $448.77 $2,112.00 $831.00Dividends+Repurchases $1,496.30 $448.77 $2,112.00 $831.00Dividend Payout Ratio 84.77%Cash Paid as % of FCFE 262.00%

ROE - Required return -1.67% 11.49% 20.90% -21.59%

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Summary of calculationsAverage Standard Deviation Maximum Minimum

Free CF to Equity ($34.20) $109.74 $96.89 ($242.17)Dividends $40.87 $32.79 $101.36 $5.97Dividends+Repurchases $40.87 $32.79 $101.36 $5.97Dividend Payout Ratio 18.59%Cash Paid as % of FCFE -119.52%

ROE - Required return 1.69% 19.07% 29.26% -19.84%

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209Aswath DamodaranMuch of the cash held backwas invested in other Tatacompanies.


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Expected Growth

Net Income Operating Income

Retention Ratio=1 - Dividends/NetIncome

Return on EquityNet Income/Book Value ofEquity

X

ReinvestmentRate = (Net CapEx + Chg inWC/EBIT(1-t)

Return on Capital =EBIT(1-t)/Book Value ofCapital

X

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Approach used To get to equity value per shareDiscount dividends per share at the costof equity Present value is value of equity per shareDiscount aggregate FCFE at the cost ofequity Present value is value of aggregate equity.Subtract the value of equity options given

to managers and divide by number of

shares.Discount aggregate FCFF at the cost ofcapital PV = Value of operating assets+ Cash & Near Cash investments

+ Value of minority cross holdings-Debt outstanding= Value of equity-Value of equity options=Value of equity in common stock/ Number of shares

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urrent as ow to rmEBIT(1-t)= 7030(1-.38)= 4,359- p = ,- g= FCFF 2,017Reinvestment Rate = 2342/4359

= . %

xpecte rowtin EBIT (1-t).5372*.0991=.0532

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ta e rowtg = 3%; Beta = 1.00;Cost of capital =7.95%

= %;

Disney - Status Quo in 2009e nves men a e

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Return on capital = 9.91%;

Reinvestment Rate=3/9=33.33%

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ost o qu ty8.91%

ost o e t(3.5%+2.5%)(1-.38)= 3.72%

ase on ac ua ra ng

Weights= % = %

Cost of Capital (WACC) = 8.91% (0.73) + 3.72% (0.27) = 7.52%

Op. Assets 65,284+ Cash: 3,795+ on op nv ,- Debt 16,682- Minority int 1,344= qu y ,- p ons

Value/Share 28.16

s ree ate:s ree ra e = . %

+Beta0.90 X

s rem um%

Unlevered Beta forec ors: .

erm r

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On June 1, 2009, Disneywas ra ng a .s are

First 5 yearsGrowth decreasesgradually to 3%

= . %

Year 1 2 3 4 5 6 7 8 9 10EBIT (1-t) $4,591 $4,835 $5,093 $5,364 $5,650 $5,924 $6,185 $6,428 $6,650 $6,850- Reinvestment$2,466 $2,598 $2,736 $2,882 $3,035 $2,941 $2,818 $2,667 $2,488 $2,283FCFF $2,125 $2,238 $2,357 $2,482 $2,615 $2,983 $3,366 $3,761 $4,162 $4,567

Cost of capital graduallyincreases to 7.95%

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254Aswath Damodaran

Cashflows from existing assetsCashflows before debt payments,but after taxes and reinvestment tomaintain exising assets

Expected Growth during high growth period

Growth from new investmentsGrowth created by making newinvestments; function of amount andquality of investments

Efficiency GrowthGrowth generated byusing existing assetsbetter

Length of the high growth periodSince value creating growth requires excess returns,this is a function of- Magnitude of competitive advantages- Sustainability of competitive advantages

Stable growth firm,with no or very

limited excess returns

Cost of capital to apply to discounting cashflowsDetermined by

- Operating risk of the company- Default risk of the company- Mix of debt and equity used in financing

How well do you manage yourexisting investments/assets?

Is there scope for moreefficient utilization ofexsting assets?

Are you building on yourcompetitive advantages?

Are you using the rightamount and kind ofdebt for your firm?

Current Cashflow to FirmI - = -. = ,

- Nt CpX= 2,101- Chg WC 241= ,

e nves men a e ==53.72%

e urn on cap a = . %

Expected Growthn -t

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Stable Growthg = %; e a = . ;

os o cap a = . %ROC= 9%;

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Disney - RestructuredReinvestment Rate . %

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Terminal Value10= 5067/(.0719-.03) = 120,982

Cost of Equity.

Cost of Debt. %+ . % -.

= . %Based on synthetic A rating

e g tsE = 60% D = 40%

os o ap a = . % . + . % . = . %

p. sse s ,+ as : ,+ Non op inv 1,763- e ,- nor y n ,=Equity 68621-Options 528

a ue are .

Riskfree Rate:

Riskfree rate = 3.5% +eta

. X

Risk Premium

6%

n evere e a orSectors: 0.7333

Term Yr7600

5067

n une , , sneywas trading at 24.34/share

rs yearsGrowth decreasesgradually to 3%

D/E=66.67%

Cost of capital graduallydecreases to 7.19%

Year 1 2 3 4 5 6 7 8 9 10EBIT (1-t) $4,640 $4,939 $5,257 $5,596 $5,957 $6,300 $6,619 $6,909 $7,164 $7,379- Reinvestment$2,492 $2,653 $2,824 $3,006 $3,200 $3,127 $3,016 $2,866 $2,680 $2,460

FCFF $2,147 $2,286 $2,433 $2,590 $2,757 $3,172 $3,603 $4,043 $4,484 $4,919

Aswath Damodaran255

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