valuation: packet 3 real options, acquisition...

VALUATION:PACKET3REALOPTIONS,ACQUISITIONVALUATIONANDVALUEENHANCEMENTAswathDamodaranUpdated:September2016

Aswath Damodaran 1

REALOPTIONS:FACTANDFANTASY

AswathDamodaran

Aswath Damodaran 2

UnderlyingTheme:SearchingforanElusivePremium

Aswath Damodaran

¨ Traditionaldiscountedcashflow modelsunderestimatethevalueofinvestments,wherethereareoptionsembeddedintheinvestmentsto¤ Delayordefermakingtheinvestment(delay)¤ Adjustoralterproductionschedulesaspricechanges(flexibility)¤ Expandintonewmarketsorproductsatlaterstagesintheprocess,baseduponobservingfavorableoutcomesattheearlystages(expansion)

¤ Stopproductionorabandoninvestmentsiftheoutcomesareunfavorableatearlystages(abandonment)

¨ Putanotherway,realoptionadvocatesbelievethatyoushouldbepayingapremiumondiscountedcashflowvalueestimates.

Abadinvestment…

Aswath Damodaran

Success

Failure

Becomesagoodone…

Aswath Damodaran

ThreeBasicQuestions

Aswath Damodaran

¨ Whenistherearealoptionembeddedinadecisionoranasset?

¨ Whendoesthatrealoptionhavesignificanteconomicvalue?

¨ Canthatvaluebeestimatedusinganoptionpricingmodel?

Whenisthereanoptionembeddedinanaction?

Aswath Damodaran

¨ Anoptionprovidestheholderwiththerighttobuyorsellaspecifiedquantityofanunderlyingassetatafixedprice(calledastrikepriceoranexerciseprice)atorbeforetheexpirationdateoftheoption.

¨ Therehastobeaclearlydefinedunderlyingassetwhosevaluechangesovertimeinunpredictableways.

¨ Thepayoffsonthisasset(realoption)havetobecontingentonanspecifiedeventoccurringwithinafiniteperiod.

PayoffDiagramonaCall

Aswath Damodaran

Price of underlying asset

StrikePrice

Net Payoff on Call

PayoffDiagramonPutOption

Aswath Damodaran

Price of underlying asset

StrikePrice

Net PayoffOn Put

Whendoestheoptionhavesignificanteconomicvalue?

Aswath Damodaran

¨ Foranoptiontohavesignificanteconomicvalue,therehastobearestrictiononcompetitionintheeventofthecontingency.Inaperfectlycompetitiveproductmarket,nocontingency,nomatterhowpositive,willgeneratepositivenetpresentvalue.

¨ Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivity- youandonlyyoucantakeadvantageofthecontingency.Theybecomelessvaluableasthebarrierstocompetitionbecomelesssteep.

Determinantsofoptionvalue

Aswath Damodaran

¨ VariablesRelatingtoUnderlyingAsset¤ ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice

(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)willbecomelessvaluable.

¤ Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecomemorevaluablebecausealloptionshavelimiteddownsideanddependuponpricevolatilityforupside.

¤ Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciationcomponentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.

¨ VariablesRelatingtoOption¤ StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)

valuableatalowerprice.¤ LifeoftheOption;bothcallsandputsbenefitfromalongerlife.

¨ LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedpriceinthefuturebecomesmore(less)valuable.

Whencanyouuseoptionpricingmodelstovaluerealoptions?

Aswath Damodaran

¨ Thenotionofareplicatingportfoliothatdrivesoptionpricingmodelsmakesthemmostsuitedforvaluingrealoptionswhere¤ Theunderlyingassetistraded- thisyieldnotonlyobservableprices

andvolatilityasinputstooptionpricingmodelsbutallowsforthepossibilityofcreatingreplicatingportfolios

¤ Anactivemarketplaceexistsfortheoptionitself.¤ Thecostofexercisingtheoptionisknownwithsomedegreeof

certainty.¨ Whenoptionpricingmodelsareusedtovaluerealassets,we

havetoacceptthefactthat¤ Thevalueestimatesthatemergewillbefarmoreimprecise.¤ Thevaluecandeviatemuchmoredramaticallyfrommarketprice

becauseofthedifficultyofarbitrage.

Creatingareplicatingportfolio

Aswath Damodaran

¨ Theobjectiveincreatingareplicatingportfolioistouseacombinationofriskfreeborrowing/lendingandtheunderlyingassettocreatethesamecashflowsastheoptionbeingvalued.¤ Call=Borrowing+BuyingDoftheUnderlyingStock¤ Put=SellingShortDonUnderlyingAsset+Lending¤ Thenumberofsharesboughtorsoldiscalledtheoptiondelta.

¨ Theprinciplesofarbitragethenapply,andthevalueoftheoptionhastobeequaltothevalueofthereplicatingportfolio.

TheBinomialOptionPricingModel

Aswath Damodaran

K = $ 40t = 2r = 11%

Option Details

StockPrice Call

50 D - 1.11 B = 1025 D - 1.11 B = 0D = 0.4, B = 9.01Call = 0.4 * 35 - 9.01 = 4.99

Call = 4.99

100 D - 1.11 B = 6050 D - 1.11 B = 10D = 1, B = 36.04Call = 1 * 70 - 36.04 = 33.96

Call = 33.9670 D - 1.11 B = 33.9635 D - 1.11 B = 4.99D = 0.8278, B = 21.61Call = 0.8278 * 50 - 21.61 = 19.42

Call = 19.42

TheLimitingDistributions….

Aswath Damodaran

¨ Asthetimeintervalisshortened,thelimitingdistribution,ast->0,cantakeoneoftwoforms.¤ Ifast->0,pricechangesbecomesmaller,thelimitingdistributionisthenormaldistributionandthepriceprocessisacontinuousone.

¤ Ifast->0,pricechangesremainlarge,thelimitingdistributionisthepoisson distribution,i.e.,adistributionthatallowsforpricejumps.

¨ TheBlack-Scholesmodelapplieswhenthelimitingdistributionisthenormaldistribution,andexplicitlyassumesthatthepriceprocessiscontinuousandthattherearenojumpsinassetprices.

BlackandScholes…

Aswath Damodaran

¨ TheversionofthemodelpresentedbyBlackandScholeswasdesignedtovalueEuropeanoptions,whichweredividend-protected.

¨ ThevalueofacalloptionintheBlack-Scholesmodelcanbewrittenasafunctionofthefollowingvariables:¤ S=Currentvalueoftheunderlyingasset¤ K=Strikepriceoftheoption¤ t=Lifetoexpirationoftheoption¤ r=Risklessinterestratecorrespondingtothelifeoftheoption¤ s2 =Varianceintheln(value)oftheunderlyingasset

TheBlackScholesModel

Aswath Damodaran

Valueofcall=SN(d1)- Ke-rt N(d2)where

d2=d1-s √t

¨ ThereplicatingportfolioisembeddedintheBlack-Scholesmodel.Toreplicatethiscall,youwouldneedto¤ BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta¤ BorrowKe-rt N(d2)

d1 = ln

# $ + (r + σ

TheNormalDistribution

Aswath Damodaran

d N(d) d N(d) d N(d)-3.00 0.0013 -1.00 0.1587 1.05 0.8531 -2.95 0.0016 -0.95 0.1711 1.10 0.8643 -2.90 0.0019 -0.90 0.1841 1.15 0.8749 -2.85 0.0022 -0.85 0.1977 1.20 0.8849 -2.80 0.0026 -0.80 0.2119 1.25 0.8944 -2.75 0.0030 -0.75 0.2266 1.30 0.9032 -2.70 0.0035 -0.70 0.2420 1.35 0.9115 -2.65 0.0040 -0.65 0.2578 1.40 0.9192 -2.60 0.0047 -0.60 0.2743 1.45 0.9265 -2.55 0.0054 -0.55 0.2912 1.50 0.9332 -2.50 0.0062 -0.50 0.3085 1.55 0.9394 -2.45 0.0071 -0.45 0.3264 1.60 0.9452 -2.40 0.0082 -0.40 0.3446 1.65 0.9505 -2.35 0.0094 -0.35 0.3632 1.70 0.9554 -2.30 0.0107 -0.30 0.3821 1.75 0.9599 -2.25 0.0122 -0.25 0.4013 1.80 0.9641 -2.20 0.0139 -0.20 0.4207 1.85 0.9678 -2.15 0.0158 -0.15 0.4404 1.90 0.9713 -2.10 0.0179 -0.10 0.4602 1.95 0.9744 -2.05 0.0202 -0.05 0.4801 2.00 0.9772 -2.00 0.0228 0.00 0.5000 2.05 0.9798 -1.95 0.0256 0.05 0.5199 2.10 0.9821 -1.90 0.0287 0.10 0.5398 2.15 0.9842 -1.85 0.0322 0.15 0.5596 2.20 0.9861 -1.80 0.0359 0.20 0.5793 2.25 0.9878 -1.75 0.0401 0.25 0.5987 2.30 0.9893 -1.70 0.0446 0.30 0.6179 2.35 0.9906 -1.65 0.0495 0.35 0.6368 2.40 0.9918 -1.60 0.0548 0.40 0.6554 2.45 0.9929 -1.55 0.0606 0.45 0.6736 2.50 0.9938 -1.50 0.0668 0.50 0.6915 2.55 0.9946 -1.45 0.0735 0.55 0.7088 2.60 0.9953 -1.40 0.0808 0.60 0.7257 2.65 0.9960 -1.35 0.0885 0.65 0.7422 2.70 0.9965 -1.30 0.0968 0.70 0.7580 2.75 0.9970 -1.25 0.1056 0.75 0.7734 2.80 0.9974 -1.20 0.1151 0.80 0.7881 2.85 0.9978 -1.15 0.1251 0.85 0.8023 2.90 0.9981 -1.10 0.1357 0.90 0.8159 2.95 0.9984 -1.05 0.1469 0.95 0.8289 3.00 0.9987 -1.00 0.1587 1.00 0.8413

AdjustingforDividends

Aswath Damodaran

¨ Ifthedividendyield(y=dividends/Currentvalueoftheasset)oftheunderlyingassetisexpectedtoremainunchangedduringthelifeoftheoption,theBlack-Scholesmodelcanbemodifiedtotakedividendsintoaccount.

¨ C=Se-yt N(d1)- Ke-rt N(d2)where,

d2=d1-s √t¨ Thevalueofaputcanalsobederived:¨ P=Ke-rt (1-N(d2))- Se-yt (1-N(d1))

d1 = ln S

# $ + (r - y + σ

ChoiceofOptionPricingModels

Aswath Damodaran

¨ MostpractitionerswhouseoptionpricingmodelstovaluerealoptionsargueforthebinomialmodelovertheBlack-Scholesandjustifythischoicebynotingthat¤ Earlyexerciseistheruleratherthantheexceptionwithrealoptions

¤ Underlyingassetvaluesaregenerallydiscontinous.¨ Ifyoucandevelopabinomialtreewithoutcomesateachnode,itlooksagreatdeallikeadecisiontreefromcapitalbudgeting.Thequestionthenbecomeswhenandwhythetwoapproachesyielddifferentestimatesofvalue.

TheDecisionTreeAlternative

Aswath Damodaran

¨ Traditionaldecisiontreeanalysistendstouse¤ Onecostofcapitaltodiscountcashflows ineachbranchtothepresent¤ Probabilitiestocomputeanexpectedvalue¤ Thesevalueswillgenerallybedifferentfromoptionpricingmodel

values¨ Ifyoumodifieddecisiontreeanalysisto

¤ Usedifferentdiscountratesateachnodetoreflectwhereyouareinthedecisiontree(ThisistheCopelandsolution) (or)

¤ Usetheriskfree ratetodiscountcashflows ineachbranch,estimatetheprobabilitiestoestimateanexpectedvalueandadjusttheexpectedvalueforthemarketriskintheinvestment

¨ DecisionTreescouldyieldthesamevaluesasoptionpricingmodels

AdecisiontreevaluationofapharmaceuticalcompanywithonedrugintheFDApipeline…

Aswath Damodaran

Abandon

Succeed

30%-$50

-$140.91

Types 1 & 2

Type 2

Type 1

Develop

Abandon

Develop

Abandon

Develop

Abandon

Succeed

20%-$328.74

-$328.74

$585.62

-$328.74

-$97.43-$366.30

-$366.30

$887.05

$50.36

$93.37

$573.71

-$143.69

$402.75

KeyTestsforRealOptions

Aswath Damodaran

¨ Isthereanoptionembeddedinthisasset/decision?¤ Canyouidentifytheunderlyingasset?¤ Canyouspecifythecontingencyunderwhichyouwillgetpayoff?

