aswath damodaran1 corporate finance in a day an analysis of grace kennedy aswath damodaran home...

Aswath Damodaran 1

Corporate Finance in a DayAn Analysis of Grace Kennedy

Aswath Damodaran

Home Page: www.stern.nyu.edu/~adamodarwww.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html

E-Mail: [email protected]

Stern School of Business

Aswath Damodaran 2

A Financial View of the Firm…

AssetsLiabilitiesInvestments alreadymadeDebtEquityBorrowed moneyOwner’s fundsInvestments yet tobe madeExisting InvestmentsGenerate cashflows todayExpected Value that will be created by future investmentsFigure 1.1: A Simple View of a Business (Firm)

Aswath Damodaran 3

First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

• Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

Aswath Damodaran 4

The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to maximize the value of the business you run (firm).

A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.

Aswath Damodaran 5

The Classical Objective Function

STOCKHOLDERS

Maximizestockholder wealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

ProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Revealinformationhonestly andon time

Markets areefficient andassess effect onvalue

No Social Costs

Costs can betraced to firm

Aswath Damodaran 6

What can go wrong?

STOCKHOLDERS

Managers puttheir interestsabove stockholders

Have little controlover managers

BONDHOLDERSLend Money

Bondholders canget ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay badnews or provide misleadinginformation

Markets makemistakes andcan over react

Significant Social Costs

Some costs cannot betraced to firm

Aswath Damodaran 7

When traditional corporate financial theory breaks down, the solution is:

To choose a different mechanism for corporate governance. Japan and Germany have corporate governance systems which are not centered around stockholders.

To choose a different objective - maximizing earnings, revenues or market share, for instance.

To maximize stock price, but reduce the potential for conflict and breakdown:• Making managers (decision makers) and employees into stockholders

• Providing lenders with prior commitments and legal protection

• By providing information honestly and promptly to financial markets

• By converting social costs into economic costs.

Aswath Damodaran 8

The Only Self Correcting Objective

STOCKHOLDERS

Managers of poorly run firms are puton notice.

1. More activistinvestors2. Hostile takeovers

BONDHOLDERS

Protect themselves

1. Covenants2. New Types

FINANCIAL MARKETS

SOCIETYManagers

Firms arepunishedfor misleadingmarkets

Investors andanalysts becomemore skeptical

Corporate Good Citizen Constraints

1. More laws2. Investor/Customer Backlash

Aswath Damodaran 9

An Analysis of Grace Kennedy

STOCKHOLDERS

Board of 14 members owns 10% of stock. UK corporate governance practices adopted. (Independent compensation committee, Review of CEO)

Company has adopted option plan for managers.

BONDHOLDERS

Loans primarily from local banks who know company well.

FINANCIAL MARKETS

SOCIETY Grace Managers

Not followed by analysts. Firm is the primary source of information.

Traded on Jamaica, Trinidad and Barbados exchanges.

Potential hot spots include a. Tax b. Culture and Environment

Aswath Damodaran 10

Looking at Grace Kennedy’s top stockholders

Directors and Senior Managers

10%

Publicly listed companies10%

Private and Nominee companies

15%

Private Individuals31%

Insurance & Trust Companies & Pension

funds23%

Investment Companies5%

Others6%

Top 10 stockholders

Jamaica Producers Group

Luli Limited

J.K. Investments

Grace Kennedy Pension

Life of Jamaica Equity Fund 1

National Insurance Fund

James S. Moss Solomon

Scojampen Limited

Joan E. Belcher

Celia Kennedy

Aswath Damodaran 11

First Principles








Aswath Damodaran 12

What is Risk?

Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese symbols for risk, reproduced below, give a much better description of risk

The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

Aswath Damodaran 13

Models of Risk and Return

The risk in an investment can be measured by the variance in actual returns around an expected returnE(R)Riskless InvestmentLow Risk InvestmentHigh Risk InvestmentE(R)E(R)Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.

The CAPMThe APMMulti-Factor ModelsProxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:

If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from aregression)

Step 1: Defining RiskStep 2: Differentiating between Rewarded and Unrewarded RiskStep 3: Measuring Market Risk

Aswath Damodaran 14

The Riskfree Rate

For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met –

• There has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free.

• There can be no uncertainty about reinvestment rates, which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed.

Using a long term default-free government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value.

Aswath Damodaran 15

Estimating Riskfree Rates in Jamaican $ and US $

The ten-year treasury bond rate in the US on May 28, 2004 was 4.70%. This would be the riskfree rate in US dollars.

