Valuation. Aswath Damodaran Aswath Damodaran 1

Transcription

1 Valuatio Aswath Damodara Aswath Damodara 1

2 Some Iitial Thoughts " Oe hudred thousad lemmigs caot be wrog" Graffiti Aswath Damodara 2

3 Miscoceptios about Valuatio Myth 1: A valuatio is a objective search for true value Truth 1.1: All valuatios are biased. The oly questios are how much ad i which directio. Truth 1.2: The directio ad magitude of the bias i your valuatio is directly proportioal to who pays you ad how much you are paid. Myth 2.: A good valuatio provides a precise estimate of value Truth 2.1: There are o precise valuatios Truth 2.2: The payoff to valuatio is greatest whe valuatio is least precise. Myth 3:. The more quatitative a model, the better the valuatio Truth 3.1: Oe s uderstadig of a valuatio model is iversely proportioal to the umber of iputs required for the model. Truth 3.2: Simpler valuatio models do much better tha complex oes. Aswath Damodara 3

4 Approaches to Valuatio Discouted cashflow valuatio, relates the value of a asset to the preset value of expected future cashflows o that asset. Relative valuatio, estimates the value of a asset by lookig at the pricig of 'comparable' assets relative to a commo variable like earigs, cashflows, book value or sales. Cotiget claim valuatio, uses optio pricig models to measure the value of assets that share optio characteristics. Aswath Damodara 4

5 Discouted Cash Flow Valuatio What is it: I discouted cash flow valuatio, the value of a asset is the preset value of the expected cash flows o the asset. Philosophical Basis: Every asset has a itrisic value that ca be estimated, based upo its characteristics i terms of cash flows, growth ad risk. Iformatio Needed: To use discouted cash flow valuatio, you eed to estimate the life of the asset to estimate the cash flows durig the life of the asset to estimate the discout rate to apply to these cash flows to get preset value Market Iefficiecy: Markets are assumed to make mistakes i pricig assets across time, ad are assumed to correct themselves over time, as ew iformatio comes out about assets. Aswath Damodara 5

6 Valuig a Firm The value of the firm is obtaied by discoutig expected cashflows to the firm, i.e., the residual cashflows after meetig all operatig expeses ad taxes, but prior to debt paymets, at the weighted average cost of capital, which is the cost of the differet compoets of fiacig used by the firm, weighted by their market value proportios. Value of Firm = t= Â t =1 CF to Firm t (1+ WACC) t where, CF to Firm t = Expected Cashflow to Firm i period t WACC = Weighted Average Cost of Capital Aswath Damodara 6

7 DISCOUNTED CASHFLOW VALUATION Cashflow to Firm EBIT (1-t) - (Cap Ex - Depr) - Chage i WC = FCFF Expected Growth Reivestmet Rate * Retur o Capital Firm is i stable growth: Grows at costat rate forever Value of Operatig Assets + Cash & No-op Assets = Value of Firm - Value of Debt = Value of Equity Termial Value= FCFF +1/(r-g) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFF... Forever Discout at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) Cost of Equity Cost of Debt (Riskfree Rate + Default Spread) (1-t) Weights Based o Market Value Riskfree Rate : - No default risk - No reivestmet risk - I same currecy ad i same terms (real or omial as cash flows + Beta - Measures market risk Type of Busiess Operatig Leverage X Fiacial Leverage Risk Premium - Premium for average risk ivestmet Base Equity Premium Coutry Risk Premium Aswath Damodara 7

8 Avg Reivestmet rate = 25.08% Curret Cashflow to Firm EBIT(1-t) : $ Nt CpX 23 - Chg WC 9 = FCFF $ 372 Reivestmet Rate = 32/404= 7.9% Embraer: Status Quo ($) Reivestmet Rate 25.08% Expected Growth i EBIT (1-t).2185*.2508= % Retur o Capital 21.85% Stable Growth g = 4.17%; Beta = 1.00; Coutry Premium= 5% Cost of capital = 8.76% ROC= 8.76%; Tax rate=34% Reivestmet Rate=g/ROC =4.17/8.76= 47.62% Op. Assets $ 5,272 + Cash: Debt Mior. It. 12 =Equity 5,349 -Optios 28 Value/Share $7.47 R$ $ Cashflows Year EBIT(1-t) Reivestmet = FCFF Discout at $ Cost of Capital (WACC) = 10.52% (.84) % (0.16) = 9.81% Termial Value5= 288/( ) = 6272 Term Yr = 288 Cost of Equity 10.52% Cost of Debt (4.17%+1%+4%)(1-.34) = 6.05% Weights E = 84% D = 16% O October 6, 2003 Embraer Price = R$15.51 Riskfree Rate: $ Riskfree Rate= 4.17% + Beta 1.07 X Mature market premium 4 % + Lambda 0.27 X Coutry Equity Risk Premium 7.67% Ulevered Beta for Sectors: 0.95 Firm s D/E Ratio: 19% Coutry Default Spread 6.01% Aswath Damodara 8 X Rel Equity Mkt Vol 1.28