¨ Isthereexclusivity?¤ Ifyes,thereisoptionvalue.¤ Ifno,thereisnone.¤ Ifinbetween,youhavetoscalevalue.

¨ Canyouuseanoptionpricingmodeltovaluetherealoption?¤ Istheunderlyingassettraded?¤ Cantheoptionbeboughtandsold?¤ Isthecostofexercisingtheoptionknownandclear?

I.OptionsinProjects/Investments/Acquisitions

Aswath Damodaran

¨ Oneofthelimitationsoftraditionalinvestmentanalysisisthatitisstaticanddoesnotdoagoodjobofcapturingtheoptionsembeddedininvestment.¤ Thefirstoftheseoptionsistheoptiontodelaytakingainvestment,whenafirmhasexclusiverightstoit,untilalaterdate.

¤ Thesecondoftheseoptionsistakingoneinvestmentmayallowustotakeadvantageofotheropportunities(investments)inthefuture

¤ Thelastoptionthatisembeddedinprojectsistheoptiontoabandonainvestment,ifthecashflowsdonotmeasureup.

¨ Theseoptionsalladdvaluetoprojectsandmaymakea“bad” investment(fromtraditionalanalysis)intoagoodone.

A.TheOptiontoDelay

Aswath Damodaran

¨ Whenafirmhasexclusiverightstoaprojectorproductforaspecificperiod,itcandelaytakingthisprojectorproductuntilalaterdate.

¨ Atraditionalinvestmentanalysisjustanswersthequestionofwhethertheprojectisa“good” oneiftakentoday.

¨ Thus,thefactthataprojectdoesnotpassmustertoday(becauseitsNPVisnegative,oritsIRRislessthanitshurdlerate)doesnotmeanthattherightstothisprojectarenotvaluable.

ValuingtheOptiontoDelayaProject

Aswath Damodaran

Present Value of Expected Cash Flows on Product

PV of Cash Flows from Project

Initial Investment in Project

Project has negativeNPV in this section

Project's NPV turns positive in this section

Example1:Valuingproductpatentsasoptions

Aswath Damodaran

¨ Aproductpatentprovidesthefirmwiththerighttodeveloptheproductandmarketit.

¨ Itwilldosoonlyifthepresentvalueoftheexpectedcashflowsfromtheproductsalesexceedthecostofdevelopment.

¨ Ifthisdoesnotoccur,thefirmcanshelvethepatentandnotincuranyfurthercosts.

¨ IfIisthepresentvalueofthecostsofdevelopingtheproduct,andVisthepresentvalueoftheexpectedcashflowsfromdevelopment,thepayoffsfromowningaproductpatentcanbewrittenas:

Payofffromowningaproductpatent =V- I ifV>I=0 ifV≤I

PayoffonProductOption

Aswath Damodaran

Present Value ofcashflows on product

Net Payoff tointroduction

Cost of product introduction

ObtainingInputsforPatentValuation

Input Estimation Process

1. Value of the Underlying Asset • Present Value of Cash Inflows from taking projectnow

• This will be noisy, but that adds value.2. Variance in value of underlying asset • Variance in cash flows of similar assets or firms

• Variance in present value from capital budgetingsimulation.

3. Exercise Price on Option • Option is exercised when investment is made.• Cost of making investment on the project ; assumed

to be constant in present value dollars.4. Expiration of the Option • Life of the patent

5. Dividend Yield • Cost of delay• Each year of delay translates into one less year of

value-creating cashflowsAnnual cost of delay = 1

ValuingaProductPatent:Avonex

Aswath Damodaran

¨ Biogen,abio-technologyfirm,hasapatentonAvonex,adrugtotreatmultiplesclerosis,forthenext17years,anditplanstoproduceandsellthedrugbyitself.

¨ Thekeyinputsonthedrugareasfollows:¤ PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion¤ PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion¤ PatentLife=t=17yearsRisklessRate=r=6.7%(17-yearT.Bond rate)¤ VarianceinExpectedPresentValues=s2 =0.224(Industryaveragefirmvariancefor

bio-techfirms)¤ ExpectedCostofDelay=y=1/17=5.89%

¨ Theoutputfromtheoptionpricingmodel¤ d1=1.1362 N(d1)=0.8720¤ d2=-0.8512 N(d2)=0.2076CallValue=3,422exp(-0.0589)(17)(0.8720)- 2,875exp(-0.067)(17) (0.2076)=$907million

TheOptimalTimetoExercise

Aswath Damodaran

31 Patent value versus Net Present value

17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1Number of years left on patent

Value of patent as option Net present value of patent

Exercise the option here: Convert patent to commercial product

Valuingafirmwithpatents

Aswath Damodaran

¨ Thevalueofafirmwithasubstantialnumberofpatentscanbederivedusingtheoptionpricingmodel.

ValueofFirm=Valueofcommercialproducts(usingDCFvalue+Valueofexistingpatents(usingoptionpricing)+(ValueofNewpatentsthatwillbeobtainedinthe

future– Costofobtainingthesepatents)¨ Thelastinputmeasurestheefficiencyofthefirmin

convertingitsR&Dintocommercialproducts.Ifweassumethatafirmearnsitscostofcapitalfromresearch,thistermwillbecomezero.

¨ Ifweusethisapproach,weshouldbecarefulnottodoublecountandallowforahighgrowthrateincashflows(intheDCFvaluation).

ValueofBiogen’sexistingproducts

Aswath Damodaran

¨ Biogenhadtwocommercialproducts(adrugtotreatHepatitisBandIntron)atthetimeofthisvaluationthatithadlicensedtootherpharmaceuticalfirms.

¨ Thelicensefeesontheseproductswereexpectedtogenerate$50millioninafter-taxcashflowseachyearforthenext12years.

¨ Tovaluethesecashflows,whichwereguaranteedcontractually,the pre-taxcostofdebtoftheguarantorswasused:PresentValueofLicenseFees=$50million(1– (1.07)-12)/.07

=$397.13million

ValueofBiogen’sFutureR&D

Aswath Damodaran

¨ Biogencontinuedtofundresearchintonewproducts,spendingabout$100milliononR&Dinthemostrecentyear.TheseR&Dexpenseswereexpectedtogrow20%ayearforthenext10years,and5%thereafter.

¨ Itwasassumedthateverydollarinvestedinresearchwouldcreate$1.25invalueinpatents(valuedusingtheoptionpricingmodeldescribedabove)forthenext10years,andbreakevenafterthat(i.e.,generate$1inpatentvalueforevery$1investedinR&D).

¨ Therewasasignificantamountofriskassociatedwiththiscomponentandthecostofcapitalwasestimatedtobe15%.

ValueofFutureR&D

Aswath Damodaran

Yr ValueofPatents R&DCost ExcessValue PV(at15%)

1 $150.00 $120.00 $30.00 $26.09

2 $180.00 $144.00 $36.00 $27.22

3 $216.00 $172.80 $43.20 $28.40

4 $259.20 $207.36 $51.84 $29.64

5 $311.04 $248.83 $62.21 $30.93

6 $373.25 $298.60 $74.65 $32.27

7 $447.90 $358.32 $89.58 $33.68

8 $537.48 $429.98 $107.50 $35.14

9 $644.97 $515.98 $128.99 $36.67

10 $773.97 $619.17 $154.79 $38.26

$318.30

ValueofBiogen

Aswath Damodaran

¨ ThevalueofBiogenasafirmisthesumofallthreecomponents– thepresentvalueofcashflowsfromexistingproducts,thevalueofAvonex(asanoption)andthevaluecreatedbynewresearch:Value=Existingproducts+ExistingPatents+Value:FutureR&D

=$397.13million+$907million+$318.30million=$1622.43million

¨ SinceBiogenhadnodebtoutstanding,thisvaluewasdividedbythenumberofsharesoutstanding(35.50million)toarriveatavaluepershare:¤Valuepershare=$1,622.43million/35.5=$45.70

TheRealOptionsTest:PatentsandTechnology

Aswath Damodaran

¨ TheOptionTest:¤ UnderlyingAsset:Productthatwouldbegeneratedbythepatent¤ Contingency:

n IfPVofCFsfromdevelopment>Costofdevelopment:PV- Costn IfPVofCFsfromdevelopment<Costofdevelopment:0

¨ TheExclusivityTest:¤ Patentsrestrictcompetitorsfromdevelopingsimilarproducts¤ Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.

¨ ThePricingTest¤ UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethepresentvaluesand

volatilitiesyourself,youcannotconstructreplicatingpositionsordoarbitrage.¤ Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.¤ CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercialproduction.Here,

experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthecost.

¨ Conclusion:Youcanestimatethevalueoftherealoptionbutthequalityofyourestimatewillbeadirectfunctionofthequalityofyourcapitalbudgeting.Itworksbestifyouarevaluingapubliclytradedfirmthatgeneratesmostofitsvaluefromoneorafewpatents- youcanusethemarketvalueofthefirmandthevarianceinthatvaluetheninyouroptionpricingmodel.

Example2:ValuingNaturalResourceOptions

Aswath Damodaran

¨ Inanaturalresourceinvestment,theunderlyingassetistheresourceandthevalueoftheassetisbasedupontwovariables- thequantityoftheresourcethatisavailableintheinvestmentandthepriceoftheresource.

¨ Inmostsuchinvestments,thereisacostassociatedwithdevelopingtheresource,andthedifferencebetweenthevalueoftheassetextractedandthecostofthedevelopmentistheprofittotheowneroftheresource.

¨ DefiningthecostofdevelopmentasX,andtheestimatedvalueoftheresourceasV,thepotentialpayoffsonanaturalresourceoptioncanbewrittenasfollows:

Payoffonnaturalresourceinvestment =V- X ifV>X=0 ifV≤X

PayoffDiagramonNaturalResourceFirms

Aswath Damodaran

Value of estimated reserve of natural resource

Net Payoff onExtraction

Cost of Developing Reserve

EstimatingInputsforNaturalResourceOptions

1. Value of Available Reserves of the Resource • Expert estimates (Geologists for oil..); Thepresent value of the after-tax cash flows fromthe resource are then estimated.

2. Cost of Developing Reserve (Str ike Price) • Past costs and the specifics of the investment

3. Time to Expiration • Relinqushment Period: if asset has to berelinquished at a point in time.

• Time to exhaust inventory - based uponinventory and capacity output.

4. Variance in value of underlying asset • based upon variability of the price of theresources and variability of available reserves.

5. Net Production Revenue (Dividend Yield) • Net production revenue every year as percentof market value.

6. Development Lag • Calculate present value of reserve based uponthe lag.

ValuingGulfOil

Aswath Damodaran

¨ GulfOilwasthetargetofatakeoverinearly1984at$70pershare(Ithad165.30millionsharesoutstanding,andtotaldebtof$9.9billion).¤ Ithadestimatedreservesof3038millionbarrelsofoilandtheaveragecostofdevelopingthesereserveswasestimatedtobe$10abarrelinpresentvaluedollars(Thedevelopmentlagisapproximatelytwoyears).

¤ Theaveragerelinquishmentlifeofthereservesis12years.¤ Thepriceofoilwas$22.38perbarrel,andtheproductioncost,taxesandroyaltieswereestimatedat$7perbarrel.

¤ Thebondrateatthetimeoftheanalysiswas9.00%.¤ Gulfwasexpectedtohavenetproductionrevenueseachyearofapproximately5%ofthevalueofthedevelopedreserves.Thevarianceinoilpricesis0.03.

ValuingUndevelopedReserves

Aswath Damodaran

¨ Inputsforvaluingundevelopedreserves¤ Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackforperiod

ofdevelopmentlag=3038*($22.38- $7)/1.052 =$42,380.44¤ Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380

million¤ Timetoexpiration=Averagelengthofrelinquishmentoption=12years¤ Varianceinvalueofasset=Varianceinoilprices=0.03¤ Risklessinterestrate=9%¤ Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.6548 N(d1)=0.9510d2=1.0548 N(d2)=0.8542CallValue=42,380.44exp(-0.05)(12)(0.9510)-30,380(exp(-0.09)(12) (0.8542)

=$13,306million

ValuingGulfOil

Aswath Damodaran

¨ Inaddition,GulfOilhadfreecashflows tothefirmfromitsoilandgasproductionof$915millionfromalreadydevelopedreservesandthesecashflows arelikelytocontinuefortenyears(theremaininglifetimeofdevelopedreserves).

