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CostsofHybrids

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¨ Preferredstocksharessomeofthecharacteristicsofdebt- thepreferreddividendispre-specifiedatthetimeoftheissueandispaidoutbeforecommondividend--andsomeofthecharacteristicsofequity- thepaymentsofpreferreddividendarenottaxdeductible.Ifpreferredstockisviewedasperpetual,thecostofpreferredstockcanbewrittenasfollows:¤ kps=PreferredDividendpershare/MarketPriceperpreferredshare

¨ Convertibledebtispartdebt(thebondpart)andpartequity(theconversionoption).Itisbesttobreakitupintoitscomponentpartsandeliminateitfromthemixaltogether.

185

WeightsforCostofCapitalCalculation

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¨ Theweightsusedinthecostofcapitalcomputationshouldbemarketvalues.

¨ Therearethreespeciousargumentsusedagainstmarketvalue¤ Bookvalueismorereliablethanmarketvaluebecauseitisnotas

volatile:Whileitistruethatbookvaluedoesnotchangeasmuchasmarketvalue,thisismoreareflectionofweaknessthanstrength

¤ Usingbookvalueratherthanmarketvalueisamoreconservativeapproachtoestimatingdebtratios:Formostcompanies,usingbookvalueswillyieldalowercostofcapitalthanusingmarketvalueweights.

¤ Sinceaccountingreturnsarecomputedbaseduponbookvalue,consistencyrequirestheuseofbookvalueincomputingcostofcapital:Whileitmayseemconsistenttousebookvaluesforbothaccountingreturnandcostofcapitalcalculations,itdoesnotmakeeconomicsense.

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Disney:Frombookvaluetomarketvalueforinterestbearingdebt…¨ InDisney’s2013financialstatements,thedebtdueovertimewasfootnoted.

¨ Disney’stotaldebtdue,inbookvalueterms,onthebalancesheetis$14,288millionandthetotalinterestexpensefortheyearwas$349million.Using3.75%asthepre-taxcostofdebt:

¨ EstimatedMVofDisneyDebt=

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Time due Amount due Weight Weight *Maturity

0.5 $1,452 11.96% 0.062 $1,300 10.71% 0.213 $1,500 12.36% 0.374 $2,650 21.83% 0.876 $500 4.12% 0.258 $1,362 11.22% 0.99 $1,400 11.53% 1.04

19 $500 4.12% 0.7826 $25 0.21% 0.0528 $950 7.83% 2.1929 $500 4.12% 1.19

$12,139 7.92

349(1− 1

(1.0375)7.92

.0375

"

#

$$$$

%

&

''''

+14, 288

(1.0375)7.92 = $13, 028 million

The debt in this table does not add up to the book value of debt, because Disney does not break down the maturity of all of its debt.

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OperatingLeasesatDisney

¨ The“debtvalue” ofoperatingleasesisthepresentvalueoftheleasepayments,ataratethatreflectstheirrisk,usuallythepre-taxcostofdebt.

¨ Thepre-taxcostofdebtatDisneyis3.75%.

¨ DebtoutstandingatDisney=$13,028+$2,933=$15,961million

Disney reported $1,784 million in commitments after year 5. Given that their average commitment over the first 5 years, we assumed 5 years @ $356.8 million each.

Aswath Damodaran

Year Commitment Present Value @3.75% 1 $507.00 $488.67 2 $422.00 $392.05 3 $342.00 $306.24 4 $272.00 $234.76 5 $217.00 $180.52

6-10 $356.80 $1,330.69 Debt value of leases $2,932.93

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ApplicationTest:EstimatingMarketValue

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¨ Estimatethe¤ MarketvalueofequityatyourfirmandBookValueofequity

¤ Marketvalueofdebtandbookvalueofdebt(Ifyoucannotfindtheaveragematurityofyourdebt,use3years):Remembertocapitalizethevalueofoperatingleasesandaddthemontoboththebookvalueandthemarketvalueofdebt.