9 Discouted Cash Flow Valuatio: High Growth with Negative Earigs Tax Rate - NOLs Curret Reveue EBIT Curret Operatig Margi Sales Turover Ratio Reveue Growth Reivestmet Competitive Advatages Expected Operatig Margi Stable Reveue Growth Stable Growth Stable Operatig Margi Stable Reivestmet Value of Operatig Assets + Cash & No-op Assets = Value of Firm - Value of Debt = Value of Equity - Equity Optios = Value of Equity i Stock FCFF = Reveue* Op Margi (1-t) - Reivestmet Termial Value= FCFF +1/(r-g) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFF... Forever Discout at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) Cost of Equity Cost of Debt (Riskfree Rate + Default Spread) (1-t) Weights Based o Market Value Riskfree Rate : - No default risk - No reivestmet risk - I same currecy ad i same terms (real or omial as cash flows + Beta - Measures market risk Type of Busiess Operatig Leverage X Fiacial Leverage Risk Premium - Premium for average risk ivestmet Base Equity Premium Coutry Risk Premium Aswath Damodara 9

10 NOL: 500 m Curret Reveue $ 1,117 EBIT -410m Curret Margi: % Sales Turover Ratio: 3.00 Reveue Growth: 42% Reivestmet: Cap ex icludes acquisitios Workig capital is 3% of reveues Competitive Advatages Expected Margi: -> 10.00% Stable Reveue Growth: 6% Stable Growth Stable Operatig Margi: 10.00% Stable ROC=20% Reivest 30% of EBIT(1-t) Termial Value= 1881/( ) =52,148 Value of Op Assets $ 14,910 + Cash $ 26 = Value of Firm $14,936 - Value of Debt $ 349 = Value of Equity $14,587 - Equity Optios $ 2,892 Value per share $ Reveues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 EBIT -$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 - Reivestmet $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1, Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50% Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00% AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55% Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61% Term. Year $41, % 35.00% $2,688 $ 807 $1,881 Forever Cost of Equity 12.90% Cost of Debt 6.5%+1.5%=8.0% Tax rate = 0% -> 35% Weights Debt= 1.2% -> 15% Riskfree Rate : T. Bod rate = 6.5% + Beta > 1.00 X Risk Premium 4% Amazo.com Jauary 2000 Stock Price = $ 84 Iteret/ Retail Operatig Leverage Curret D/E: 1.21% Base Equity Premium Coutry Risk Premium Aswath Damodara 10

11 Choosig a Currecy for the Valuatio Ay compay ca be valued i ay currecy, as log as you maitai iteral cosistecy by: Usig the same currecy for cashflows, growth rate ad discout rate estimates Beig cosistet i iflatio assumptios whe estimatig growth rates, discout rates ad expected future exchage rates. The currecy you choose to value a compay i is therefore drive by pragmatic cocers. I other words, i which currecy will the estimates of the cashflows ad discout rates be easiest to make. For Embraer, which derives almost all of its cashflows from dollar sources ad has almost all dollar deomiated debt, both cashflows ad discout rates are easier to estimate i US dollars. Aswath Damodara 11

12 I. Discout Rates:Cost of Equity Preferably, a bottom-up beta, based upo other firms i the busiess, ad firm s ow fiacial leverage Cost of Equity = Riskfree Rate + Beta * (Risk Premium) Has to be i the same currecy as cash flows, ad defied i same terms (real or omial) as the cash flows Historical Premium 1. Mature Equity Market Premium: Average premium eared by stocks over T.Bods i U.S. 2. Coutry risk premium = Coutry Default Spread* ( sequity/scoutry bod) or Implied Premium Based o how equity market is priced today ad a simple valuatio model Aswath Damodara 12

13 A Simple Test o o o You are valuig Embraer i U.S. dollars ad are attemptig to estimate a risk free rate to use i the aalysis. The risk free rate that you should use is The iterest rate o a omial real deomiated Brazilia govermet bod The iterest rate o a iflatio-idexed Brazilia govermet bod The iterest rate o a dollar deomiated Brazilia govermet bod (10.18%) o The iterest rate o a U.S. treasury bod (4.17%) Aswath Damodara 13