¨ Thepresentvalueofthesedevelopedreserves,discountedattheweightedaveragecostofcapitalof12.5%,yields:¤ Valueofalreadydevelopedreserves=915(1- 1.125-10)/.125=$5065.83

¨ AddingthevalueofthedevelopedandundevelopedreservesValueofundevelopedreserves =$13,306millionValueofproductioninplace =$5,066millionTotalvalueoffirm =$18,372millionLessOutstandingDebt =$9,900millionValueofEquity =$8,472millionValuepershare =$8,472/165.3 =$51.25

TheOptiontoExpand/TakeOtherProjects

Aswath Damodaran

¨ Takingaprojecttodaymayallowafirmtoconsiderandtakeothervaluableprojectsinthefuture.

¨ Thus,eventhoughaprojectmayhaveanegativeNPV,itmaybeaprojectworthtakingiftheoptionitprovidesthefirm(totakeotherprojectsinthefuture)providesamore-than-compensatingvalue.

¨ Thesearetheoptionsthatfirmsoftencall“strategicoptions” anduseasarationalefortakingon“negativeNPV” oreven“negativereturn” projects.

B.TheOptiontoExpand

Aswath Damodaran

Present Value of Expected Cash Flows on Expansion

PV of Cash Flows from Expansion

Additional Investment to Expand

Firm will not expand inthis section

Expansion becomes attractive in this section

Theoptiontoexpand:Valuingayoung,start-upcompany

Aswath Damodaran

¨ YouhavecompleteaDCFvaluationofasmallanti-virussoftwarecompany,SecureMail,andestimatedavalueof$115million.

¨ Assumethatthereisthepossibilitythatthecompanycouldusethecustomerbasethatitdevelopsfortheanti-virussoftwareandthetechnologyonwhichthesoftwareisbasedtocreateadatabasesoftwareprogramsometimeinthenext5years.¤ ItwillcostSecureMailabout$500milliontodevelopanewdatabase

program,iftheydecidedtodoittoday.¤ Basedupontheinformationyouhavenowonthepotentialforadatabase

program,thecompanycanexpecttogenerateabout$40millionayearinafter-taxcashflowsfortenyears.Thecostofcapitalforprivatecompaniesthatprovidedatabasesoftwareis12%.

¤ Theannualizedstandarddeviationinfirmvalueatpubliclytradeddatabasecompaniesis50%.

¤ Thefive-yeartreasurybondrateis3%.

ValuingtheExpansionOption

Aswath Damodaran

S =Valueofenteringthedatabasesoftwaremarket=PVof$40millionfor10years@12% =$226million

K =Exerciseprice=Costofenteringthedatabasesoftwaremarket=$500million

t =Periodoverwhichyouhavetherighttoenterthemarket=5years

s =Standarddeviationofstockpricesofdatabasefirms=50%r =Risklessrate=3%¨ CallValue=$56MillionDCFvaluationofthefirm =$115millionValueofOptiontoExpandtoDatabasemarket =$56millionValueofthecompanywithoptiontoexpand =$171million

Anoteofcaution:Opportunitiesarenotoptions…

Aswath Damodaran

An Exclusive Right toSecond Investment

A Zero competitiveadvantage on Second Investment

100% of option valueNo option value

Increasing competitive advantage/ barriers to entry

Pharmaceuticalpatents

TelecomLicenses

Brand Name

TechnologicalEdge

First-Mover

Second Investment has zero excess returns

Second investmenthas large sustainableexcess return

Option has no value Option has high value

Is the first investment necessary for the second investment?

Pre-RequisitNot necessary

TheRealOptionsTestforExpansionOptions

Aswath Damodaran

¨ TheOptionsTest¤ UnderlyingAsset:ExpansionProject¤ Contingency¤ IfPVofCFfromexpansion>ExpansionCost:PV- ExpansionCost¤ IfPVofCFfromexpansion<ExpansionCost:0

¨ TheExclusivityTest¤ Barriersmayrangefromstrong(exclusivelicensesgrantedbythegovernment)toweaker

(brandname,knowledgeofthemarket)toweakest(firstmover).¨ ThePricingTest

¤ UnderlyingAsset:Aswithpatents,thereisnotradingintheunderlyingassetandyouhavetoestimatevalueandvolatility.

¤ Option:Licensesaresometimesboughtandsold,butmorediffuseexpansionoptionsarenot.¤ CostofExercisingtheOption:Notknownwithanyprecisionandmayitselfevolveovertimeas

themarketevolves.¨ Usingoptionpricingmodelstovalueexpansionoptionswillnotonlyyield

extremelynoisyestimates,butmayattachinappropriatepremiumstodiscountedcashflow estimates.

C.TheOptiontoAbandon

Aswath Damodaran

¨ Afirmmaysometimeshavetheoptiontoabandonaproject,ifthecashflowsdonotmeasureuptoexpectations.

¨ Ifabandoningtheprojectallowsthefirmtosaveitselffromfurtherlosses,thisoptioncanmakeaprojectmorevaluable.

Present Value of Expected Cash Flows on Project

PV of Cash Flows from Project

Cost of Abandonment

ValuingtheOptiontoAbandon

Aswath Damodaran

¨ AirbusisconsideringajointventurewithLearAircrafttoproduceasmallcommercialairplane(capableofcarrying40-50passengersonshorthaulflights)¤ Airbuswillhavetoinvest$500millionfora50%shareoftheventure¤ Itsshareofthepresentvalueofexpectedcashflowsis480million.

¨ LearAircraft,whichiseagertoenterintothedeal,offerstobuyAirbus’s50%shareoftheinvestmentanytimeoverthenextfiveyearsfor$400million,ifAirbusdecidestogetoutoftheventure.

¨ Asimulationofthecashflowsonthistimeshareinvestmentyieldsavarianceinthepresentvalueofthecashflowsfrombeinginthepartnershipis0.16.

¨ Theprojecthasalifeof30years.

ProjectwithOptiontoAbandon

Aswath Damodaran

¨ ValueoftheUnderlyingAsset(S)=PVofCashFlowsfromProject =$480million

¨ StrikePrice(K)=SalvageValuefromAbandonment=$400million

¨ VarianceinUnderlyingAsset’sValue=0.16¨ Timetoexpiration=LifeoftheProject=5years¨ DividendYield=1/LifeoftheProject=1/30=0.033(Weareassumingthattheproject’spresentvaluewilldropbyroughly1/neachyearintotheproject)

¨ Assumethatthefive-yearrisklessrateis6%.Thevalueoftheputoptioncanbeestimated.

ShouldAirbusenterintothejointventure?

Aswath Damodaran

ValueofPut=Ke-rt (1-N(d2))- Se-yt (1-N(d1))=400exp(-0.06)(5)(1-0.4624)- 480exp(-0.033)(5)(1-0.7882)=$73.23million

¨ Thevalueofthisabandonmentoptionhastobeaddedontothenetpresentvalueoftheprojectof-$20million,yieldingatotalnetpresentvaluewiththeabandonmentoptionof$53.23million.

ImplicationsforInvestmentAnalysis/Valuation

Aswath Damodaran

¨ Havingaoptiontoabandonaprojectcanmakeotherwiseunacceptableprojectsacceptable.

¨ Otherthingsremainingequal,youwouldattachmorevaluetocompanieswith¤ Morecostflexibility,thatis,makingmoreofthecostsoftheprojectsintovariablecostsasopposedtofixedcosts.

¤ Fewerlong-termcontracts/obligationswithemployeesandcustomers,sincetheseaddtothecostofabandoningaproject.

¨ Theseactionswillundoubtedlycostthefirmsomevalue,butthishastobeweighedoffagainsttheincreaseinthevalueoftheabandonmentoption.

D.OptionsinCapitalStructure

Aswath Damodaran

¨ Themostdirectapplicationsofoptionpricingincapitalstructuredecisionsisinthedesignofsecurities.Infact,mostcomplexfinancialinstrumentscanbebrokendownintosomecombinationofasimplebond/commonstockandavarietyofoptions.¤ Ifthesesecuritiesaretobeissuedtothepublic,andtraded,the

optionshavetobepriced.¤ Ifthesearenon-tradedinstruments(bankloans,forinstance),they

stillhavetobepricedintotheinterestrateontheinstrument.¨ Theotherapplicationofoptionpricingisinvaluingflexibility.

Often,firmspreservedebtcapacityorholdbackonissuingdebtbecausetheywanttomaintainflexibility.

TheValueofFlexibility

Aswath Damodaran

¨ Firmsmaintainexcessdebtcapacityorlargercashbalancesthanarewarrantedbycurrentneeds,tomeetunexpectedfuturerequirements.

¨ Whilemaintainingthisfinancingflexibilityhasvaluetofirms,italsohasacost;theexcessdebtcapacityimpliesthatthefirmisgivingupsomevalueandhasahighercostofcapital.

¨ Thevalueofflexibilitycanbeanalyzedusingtheoptionpricingframework;afirmmaintainslargecashbalancesandexcessdebtcapacityinordertohavetheoptiontotakeprojectsthatmightariseinthefuture.

TheValueofFlexibility

Aswath Damodaran

Actual ReinvestmentNeeds

Expected (Normal) Reinvestment Needs that can be financed without flexibility

Cost of Maintaining Financing Flexibility

Use financing flexibilityto take unanticipatedinvestments (acquisitions)

Payoff: (S-K)*Excess Return/WACC

Excess Return/WACC = PV of excess returns in perpetutity

Disney’sOptimalDebtRatio

Aswath Damodaran

DebtRatio CostofEquity CostofDebt CostofCapital0.00% 13.00% 4.61% 13.00%10.00% 13.43% 4.61% 12.55%Current:18% 13.85% 4.80% 12.22%20.00% 13.96% 4.99% 12.17%30.00% 14.65% 5.28% 11.84%40.00% 15.56% 5.76% 11.64%50.00% 16.85% 6.56% 11.70%60.00% 18.77% 7.68% 12.11%70.00% 21.97% 7.68% 11.97%80.00% 28.95% 7.97% 12.17%90.00% 52.14% 9.42% 13.69%

InputstoOptionValuationModel- Disney

Aswath Damodaran

Model input

Estimated as In general… For Disney

S Expected annual reinvestment needs (as % of firm value)

Measures magnitude of reinvestment needs

Average of Reinvestment/ Value over last 5 years = 5.3%

s2 Variance in annual reinvestment needs

Measures how much volatility there is in investment needs.

Variance over last 5 years in ln(Reinvestment/Value) =0.375

K (Internal + Normal access to external funds)/ Value

Measures the capital constraint

Average over last 5 years = 4.8%

T 1 year Measures an annual value for flexibility

ValuingFlexibilityatDisney

Aswath Damodaran

¨ Thevalueofanoptionwiththesecharacteristicsis1.6092%.Youcanconsiderthisthevalueoftheoptiontotakeaproject,buttheoverallvalueofflexibilitywillstilldependuponthequalityoftheprojectstaken.Inotherwords,thevalueoftheoptiontotakeaprojectiszeroiftheprojecthaszeronetpresentvalue.

¨ Disneyearns18.69%onitsprojectshasacostofcapitalof12.22%.Theexcessreturn(annually)is6.47%.Assumingthattheycancontinuetogeneratetheseexcessreturnsinperpetuity:ValueofFlexibility(annual)=1.6092%(.0647/.1222)=0.85%ofvalue

¨ Disney’scostofcapitalatitsoptimaldebtratiois11.64%.Thecostitincurstomaintainflexibilityistherefore0.58%annually(12.22%-11.64%).Itthereforepaystomaintainflexibility.

DeterminantsoftheValueofFlexibility

Aswath Damodaran

¨ CapitalConstraints(ExternalandInternal):Thegreaterthecapacitytoraisefunds,eitherinternallyorexternally,thelessthevalueofflexibility.¤ 1.1:Firmswithsignificantinternaloperatingcashflowsshouldvalue

flexibilitylessthanfirmswithsmallornegativeoperatingcashflows.¤ 1.2:Firmswitheasyaccesstofinancialmarketsshouldhavealower

valueforflexibilitythanfirmswithoutthataccess.¨ Unpredictabilityofreinvestmentneeds:Themore

unpredictablethereinvestmentneedsofafirm,thegreaterthevalueofflexibility.