The riskfree rate in Jamaica is much more difficult to estimate. • The Bank of Jamaica lowered the one-year open market rate to 16.4% from 16.9%

on May 6, 2004.

• The most recent debentures issued by the Government of Jamaica have coupon rates of between 16 and 17%. The most recent 6-month T.Bill rate is 15.09%.

• On May 27, investors in savings accounts in Jamaica could expect to earn 11.37%. The riskfree rate should be higher than this number.

My guess: The long term riskfree rate in Jamaican $ is about 15%.

Aswath Damodaran 16

The Risk Premium: What is it?

The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate.

Assume that stocks are the only risky assets and that you are offered two investment options:

• a riskless investment (say a Government Security), on which you can make 5%• a mutual fund of all stocks, on which the returns are uncertain

How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund?

Less than 5% Between 5 - 7% Between 7 - 9% Between 9 - 11% Between 11 - 13% More than 13%

Aswath Damodaran 17

One way to estimate risk premiums: Look at history

Arithmetic average Geometric AverageStocks - Stocks - Stocks - Stocks -

Historical Period T.Bills T.Bonds T.Bills T.Bonds1928-2003 7.92% 6.54% 5.99% 4.82%1963-2003 6.09% 4.70% 4.85% 3.82%1993-2003 8.43% 4.87% 6.68% 3.57%

What is the right premium? Go back as far as you can. Otherwise, the standard error in the estimate will be large. ( Be consistent in your use of a riskfree rate. Use arithmetic premiums for one-year estimates of costs of equity and geometric

premiums for estimates of long term costs of equity.Data Source: Check out the returns by year and estimate your own historical premiums by

going to updated data on my web site.

Aswath Damodaran 18

Assessing Country Risk: The Caribbean Region (defined loosely)

Country Long-Term Rating Defaault spread over U.S. treasuriesBahamas A1 80Barbados A3 95Bermuda Aaa 0Cayman Islands Aa3 70Dominican Republic B2 550Ecuador Caa1 750El Salvador Baa2 130Jamaica Ba2 300Trinidad Baa1 120United States Aaa 0Venezuela Caa1 750

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Adjusted Equity Risk Premium

Start with the U.S. historical risk premium as a base (4.82%) Add the default spread of the country in which you plan to operate to the U.S.

risk premium to arrive at an equity risk premium for that market. • Jamaica Equity Risk Premium = 4.82% + 3% = 7.82%

• Trinidad Equity Risk Premium = 4.82% + 1.20% = 6.02%

• Barbados Equity Risk Premium = 4.82% + 0.95% = 5.77%

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Estimating Beta

The beta of a stock measures the risk in a stock that cannot be diversified away. It is determined by both how volatile a stock is and how it moves with the market.

The standard procedure for estimating betas is to regress stock returns (R j) against market returns (Rm) -

Rj = a + b Rm

where a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock, and measures

the riskiness of the stock.

Aswath Damodaran 21

Beta Estimation in Practice: A Bloomberg Page

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Determinants of Betas

Beta of Firm (Unlevered Beta)Beta of Equity (Levered Beta)Nature of product or service offered by company :Other things remaining equal, the more discretionary the product or service, the higher the beta.

Operating Leverage (Fixed Costs as percent of total costs):Other things remaining equal the greater the proportion of the costs that are fixed, the higher the beta of the company.

Financial Leverage:Other things remaining equal, the greater the proportion of capital that a firm raises from debt,the higher its equity beta will be

Implications1. Cyclical companies should have higher betas than non-cyclical companies.2. Luxury goods firms should have higher betas than basic goods.3. High priced goods/service firms should have higher betas than low prices goods/services firms.4. Growth firms should have higher betas.

Implications1. Firms with high infrastructure needs and rigid cost structures should have higher betas than firms with flexible cost structures.2. Smaller firms should have higher betas than larger firms.3. Young firms should have higher betas than more mature firms.

ImplciationsHighly levered firms should have highe betas than firms with less debt.Equity Beta (Levered beta) = Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

Aswath Damodaran 23

Bottom-up Betas: Estimating betas by looking at comparable firms

Business Comparable firms Unlevered Beta

Operating Income

Weight in Grace

Debt/Equity Ratio

Levered Beta

Cost of Equity (J$)

Food Trading

Food Producers 0.81 496.5 21.75% 11.36% 0.87 21.81%

Retailing Miscellaneous Retailers

0.79 143.3 6.28% 11.36% 0.85 21.65%

Financial Services

Banks and Insurance Companies

0.51 991.3 43.43% 31.04% 0.62 19.81%

Maritime Maritime Transportation

0.38 130.6 5.72% 11.36% 0.41 18.20%

Information Services

Data Services 0.79 520.7 22.81% 11.36% 0.85 21.65%

Grace Kennedy

0.65 2282.4 11.36% 0.70 20.46%

Aswath Damodaran 24

US Dollar Cost of Equity: By division and By investment region (In US dollar terms)