14 Everyoe uses historical premiums, but.. The historical premium is the premium that stocks have historically eared over riskless securities. Practitioers ever seem to agree o the premium; it is sesitive to How far back you go i history Whether you use T.bill rates or T.Bod rates Whether you use geometric or arithmetic averages. For istace, lookig at the US: Arithmetic average Geometric Average Stocks - Stocks - Stocks - Stocks - Historical Period T.Bills T.Bods T.Bills T.Bods % 6.25% 5.73% 4.53% % 3.66% 3.90% 2.76% % 2.15% 4.69% 0.95% Aswath Damodara 14

15 Two Ways of Estimatig Coutry Risk Premiums Default spread o Coutry Bod: I this approach, the coutry risk premium is based upo the default spread of the bod issued by the coutry (but oly if it is deomiated i a currecy where a default free etity exists. Brazil was rated B2 by Moody s ad the default spread o the Brazilia dollar deomiated C.Bod at the ed of September 2003 was 6.01%. (10.18%-4.17%) Relative Equity Market approach: The coutry risk premium is based upo the volatility of the market i questio relative to U.S market. Coutry risk premium = Risk Premium US * s Coutry Equity / s US Equity Usig a 4.53% premium for the US, this approach would yield: Total risk premium for Brazil = 4.53% (33.37%/18.59%) = 8.13% Coutry risk premium for Brazil = 8.13% % = 3.60% (The stadard deviatio i weekly returs from 2001 to 2003 for the Bovespa was 33.37% whereas the stadard deviatio i the S&P 500 was 18.59%) Aswath Damodara 15

16 Ad a third approach Coutry ratigs measure default risk. While default risk premiums ad equity risk premiums are highly correlated, oe would expect equity spreads to be higher tha debt spreads. Aother is to multiply the bod default spread by the relative volatility of stock ad bod prices i that market. I this approach: Coutry risk premium = Default spread o coutry bod* s Coutry Equity / s Coutry Bod Stadard Deviatio i Bovespa (Equity) = 33.37% Stadard Deviatio i Brazil C-Bod = 26.15% Default spread o C-Bod = 6.01% Coutry Risk Premium for Brazil = 6.01% (33.37%/26.15%) = 7.67%% Aswath Damodara 16

17 From Coutry Spreads to Corporate Risk premiums Approach 1: Assume that every compay i the coutry is equally exposed to coutry risk. I this case, E(Retur) = Riskfree Rate + Coutry Spread + Beta (US premium) Implicitly, this is what you are assumig whe you use the local Govermet s dollar borrowig rate as your riskfree rate. Approach 2: Assume that a compay s exposure to coutry risk is similar to its exposure to other market risk. E(Retur) = Riskfree Rate + Beta (US premium + Coutry Spread) Approach 3: Treat coutry risk as a separate risk factor ad allow firms to have differet exposures to coutry risk (perhaps based upo the proportio of their reveues come from o-domestic sales) E(Retur)=Riskfree Rate+ b (US premium) + l (Coutry Spread) Aswath Damodara 17

18 Estimatig Compay Exposure to Coutry Risk: Determiats Source of reveues: Other thigs remaiig equal, a compay should be more exposed to risk i a coutry if it geerates more of its reveues from that coutry. A Brazilia firm that geerates the bulk of its reveues i Brazil should be more exposed to coutry risk tha oe that geerates a smaller percet of its busiess withi Brazil. Maufacturig facilities: Other thigs remaiig equal, a firm that has all of its productio facilities i Brazil should be more exposed to coutry risk tha oe which has productio facilities spread over multiple coutries. The problem will be acceted for compaies that caot move their productio facilities (miig ad petroleum compaies, for istace). Use of risk maagemet products: Compaies ca use both optios/futures markets ad isurace to hedge some or a sigificat portio of coutry risk. Aswath Damodara 18

19 Estimatig Lambdas: The Reveue Approach The easiest ad most accessible data is o reveues. Most compaies break their reveues dow by regio. Oe simplistic solutio would be to do the followig: l = % of reveues domestically firm / % of reveues domestically avg firm Cosider, for istace, Embraer ad Embratel, both of which are icorporated ad traded i Brazil. Embraer gets 3% of its reveues from Brazil whereas Embratel gets almost all of its reveues i Brazil. The average Brazilia compay gets about 77% of its reveues i Brazil: Lambda Embraer = 3%/ 77% =.04 Lambda Embratel = 100%/77% = 1.30 There are two implicatios A compay s risk exposure is determied by where it does busiess ad ot by where it is located Firms might be able to actively maage their coutry risk exposures Aswath Damodara 19