¨ Capacitytoearnexcessreturns:Thegreaterthecapacitytoearnexcessreturns,thegreaterthevalueofflexibility.¤ 1.3:Firmsthatdonothavethecapacitytoearnorsustainexcess

returnsgetnovaluefromflexibility.

E.ValuingEquityasanoption

Aswath Damodaran

¨ Theequityinafirmisaresidualclaim,i.e.,equityholderslayclaimtoallcashflowsleftoverafterotherfinancialclaim-holders(debt,preferredstocketc.)havebeensatisfied.

¨ Ifafirmisliquidated,thesameprincipleapplies,withequityinvestorsreceivingwhateverisleftoverinthefirmafteralloutstandingdebtsandotherfinancialclaimsarepaidoff.

¨ Theprincipleoflimitedliability,however,protectsequityinvestorsinpubliclytradedfirmsifthevalueofthefirmislessthanthevalueoftheoutstandingdebt,andtheycannotlosemorethantheirinvestmentinthefirm.

PayoffDiagramforLiquidationOption

Aswath Damodaran

Value of firm

Net Payoffon Equity

Face Valueof Debt

Applicationtovaluation:Asimpleexample

Aswath Damodaran

¨ Assumethatyouhaveafirmwhoseassetsarecurrentlyvaluedat$100millionandthatthestandarddeviationinthisassetvalueis40%.

¨ Further,assumethatthefacevalueofdebtis$80million(Itiszerocoupondebtwith10yearslefttomaturity).

¨ Iftheten-yeartreasurybondrateis10%,¤ howmuchistheequityworth?¤ Whatshouldtheinterestrateondebtbe?

ModelParameters

Aswath Damodaran

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million

¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million

¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years

¨ Varianceinthevalueoftheunderlyingasset=s2

¤ Varianceinfirmvalue=0.16¨ Risklessrate=r

¤ Treasurybondratecorrespondingtooptionlife=10%

ValuingEquityasaCallOption

Aswath Damodaran

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.5994 N(d1)=0.9451d2=0.3345 N(d2)=0.6310

¨ Valueofthecall=100(0.9451)- 80exp(-0.10)(10)(0.6310)=$75.94million

¨ Valueoftheoutstandingdebt=$100- $75.94=$24.06million

¨ Interestrateondebt=($80/$24.06)1/10-1=12.77%

I.TheEffectofCatastrophicDropsinValue

Aswath Damodaran

¨ Assumenowthatacatastrophewipesouthalfthevalueofthisfirm(thevaluedropsto$50million),whilethefacevalueofthedebtremainsat$80million.Whatwillhappentotheequityvalueofthisfirm?a. Itwilldropinvalueto$25.94million[$50million-

marketvalueofdebtfrompreviouspage]b. Itwillbeworthnothingsincedebtoutstanding>Firm

Valuec. Itwillbeworthmorethan$25.94million

ValuingEquityintheTroubledFirm

Aswath Damodaran

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$50million

¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years

¨ Varianceinthevalueoftheunderlyingasset=s2

TheValueofEquityasanOption

Aswath Damodaran

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.0515 N(d1)=0.8534d2=-0.2135 N(d2)=0.4155

¨ Valueofthecall=50(0.8534)- 80exp(-0.10)(10) (0.4155)=$30.44million

¨ Valueofthebond=$50- $30.44=$19.56million¨ Theequityinthisfirmdropsby$45.50million,lessthantheoveralldropinvalueof$50million,becauseoftheoptioncharacteristicsofequity.

¨ Thismightexplainwhystockinfirms,whichareinChapter11andessentiallybankrupt,stillhasvalue.

Equityvaluepersists..

Aswath Damodaran

Value of Equity as Firm Value Changes

100 90 80 70 60 50 40 30 20 10Value of Firm ($ 80 Face Value of Debt)

II.Theconflictbetweenstockholdersandbondholders

Aswath Damodaran

¨ Consideragainthefirmdescribedintheearlierexample,withavalueofassetsof$100million,afacevalueofzero-couponten-yeardebtof$80million,astandarddeviationinthevalueofthefirmof40%.Theequityanddebtinthisfirmwerevaluedasfollows:¤ ValueofEquity=$75.94million¤ ValueofDebt=$24.06million¤ ValueofFirm==$100million

¨ Nowassumethatthestockholdershavetheopportunitytotakeaprojectwithanegativenetpresentvalueof-$2million,butassumethatthisprojectisaveryriskyprojectthatwillpushupthestandarddeviationinfirmvalueto50%.Wouldyouinvestinthisproject?a. Yesb. No

ValuingEquityaftertheProject

Aswath Damodaran

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million- $2million=$98million(Thevalueofthefirmisloweredbecauseofthenegativenetpresentvalueproject)

¨ Lifeoftheoption=t¨ Lifeofzero-coupondebt=10years¨ Varianceinthevalueoftheunderlyingasset=s2

OptionValuation

Aswath Damodaran

¨ OptionPricingResultsforEquityandDebtValue¤ ValueofEquity=$77.71¤ ValueofDebt=$20.29¤ ValueofFirm=$98.00

¨ Thevalueofequityrisesfrom$75.94millionto$77.71million,eventhoughthefirmvaluedeclinesby$2million.Theincreaseinequityvaluecomesattheexpenseofbondholders,whofindtheirwealthdeclinefrom$24.06millionto$20.19million.

EffectsofanAcquisition

Aswath Damodaran

¨ Assumethatyouarethemanagerofafirmandthatyoubuyanotherfirm,withafairmarketvalueof$150million,forexactly$150million.Inanefficientmarket,thestockpriceofyourfirmwilla. Increaseb. Decreasec. RemainUnchanged

Effectsonequityofaconglomeratemerger

Aswath Damodaran

¨ Youareprovidedinformationontwofirms,whichoperateinunrelatedbusinessesandhopetomerge.

FirmA FirmBValueofthefirm $100million $150millionFaceValueofDebt(10yr zeros) $80million $50millionMaturityofdebt 10years 10yearsStd.Dev.invalue 40% 50%Correlationbetweencashflows 0.4¤ Theten-yearbondrateis10%.

¨ Thevarianceinthevalueofthefirmaftertheacquisitioncanbecalculatedasfollows:Varianceincombinedfirmvalue =w1

2 s12 +w2

2 s22 +2w1 w2 r12s1s2

=(0.4)2 (0.16)+(0.6)2 (0.25)+2(0.4)(0.6)(0.4)(0.4)(0.5)=0.154

ValuingtheCombinedFirm

Aswath Damodaran

¨ Thevaluesofequityanddebtintheindividualfirmsandthecombinedfirmcanthenbeestimatedusingtheoptionpricingmodel:

FirmA FirmB CombinedfirmValueofequityinthefirm $75.94 $134.47 $207.43Valueofdebtinthefirm $24.06 $15.53 $42.57Valueofthefirm $100.00 $150.00 $250.00¨ Thecombinedvalueoftheequitypriortothemergeris$210.41million

anditdeclinesto$207.43millionafter.¨ Thewealthofthebondholdersincreasesbyanequalamount.¨ Thereisatransferofwealthfromstockholderstobondholders,asa

consequenceofthemerger.Thus,conglomeratemergersthatarenotfollowedbyincreasesinleveragearelikelytoseethisredistributionofwealthoccuracrossclaimholdersinthefirm.

Obtainingoptionpricinginputs- Somerealworldproblems

Aswath Damodaran

¨ Theexamplesthathavebeenusedtoillustratetheuseofoptionpricingtheorytovalueequityhavemadesomesimplifyingassumptions.Amongthemarethefollowing:(1)Therewereonlytwoclaimholdersinthefirm- debtandequity.(2)Thereisonlyoneissueofdebtoutstandinganditcanberetiredatfacevalue.(3)Thedebthasazerocouponandnospecialfeatures(convertibility,putclausesetc.)(4)Thevalueofthefirmandthevarianceinthatvaluecanbeestimated.

RealWorldApproachestoValuingEquityinTroubledFirms:GettingInputs

Value of the Firm • Cumulate market values of equity and debt (or)

• Value the assets in place using FCFF and WACC (or)

• Use cumulated market value of assets, if traded.

Variance in Firm Value • If stocks and bonds are traded,

σ2firm = we2 σe2 + wd2 σd2 + 2 we wd ρed σe σd

where σe2 = variance in the stock price

we = MV weight of Equity

σd2 = the variance in the bond price wd = MV weight of

• If not traded, use variances of similarly rated bonds.

• Use average firm value variance from the industry in

which company operates.

Value of the Debt • If the debt is short term, you can use only the face or book

value of the debt.

• If the debt is long term and coupon bearing, add the

cumulated nominal value of these coupons to the face

value of the debt.

Maturity of the Debt • Face value weighted duration of bonds outstanding (or)

• If not available, use weighted maturity

ValuingEquityasanoption- Eurotunnelinearly1998

Aswath Damodaran

¨ Eurotunnelhasbeenafinancialdisastersinceitsopening¤ In1997,Eurotunnelhadearningsbeforeinterestandtaxesof-£56millionandnetincomeof-£685million

¤ Attheendof1997,itsbookvalueofequitywas-£117million¨ Ithad£8,865millioninfacevalueofdebtoutstanding

¤ Theweightedaveragedurationofthisdebtwas10.93yearsDebtType FaceValue DurationShortterm 935 0.5010year 2435 6.720year 3555 12.6Longer 1940 18.2Total £8,865mil 10.93years

TheBasicDCFValuation

Aswath Damodaran

¨ Thevalueofthefirmestimatedusingprojectedcashflowstothefirm,discountedattheweightedaveragecostofcapitalwas£2,312million.

¨ Thiswasbaseduponthefollowingassumptions–¤ Revenueswillgrow5%ayearinperpetuity.¤ TheCOGSwhichiscurrently85%ofrevenueswilldropto65%of

revenuesinyr5andstayatthatlevel.¤ Capitalspendinganddepreciationwillgrow5%ayearinperpetuity.¤ Therearenoworkingcapitalrequirements.¤ Thedebtratio,whichiscurrently95.35%,willdropto70%afteryear5.

Thecostofdebtis10%inhighgrowthperiodand8%afterthat.¤ Thebetaforthestockwillbe1.10forthenextfiveyears,anddropto

0.8afterthenext5years.¤ Thelongtermbondrateis6%.

OtherInputs

Aswath Damodaran

¨ ThestockhasbeentradedontheLondonExchange,andtheannualizedstd deviationbaseduponln (prices)is41%.

¨ ThereareEurotunnelbonds,thathavebeentraded;theannualizedstd deviationinln(price)forthebondsis17%.¤ Thecorrelationbetweenstockpriceandbondpricechangeshasbeen

0.5.Theproportionofdebtinthecapitalstructureduringtheperiod(1992-1996)was85%.

¤ Annualizedvarianceinfirmvalue=(0.15)2 (0.41)2 +(0.85)2 (0.17)2 +2(0.15)(0.85)(0.5)(0.41)(0.17)=0.0335

¨ The15-yearbondrateis6%.(Iusedabondwithadurationofroughly11yearstomatchthelifeofmyoption)

ValuingEurotunnelEquityandDebt

Aswath Damodaran

¨ InputstoModel¤ Valueoftheunderlyingasset=S=Valueofthefirm=£2,312million¤ Exerciseprice=K=FaceValueofoutstandingdebt=£8,865million¤ Lifeoftheoption=t=Weightedaveragedurationofdebt=10.93years¤ Varianceinthevalueoftheunderlyingasset=s2 =Varianceinfirmvalue=

0.0335¤ Risklessrate=r=Treasurybondratecorrespondingtooptionlife=6%

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:¤ d1=-0.8337 N(d1)=0.2023¤ d2=-1.4392 N(d2)=0.0751

¨ Valueofthecall=2312(0.2023)- 8,865exp(-0.06)(10.93) (0.0751)=£122million

¨ Appropriateinterestrateondebt=(8865/2190)(1/10.93)-1=13.65%

InClosing…

Aswath Damodaran

¨ Therearerealoptionseverywhere.¨ Mostofthemhavenosignificanteconomicvaluebecause

thereisnoexclusivityassociatedwithusingthem.¨ Whenoptionshavesignificanteconomicvalue,theinputs

neededtovaluetheminabinomialmodelcanbeusedinmoretraditionalapproaches(decisiontrees)toyieldequivalentvalue.