Division Jamaica Trinidad Barbados United StatesFood Trading 11.51% 9.95% 9.73% 8.90%Retailing 11.35% 9.82% 9.60% 8.80%Financial Services 9.51% 8.41% 8.25% 7.67%Maritime 7.90% 7.16% 7.06% 6.67%Information Services 11.35% 9.82% 9.60% 8.80%Grace Kennedy 10.16% 8.90% 8.73% 8.07%

Riskfree rate used = US dollar riskfree rate of 4.70%Risk premium = 7.82% for Jamaica

6.02% for Trinidad5.77% for Barbados4.82% for US

Aswath Damodaran 25

From Cost of Equity to Cost of Capital

The cost of capital is a composite cost to the firm of raising financing to fund its projects.

In addition to equity, firms can raise capital from debt. To get to the cost of capital, we need to

• First estimate the cost of borrowing money

• And then weight debt and equity in the proportions that they are used in financing. The cost of debt for a firm is the rate at which it can borrow money today. It

should a be a direct function of how much risk of default a firm carries and can be written as

• Cost of Debt = Riskfree Rate + Default Spread

Aswath Damodaran 26

Default Spreads and Bond Ratings

Many firms in the United States are rated by bond ratings agencies like Standard and Poor’s and Moody’s for default risk. If you have a rating, you can estimate the default spread from it.

If your firm is not rated, you can estimate a “synthetic rating” using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio

Interest Coverage Ratio = EBIT / Interest Expenses For Grace Kennedy, the interest coverage ratio in 2003 is estimated from the

operating income of 1986.292 million J$ and the interest expenses of 321.902 million J$.

Interest Coverage Ratio = 1986/322 = 5.00

Aswath Damodaran 27

Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2004)

>12.50 AAA 0.35%

9.5-12.5 AA 0.50%

7.5-9.5 A+ 0.70%

6-7.5 A 0.85%

4.5-6 A– 1.00%

4-4.5 BBB 1.50%

3.5-4 BB+ 2.00%

3-3.5 BB 2.50%

2.5-3 B+ 3.25%

2-2.5 B 4.00%

1.5-2 B – 6.00%

1.25-1.5 CCC 8.00%

0.8-1.25 CC 10.00%

0.5-0.8 C 12.00%

<0.5 D 20.00%

Aswath Damodaran 28

Grace Kennedy’s Cost of Debt

Based upon the interest coverage ratio of 5, we would assign a bond rating of A- to Grace Kennedy, leading to a default spread of 1% over a US dollar riskfree rate. Since the riskfree rate in Jamaica is roughly three times higher, we will triple this default spread, leading to a pre-tax cost of debt of

• Cost of debt = Riskfree Rate + Default Spread = 15% + 3% = 18%

• Cost of debt (US $) = Riskfree Rate + Default spread =4.70% + 1% = 5.70% With a tax rate of 33.33%, the after-tax cost of debt can be computed:

• Aftet-tax cost of debt in J$ = 18% (1-.3333) = 12%

• After-tax cost of debt in US $ = 5.70% (1-.3333) = 3.80%

Aswath Damodaran 29

Estimating Market Value Weights

Market Value of Equity should include the following• Market Value of Shares outstanding

• Market Value of Warrants outstanding

• Market Value of Conversion Option in Convertible Bonds Market Value of Debt is more difficult to estimate because few firms have

only publicly traded debt. There are two solutions:• Assume book value of debt is equal to market value

• Estimate the market value of debt from the book value

Aswath Damodaran 30

Estimating Cost of Capital in J$: Grace Kennedy

Business Cost of Equity After-tax Cost of Debt Debt to Capital Ratio Cost of CapitalFood Trading 21.81% 12.00% 10.20% 20.81%Retailing 21.65% 12.00% 10.20% 20.66%Financial Services 19.81% 12.00% 23.69% 17.96%Maritime 18.20% 12.00% 10.20% 17.56%Information Services 21.65% 12.00% 10.20% 20.66%Grace Kennedy 20.46% 12.00% 10.20% 19.60%

Aswath Damodaran 31

US Dollar Cost of Capital: By division and By investment region (In US dollar terms)

Division Jamaica Trinidad Barbados United States

Food Trading 10.73% 8.67% 9.73% 8.90%

Retailing 10.58% 8.57% 9.60% 8.80%

Financial Services 8.16% 7.58% 8.25% 7.67%

Maritime 7.48% 6.57% 7.06% 6.67%

Information Services 10.58% 8.57% 9.60% 8.80%

Grace Kennedy 9.51% 7.90% 8.73% 8.07%

Aswath Damodaran 32

First Principles








Aswath Damodaran 33

Measures of return: earnings versus cash flows

Principles Governing Accounting Earnings Measurement• Accrual Accounting: Show revenues when products and services are sold or

provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses.

• Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization)

To get from accounting earnings to cash flows:• you have to add back non-cash expenses (like depreciation)

• you have to subtract out cash outflows which are not expensed (such as capital expenditures)

• you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital).

Aswath Damodaran 34

Measuring Returns Right: The Basic Principles

Use cash flows rather than earnings. You cannot spend earnings. Use “incremental” cash flows relating to the investment decision, i.e.,

cashflows that occur as a consequence of the decision, rather than total cash flows.

Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

The Return Mantra: “Time-weighted, Incremental Cash Flow Return”

Aswath Damodaran 35

Earnings versus Cash Flows: A Proposed Grace Kennedy Investment - American Roti

Grace Kennedy is planning to introduce a new line of frozen Jamaican dinners and snacks under the brand name American Roti and aimed at broad US market. It has already spent $ 5 million in market testing and collecting information.

To make the investment, Grace Kennedy believes that it will need to invest $ 50 million upfront and that this investment can be depreciated straight line over 5 years down to a salvage value of $ 10 million. In addition, it will need to maintain a working capital investment equal to 20% of its revenues, with the investment at the beginning of each year.

The market testing has yielded potential market share estimates and revenues (shown on the next page). Grace Kennedy will allocate 20% of its General and administrative expenses to this investment, though 60% of this cost is fixed.

Aswath Damodaran 36

Estimated Earnings on Project

1 2 3 4 5 NotesRevenues $80.00 $100.00 $125.00 $160.00 $200.00 From market test - Operating Expenses $40.00 $50.00 $62.50 $80.00 $100.00 (50% of revenues) - Advertising $28.00 $24.00 $15.00 $15.00 $15.00 ( Tapered down over time) - Allocated G&A $15.00 $25.00 $31.25 $40.00 $50.00 (From headquarters) - Depreciation $8.00 $8.00 $8.00 $8.00 $8.00 (Straight line on 40 m)Operating Income -$11.00 -$7.00 $8.25 $17.00 $27.00 - Taxes -$3.67 -$2.33 $2.75 $5.67 $9.00 (33.33% tax rate)Operating Income after-tax -$7.33 -$4.67 $5.50 $11.33 $18.00

Aswath Damodaran 37

Currency Conversions

If you wanted to convert these US dollar cashflows into Jamaican dollar cashflows, what exchange rate would you use?

The current exchange rate Expected future exchange rates

Why?

Aswath Damodaran 38

And The Accounting View of Return

Capital Invested 1 2 3 4 5Fixed Assets 50 42 34 26 18Working Capital 16 20 25 32 40Capital invested 66 62 59 58 58

Year Operating Income after tax Book Capital (beginning) Book Capital (Ending) Book Capital (Average) Return on Capital1 -$7.33 66 62 64 -11.46%2 -$4.67 62 59 60.5 -7.71%3 $5.50 59 58 58.5 9.40%4 $11.33 58 58 58 19.54%5 $18.00 58 50 54 33.34%

Average 8.62%

Aswath Damodaran 39

Would lead use to conclude that...

Do not invest in American Roti. The US $ return on capital of 8.62% is lower than the US$ cost of capital for food division investments in the United States of 8.90% This would suggest that the project should not be taken.

Given that we have computed the average over an arbitrary period of 5 years, while the investment would have a life greater than 5 years, would you feel comfortable with this conclusion?

Yes No

Aswath Damodaran 40

The cash flow view of this project..