20 Estimatig Lambdas: Earigs Approach Figure 2: EPS chages versus Coutry Risk: Embraer ad Embratel % % % Quarterly EPS Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q % 0.00% % chage i C Bod Price % % -2 Quarter Embraer Embratel C Bod % Aswath Damodara 20

21 Estimatig Lambdas: Stock Returs versus C-Bod Returs Retur Embraer = Retur C Bod Retur Embratel = Retur C Bod 40 Embraer versus C Bod: Embratel versus C Bod: Retur o Embraer 0-20 Retur o Embratel Retur o C-Bod Retur o C-Bod Aswath Damodara 21

22 Estimatig a US Dollar Cost of Equity for Embraer Assume that the beta for Embraer is 1.07, ad that the riskfree rate used is 4.17%. Also assume that the risk premium for the US is 4.53% ad the coutry risk premium for Brazil is 7.67%. Approach 1: Assume that every compay i the coutry is equally exposed to coutry risk. I this case, E(Retur) = 4.17% (4.53%) % = 16.69% Approach 2: Assume that a compay s exposure to coutry risk is similar to its exposure to other market risk. E(Retur) = 4.17 % (4.53%+ 7.67%) = 17.22% Approach 3: Treat coutry risk as a separate risk factor ad allow firms to have differet exposures to coutry risk (perhaps based upo the proportio of their reveues come from o-domestic sales) E(Retur)= 4.17% (4.53%) (7.67%) = 11.09% Aswath Damodara 22

23 Implied Equity Risk Premiums A implied equity risk premium is a forward lookig estimate, based upo how stocks are priced today ad expected cashflows i the future. O Jauary 1, 2003, the S&P was tradig at Treasury bod rate = 3.81% Expected Growth rate i earigs (ext 5 years) = 8% (Cosesus estimate for S&P 500 earigs) Expected growth rate after year 5 = 3.81% Divideds + stock buybacks = 3.29% of idex (i latest year) Year 1 Year 2 Year 3 Year 4 Year 5 Expected Divideds = $31.25 $33.75 $36.45 $39.37 $ Stock Buybacks Expected divideds + buybacks i year 6 = (1.0381) = $ = 31.25/(1+r) /(1+r) /(1+r) /(1+r) 4 + (42.52+(44.14/(r-.0381))/(1+r) 5 Solvig for r, r = 7.91%. (Oly way to do this is trial ad error) Implied risk premium = 7.91% % = 4.10% Aswath Damodara 23

24 U.S. Equity Risk Premiums Implied Premium for US Equity Market 7.00% 6.00% 5.00% Implied Premium 4.00% 3.00% 2.00% 1.00% 0.00% Year Aswath Damodara 24

25 Mothly Premiums: Aswath Damodara 25

26 A Itermediate Solutio The historical risk premium of 4.53% for the Uited States is too high a premium to use i valuatio. It is much higher tha the actual implied equity risk premium i the market The curret implied equity risk premium requires us to assume that the market is correctly priced today. (If I were required to be market eutral, this is the premium I would use) The average implied equity risk premium betwee i the Uited States is about 4%. We will use this as the premium for a mature equity market. Aswath Damodara 26

27 Implied Premium for Brazil: September 2003 Level of the Idex = Divideds o the Idex = 4.55% of Other parameters (all i US dollars) Riskfree Rate = 4.17% Expected Growth (i dollars) Next 5 years = 15% (Used expected growth rate i Earigs) After year 5 = 5% Solvig for the expected retur: Expected retur o Equity = 12.17% Implied Equity premium = 12.17% % = 8.00% Implied Equity premium for US o same day = 3.79% Implied coutry premium for Brazil = 4.21% Aswath Damodara 27

28 Estimatig Beta The stadard procedure for estimatig betas is to regress stock returs (R j ) agaist market returs (R m ) - R j = a + b R m where a is the itercept ad b is the slope of the regressio. The slope of the regressio correspods to the beta of the stock, ad measures the riskiess of the stock. This beta has three problems: It has high stadard error It reflects the firm s busiess mix over the period of the regressio, ot the curret mix It reflects the firm s average fiacial leverage over the period rather tha the curret leverage. Aswath Damodara 28

