Disney - Estimating cost of capital. Valuation example. Use actual data for Disney to do estimations relevant for valuation. Early 2004.

Transcription

1 Disney - Estimating cost of capital Valuation example. Use actual data for Disney to do estimations relevant for valuation. Early 2004.

2 Estimating CAPM parameters for Disney Use regression, monthly returns on the stock from January 1999 to December 2003 The returns on the S&P 500 index as the proxy for the market. R code on your homepage.

3 Estimating CAPM parameters for Disney Dependent variable: R S&P500 R Disn (0.217) Constant (0.011) Observations 60 R Adjusted R Residual Std. Error (df = 58) F Statistic (df = 1; 58) Note: p<0.1; p<0.05; p<0.01

4 Estimating CAPM parameters for Disney The point estimate of the beta for Disney is Using standard error: true beta of Disney could range from to 1.3 with 67% confidence from 0.65 to 1.52 with 95% confidence. Consider estimates of betas from regressions with caution.

5 Estimating CAPM parameters for Disney Alternative to doing the regression Estimation service, such as Barra, Value Line, Standard & Poors, Morningstar, Bloomberg begin with regression betas and make what they feel are necessary changes to make them better estimates for the future. In general, betas reported by different services for the same firm can be very different.

6 Alternative to estimated beta: Bottom-up Beta Disney is an entertainment firm with diverse holdings. To estimate Disney s beta in 2005, break the business into four major components. 1. Studio entertainment, which is the production and acquisition of motion pictures. Disney produces movies under five imprints Walt Disney Pictures, Touchstone Pictures, Hollywood Pictures, Miramax, and Dimension. 2. Media networks, which include the ABC television and radio networks. 3. Park Resorts, which include Disney World (in Orlando, Florida), and Disneyland (in Anaheim, California), as well as royalty holdings in Tokyo Disneyland and Disneyland Paris. 4. Consumer products, a grab bag of businesses including Disney s retail outlets, its licensing revenues, software, interactive products, and publishing.

7 Bottom-up Beta for Disney The breakdown reflects Disney s reporting in its annual report. In reality, embedded in these four businesses are several smaller businesses that Disney is in, including: Cruise lines. Disney operates two ships Disney Magic and Disney Wonder that operate out of Florida and visit Caribbean ports. Internet operations. Disney made extensive investments in the Go network and other online operations. While much of this investment was written off by 2002, it still represents a potential source of future revenues. Sports franchises. Disney owns the Mighty Ducks of Anaheim, a National Hockey League franchise; in 2002 it sold its stake in the Anaheim Angels, a Major League Baseball team. Absent detailed information on the operations of these businesses, we will assume that they represent too small a portion of Disney s overall revenues to make a significant difference in the risk calculation.

8 For the four businesses for which we have detailed information, we estimated the unlevered beta by looking at comparable firms in each business. Average Median Comparable Number Levered D/E Unlevered Business Firms of Firms beta (%) Beta Media Radio and TV networks broadcasting companies Parks and Theme parks and resorts entertainment firms Studio Movie entertainment companies Consumer Toy and apparel products retailers; Entertainment software

9 The unlevered beta for Disney as a company is a value-weighted average of the betas of each of the different business areas. The following table summarizes the calculation Revenues Estimated Firm Value in 2003 Enterprise value Proportion Unlever Business ($mill) value/sales ($mill) (%) Beta Media networks 10, , Parks and resorts 6, , Studio entertainment 7, , Consumer products 2, , Disney 27,061 75,

10 The equity beta can then be calculated using the financial leverage for Disney as a firm. The market value of equity is $55,101 million. The estimated market value of debt is $14,668 million. The marginal tax rate is 37.3% The equity beta for Disney ( ) 14, 668 β E = ( ) = , 101 This contrasts with the beta of 1.08 that we obtained from the regression, and is, in our view, a much truer reflection of the risk in Disney.

11 The cost of debt for Disney In early 2004, Disney has bonds outstanding and was rated by S&P and Moody s. The S&P bond rating was BBB+, and the default spread for BBB+ rated bonds was 1.25%. Adding this default spread on to the then prevailing Treasury bond rate of 4% yielded a pretax cost of debt of 5.25%. Cost of debt for Disney = (Risk-free rate + Default Spread) = 4% % = 5.25% Using the marginal tax rate of 37.3% results in an after-tax cost of debt of 3.29% After-tax cost of debt for Disney = (Risk-free rate + Default Spread) (1-Tax Rate) = (4% %)( ) = 3.29%

12 Breaking Down a Convertible Bond into Debt and Equity Components In March 2004, Disney had convertible bonds outstanding with 19 years left to maturity and a coupon rate of 2.125%, trading at $1,064 a bond. Holders of this bond have the right to convert the bond into shares of stock anytime over the bond s remaining life. To break the convertible bond into straight bond and conversion option components, we will value the bond using Disney s pretax cost of debt of 5.25%.

13 Straight bond component = Value of a 2.125% coupon bond due in 19 years with a market interest rate of 5.25% = PV of $21.25 in coupons each year for 19 years + PV of $1,000 at end of year 19. [ 1 (1.0525) 19 ] + 1, = = The straight bond component of $630 is treated as debt, while the conversion option of $434 is treated as equity ( ).

14 The Market Value and Book Value Debt Ratios for Disney Weighted Disney has a number of debt issues on its books, with varying coupon rates and maturities. The following table summarizes Disney s outstanding debt in early 2004: Stated Maturity Face Value Interest (based on Debt (millions) Rate (%) Maturity face value Medium-term paper 8, Senior convertibles 1, Other dollar -denominated debt Privately placed debt Euro medium-term debt 1, Preferred stock Cap Cities debt Other Total 13,

15 To convert the book value of debt to market value, we use the pretax cost of debt for Disney of 5.25% as the discount rate, $13,100 million as the book value of debt, and the current year s interest expenses of $666 million as the coupon: Estimated MV of Disney Debt [ ] 1 1 ( ) = , ( ) = $12, 915 million

16 To this amount, we add the present value of Disney s operating lease committments. This present value is computed by discounting the lease commitment each year at the pretax cost of debt for Disney (5.25%). Commitment Present Value Year (millions) (millions) Debt value of leases 1,7525

17 Adding the debt value of operating leases to the market value of debt $12,915 million yields a total market value of debt of $14,668 million at Disney. Used in conjunction with the market value of equity of $55,101 million, we arrive at market debt-to-capital of 21.01%. To provide a contrast, consider the debt ratios we would have obtained if we had used the book values of $13,100 million for the debt and $24,291 million for equity. The resulting debt-to-capital ratio would have been 35.10%.

18 Cost of Capital Cost of capital can be calculated for divisions as well as for Disney as a whole. We begin with the unlevered betas and Disney s cost of debt. We assume that all divisions are funded with the same mix of debt and equity as the parent company. Levered equity debt Cost of Business beta cost cost E E+D D E+D Capital Media networks Parks and resorts Studio entertainment Consumer products Disney

19 Source This example is taken from Damodaran (2006).

20 Aswath Damodaran. Damodaran on Valuation. Wiley, New York, second edition, 2006.