¨ Estimatethe¤ Weightsforequityanddebtbaseduponmarketvalue¤ Weightsforequityanddebtbaseduponbookvalue

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CurrentCostofCapital:Disney

¨ Equity¤ CostofEquity=Riskfree rate+Beta*RiskPremium

=2.75%+1.0013(5.76%)=8.52%¤ MarketValueofEquity= $121,878million¤ Equity/(Debt+Equity )= 88.42%

¨ Debt¤ After-taxCostofdebt=(Riskfree rate+DefaultSpread)(1-t)

=(2.75%+1%)(1-.361)= 2.40%¤ MarketValueofDebt=$13,028+$2933= $15,961million¤ Debt/(Debt+Equity)= 11.58%

¨ CostofCapital=8.52%(.8842)+2.40%(.1158)=7.81%

121,878/ (121,878+15,961)Aswath Damodaran

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DivisionalCostsofCapital:DisneyandVale

Disney

Vale

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!!Cost!of!equity!

Cost!of!debt!

Marginal!tax!rate!

After6tax!cost!of!debt!

Debt!ratio!

Cost!of!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%!

Business Cost of equity

After-tax cost of debt

Debt ratio

Cost of capital (in US$)

Cost of capital (in $R)

Metals & Mining 11.35% 2.67% 35.48% 8.27% 15.70% Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55% Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63% Logistics 10.29% 2.67% 35.48% 7.59% 14.97% Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%

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CostsofCapital:TataMotors,BaiduandBookscape

¨ ToestimatethecostsofcapitalforTataMotorsinIndianrupees:Costofcapital=14.49%(1-.2928)+6.50%(.2928)=12.15%

¨ ForBaidu,wefollowthesamepathtoestimateacostofequityinChineseRMB:Costofcapital=12.91%(1-.0523)+3.45%(.0523)=12.42%

¨ ForBookscape,thecostofcapitalisdifferentdependingonwhetheryoulookatmarketortotalbeta:

Aswath Damodaran

Cost of equity Pre-tax Cost of debt

After-tax cost of debt D/(D+E) Cost of capital

Market Beta 7.46% 4.05% 2.43% 17.63% 6.57% Total Beta 11.98% 4.05% 2.43% 17.63% 10.30%

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ApplicationTest:EstimatingCostofCapital

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¨ Usingthebottom-upunleveredbetathatyoucomputedforyourfirm,andthevaluesofdebtandequityyouhaveestimatedforyourfirm,estimateabottom-upleveredbetaandcostofequityforyourfirm.

¨ Baseduponthecostsofequityanddebtthatyouhaveestimated,andtheweightsforeach,estimatethecostofcapitalforyourfirm.

¨ Howdifferentwouldyourcostofcapitalhavebeen,ifyouusedbookvalueweights?

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ChoosingaHurdleRate

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¨ Eitherthecostofequityorthecostofcapitalcanbeusedasahurdlerate,dependinguponwhetherthereturnsmeasuredaretoequityinvestorsortoallclaimholdersonthefirm(capital)

¨ Ifreturnsaremeasuredtoequityinvestors,theappropriatehurdlerateisthecostofequity.

¨ Ifreturnsaremeasuredtocapital(orthefirm),theappropriatehurdlerateisthecostofcapital.

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BacktoFirstPrinciples

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MEASURINGINVESTMENTRETURNSI:THEMECHANICSOFINVESTMENTANALYSIS

“Showmethemoney”fromJerryMaguire

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FirstPrinciples

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Measuresofreturn:earningsversuscashflows

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¨ PrinciplesGoverningAccountingEarningsMeasurement¤ AccrualAccounting:Showrevenueswhenproductsandservicesare

soldorprovided,notwhentheyarepaidfor.Showexpensesassociatedwiththeserevenuesratherthancashexpenses.