29 Beta Estimatio: Amazo Aswath Damodara 29

30 Beta Estimatio for Embraer: The Idex Effect Aswath Damodara 30

31 Determiats of Betas Product or Service: The beta value for a firm depeds upo the sesitivity of the demad for its products ad services ad of its costs to macroecoomic factors that affect the overall market. Cyclical compaies have higher betas tha o-cyclical firms Firms which sell more discretioary products will have higher betas tha firms that sell less discretioary products Operatig Leverage: The greater the proportio of fixed costs i the cost structure of a busiess, the higher the beta will be of that busiess. Higher fixed costs icrease your exposure to all risk, icludig market risk. Fiacial Leverage: The more debt a firm takes o, the higher the beta will be of the equity i that busiess. Debt creates a fixed cost, iterest expeses, that icreases exposure to market risk. The beta of equity aloe ca be writte as a fuctio of the ulevered beta ad the debt-equity ratio b L = b u (1+ ((1-t)D/E) b L = Levered or Equity Beta t = Corporate margial tax rate E = Market Value of Equity b u = Ulevered Beta D = Market Value of Debt Aswath Damodara 31

32 The Solutio: Bottom-up Betas The bottom up beta ca be estimated by : Takig a weighted (by sales or operatig icome) average of the ulevered betas of the differet busiesses a firm is i. j =k  j =1 b j È Operatig Icome j Í Î Operatig Icome Firm (The ulevered beta of a busiess ca be estimated by lookig at other firms i the same busiess) Lever up usig the firm s debt/equity ratio b levered = b ulevered [ 1+ (1- tax rate) (Curret Debt/Equity Ratio) ] The bottom up beta will give you a better estimate of the true beta whe It has lower stadard error (SE average = SE firm / ( = umber of firms) It reflects the firm s curret busiess mix ad fiacial leverage It ca be estimated for divisios ad private firms. Aswath Damodara 32

33 Embraer s Bottom-up Beta Busiess Ulevered D/E Ratio Levered beta Proportio of Value Aerospace % % Levered Beta = Ulevered Beta ( 1 + (1- tax rate) (D/E Ratio) = 0.95 ( 1 + (1-.34) (.1895)) = 1.07 A Hypothetical sceario: Assume that Embraer had bee i two busiesses- aerospace ad trasportatio. You could estimate a beta for the combied firm as follows Comparable firms Busiess Reveues Value/Sales Ulevered beta Value Weight Weight*Beta Aerospace %.60*.95 Trasport %.40*.80 Firm =0.89 Aswath Damodara 33

34 Gross Debt versus Net Debt Approaches Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity = ( )/ 11,042 = -3.32% Levered Beta for Embraer = 0.95 (1 + (1-.34) (-.0332)) = 0.93 The cost of Equity usig et debt levered beta for Embraer will be much lower tha with the gross debt approach. The cost of capital for Embraer, though, will eve out sice the debt ratio used i the cost of capital equatio will ow be a et debt ratio rather tha a gross debt ratio. Aswath Damodara 34

35 Amazo s Bottom-up Beta Ulevered beta for firms i iteret retailig = 1.60 Ulevered beta for firms i specialty retailig = 1.00 Amazo is a specialty retailer, but its risk curretly seems to be determied by the fact that it is a olie retailer. Hece we will use the beta of iteret compaies to begi the valuatio By the fifth year, we are estimatig substatial reveues for Amazo ad we move the beta towards to beta of the retailig busiess. Aswath Damodara 35

36 From Cost of Equity to Cost of Capital Cost of borrowig should be based upo (1) sythetic or actual bod ratig (2) default spread Cost of Borrowig = Riskfree rate + Default spread Margial tax rate, reflectig tax beefits of debt Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowig (1-t) (Debt/(Debt + Equity)) Cost of equity based upo bottom-up beta Weights should be market value weights Aswath Damodara 36

37 Estimatig Sythetic Ratigs The ratig for a firm ca be estimated usig the fiacial characteristics of the firm. I its simplest form, the ratig ca be estimated from the iterest coverage ratio Iterest Coverage Ratio = EBIT / Iterest Expeses For Embraer s iterest coverage ratio, we used the iterest expeses ad EBIT from Iterest Coverage Ratio = 2166/ 222 = 9.74 Amazo.com has egative operatig icome; this yields a egative iterest coverage ratio, which should suggest a low ratig. We computed a average iterest coverage ratio of 2.82 over the ext 5 years. Aswath Damodara 37