¨ Therealvaluefromrealoptionsliesin¤ Recognizingthatbuildinginflexibilityandescapehatchesintolarge

decisionshasvalue¤ Insightswegetonunderstandinghowandwhycompaniesbehavethe

waytheydoininvestmentanalysisandcapitalstructurechoices.

AcquirersAnonymous:SevenStepsbacktoSobriety…

AswathDamodaran

Aswath Damodaran 84

Acquisitionsaregreatfortargetcompaniesbutnotalwaysforacquiringcompanystockholders…

Aswath Damodaran

Andthelong-termfollowupisnotpositiveeither..

Aswath Damodaran

¨ Managersoftenarguethatthemarketisunabletoseethelongtermbenefitsofmergersthattheycanseeatthetimeofthedeal.Iftheyareright,mergersshouldcreatelongtermbenefitstoacquiringfirms.

¨ Theevidencedoesnotsupportthishypothesis:¤ McKinseyandCo.hasexaminedacquisitionprogramsatcompanieson

n Didthereturnoncapitalinvestedinacquisitionsexceedthecostofcapital?n Didtheacquisitionshelptheparentcompaniesoutperformthecompetition?n Halfofallprogramsfailedonetest,andaquarterfailedboth.

¤ Synergyiselusive.KPMGinamorerecentstudyofglobalacquisitionsconcludesthatmostmergers(>80%)fail- themergedcompaniesdoworsethantheirpeergroup.

¤ Alargenumberofacquisitionsthatarereversedwithinfairlyshorttimeperiods.About20%oftheacquisitionsmadebetween1982and1986weredivestedby1988.Instudiesthathavetrackedacquisitionsforlongertimeperiods(tenyearsormore)thedivestiturerateofacquisitionsrisestoalmost50%.

Ascarythought…Thediseaseisspreading…IndianfirmsacquiringUStargets– 1999- 2005

Aswath Damodaran

Months around takeover

Growingthroughacquisitionsseemstobea“loser’sgame”

Aswath Damodaran

¨ Firmsthatgrowthroughacquisitionshavegenerallyhadfarmoretroublecreatingvaluethanfirmsthatgrowthroughinternalinvestments.

¨ Ingeneral,acquiringfirmstendto¤ Paytoomuchfortargetfirms¤ Overestimatethevalueof“synergy” and“control”¤ Haveadifficulttimedeliveringthepromisedbenefits

¨ Worsestill,thereseemstobeverylittlelearningbuiltintotheprocess.Thesamemistakesaremadeoverandoveragain,oftenbythesamefirmswiththesameadvisors.

¨ Conclusion:Thereissomethingstructurallywrongwiththeprocessforacquisitionswhichisfeedingintothemistakes.

Thesevensinsinacquisitions…

Aswath Damodaran

1. RiskTransference:Attributingacquiringcompanyriskcharacteristicstothetargetfirm.

2. Debtsubsidies:Subsidingtargetfirmstockholdersforthestrengthsoftheacquiringfirm.

3. Auto-pilotControl:The“20%controlpremium” andothermyth…

4. ElusiveSynergy:Misidentifyingandmis-valuingsynergy.5. Itsallrelative:Transactionmultiples,exitmultiples…6. Verdictfirst,trialafterwards:Pricefirst,valuationtofollow7. It’snotmyfault:Holdingnooneresponsiblefordelivering

results.

Testingsheet

Aswath Damodaran

Test Passed/Failed Rationalization

Risk transference

Debt subsidies

Control premium

The value of synergy

Comparables and Exit MultiplesBias

A successful acquisition strategy

Letsstartwithatargetfirm

Aswath Damodaran

¨ Thetargetfirmhasthefollowingincomestatement:Revenues 100OperatingExpenses 80= OperatingIncome 20Taxes 8=After-taxOI 12

¨ Assumethatthisfirmwillgeneratethisoperatingincomeforever(withnogrowth)andthatthecostofequityforthisfirmis20%.Thefirmhasnodebtoutstanding.Whatisthevalueofthisfirm?

Test1:RiskTransference…

Aswath Damodaran

¨ Assumethatasanacquiringfirm,youareinamuchsaferbusinessandhaveacostofequityof10%.Whatisthevalueofthetargetfirmtoyou?

Lesson1:Don’ttransferyourriskcharacteristicstothetargetfirm

Aswath Damodaran

¨ Thecostofequityusedforaninvestmentshouldreflecttheriskoftheinvestmentandnottheriskcharacteristicsoftheinvestorwhoraisedthefunds.

¨ Riskybusinessescannotbecomesafejustbecausethebuyerofthesebusinessesisinasafebusiness.

Test2:Cheapdebt?

Aswath Damodaran

¨ Assumeasanacquirerthatyouhaveaccesstocheapdebt(at4%)andthatyouplantofundhalftheacquisitionwithdebt.Howmuchwouldyoubewillingtopayforthetargetfirm?

Lesson2:Renderuntothetargetfirmthatwhichisthetargetfirm’sbutnotapennymore..

Aswath Damodaran

¨ Asanacquiringfirm,itisentirelypossiblethatyoucanborrowmuchmorethanthetargetfirmcanonitsownandatamuchlowerrate.Ifyoubuildthesecharacteristicsintothevaluationofthetargetfirm,youareessentiallytransferringwealthfromyourfirm’sstockholdertothetargetfirm’sstockholders.

¨ Whenvaluingatargetfirm,useacostofcapitalthatreflectsthedebtcapacityandthecostofdebtthatwouldapplytothefirm.

Test3:ControlPremiums

Aswath Damodaran

¨ Assumethatyouarenowtoldthatitisconventionaltopaya20%premiumforcontrolinacquisitions(backedupbyMergerstat).Howmuchwouldyoubewillingtopayforthetargetfirm?

¨ WouldyouranswerchangeifItoldyouthatyoucanrunthetargetfirmbetterandthatifyoudo,youwillbeabletogeneratea30%pre-taxoperatingmargin(ratherthanthe20%marginthatiscurrentlybeingearned).

¨ Whatifthetargetfirmwereperfectlyrun?

Lesson3:Bewareofrulesofthumb…

Aswath Damodaran

¨ Valuationisclutteredwithrulesofthumb.Afterpainstakinglyvaluingatargetfirm,usingyourbestestimates,youwillbeoftenbetoldthat¤ Itiscommonpracticetoaddarbitrarypremiumsforbrandname,qualityofmanagement,controletc…

¤ Thesepremiumswillbeoftenbebackedupbydata,studiesandservices.Whattheywillnotrevealistheenormoussamplingbiasinthestudiesandthestandarderrorsintheestimates.

¤ Ifyouhavedoneyourvaluationright,thosepremiumsshouldalreadybeincorporatedinyourestimatedvalue.Payingapremiumwillbedoublecounting.

Test4:Synergy….

Aswath Damodaran

¨ Assumethatyouaretoldthatthecombinedfirmwillbelessriskythanthetwoindividualfirmsandthatitshouldhavealowercostofcapital(andahighervalue).Isthislikely?

¨ Assumenowthatyouaretoldthattherearepotentialgrowthandcostsavingssynergiesintheacquisition.Wouldthatincreasethevalueofthetargetfirm?

¨ Shouldyoupaythisasapremium?

TheValueofSynergy

Aswath Damodaran

Synergy is created when two firms are combined and can be either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Higher returns on new investments

More newInvestments

Cost Savings in current operations

Tax BenefitsAdded Debt Capacity Diversification?

Higher ROC

Higher Growth Rate

Higher Reinvestment

Higher Growth RateHigher Margin

Higher Base-year EBIT

Strategic Advantages Economies of Scale

Longer GrowthPeriod

More sustainableexcess returns

Lower taxes on earnings due to - higher depreciaiton- operating loss carryforwards

Higher debt raito and lower cost of capital

May reducecost of equity for private or closely heldfirm

ValuingSynergy

Aswath Damodaran

(1)thefirmsinvolvedinthemergerarevaluedindependently,bydiscountingexpectedcashflowstoeachfirmattheweightedaveragecostofcapitalforthatfirm.(2)thevalueofthecombinedfirm,withnosynergy,isobtainedbyaddingthevaluesobtainedforeachfirminthefirststep.(3)Theeffectsofsynergyarebuiltintoexpectedgrowthratesandcashflows,andthecombinedfirmisre-valuedwithsynergy.

ValueofSynergy=Valueofthecombinedfirm,withsynergy-Valueofthecombinedfirm,withoutsynergy

Synergy- Example1Highergrowthandcostsavings

Aswath Damodaran

P&G Gillette Piglet: No Synergy Piglet: SynergyFree Cashflow to Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual operating expenses reduced by $250 millionGrowth rate for first 5 years 12% 10% 11.58% 12.50% Slighly higher growth rateGrowth rate after five years 4% 4% 4.00% 4.00%Beta 0.90 0.80 0.88 0.88Cost of Equity 7.90% 7.50% 7.81% 7.81% Value of synergyValue of Equity $221,292 $59,878 $281,170 $298,355 $17,185

Synergy:Example3TaxBenefits?

Aswath Damodaran

¨ AssumethatyouareBestBuy,theelectronicsretailer,andthatyouwouldliketoenterthehardwarecomponentofthemarket.YouhavebeenapproachedbyinvestmentbankersforZenith,whichwhilestillarecognizedbrandname,isonitslastlegsfinancially.Thefirmhasnetoperatinglossesof$2billion.Ifyourtaxrateis36%,estimatethetaxbenefitsfromthisacquisition.

¨ IfBestBuyhadonly$500millionintaxableincome,howwouldyoucomputethetaxbenefits?

¨ IfthemarketvalueofZenithis$800million,wouldyoupaythistaxbenefitasapremiumonthemarketvalue?

Lesson4:Don’tpayforbuzzwords

Aswath Damodaran

¨ Throughtime,acquirershavealwaysfoundwaysofjustifyingpayingforpremiumsoverestimatedvaluebyusingbuzzwords- synergyinthe1980s,strategicconsiderationsinthe1990sandrealoptionsinthisdecade.

¨ Whileallofthesecanhavevalue,theonusshouldbeonthosepushingfortheacquisitionstoshowthattheydoandnotonthosepushingagainstthemtoshowthattheydonot.

Test5:ComparablesandExitMultiples

Aswath Damodaran

¨ Nowassumethatyouaretoldthatananalysisofotheracquisitionsrevealsthatacquirershavebeenwillingtopay5timesEBIT..GiventhatyourtargetfirmhasEBITof$20million,wouldyoubewillingtopay$100millionfortheacquisition?

¨ WhatifIestimatetheterminalvalueusinganexitmultipleof5timesEBIT?

¨ Asanadditionalinput,yourinvestmentbankertellsyouthattheacquisitionisaccretive.(YourPEratiois20whereasthePEratioofthetargetisonly10…Therefore,youwillgetajumpinearningspershareaftertheacquisition…)

Biasedsamples=Poorresults

Aswath Damodaran

¨ Biasedsamplesyieldbiasedresults.Basingwhatyoupayonwhatotheracquirershavepaidisarecipefordisaster.Afterall,weknowthatacquirer,onaverage,paytoomuchforacquisitions.Bymatchingtheirprices,weriskreplicatingtheirmistakes.

¨ Evenwhenweusethepricingmetricsofotherfirmsinthesector,wemaybebasingthepriceswepayonfirmsthatarenottrulycomparable.

¨ Whenweuseexitmultiples,weareassumingthatwhatthemarketispayingforcomparablecompaniestodayiswhatitwillcontinuetopayinthefuture.

Lesson5:Don’tbealemming…

Aswath Damodaran

¨ Alltoooften,acquisitionsarejustifiedbyusingoneofthefollowingtwoarguments:¤ Everyoneelseinyoursectorisdoingacquisitions.Youhavetodothesametosurvive.

¤ Thevalueofatargetfirmisbaseduponwhatothershavepaidonacquisitions,whichmaybemuchhigherthanwhatyourestimateofvalueforthefirmis.