¤ OperatingversusCapitalExpenditures:Onlyexpensesassociatedwithcreatingrevenuesinthecurrentperiodshouldbetreatedasoperatingexpenses.Expensesthatcreatebenefitsoverseveralperiodsarewrittenoffovermultipleperiods(asdepreciationoramortization)

¨ Togetfromaccountingearningstocashflows:¤ youhavetoaddbacknon-cashexpenses(likedepreciation)¤ youhavetosubtractoutcashoutflowswhicharenotexpensed(such

ascapitalexpenditures)¤ youhavetomakeaccrualrevenuesandexpensesintocashrevenues

andexpenses(byconsideringchangesinworkingcapital).

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MeasuringReturnsRight:TheBasicPrinciples

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¨ Usecashflowsratherthanearnings.Youcannotspendearnings.

¨ Use“incremental” cashflowsrelatingtotheinvestmentdecision,i.e.,cashflowsthatoccurasaconsequenceofthedecision,ratherthantotalcashflows.

¨ Use“timeweighted” returns,i.e.,valuecashflowsthatoccurearliermorethancashflowsthatoccurlater.TheReturnMantra:“Time-weighted,IncrementalCash

FlowReturn”

199

Settingthetable:Whatisaninvestment/project?

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¨ Aninvestment/projectcanrangethespectrumfrombigtosmall,moneymakingtocostsaving:¤ Majorstrategicdecisionstoenternewareasofbusinessornew

markets.¤ Acquisitionsofotherfirmsareprojectsaswell,notwithstanding

attemptstocreateseparatesetsofrulesforthem.¤ Decisionsonnewventureswithinexistingbusinessesormarkets.¤ Decisionsthatmaychangethewayexistingventuresandprojectsare

run.¤ Decisionsonhowbesttodeliveraservicethatisnecessaryforthe

businesstorunsmoothly.¨ Putinbroaderterms,everychoicemadebyafirmcanbe

framedasaninvestment.

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Herearefourexamples…

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¨ RioDisney:WewillconsiderwhetherDisneyshouldinvestinitsfirstthemeparksinSouthAmerica.Theseparks,whilesimilartothosethatDisneyhasinotherpartsoftheworld,willrequireustoconsidertheeffectsofcountryriskandcurrencyissuesinprojectanalysis.

¨ NewironoremineforVale:ThisisanironoreminethatValeisconsideringinWesternLabrador,Canada.

¨ AnOnlineStoreforBookscape:Bookscapeisevaluatingwhetheritshouldcreateanonlinestoretosellbooks.Whileitisanextensionoftheirbasisbusiness,itwillrequiredifferentinvestments(andpotentiallyexposethemtodifferenttypesofrisk).

¨ AcquisitionofHarmanbyTataMotors:Across-borderbidbyTataforHarmanInternational,apubliclytradedUSfirmthatmanufactureshigh-endaudioequipment,withtheintentofupgradingtheaudioupgradesonTataMotors’automobiles.Thisinvestmentwillallowustoexaminecurrencyandriskissuesinsuchatransaction.

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EarningsversusCashFlows:ADisneyThemePark

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¨ ThethemeparkstobebuiltnearRio,modeledonEuroDisneyinParisandDisneyWorldinOrlando.

¨ Thecomplexwillincludea“MagicKingdom” tobeconstructed,beginningimmediately,andbecomingoperationalatthebeginningofthesecondyear,andasecondthemeparkmodeledonEpcotCenteratOrlandotobeconstructedinthesecondandthirdyearandbecomingoperationalatthebeginningofthefourthyear.

¨ TheearningsandcashflowsareestimatedinnominalU.S.Dollars.

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KeyAssumptionsonStartUpandConstruction

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¨ Disneyhasalreadyspent$0.5Billionresearchingtheproposalandgettingthenecessarylicensesforthepark;noneofthisinvestmentcanberecoverediftheparkisnotbuilt.Thisexpenditurehasbeencapitalizedandwillbedepreciatedstraightlineovertenyearstoasalvagevalueofzero.