•

To get from income to cash flow, weadded back all non-cash charges such as depreciationsubtracted out the capital expendituressubtracted out the change in non-cash working capital

0 1 2 3 4 5After-tax Operating Income -$7.33 -$4.67 $5.50 $11.33 $18.00 + Depreciation $8.00 $8.00 $8.00 $8.00 $8.00 - Capital Expenditures -$50.00 $10.00 - Change in Working Capital -$16.00 -$4.00 -$5.00 -$7.00 -$8.00 $40.00Cashflow -$66.00 -$3.33 -$1.67 $6.50 $11.33 $76.00

Aswath Damodaran 41

Depreciation Methods

We used straight line depreciation to estimate the cashflows. Assume that you had been able to depreciate more of the asset in the earlier years and less in later years (though the total depreciation would remain unchanged). Switching to an accelerated depreciation method would

Increase earnings in the early years and decrease the cashflows Decrease earnings in the early years but increase the cashflow Decrease both earnings and cashflow in the early years Increase both earnings and cashflow in the early years

Aswath Damodaran 42

The incremental cash flows on the project

To get from cash flow to incremental cash flows, weIgnore the investment in market testing because it has occurred already and cannot be recovered. Add back the non-incremental allocated costs (in after-tax terms)

0 1 2 3 4 5After-tax Operating Income -$7.33 -$4.67 $5.50 $11.33 $18.00 + Depreciation $8.00 $8.00 $8.00 $8.00 $8.00 - Capital Expenditures -$50.00 $10.00 - Change in Working Capital -$16.00 -$4.00 -$5.00 -$7.00 -$8.00 $40.00Cashflow -$66.00 -$3.33 -$1.67 $6.50 $11.33 $76.00 + Non-increment G&A (1-t) $6.00 $10.00 $12.50 $16.00 $20.00Incremental Cashflow -$66.00 $2.67 $8.33 $19.00 $27.33 $96.00

Aswath Damodaran 43

To Time-Weighted Cash Flows

Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment).

NPV = Sum of the present values of all cash flows on the project, including the initial investment, with the cash flows being discounted at the appropriate hurdle rate (cost of capital, if cash flow is cash flow to the firm, and cost of equity, if cash flow is to equity investors)

• Decision Rule: Accept if NPV > 0 Internal Rate of Return (IRR): The internal rate of return is the discount rate

that sets the net present value equal to zero. It is the percentage rate of return, based upon incremental time-weighted cash flows.

• Decision Rule: Accept if IRR > hurdle rate

Aswath Damodaran 44

Which yields a NPV of..

Year Incremental Cashflow PV at 8.90%0 -$66.00 -$66.001 $2.67 $2.452 $8.33 $7.033 $19.00 $14.714 $27.33 $19.445 $96.00 $62.68

NPV $40.31

Aswath Damodaran 45

Which makes the argument that..

The project should be accepted. The positive net present value suggests that the project will add value to the firm, and earn a return in excess of the cost of capital.

By taking the project, Grace Kennedy will increase its value as a firm by $40.31 million.

Aswath Damodaran 46

The IRR of this project

American Roti: Net Present Value Profile

($40.00)

($20.00)

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34% 36% 38% 40%

Internal Rate of Return = 22%

Aswath Damodaran 47

The IRR suggests..

The project is a good one. Using time-weighted, incremental cash flows, this project provides a return of 22%. This is greater than the cost of capital of 8.90%.

The IRR and the NPV will yield similar results most of the time, though there are differences between the two approaches that may cause project rankings to vary depending upon the approach used.

Aswath Damodaran 48

The Importance of Working Capital

0

10

20

30

40

50

60

0% 5% 10% 15% 20% 25% 30%

Working Capital as % of Revenues

NPV

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

IRRNPV

IRR

Aswath Damodaran 49

The Role of Sensitivity Analysis

Our conclusions on a project are clearly conditioned on a large number of assumptions about revenues, costs and other variables over very long time periods.

To the degree that these assumptions are wrong, our conclusions can also be wrong.

One way to gain confidence in the conclusions is to check to see how sensitive the decision measure (NPV, IRR..) is to changes in key assumptions.

Aswath Damodaran 50

Side Costs and Benefits

Most projects considered by any business create side costs and benefits for that business.

The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have.

The benefits that may not be captured in the traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay, expand or abandon a project).

The returns on a project should incorporate these costs and benefits.

Aswath Damodaran 51

First Principles







Aswath Damodaran 52

Debt: The Trade-Off

Advantages of Borrowing Disadvantages of Borrowing

1. Tax Benefit:

Higher tax rates --> Higher tax benefit

1. Bankruptcy Cost:

Higher business risk --> Higher Cost

2. Added Discipline:

Greater the separation between managers

and stockholders --> Greater the benefit

2. Agency Cost:

Greater the separation between stock-

holders & lenders --> Higher Cost

3. Loss of Future Financing Flexibility:

Greater the uncertainty about future

financing needs --> Higher Cost

Aswath Damodaran 53

A Hypothetical Scenario

Assume you operate in an environment, where• (a) there are no taxes

• (b) there is no separation between stockholders and managers.