¨ Withtherightsetofcomparablefirms,youcanjustifyalmostanyprice.

¨ EPSaccretionisameaninglessmeasure.Afterall,buyingancompanywithaPElowerthanyourswillleadmathematicallytoEPSaccretion.

Test6:TheCEOreallywantstodothis…ortherearecompetitivepressures…

Aswath Damodaran

¨ NowassumethatyouknowthattheCEOoftheacquiringfirmreally,reallywantstodothisacquisitionandthattheinvestmentbankersonbothsideshaveproducedfairnessopinionsthatindicatethatthefirmisworth$100million.Wouldyoubewillingtogoalong?

¨ Nowassumethatyouaretoldthatyourcompetitorsarealldoingacquisitionsandthatifyoudon’tdothem,youwillbeatadisadvantage?Wouldyoubewillingtogoalong?

Lesson6:Don’tletegosorinvestmentbankersgetthebetterofcommonsense…

Aswath Damodaran

¨ Ifyoudefineyourobjectiveinabiddingwaraswinningtheauctionatanycost,youwillwin.Butbewarethewinner’scurse!

¨ Thepremiumspaidonacquisitionsoftenhavenothingtodowithsynergy,controlorstrategicconsiderations(thoughtheymaybeprovidedasthereasons).TheymayjustreflecttheegosoftheCEOsoftheacquiringfirms.Thereisevidencethat“overconfident”CEOsaremorelikelytomakeacquisitionsandthattheyleaveatrailacrossthefirmsthattheyrun.

¨ Pre-emptiveordefensiveacquisitions,whereyouoverpay,eitherbecauseeveryoneelseisoverpayingorbecauseyouareafraidthatyouwillbeleftbehindifyoudon’tacquirearedangerous.Iftheonlywayyoucanstaycompetitiveinabusinessisbymakingbadinvestments,itmaybebesttothinkaboutgettingoutofthebusiness.

Toillustrate:Abaddealismade,andjustifiedbyaccountants&bankers

Aswath Damodaran

TheCEOstepsin…anddigsahole…

Aswath Damodaran

¨ LeoApothekerwastheCEOofHPatthetimeofthedeal,broughtintoreplaceMarkHurd,thepreviousCEOwhowasforcedtoresignbecauseofa“sex”scandal.

¨ InthefaceofalmostuniversalfeelingthatHPhadpaidtoomuchforAutonomy,Mr. Apotheker addressing a conference at the time of the deal: “We have a pretty rigorous process inside H.P. that we follow for all our acquisitions, which is a D.C.F.-based model,”he said, in a reference to discounted cash flow, a standard valuation methodology. “And we try to take a very conservative view.”

¨ Apotheker added, “Just to make sure everybody understands, Autonomy will be, on Day 1, accretive to H.P….. “Just take it from us. We did that analysis at great length, in great detail, and we feel that we paid a very fair price for Autonomy. And it will give a great return to our shareholders.

Ayearlater…HPadmitsamistake…andexplainsit…

Test7:Isithopeless?

Aswath Damodaran

¨ Theoddsseemtobeclearlyweightedagainstsuccessinacquisitions.Ifyouweretocreateastrategytogrow,baseduponacquisitions,whichofthefollowingoffersyourbestchanceofsuccess?

This OrthisSoleBidder BiddingWarPublictarget PrivatetargetPaywithcash PaywithstockSmalltarget LargetargetCostsynergies Growthsynergies

Bettertoloseabiddingwarthantowinone…

Aswath Damodaran

Returns in the 40 months before & after bidding warSource: Malmendier, Moretti & Peters (2011)

Youarebetteroffbuyingsmallratherthanlargetargets…withcashratherthanstock

Aswath Damodaran

Andfocusingonprivatefirmsandsubsidiaries,ratherthanpublicfirms…

Aswath Damodaran

GrowthvsCostSynergies

Aswath Damodaran

Synergy:Oddsofsuccess

Aswath Damodaran

¨ Studiesthathavefocusedonsynergieshaveconcludedthatyouarefarmorelikelytodelivercostsynergiesthangrowthsynergies.

¨ Synergiesthatareconcreteandplannedforatthetimeofthemergeraremorelikelytobedeliveredthanfuzzysynergies.

¨ Synergyismuchmorelikelytoshowupwhensomeoneisheldresponsiblefordeliveringthesynergy.

¨ Youaremorelikelytogetashareofthesynergygainsinanacquisitionwhenyouareasinglebidderthanifyouareoneofmultiplebidders.

Lesson7:Foracquisitionstocreatevalue,youhavetostaydisciplined..

Aswath Damodaran

1. Ifyouhaveasuccessfulacquisitionstrategy,stayfocusedonthatstrategy.Don’tletsizeorhubrisdriveyouto“expand” thestrategy.

2. Realisticplansfordeliveringsynergyandcontrolhavetobeputinplacebeforethemergeriscompleted.Byrealistic,wehavetomeanthatthemagnitudeofthebenefitshavetobereachableandnotpipedreamsandthatthetimeframeshouldreflecttherealitythatittakesawhilefortwoorganizationstoworkasone.

3. Thebestthingtodoinabiddingwaristodropout.4. Someone(preferablythepersonpushinghardestforthemerger)

shouldbeheldtoaccountfordeliveringthebenefits.5. Thecompensationforinvestmentbankersandothersinvolvedin

thedealshouldbetiedtohowwellthedealworksratherthanforgettingthedealdone.

AReallyBigDeal!

TheAcquirer(ABInBev)

LatinAmerica42%

Africa0%

AsiaPacific11%

Europe11%

NorthAmerica36%

RevenueBreakdown(2014)

TheTarget(SABMiller)

CapitalMix Operating MetricsInterest-bearingDebt $12,550 Revenues $22,130.00LeaseDebt $368 OperatingIncome(EBIT) $4,420.00MarketCapitalization $75,116 OperatingMargin 19.97%DebttoEquityratio 17.20% Effectivetaxrate 26.40%DebttoCapitalratio 14.67% After-taxreturnoncapital 10.32%BondRating A3 ReinvestmentRate= 16.02%

LatinAmerica35%

Africa31%

AsiaPacific14%

Europe19%

NorthAmerica

RevenueBreakdown(2015)

Settingupthechallenge

¨ SABMiller’smarketcapitalizationwas$75billiononSeptember15,2015,thedayABInBev announceditsintenttoacquireSABMiller.

¨ Thedealwascompleted(pendingregulatoryapproval)amonthlater,withABInBev agreeingtopay$104billionforSABMiller.

¨ CanABInBev create$29billioninadditionalvaluefromthisacquisitionandifsowherewillitfindthevalue?¤ Themarketseemstothinkso,adding$33billioninmarketvaluetothecombinedcompany.

TheThree(Value)ReasonsforAcquisitions

¨ Undervaluation:Youbuyatargetcompanybecauseyoubelievethatthemarketismispricingthecompanyandthatyoucanbuyitforlessthanits"fair"value.

¨ Control:Youbuyacompanythatyoubelieveisbadlymanaged,withtheintentofchangingthewayitisrun.Ifyouarerightonthefirstcountandcanmakethenecessarychanges,thevalueofthefirmshouldincreaseunderyourmanagement

¨ Synergy:Youbuyacompanythatyoubelieve,whencombinedwithabusiness(orresource)thatyoualreadyown,willbeabletodothingsthatyoucouldnothavedoneasseparateentities.Thissynergycanbe¤ Offensivesynergy:Highergrowthandincreasedpricingpower¤ Defensivesynergy:Costcutting,consolidation&preemptingcompetitors.¤ Taxsynergy:Directlyfromtaxclausesorindirectlythroughdent

Fournumberstowatch

1. AcquisitionPrice:Thisisthepriceatwhichyoucanacquirethetargetcompany.Ifitisaprivatebusiness,itwillbenegotiatedandprobablybasedonwhatothersarepayingforsimilarbusinesses.Ifitisapubliccompany,itwillbeatapremiumoverthemarketprice.

2. StatusQuoValue:Valueofthetargetcompany,runbyexistingmanagement.

3. RestructuredValue:Valueofthetargetcompany,withchangestoinvesting,financinganddividendpolicies.

4. Synergyvalue:Valueofthecombinedcompany(withthesynergybenefitsbuiltin)– (Valueoftheacquiringcompany,asastandaloneentity,andtherestructuredvalueofthetargetcompany)

¨ TheAcidTest¤ Undervaluation:Pricefortargetcompany<StatusQuoValue¤ Control:Pricefortargetcompany<RestructuredValue¤ Synergy:Pricefortargetcompany<RestructuredValue+ValueofSynergy

SABMillerStatusQuoValue

SABMiller +CoorsJV +ShareofAssociates SABMillerConsolidatedRevenues $22,130.00 $5,201.00 $6,099.00OperatingMargin 19.97% 15.38% 10.72%OperatingIncome(EBIT) $4,420.00 $800.00 $654.00InvestedCapital $31,526.00 $5,428.00 $4,459.00Beta 0.7977 0.6872 0.6872ERP 8.90% 6.00% 7.90%CostofEquity= 9.10% 6.12% 7.43%After-taxcostofdebt= 2.24% 2.08% 2.24%DebttoCapitalRatio 14.67% 0.00% 0.00%Costofcapital= 8.09% 6.12% 7.43%

After-taxreturnoncapital= 10.33% 11.05% 11.00%ReinvestmentRate= 16.02% 40.00% 40.00%Expectedgrowthrate= 1.65% 4.42% 4.40%Numberofyearsofgrowth 5 5 5ValueoffirmPVofFCFFinhighgrowth= $11,411.72 $1,715.25 $1,351.68Terminalvalue= $47,711.04 $15,094.36 $9,354.28Valueofoperatingassetstoday= $43,747.24 $12,929.46 $7,889.56 $64,566.26+Cash $1,027.00- Debt $12,918.00- MinorityInterests $1,183.00Valueofequity $51,492.26

Price on September 15, 2015: $75 billion > $51.5 billion

SABMiller:PotentialforControl

SABMiller ABInBevGlobal Alcoholic Beverage Sector

Pre-taxOperatingMargin 19.97% 32.28% 19.23%

EffectiveTaxRate 26.36% 18.00% 22.00%

Pre-taxROIC 14.02% 14.76% 17.16%

ROIC 10.33% 12.10% 13.38%

ReinvestmentRate 16.02% 50.99% 33.29%

DebttoCapital 14.67% 23.38% 18.82%

SABMiller:ValueofControl

Status Quo Value Optimal valueCost of Equity = 9.10% 9.37%After-tax cost of debt = 2.24% 2.24%Cost of capital = 8.09% 8.03%

After-tax return on capital = 10.33% 12.64%Reinvestment Rate = 16.02% 33.29%Expected growth rate= 1.65% 4.21%

Value of firmPV of FCFF in high growth = $11,411.72 $9,757.08Terminal value = $47,711.04 $56,935.06Value of operating assets today = $43,747.24 $48,449.42+ Cash $1,027.00 $1,027.00+ Minority Holdings $20,819.02 $20,819.02- Debt $12,918.00 $12,918.00- Minority Interests $1,183.00 $1,183.00 Value of Control

Value of equity $51,492.26 $56,194.44 $4,702.17Price on September 15, 2015: $75 billion > $51.5 + $4.7 billion

TheSynergies?

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)LeveredBeta 0.85 0.8289 0.84641 0.84641Pre-taxcostofdebt 3.0000% 3.2000% 3.00% 3.00%Effectivetaxrate 18.00% 26.36% 19.92% 19.92%DebttoEquityRatio 30.51% 23.18% 29.71% 29.71%

Revenues $45,762.00 $22,130.00 $67,892.00 $67,892.00

OperatingMargin 32.28% 19.97% 28.27% 30.00%OperatingIncome(EBIT) $14,771.97 $4,419.36 $19,191.33 $20.368

After-taxreturnoncapital 12.10% 12.64% 11.68% 12.00%ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%ExpectedGrowthRate 6.17% 4.21% 5.09% 6.00%

Thevalueofsynergy

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)CostofEquity= 8.93% 9.37% 9.12% 9.12%After-taxcostofdebt= 2.10% 2.24% 2.10% 2.10%Costofcapital= 7.33% 8.03% 7.51% 7.51%

After-taxreturnoncapital= 12.10% 12.64% 11.68% 12.00%

ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%

Expectedgrowthrate= 6.17% 4.21% 5.09% 6.00%

Value of firmPVofFCFFinhighgrowth= $28,733 $9,806 $38,539 $39,151Terminalvalue= $260,982 $58,736 $319,717 $340,175Valueofoperatingassets= $211,953 $50,065 $262,018 $276,610

Value of synergy = 276,610 – 262,018 = 14,592 million

PassingJudgment

¨ Ifyouadduptherestructuredfirmvalueof$56.2billiontothesynergyvalueof$14.6billion,yougetavalueofabout$70.8billion.