¨ Disneywillfacesubstantialconstructioncosts,ifitchoosestobuildthethemeparks.¤ ThecostofconstructingMagicKingdomwillbe$3billion,with$2billion

tobespentrightnow,and$1Billiontobespentoneyearfromnow.¤ ThecostofconstructingEpcotIIwillbe$1.5billion,with$1billiontobe

spentattheendofthesecondyearand$0.5billionattheendofthethirdyear.

¤ Theseinvestmentswillbedepreciatedbaseduponadepreciationscheduleinthetaxcode,wheredepreciationwillbedifferenteachyear.

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KeyRevenueAssumptions

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¨ Revenueestimatesfortheparksandresortproperties(inmillions)Year MagicKingdom EpcotII ResortPropertiesTotal1 $0 $0 $0 $02 $1,000 $0 $250 $1,2503 $1,400 $0 $350 $1.7504 $1,700 $300 $500 $2.5005 $2,000 $500 $625 $3.1256 $2,200 $550 $688 $3,4387 $2,420 $605 $756 $3,7818 $2,662 $666 $832 $4,1599 $2,928 $732 $915 $4,57510 $2,987 $747 $933 $4,667¨

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KeyExpenseAssumptions

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¨ Theoperatingexpensesareassumedtobe60%oftherevenuesattheparks,and75%ofrevenuesattheresortproperties.

¨ Disneywillalsoallocatecorporategeneralandadministrativecoststothisproject,baseduponrevenues;theG&Aallocationwillbe15%oftherevenueseachyear.Itisworthnotingthatarecentanalysisoftheseexpensesfoundthatonlyone-thirdoftheseexpensesarevariable(andafunctionoftotalrevenue)andthattwo-thirdsarefixed.

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DepreciationandCapitalMaintenance

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¨ Thecapitalmaintenanceexpendituresarelowintheearlyyears,whentheparksarestillnewbutincreaseastheparksage.

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OtherAssumptions

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¨ Disneywillhavetomaintainnon-cashworkingcapital(primarilyconsistingofinventoryatthethemeparksandtheresortproperties,nettedagainstaccountspayable)of5%ofrevenues,withtheinvestmentsbeingmadeattheendofeachyear.

¨ TheincomefromtheinvestmentwillbetaxedatDisney’smarginaltaxrateof36.1%.

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Layingthegroundwork:BookCapital,WorkingCapitalandDepreciation

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12.5% of book value at end of prior year ($3,000)

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Step1:EstimateAccountingEarningsonProject

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AndtheAccountingViewofReturn

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(a) Based upon average book capital over the year(b) Based upon book capital at the start of each year

Year

After-tax Operating Income

BV of pre-project

investment

BV of fixed assets

BV of Working capital

BV of Capital

Average BV of Capital ROC(a) ROC(b)

0 500 2000 0 $2,500 1 -$32 $450 $3,000 $0 $3,450 $2,975 -1.07% -1.28% 2 -$96 $400 $3,813 $63 $4,275 $3,863 -2.48% -2.78% 3 -$54 $350 $4,145 $88 $4,582 $4,429 -1.22% -1.26% 4 $68 $300 $4,027 $125 $4,452 $4,517 1.50% 1.48% 5 $202 $250 $3,962 $156 $4,368 $4,410 4.57% 4.53% 6 $249 $200 $3,931 $172 $4,302 $4,335 5.74% 5.69% 7 $299 $150 $3,931 $189 $4,270 $4,286 6.97% 6.94% 8 $352 $100 $3,946 $208 $4,254 $4,262 8.26% 8.24% 9 $410 $50 $3,978 $229 $4,257 $4,255 9.62% 9.63% 10 $421 $0 $4,010 $233 $4,243 $4,250 9.90% 9.89%

Average 4.18% 4.11%

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Whatshouldthisreturnbecomparedto?