38 Iterest Coverage Ratios, Ratigs ad Default Spreads If Iterest Coverage Ratio is Estimated Bod Ratig Default Spread(1/00) Default Spread(1/03) > 8.50 (>12.50) AAA 0.20% 0.75% ( ) AA 0.50% 1.00% ( ) A+ 0.80% 1.50% (6-7.5) A 1.00% 1.80% (4.5-6) A 1.25% 2.00% ( ) BBB 1.50% 2.25% ((3-3.5) BB 2.00% 3.50% (2.5-3) B+ 2.50% 4.75% (2-2.5) B 3.25% 6.50% (1.5-2) B 4.25% 8.00% ( ) CCC 5.00% 10.00% ( ) CC 6.00% 11.50% ( ) C 7.50% 12.70% < 0.20 (<0.5) D 10.00% 15.00% For Embraer, I used the iterest coverage ratio table for smaller/riskier firms (the umbers i brackets) which yields a lower ratig for the same iterest coverage ratio. Aswath Damodara 38

39 Estimatig the cost of debt for a firm The sythetic ratig for Embraer is AA. Usig the 2003 default spread of 1.00%, we estimate a cost of debt of 9.17% (usig a riskfree rate of 4.17% ad addig i two thirds of the coutry default spread of 6.01%): Cost of debt = Riskfree rate + 2/3(Brazil coutry default spread) + Compay default spread =4.17% %+ 1.00% = 9.17% The sythetic ratig for Amazo.com i 2000 was BBB. The default spread for BBB rated bod was 1.50% i 2000 ad the treasury bod rate was 6.5%. Pre-tax cost of debt = Riskfree Rate + Default spread = 6.50% % = 8.00% The firm is payig o taxes curretly. As the firm s tax rate chages ad its cost of debt chages, the after tax cost of debt will chage as well Pre-tax 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00% Tax rate 0% 0% 0% 16.13% 35% 35% 35% 35% 35% 35% After-tax 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55% Aswath Damodara 39

40 Weights for the Cost of Capital Computatio The weights used to compute the cost of capital should be the market value weights for debt ad equity. There is a elemet of circularity that is itroduced ito every valuatio by doig this, sice the values that we attach to the firm ad equity at the ed of the aalysis are differet from the values we gave them at the begiig. As a geeral rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital. Aswath Damodara 40

41 Estimatig Cost of Capital: Amazo.com Equity Cost of Equity = 6.50% (4.00%) = 12.90% Market Value of Equity = $ 84/share* mil shs = $ 28,626 mil (98.8%) Debt Cost of debt = 6.50% % (default spread) = 8.00% Market Value of Debt = $ 349 mil (1.2%) Cost of Capital Cost of Capital = 12.9 % (.988) % (1-0) (.012)) = 12.84% Aswath Damodara 41

42 Estimatig Cost of Capital: Embraer Equity Cost of Equity = 4.17% (4%) (7.67%) = 10.52% Market Value of Equity =11,042 millio BR ($ 3,781 millio) Debt Cost of debt = 4.17% % +1.00%= 9.17% Market Value of Debt = 2,093 millio BR ($717 millio) Cost of Capital Cost of Capital = % (.84) % (1-.34) (0.16)) = 9.81% The book value of equity at Embraer is 3,350 millio BR. The book value of debt at Embraer is 1,953 millio BR; Iterest expese is 222 mil; Average maturity of debt = 4 years Estimated market value of debt = 222 millio (PV of auity, 4 years, 9.17%) + $361 millio/ = 2,093 millio BR Aswath Damodara 42

43 If you had to do it.covertig a Dollar Cost of Capital to a Nomial Real Cost of Capital Approach 1: Use a BR riskfree rate i all of the calculatios above. For istace, if the BR riskfree rate was 12%, the cost of capital would be computed as follows: Cost of Equity = 12% (4%) (7.67%) = 18.35% Cost of Debt = 12% + 1% = 13% (This assumes the riskfree rate has o coutry risk premium embedded i it.) Approach 2: Use the differetial iflatio rate to estimate the cost of capital. For istace, if the iflatio rate i BR is 8% ad the iflatio rate i the U.S. is 2% È Cost of capital= (1+ Cost of Capital $ ) 1+ Iflatio BR Í Î 1+ Iflatio $ = (1.08/1.02)-1 = or 16.27% Aswath Damodara 43

44 II. Estimatig Cash Flows to Firm Operatig leases - Covert ito debt - Adjust operatig icome R&D Expeses - Covert ito asset - Adjust operatig icome Update - Trailig Earigs - Uofficial umbers Normalize - History - Idustry Clease operatig items of - Fiacial Expeses - Capital Expeses - No-recurrig expeses Tax rate - ca be effective for ear future, but move to margial - reflect et operatig losses Iclude - R&D - Acquisitios Earigs before iterest ad taxes - Tax rate * EBIT = EBIT ( 1- tax rate) - (Capital Expeditures - Depreciatio) - Chage i o-cash workig capital = Free Cash flow to the firm (FCFF) Defied as No-cash CA - No-debt CL Aswath Damodara 44