• (c) there is no default risk

• (d) there is no separation between stockholders and bondholders

• (e) firms know their future financing needs

Aswath Damodaran 54

The Miller-Modigliani Theorem

In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.

The value of a firm is independent of its debt ratio.

Aswath Damodaran 55

An Alternate View : The cost of capital can change as you change your financing mix

The trade-off between debt and equity becomes more complicated when there are both tax advantages and bankruptcy risk to consider. When debt has a tax advantage and increases default risk, the firm value will change as the financing mix changes. The optimal financing mix is the one that maximizes firm value.

The cost of capital has embedded in it, both the tax advantages of debt (through the use of the after-tax cost of debt) and the increased default risk (through the use of a cost of equity and the cost of debt)

Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

Aswath Damodaran 56

The Cost of Capital: The Textbook Example

D/(D+E) ke kd After-tax Cost of Debt WACC

0 10.50% 8% 4.80% 10.50%

10% 11% 8.50% 5.10% 10.41%

20% 11.60% 9.00% 5.40% 10.36%

30% 12.30% 9.00% 5.40% 10.23%

40% 13.10% 9.50% 5.70% 10.14%

50% 14% 10.50% 6.30% 10.15%

60% 15% 12% 7.20% 10.32%

70% 16.10% 13.50% 8.10% 10.50%

80% 17.20% 15% 9.00% 10.64%

90% 18.40% 17% 10.20% 11.02%

100% 19.70% 19% 11.40% 11.40%

Aswath Damodaran 57

WACC and Debt Ratios

Weighted Average Cost of Capital and Debt Ratios

Debt Ratio

WA

CC

9.40%9.60%9.80%

10.00%10.20%10.40%10.60%10.80%11.00%11.20%11.40%

0

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Aswath Damodaran 58

Current Cost of Capital: Grace Kennedy

Equity• Cost of Equity = 10.16%

• Market Value of Equity = 29,076.75 million J$

• Equity/(Debt+Equity ) = 89.8% Debt

• After-tax Cost of debt = 5.70% (1-.3333) = 3.80%

• Market Value of Debt = 3,303 million J$

• Debt/(Debt +Equity) = 10.2% Cost of Capital = 10.16%(.898)+ 3.80%(.102) = 9.51%

Aswath Damodaran 59

Mechanics of Cost of Capital Estimation

1. Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Beta will increase -> Cost of Equity will increase.

Estimation will use levered beta calculation

2. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt

will increase.

To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense)

3. Estimate the Cost of Capital at different levels of debt

4. Calculate the effect on Firm Value and Stock Price.

Aswath Damodaran 60

Estimating Cost of Equity from Betas: Grace Kennedy at different debt ratios

Current Beta = 0.70 Unlevered Beta = 0.65

Market premium = 7.82% T.Bond Rate = 4.70% t= 33.33%

Debt Ratio Beta Cost of Equity

0% 0.65 9.79%

10% 0.70 10.17%

20% 0.76 10.64%

30% 0.84 11.24%

40% 0.94 12.05%

50% 1.12 13.46%

60% 1.43 15.86%

70% 1.90 19.59%

80% 2.98 28.04%

90% 5.97 51.37%

Aswath Damodaran 61

Bond Ratings, Cost of Debt and Debt Ratios: Grace Kennedy at different debt ratios

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%$ Debt $0 $3,238 $6,476 $9,714 $12,952 $16,190 $19,428 $22,666 $25,904 $29,141

EBITDA $2,456 $2,456 $2,456 $2,456 $2,456 $2,456 $2,456 $2,456 $2,456 $2,456Depreciation $470 $470 $470 $470 $470 $470 $470 $470 $470 $470EBIT $1,986 $1,986 $1,986 $1,986 $1,986 $1,986 $1,986 $1,986 $1,986 $1,986Interest $0 $168 $369 $772 $1,904 $2,380 $3,244 $3,785 $6,398 $7,198Pre-tax Int. cov ∞ 11.80 5.38 2.57 1.04 0.83 0.61 0.52 0.31 0.28Likely Rating AAA AA A- B+ CC CC C C D DPre-tax cost of debt 5.05% 5.20% 5.70% 7.95% 14.70% 14.70% 16.70% 16.70% 24.70% 24.70%Eff. Tax Rate 33.33% 33.33% 33.33% 33.33% 33.33% 27.81% 20.40% 17.49% 10.35% 9.20%Cost of debt 3.37% 3.47% 3.80% 5.30% 9.80% 10.61% 13.29% 13.78% 22.14% 22.43%