¨ Thecomputedreturnoncapitalonthisinvestmentisabout4.18%.Tomakeajudgmentonwhetherthisisasufficientreturn,weneedtocomparethisreturntoa“hurdlerate”.Whichofthefollowingistherighthurdlerate?Whyorwhynot?a. Theriskfreerateof2.75%(T.Bondrate)b. ThecostofequityforDisneyasacompany(8.52%)c. ThecostofequityforDisneythemeparks(7.09%)d. ThecostofcapitalforDisneyasacompany(7.81%)e. ThecostofcapitalforDisneythemeparks(6.61%)f. Noneoftheabove

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211

Shouldtherebeariskpremiumforforeignprojects?

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¨ Theexchangerateriskshouldbediversifiablerisk(andhenceshouldnotcommandapremium)if¤ thecompanyhasprojectsisalargenumberofcountries(or)¤ theinvestorsinthecompanyaregloballydiversified.¤ ForDisney,thisriskshouldnotaffectthecostofcapitalused.

Consequently,wewouldnotadjustthecostofcapitalforDisney’sinvestmentsinothermaturemarkets(Germany,UK,France)

¨ Thesamediversificationargumentcanalsobeappliedagainstsomepoliticalrisk,whichwouldmeanthatittooshouldnotaffectthediscountrate.However,thereareaspectsofpoliticalriskespeciallyinemergingmarketsthatwillbedifficulttodiversifyandmayaffectthecashflows,byreducingtheexpectedlifeorcashflowsontheproject.

¨ ForDisney,thisistheriskthatweareincorporatingintothecostofcapitalwhenitinvestsinBrazil(oranyotheremergingmarket)

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Shouldtherebeariskpremiumforforeignprojects?¨ Theexchangerateriskshouldbediversifiablerisk(andhence

shouldnotcommandapremium)if¤ thecompanyhasprojectsisalargenumberofcountries(or)¤ theinvestorsinthecompanyaregloballydiversified.¤ ForDisney,thisriskshouldnotaffectthecostofcapitalused.

Consequently,wewouldnotadjustthecostofcapitalforDisney’sinvestmentsinothermaturemarkets(Germany,UK,France)

¨ Thesamediversificationargumentcanalsobeappliedagainstsomepoliticalrisk,whichwouldmeanthatittooshouldnotaffectthediscountrate.However,thereareaspectsofpoliticalriskespeciallyinemergingmarketsthatwillbedifficulttodiversifyandmayaffectthecashflows,byreducingtheexpectedlifeorcashflowsontheproject.

¨ ForDisney,thisistheriskthatweareincorporatingintothecostofcapitalwhenitinvestsinBrazil(oranyotheremergingmarket)

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EstimatingahurdlerateforRioDisney

¨ Wedidestimateacostofcapitalof6.61%fortheDisneythemeparkbusiness,usingabottom-upleveredbetaof0.7537forthebusiness.

¨ Thiscostofequitymaynotadequatelyreflecttheadditionalriskassociatedwiththethemeparkbeinginanemergingmarket.

¨ Theonlyconcernwewouldhavewithusingthiscostofequityforthisprojectisthatitmaynotadequatelyreflecttheadditionalriskassociatedwiththethemeparkbeinginanemergingmarket(Brazil).WefirstcomputedtheBrazilcountryriskpremium(bymultiplyingthedefaultspreadforBrazilbytherelativeequitymarketvolatility)andthenre-estimatedthecostofequity:¤ CountryriskpremiumforBrazil=5.5%+3%=8.5%¤ CostofEquityinUS$=2.75%+0.7537(8.5%)=9.16%

¨ Usingthisestimateofthecostofequity,Disney’sthemeparkdebtratioof10.24%anditsafter-taxcostofdebtof2.40%(seechapter4),wecanestimatethecostofcapitalfortheproject:¤ CostofCapitalinUS$=9.16%(0.8976)+2.40%(0.1024)=8.46%

Aswath Damodaran