45 The Importace of Updatig The operatig icome ad reveue that we use i valuatio should be updated umbers. Oe of the problems with usig fiacial statemets is that they are dated. As a geeral rule, it is better to use 12-moth trailig estimates for earigs ad reveues tha umbers for the most recet fiacial year. This rule becomes eve more critical whe valuig compaies that are evolvig ad growig rapidly. Last 10-K Trailig 12-moth Reveues $ 610 millio $1,117 millio EBIT - $125 millio - $ 410 millio Aswath Damodara 45

46 Normalizig Earigs: Amazo Year Reveues Operatig Margi EBIT Tr12m $1, % -$410 1 $2, % -$373 2 $5, % -$94 3 $9, % $407 4 $14, % $1,038 5 $19, % $1,628 6 $23, % $2,212 7 $28, % $2,768 8 $33, % $3,261 9 $36, % $3, $39, % $3,883 TY(11) $41, % $4,135 Idustry Average Aswath Damodara 46

47 Operatig Leases at The Home Depot i 1998 The pre-tax cost of debt at the Home Depot is 6.25% Yr Operatig Lease Expese Preset Value 1 $ 294 $ $ 291 $ $ 264 $ $ 245 $ $ 236 $ $ 270 $ 1,450 (PV of 10-yr auity) Preset Value of Operatig Leases =$ 2,571 Debt outstadig at the Home Depot = $1,205 + $2,571 = $3,776 mil (The Home Depot has other debt outstadig of $1,205 millio) Adjusted Operatig Icome = $2, ,571 (.0625) = $2,177 mil Aswath Damodara 47

48 Capitalizig R&D Expeses: Shire Pharmaceuticals To capitalize R&D, Specify a amortizable life for R&D (2-10 years) Collect past R&D expeses for as log as the amortizable life Sum up the uamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset ca be obtaied by addig up 1/5th of the R&D expese from five years ago, 2/5th of the R&D expese from four years ago...: R & D was assumed to have a 5-year life. Year R&D Uamortized R&D Amortizatio Curret Value of research asset = Amortizatio of research asset i 2000 = Adjustmet to Operatig Icome = + R&D - Amortizatio of R&D Adjusted Operatig Icome = = Aswath Damodara 48

49 The Effect of Net Operatig Losses: Amazo.com s Tax Rate Year EBIT -$373 -$94 $407 $1,038 $1,628 Taxes $0 $0 $0 $167 $570 EBIT(1-t) -$373 -$94 $407 $871 $1,058 Tax rate 0% 0% 0% 16.13% 35% NOL $500 $873 $967 $560 $0 After year 5, the tax rate becomes 35%. Aswath Damodara 49

50 Estimatig Actual FCFF: Embraer EBIT = 2,166 millio BR Tax rate = 34% Net Capital expeditures = Cap Ex - Depreciatio = = millio BR Chage i Workig Capital = + 33 millio BR Average exchage rate durig 2002 = 3.54 BR/ US $ BR US dollars Curret EBIT * (1 - tax rate) = 1,430 m 404 m - (Capital Spedig - Depreciatio) 80 m 23 m - Chage i Workig Capital 33 m 9 m Curret FCFF 1,317 m 372 m Aswath Damodara 50

51 Estimatig FCFF: Amazo.com EBIT (Trailig 1999) = -$ 410 millio Tax rate used = 0% (Assumed Effective = Margial) Capital spedig (Trailig 1999) = $ 243 millio Depreciatio (Trailig 1999) = $ 31 millio No-cash Workig capital Chage (1999) = - 80 millio Estimatig FCFF (1999) Curret EBIT * (1 - tax rate) = (1-0) = - $410 millio - (Capital Spedig - Depreciatio) = $212 millio - Chage i Workig Capital = -$ 80 millio Curret FCFF = - $542 millio Aswath Damodara 51

52 IV. Expected Growth i EBIT ad Fudametals Reivestmet Rate ad Retur o Capital g EBIT = (Net Capital Expeditures + Chage i WC)/EBIT(1-t) * ROC = Reivestmet Rate * ROC Propositio: No firm ca expect its operatig icome to grow over time without reivestig some of the operatig icome i et capital expeditures ad/or workig capital. Propositio: The et capital expediture eeds of a firm, for a give growth rate, should be iversely proportioal to the quality of its ivestmets. Aswath Damodara 52