Aswath Damodaran 62

Grace Kennedy’s Cost of Capital Schedule

Debt Ratio Beta Cost of EquityCost of Debt (after-tax) WACC0% 0.65 9.79% 3.37% 9.79%10% 0.70 10.17% 3.47% 9.50%20% 0.76 10.64% 3.80% 9.27%30% 0.84 11.24% 5.30% 9.46%40% 0.94 12.05% 9.80% 11.15%50% 1.12 13.46% 10.61% 12.04%60% 1.43 15.86% 13.29% 14.32%70% 1.90 19.59% 13.78% 15.52%80% 2.98 28.04% 22.14% 23.32%90% 5.97 51.37% 22.43% 25.32%

Aswath Damodaran 63

Grace Kennedy: Cost of Capital Chart

Cost of Capital and Debt Ratios

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Debt Ratio

Aswath Damodaran 64

A Framework for Getting to the Optimal

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

Actual > OptimalOverlevered

Actual < OptimalUnderlevered

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

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No


YesTake good projects withdebt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

Aswath Damodaran 65

Grace Kennedy: Applying the Framework

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

Actual > OptimalOverlevered

Actual < OptimalUnderlevered

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

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders


YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No


YesTake good projects withdebt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

Aswath Damodaran 66

Designing Debt: The Fundamental Principle

The objective in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets.

By doing so, we reduce our risk of default, increase debt capacity and increase firm value.

Aswath Damodaran 67

Design the perfect financing instrument

The perfect financing instrument will• Have all of the tax advantages of debt

• While preserving the flexibility offered by equity

DurationCurrencyEffect of InflationUncertainty about FutureGrowth PatternsCyclicality &Other EffectsDefine DebtCharacteristicsDuration/MaturityCurrencyMixFixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Commodity BondsCatastrophe NotesDesign debt to have cash flows that match up to cash flows on the assets financed

Aswath Damodaran 68

Coming up with the financing details: Intuitive Approach

Business Typical Project Debt Food Trading The manufacturing facilities may

medium term but the product (and associated brand name) can have long life. Increasing sales outside of Jamaica.

Medium to long term debt, with currency depending upon where the product revenues are growing. In markets where Grace Kennedy has pricing power (like Jamaica), it can be floating rate debt.

Retailing Medium term for both supermarker/ hypermarket stores and hardware retailing.

Operating leases because they link the debt to the store and allow Grace Kennedy to abandon lease if the store is doing badly.

Financial Services Mix of long term (bank branches) and short term (money management, insurance). Money management business focused on attracting international investment. Driven by regulatory concerns.

Long term debt for long term capital needed for expansion and to meet capital ratio requirements.

Maritime Wharf and stevedoring business requires investment in long term assets. Entirely in Jamaica.

Long term, fixed rate, Jamaican dollar debt

Information Processing

Short term, especially for software products since they have short lifetimes.

Short term, fixed rate, Jamaican dollar debt,

Aswath Damodaran 69

First Principles







Aswath Damodaran 70

Dividends are sticky..

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Dividends tend to follow earnings

Aswath Damodaran 72

Questions to Ask in Dividend Policy Analysis

How much could the company have paid out during the period under question?

How much did the the company actually pay out during the period in question?

How much do I trust the management of this company with excess cash?• How well did they make investments during the period in question?

• How well has my stock performed during the period in question?

Aswath Damodaran 73

Measuring Potential Dividends

Begin with the net income (which is after interest expenses and taxes)Add back the non-cash charges such as depreciation & amortizationSubtract out reinvestment needs- Capital expenditures- Investments in Non-cash Working Capital (Change)

Subtract out payments to non-equity investors- Principal Repayments- Preferred Stock Dividends

Add any cash inflows from new debt - New Debt IssuesTo get to the Cash that is available for return to Owners

Aswath Damodaran 74

How much can you return to stockholders?Grace Kennedy’s Free Cashflow to Equity

2002 2003Net Income $1,603.27 $1,980.19 + Depreciation $363.66 $469.73 - Capital Expenditures $547.01 $837.39 - Change in non-cash Working Capital $522.08 $1,978.80 - Debt Repaid $232.49 $299.45 + New Debt Issued $142.44 $1,202.01FCFE $807.80 $536.29

Aswath Damodaran 75

How much did your return? Grace Kennedy’s Dividends

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

$800.00

$900.00

2002 2003

Dividends versus FCFE

FCFE

Dividends Paid

Aswath Damodaran 76

Can you trust Grace Kennedy’s management?