¨ Thatiswellbelowthe$104billionthatABInBev isplanningtopayforSABMiller.

¨ Oneofthefollowinghastobetrue:¤ Ihavemassivelyunderestimatedthepotentialforsynergyinthismerger(eitherintermsofhighermarginsorhighergrowth).

¤ ABInBev hasoverpaidsignificantlyonthisdeal.Thatwouldgoagainsttheirhistoryasagoodacquirerandagainstthehistoryof3GCapitalasagoodstewardofcapital.

VALUEENHANCEMENTANDTHEEXPECTEDVALUEOFCONTROL:BACKTOBASICS

Aswath Damodaran 131

PriceEnhancementversusValueEnhancement

Aswath Damodaran

Themarketgives… Andtakesaway….

ThePathstoValueCreation

Aswath Damodaran

¨ UsingtheDCFframework,therearefourbasicwaysinwhichthevalueofafirmcanbeenhanced:¤ Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither

n increasingafter-taxearningsfromassetsinplaceorn reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)

¤ Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeithern Increasingtherateofreinvestmentinthefirmn Improvingthereturnoncapitalonthosereinvestments

¤ Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyearsofhighgrowth.

¤ Thecostofcapitalcanbereducedbyn Reducingtheoperatingriskininvestments/assetsn Changingthefinancialmixn Changingthefinancingcomposition

ValueCreation1:IncreaseCashFlowsfromAssetsinPlace

Aswath Damodaran

Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF

Divest assets thathave negative EBIT

More efficient operations and cost cuttting: Higher Margins

Reduce tax rate- moving income to lower tax locales- transfer pricing- risk management

Live off past over- investment

Better inventory management and tighter credit policies

ValueCreation2:IncreaseExpectedGrowth

Aswath Damodaran

Reinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojects

Do acquisitions

Increase operatingmargins

Increase capital turnover ratio

PricingStrategiesPriceLeaderversusVolumeLeaderStrategiesReturnonCapital=OperatingMargin*CapitalTurnoverRatio

GametheoryHowwillyourcompetitorsreacttoyourmoves?Howwillyoureacttoyourcompetitors’moves?

ValueCreatingGrowth…EvaluatingtheAlternatives..

Aswath Damodaran

III.BuildingCompetitiveAdvantages:Increaselengthofthegrowthperiod

Aswath Damodaran

Increase length of growth period

Build on existing competitive advantages

Find new competitive advantages

Brand name

Legal Protection

Switching Costs

Cost advantages

ValueCreation4:ReduceCostofCapital

Aswath Damodaran

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Change financing mix

Make product or service less discretionary to customers

Reduce operating leverage

Match debt to assets, reducing default risk

Changing product characteristics

More effective advertising

Outsourcing Flexible wage contracts &cost structure

Swaps Derivatives Hybrids

Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414

=57.42%

Expected Growth in EBIT (1-t).5742*.1993=.114411.44%

Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 20%Cost of capital = 6.62% ROC= 6.62%; Tax rate=35%Reinvestment Rate=51.54%

Terminal Value10= 1717/(.0662-.0341) = 53546

Cost of Equity8.77%

Cost of Debt(3.41%+..35%)(1-.3654)= 2.39%

WeightsE = 98.6% D = 1.4%

Cost of Capital (WACC) = 8.77% (0.986) + 2.39% (0.014) = 8.68%

Op. Assets 31,615+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 34,656-Options 180Value/Share106.12

Riskfree Rate:Euro riskfree rate = 3.41% +

Beta 1.26 X

Risk Premium4.25%

Unlevered Beta for Sectors: 1.25

Mature riskpremium4%

Country Equity Prem0.25%

SAP: Status Quo Reinvestment Rate 57.42%

Return on Capital19.93%

Term Yr5451354318261717

Avg Reinvestment rate = 36.94%

On May 5, 2005, SAP was trading at 122 Euros/share

First 5 yearsGrowth decreases gradually to 3.41%

Debt ratio increases to 20%Beta decreases to 1.00

Year 1 2 3 4 5 6 7 8 9 10EBIT 2,483 2,767 3,083 3,436 3,829 4,206 4,552 4,854 5,097 5,271EBIT(1-t) 1,576 1,756 1,957 2,181 2,430 2,669 2,889 3,080 3,235 3,345 - Reinvestm 905 1,008 1,124 1,252 1,395 1,501 1,591 1,660 1,705 1,724 = FCFF 671 748 833 929 1,035 1,168 1,298 1,420 1,530 1,621

Aswath Damodaran139

SAP:OptimalCapitalStructure

Aswath Damodaran

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 1.25 8.72% AAA 3.76% 36.54% 2.39% 8.72% $39,08810% 1.34 9.09% AAA 3.76% 36.54% 2.39% 8.42% $41,48020% 1.45 9.56% A 4.26% 36.54% 2.70% 8.19% $43,56730% 1.59 10.16% A- 4.41% 36.54% 2.80% 7.95% $45,90040% 1.78 10.96% CCC 11.41% 36.54% 7.24% 9.47% $34,04350% 2.22 12.85% C 15.41% 22.08% 12.01% 12.43% $22,44460% 2.78 15.21% C 15.41% 18.40% 12.58% 13.63% $19,65070% 3.70 19.15% C 15.41% 15.77% 12.98% 14.83% $17,44480% 5.55 27.01% C 15.41% 13.80% 13.28% 16.03% $15,65890% 11.11 50.62% C 15.41% 12.26% 13.52% 17.23% $14,181

Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414

=57.42%

Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 30%Cost of capital = 6.27% ROC= 6.27%; Tax rate=35%Reinvestment Rate=54.38%

Terminal Value10= 1898/(.0627-.0341) = 66367

Cost of Equity10.57%

Cost of Debt(3.41%+1.00%)(1-.3654)= 2.80%

WeightsE = 70% D = 30%

Cost of Capital (WACC) = 10.57% (0.70) + 2.80% (0.30) = 8.24%

Op. Assets 38045+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 40157-Options 180Value/Share 126.51

Riskfree Rate:Euro riskfree rate = 3.41% +

Beta 1.59 X

Risk Premium4.50%

Country Equity Prem0.5%

SAP: Restructured Reinvestment Rate70%

Term Yr6402416122631898

Avg Reinvestment rate = 36.94%

On May 5, 2005, SAP was trading at 122 Euros/share

First 5 yearsGrowth decreases gradually to 3.41%

Year 1 2 3 4 5 6 7 8 9 10EBIT 2,543 2,898 3,304 3,766 4,293 4,802 5,271 5,673 5,987 6,191EBIT(1-t) 1,614 1,839 2,097 2,390 2,724 3,047 3,345 3,600 3,799 3,929 - Reinvest 1,130 1,288 1,468 1,673 1,907 2,011 2,074 2,089 2,052 1,965 = FCFF 484 552 629 717 817 1,036 1,271 1,512 1,747 1,963

Reinvest more in Reinvest more in emerging marketsemerging markets

Use more debt financing.Use more debt financing.

Aswath Damodaran141

Current Cashflow to FirmEBIT(1-t) : 163- Nt CpX 39 - Chg WC 4= FCFF 120Reinvestment Rate = 43/163

=26.46%

Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 104/(.0676-.03) = 2714

Cost of Equity8.50%

Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%

Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Op. Assets 2,472+ Cash: 330- Debt 1847=Equity 955-Options 0Value/Share $ 5.13

Riskfree Rate:Riskfree rate = 4.10% +

Beta 1.10 X

Risk Premium4%

Firmʼs D/ERatio: 21.35%

Country Equity Prem0%

Blockbuster: Status Quo Reinvestment Rate 26.46%

Term Yr184 82102

1 2 3 4 5EBIT (1-t) $165 $167 $169 $173 $178 - Reinvestment $44 $44 $51 $64 $79 FCFF $121 $123 $118 $109 $99

Aswath Damodaran142

Current Cashflow to FirmEBIT(1-t) : 249- Nt CpX 39 - Chg WC 4= FCFF 206Reinvestment Rate = 43/249

=17.32%

Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 156/(.0676-.03) = 4145

Cost of Equity8.50%

Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%

Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Op. Assets 3,840+ Cash: 330- Debt 1847=Equity 2323-Options 0Value/Share $ 12.47

Riskfree Rate:Riskfree rate = 4.10% +

Beta 1.10 X

Risk Premium4%

Firmʼs D/ERatio: 21.35%

Country Equity Prem0%

Blockbuster: Restructured Reinvestment Rate 17.32%

Term Yr280124156

1 2 3 4 5EBIT (1-t) $252 $255 $258 $264 $272 - Reinvestment $44 $44 $59 $89 $121 FCFF $208 $211 $200 $176 $151

Aswath Damodaran143

TheExpectedValueofControl

Aswath Damodaran

The Value of ControlProbability that you can change the management of the firm

Change in firm value from changingmanagementX

Takeover Restrictions

Voting Rules & Rights

Access to Funds

Size of company

Value of the firm run optimally

Value of the firm run status quo-

Whytheprobabilityofmanagementchangingshiftsovertime….

Aswath Damodaran

¨ Corporategovernancerulescanchangeovertime,asnewlawsarepassed.Ifthechangegivesstockholdersmorepower,thelikelihoodofmanagementchangingwillincrease.

¨ Activistinvestingebbsandflowswithmarketmovements(activistinvestorsaremorevisibleindownmarkets)andofteninresponsetoscandals.

¨ Eventssuchashostileacquisitionscanmakeinvestorsreassessthelikelihoodofchangebyremindingthemofthepowerthattheydopossess.

EstimatingtheProbabilityofChange

Aswath Damodaran

¨ Youcanestimatetheprobabilityofmanagementchangesbyusinghistoricaldata(oncompanieswherechangehasoccurred)andstatisticaltechniquessuchasprobits orlogits.

¨ Empirically,thefollowingseemtoberelatedtotheprobabilityofmanagementchange:¤ Stockpriceandearningsperformance,withforcedturnovermorelikelyinfirms

thathaveperformedpoorlyrelativetotheirpeergroupandtoexpectations.¤ Structureoftheboard,withforcedCEOchangesmorelikelytooccurwhenthe

boardissmall,iscomposedofoutsidersandwhentheCEOisnotalsothechairmanoftheboardofdirectors.

¤ Ownershipstructure,sinceforcedCEOchangesaremorecommonincompanieswithhighinstitutionalandlowinsiderholdings.Theyalsoseemtooccurmorefrequentlyinfirmsthataremoredependentuponequitymarketsfornewcapital.

¤ Industrystructure,withCEOsmorelikelytobereplacedincompetitiveindustries.

ManifestationsoftheValueofControl

Aswath Damodaran

¨ Hostileacquisitions:Inhostileacquisitionswhicharemotivatedbycontrol,thecontrolpremiumshouldreflectthechangeinvaluethatwillcomefromchangingmanagement.

¨ Valuingpubliclytradedfirms:Themarketpriceforeverypubliclytradedfirmshouldincorporateanexpectedvalueofcontrol,asafunctionofthevalueofcontrolandtheprobabilityofcontrolchanging.¤ Marketvalue=Statusquovalue+(Optimalvalue– Statusquovalue)*

Probabilityofmanagementchanging¨ Votingandnon-votingshares:Thepremium(ifany)thatyouwould

payforavotingshareshouldincreasewiththeexpectedvalueofcontrol.

¨ MinorityDiscountsinprivatecompanies:Theminoritydiscount(attachedtobuyinglessthanacontrollingstake)inaprivatebusinessshouldbeincreasewiththeexpectedvalueofcontrol.

1.HostileAcquisition:Example

Aswath Damodaran

¨ Inahostileacquisition,youcanensuremanagementchangeafteryoutakeoverthefirm.Consequently,youwouldbewillingtopayuptotheoptimalvalue.