During the period 2002-2203, Grace Kennedy • Had an average return on equity of 18.7% on projects taken

• Saw it’s stock almost double between 2002 and 2003

• Faced a cost of equity of about 20.46%

• Has accumulated a cash balance of 24,805 million J$

If you were a Grace Kennedy stockholder, would you be comfortable with it’s dividend policy?

Yes No

Aswath Damodaran 77

The Bottom Line on Grace Kennedy Dividends

Grace Kennedy could have afforded to pay more in dividends during the period of the analysis.

It chose not to, and has accumulated the cash. Whether it can continue to hold this cash will depend upon how well it invests

in the coming years.

Aswath Damodaran 78

A Practical Framework for Analyzing Dividend Policy

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

Firm pays out too littleFCFE > Dividends

Firm pays out too muchFCFE < Dividends

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

ROC to WACC

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

ROC to WACC

Firm has history of good project choice and good projects in the future

Firm has historyof poor project choice

Firm has good projects

Firm has poor projects

Give managers the flexibility to keep cash and set dividends

Force managers to justify holding cash or return cash to stockholders

Firm should cut dividends and reinvest more

Firm should deal with its investment problem first and then cut dividends

Aswath Damodaran 79

First Principles








Aswath Damodaran 80

Current Cashflow to FirmEBIT(1-t) : 27- Nt CpX 3 - Chg WC 39= FCFF -$15Reinvestment Rate =42/27 = 154%

Expected Growth in EBIT (1-t).4451*.1419=.06316.31%

Stable Growthg = 4.70%; Beta = 0.80;Cost of capital = 9.96% ROC= 9.96%; Tax rate=33.33%Reinvestment Rate=g/ROC

=4.70/9.96= 47.20%

Terminal Value5= 27.6/(.0996-.047) = 526Cost of Equity10.17 %Cost of Debt(4.70%+1%)(1-.3333)= 3.80%

WeightsE = 89.8% D = 10.2%Discount at $ Cost of Capital (WACC) = 10.17% (.898) + 3.80% (0.102) = 9.52%Op. Assets $ 340+ Cash, Mksec 121- Debt 55- Minor. Int. 17=Equity 389-Options 0Value/Sh $1.21

j$ 72.66/sh

Riskfree Rate :$ Riskfree Rate= 4.70%+Beta 0.70XMature market premium 4.82%

Unlevered Beta for Sectors: 0.65Firm’s D/ERatio: 11%Grace Kennedy: Status Quo (US $)Reinvestment Rate 44.51%Return on Capital14.19%Term Yr 52.4 - 24.8= 27.6

+ Country Equity RiskPremium3.00%

On May 28, 2004Grace Kennedy price = 90 J$$ CashflowsYear 1 2 3 4 5 6 7 8 9 10EBIT (1-t) $28.8 $30.6 $32.6 $34.6 $36.8 $39.1 $41.6 $44.2 $47.0 $50.0 - Reinvestment $12.8 $13.6 $14.5 $15.4 $16.4 $17.4 $18.5 $19.7 $20.9 $22.3 FCFF $16.0 $17.0 $18.1 $19.2 $20.4 $21.7 $23.1 $24.6 $26.1 $27.8

Equity Risk Premium 7.82%

Aswath Damodaran 81

The Paths to Value Creation

Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced:

• The cash flows from existing assets to the firm can be increased, by either – increasing after-tax earnings from assets in place or – reducing reinvestment needs (net capital expenditures or working capital)

• The expected growth rate in these cash flows can be increased by either– Increasing the rate of reinvestment in the firm– Improving the return on capital on those reinvestments

• The length of the high growth period can be extended to allow for more years of high growth.

• The cost of capital can be reduced by– Reducing the operating risk in investments/assets– Changing the financial mix– Changing the financing composition

Aswath Damodaran 82

Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

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

Divest assets thathave negative EBITMore efficient operations and cost cuttting: Higher Margins

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

Live off past over- investmentBetter inventory management and tighter credit policies

Increase Cash FlowsReinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojectsDo acquisitionsIncrease operatingmarginsIncrease capital turnover ratioIncrease Expected GrowthFirm ValueIncrease length of growth periodBuild on existing competitive advantages

Create new competitive advantages

Reduce the cost of capitalCost of Equity * (Equity/Capital) + Pre-tax Cost of Debt (1- tax rate) * (Debt/Capital)

Make your product/service less discretionary

Reduce Operating leverage

Match your financing to your assets: Reduce your default risk and cost of debt

Reduce betaShift interest expenses to higher tax locales

Change financing mix to reduce cost of capital

Aswath Damodaran 83

First Principles








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managers bondholders

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