¨ Asanexample,Blockbusterwastradingat$9.50pershareinJuly2005.Theoptimalvaluepersharethatweestimatedas$12.47pershare.Assumingthatthisisareasonableestimate,youwouldbewillingtopayupto$2.97asapremiuminacquiringtheshares.

¨ Issuestoponder:¤ Wouldyouautomaticallypay$2.97asapremiumpershare?Whyorwhynot?

¤ Whatwouldyourpremiumpersharebeifchangewilltakethreeyearstoimplement?

2.MarketpricesofPubliclyTradedCompanies:Anexample

Aswath Damodaran

¨ Themarketpricepershareatthetimeofthevaluation(May2005)wasroughly$9.50.¤ Expectedvaluepershare=StatusQuoValue+Probabilityofcontrol

changing*(OptimalValue– StatusQuoValue)¤ $9.50=$5.13+Probabilityofcontrolchanging($12.47- $5.13)

¨ Themarketisattachingaprobabilityof59.5%thatmanagementpoliciescanbechanged.ThiswasafterIcahn’ssuccessfulchallengeofmanagement.Priortohisarriving,themarketpricepersharewas$8.20,yieldingaprobabilityofonly41.8%ofmanagementchanging.

Value of Equity Value per s hare

Status Quo $ 955 million $ 5.13 per share

Optimally mana ged $2,323 million $12.47 per share

Valueofstockinapubliclytradedfirm

Aswath Damodaran

¨ Whenafirmisbadlymanaged,themarketstillassessestheprobabilitythatitwillberunbetterinthefutureandattachesavalueofcontroltothestockpricetoday:

¨ Withvotingsharesandnon-votingshares,adisproportionateshareofthevalueofcontrolwillgotothevotingshares.Intheextremescenariowherenon-votingsharesarecompletelyunprotected:€

Value per share = Status Quo Value + Probability of control change (Optimal - Status Quo Value)Number of shares outstanding

Value per non - voting share = Status Quo Value # Voting Shares + # Non - voting shares

Value per voting share = Value of non - voting share + Probability of control change (Optimal - Status Quo Value)# Voting Shares

3.VotingandNon-votingShares:AnExample

Aswath Damodaran

¨ Tovaluevotingandnon-votingshares,wewillconsiderEmbraer,theBrazilianaerospacecompany.AsistypicalofmostBraziliancompanies,thecompanyhascommon(voting)sharesandpreferred(non-votingshares).¤ StatusQuoValue=12.5billion$Rfortheequity;¤ OptimalValue=14.7billion$R,assumingthatthefirmwouldbemoreaggressivebothinits

useofdebtandinitsreinvestmentpolicy.

¨ Thereare242.5millionvotingsharesand476.7non-votingsharesinthecompanyandtheprobabilityofmanagementchangeisrelativelylow.Assumingaprobabilityof20%thatmanagementwillchange,weestimatedthevaluepernon-votingandvotingshare:¤ Valuepernon-votingshare=StatusQuoValue/(#votingshares+#non-votingshares)=

12,500/(242.5+476.7)=17.38$R/share¤ Valuepervotingshare=StatusQuovalue/sh+Probabilityofmanagementchange*(Optimal

value– StatusQuoValue)=17.38+0.2*(14,700-12,500)/242.5=19.19$R/share

¨ Withourassumptions,thevotingsharesshouldtradeatapremiumof10.4%overthenon-votingshares.

4.MinorityDiscount:Anexample

Aswath Damodaran

¨ AssumethatyouarevaluingKristinKandy,aprivatelyownedcandybusinessforsaleinaprivatetransaction.Youhaveestimatedavalueof$1.6millionfortheequityinthisfirm,assumingthattheexistingmanagementofthefirmcontinuesintothefutureandavalueof$2millionfortheequitywithnewandmorecreativemanagementinplace.¤ Valueof51%ofthefirm=51%ofoptimalvalue=0.51*$2million=

$1.02million¤ Valueof49%ofthefirm=49%ofstatusquovalue=0.49*$1.6million

=$784,000¨ Notethata2%differenceinownershiptranslatesintoalarge

differenceinvaluebecauseonestakeensurescontrolandtheotherdoesnot.

AlternativeApproachestoValueEnhancement

Aswath Damodaran

¨ Maximizeavariablethatiscorrelatedwiththevalueofthefirm.Thereareseveralchoicesforsuchavariable.Itcouldbe¤ anaccountingvariable,suchasearningsorreturnoninvestment¤ amarketingvariable,suchasmarketshare¤ acashflowvariable,suchascashflowreturnoninvestment(CFROI)¤ arisk-adjustedcashflowvariable,suchasEconomicValueAdded(EVA)

¨ Theadvantagesofusingthesevariablesarethatthey¤ AreoftensimplerandeasiertousethanDCFvalue.

¨ Thedisadvantageisthatthe¤ Simplicitycomesatacost;thesevariablesarenotperfectlycorrelated

withDCFvalue.

EconomicValueAdded(EVA)andCFROI

Aswath Damodaran

¨ TheEconomicValueAdded(EVA)isameasureofsurplusvaluecreatedonaninvestment.¤ Definethereturnoncapital(ROC)tobethe“true” cashflowreturnoncapitalearnedonaninvestment.

¤ Definethecostofcapitalastheweightedaverageofthecostsofthedifferentfinancinginstrumentsusedtofinancetheinvestment.

¤ EVA=(ReturnonCapital- CostofCapital)(CapitalInvestedinProject)

¨ TheCFROIisameasureofthecashflowreturnmadeoncapital¤ ItiscomputedasanIRR,baseduponabasevalueofcapitalinvestedandthecashflowonthatcapital.

Thebottomline…

Aswath Damodaran

¨ Thevalueofafirmisnotgoingtochangejustbecauseyouuseadifferentmetricforvalue.Allapproachesthatarediscountedcashflowapproachesshouldyieldthesamevalueforabusiness,iftheymakeconsistentassumptions.

¨ Iftherearedifferencesinvaluefromusingdifferentapproaches,theymustbeattributabletodifferencesinassumptions,eitherexplicitorimplicit,behindthevaluation.

ASimpleIllustration

Aswath Damodaran

¨ Assumethatyouhaveafirmwithabookvaluevalueofcapitalof$100million,onwhichitexpectstogenerateareturnoncapitalof15%inperpetuitywithacostofcapitalof10%.

¨ Thisfirmisexpectedtomakeadditionalinvestmentsof$10millionatthebeginningofeachyearforthenext5years.Theseinvestmentsarealsoexpectedtogenerate15%asreturnoncapitalinperpetuity,withacostofcapitalof10%.

¨ Afteryear5,assumethat¤ Theearningswillgrow5%ayearinperpetuity.¤ Thefirmwillkeepreinvestingbackintothebusinessbutthereturnon

capitalonthesenewinvestmentswillbeequaltothecostofcapital(10%).

FirmValueusingEVAApproach

Aswath Damodaran

CapitalInvestedinAssetsinPlace = $100EVAfromAssetsinPlace=(.15– .10)(100)/.10 = $50

+PVofEVAfromNewInvestmentsinYear1=[(.15-– .10)(10)/.10] = $5

+PVofEVAfromNewInvestmentsinYear2=[(.15-– .10)(10)/.10]/1.1= $4.55+PVofEVAfromNewInvestmentsinYear3=[(.15-– .10)(10)/.10]/1.12= $4.13

+PVofEVAfromNewInvestmentsinYear4=[(.15-– .10)(10)/.10]/1.13= $3.76+PVofEVAfromNewInvestmentsinYear5=[(.15-– .10)(10)/.10]/1.14= $3.42

ValueofFirm = $170.85

FirmValueusingDCFValuation:EstimatingFCFF

Aswath Damodaran

BaseY ear

1 2 3 4 5 Term.Y ear

EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00

EBIT(1-t) :Investments- Yr 1 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t) :Investments- Yr 2 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 3 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 4 $ 1.50 $ 1.50

EBIT(1-t): Investments- Yr 5 $ 1.50

Total EBIT(1-t) $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63

- Net Capital Expenditures $10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25 $ 11.81

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

After year 5, the reinvestment rate is 50% = g/ ROC

FirmValue:PresentValueofFCFF

Aswath Damodaran

Year 0 1 2 3 4 5 Term Year

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

PV of FCFF ($10) $ 5.91 $ 6.61 $ 7.14 $ 7.51 $ 6.99

Terminal Value $ 236.25

PV of Terminal Value $ 146.69

Value of Firm $170.85

Implications

Aswath Damodaran

¨ Growth,byitself,doesnotcreatevalue.Itisgrowth,withinvestmentinexcessreturnprojects,thatcreatesvalue.¤ Thegrowthof5%ayearafteryear5createsnoadditionalvalue.

¨ The“marketvalueadded” (MVA),whichisdefinedtobetheexcessofmarketvalueovercapitalinvestedisafunctionofttheexcessvaluecreated.¤ Intheexampleabove,themarketvalueof$170.85millionexceedsthebookvalueof$100million,becausethereturnoncapitalis5%higherthanthecostofcapital.

Year-by-yearEVAChanges

Aswath Damodaran

¨ Firmsareoftenevaluatedbaseduponyear-to-yearchangesinEVAratherthanthepresentvalueofEVAovertime.

¨ Theadvantageofthiscomparisonisthatitissimpleanddoesnotrequirethemakingofforecastsaboutfutureearningspotential.

¨ Anotheradvantageisthatitcanbebrokendownbyanyunit-person,divisionetc.,aslongasoneiswillingtoassigncapitalandallocateearningsacrossthesesameunits.

¨ WhileitissimplerthanDCFvaluation,usingyear-by-yearEVAchangescomesatacost.Inparticular,itisentirelypossiblethatafirmwhichfocusesonincreasingEVAonayear-to-yearbasismayendupbeinglessvaluable.

Gamingthesystem:DeliveringhighcurrentEVAwhiledestroyingvalue…

Aswath Damodaran

¨ TheGrowthtradeoffgame:ManagersmaygiveupvaluablegrowthopportunitiesinthefuturetodeliverhigherEVAinthecurrentyear.

¨ TheRiskgame:ManagersmaybeabletodeliverahigherdollarEVAbutinriskierbusinesses.ThevalueofthebusinessisthepresentvalueofEVAovertimeandtheriskeffectmaydominatetheincreasedEVA.

¨ TheCapitalInvestedgame:ThekeytodeliveringpositiveEVAistomakeinvestmentsthatdonotshowupaspartofcapitalinvested.Thatway,youroperatingincomewillincreasewhilecapitalinvestedwilldecrease.

DeliveringahighEVAmaynottranslateintohigherstockprices…

Aswath Damodaran

¨ TherelationshipbetweenEVAandMarketValueChangesismorecomplicatedthantheonebetweenEVAandFirmValue.

¨ ThemarketvalueofafirmreflectsnotonlytheExpectedEVAofAssetsinPlacebutalsotheExpectedEVAfromFutureProjects

¨ TotheextentthattheactualeconomicvalueaddedissmallerthantheexpectedEVAthemarketvaluecandecreaseeventhoughtheEVAishigher.

Whenfocusingonyear-to-yearEVAchangeshasleastsideeffects

Aswath Damodaran

¨ 1.Mostoralloftheassetsofthefirmarealreadyinplace;i.e,verylittleornoneofthevalueofthefirmisexpectedtocomefromfuturegrowth.¤ ThisminimizestheriskthatincreasesincurrentEVAcomeatthe

expenseoffutureEVA¨ 2.Theleverageisstableandthecostofcapitalcannotbe

alteredeasilybytheinvestmentdecisionsmadebythefirm.¤ ThisminimizestheriskthatthehigherEVAisaccompaniedbyan

increaseinthecostofcapital¨ 3.Thefirmisinasectorwhereinvestorsanticipatelittleor

notsurplusreturns;i.e.,firmsinthissectorareexpectedtoearntheircostofcapital.¤ ThisminimizestheriskthattheincreaseinEVAislessthanwhatthe

marketexpectedittobe,leadingtoadropinthemarketprice.

TheBottomline…

Aswath Damodaran

¨ Valuecreationishardwork.Therearenoshortcuts.¨ Investmentbanks/Consultants/Expertswhoclaimtohaveshortcutsandmetricsthatallowforeasyvaluecreationareholdingbackonhardtruths.

¨ Valuecreationdoesnothappeninfinancedepartmentsofbusinesses.Everyemployeehasaroletoplay.

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