53 Normalizig Reivestmet: Embraer Total Reveues EBIT Operatig Margi 11.15% 14.68% 17.48% 18.53% 27.96% 21.31% Net Cap ex No-cash WC Net Cap ex as % of EBIT (1-t) No-cash WC as % of Reveue 16.54% 14.24% Aswath Damodara 53

54 Expected Growth Estimate: Embraer Estimatig ormalized reivestmet rate Normalized Chage i workig capital = (Workig capital as percet of reveues) * Chage i reveues i 2002 =.1424 ( ) = 122 mil BR Normalized Net Cap Ex = Net Cap ex as % of EBIT(1-t) * EBIT (1-t) i 2001 =.1654*(2166 (1-.34)) = 236 millio BR Normalized reivestmet rate = ( )/(2166 (1-.34))= 25.04% (This will be the same, if estimated i U.S. dollars) Estimatig retur o capital i $ terms Estimate after-tax operatig icome i dollars = 2166 (1-.34)) / 3.54 = $ 404 m Divide by dollar value book value of capital at start of period = Book value of equity (1073) + Book value of debt (776) = $ 1, 849 millio Retur o capital = 404 / 1,849 = 21.85% Expected growth rate =.2504*.2185 = 5.48% Aswath Damodara 54

55 Reveue Growth ad Operatig Margis With egative operatig icome ad a egative retur o capital, the fudametal growth equatio is of little use for Amazo.com For Amazo, the effect of reivestmet shows up i reveue growth rates ad chages i expected operatig margis: Expected Reveue Growth i $ = Reivestmet (i $ terms) * (Sales/ Capital) The effect o expected margis is more subtle. Amazo s reivestmets (especially i acquisitios) may help create barriers to etry ad other competitive advatages that will ultimately traslate ito high operatig margis ad high profits. Aswath Damodara 55

56 Growth i Reveues, Earigs ad Reivestmet: Amazo Year Reveue Chg i Reivestmet Chg Rev/ Chg Reivestmet ROC Growth Reveue % $1,676 $ % % $2,793 $ % % $4,189 $1, % % $4,887 $1, % % $4,398 $1, % % $4,803 $1, % % $4,868 $1, % % $4,482 $1, % % $3,587 $1, % % $2,208 $ % Assume that firm ca ear high returs because of established ecoomies of scale. Aswath Damodara 56

57 V. Growth Patters A key assumptio i all discouted cash flow models is the period of high growth, ad the patter of growth durig that period. I geeral, we ca make oe of three assumptios: there is o high growth, i which case the firm is already i stable growth there will be high growth for a period, at the ed of which the growth rate will drop to the stable growth rate (2-stage) there will be high growth for a period, at the ed of which the growth rate will declie gradually to a stable growth rate(3-stage) Stable Growth 2-Stage Growth 3-Stage Growth Aswath Damodara 57

58 Determiats of Growth Patters Size of the firm Success usually makes a firm larger. As firms become larger, it becomes much more difficult for them to maitai high growth rates Curret growth rate While past growth is ot always a reliable idicator of future growth, there is a correlatio betwee curret growth ad future growth. Thus, a firm growig at 30% curretly probably has higher growth ad a loger expected growth period tha oe growig 10% a year ow. Barriers to etry ad differetial advatages Ultimately, high growth comes from high project returs, which, i tur, comes from barriers to etry ad differetial advatages. The questio of how log growth will last ad how high it will be ca therefore be framed as a questio about what the barriers to etry are, how log they will stay up ad how strog they will remai. Aswath Damodara 58

59 Stable Growth Characteristics I stable growth, firms should have the characteristics of other stable growth firms. I particular, The risk of the firm, as measured by beta ad ratigs, should reflect that of a stable growth firm. Beta should move towards oe The cost of debt should reflect the safety of stable firms (BBB or higher) The debt ratio of the firm might icrease to reflect the larger ad more stable earigs of these firms. The debt ratio of the firm might moved to the optimal or a idustry average If the maagers of the firm are deeply averse to debt, this may ever happe The reivestmet rate of the firm should reflect the expected growth rate ad the firm s retur o capital Reivestmet Rate = Expected Growth Rate / Retur o Capital Aswath Damodara 59

60 Embraer ad Amazo.com: Stable Growth Iputs Embraer High Growth Stable Growth Beta Lambda Coury risk premium 7.67% 5.00% Debt Ratio 15.93% 15.93% Retur o Capital 21.85% 8.76% Cost of Capital 9.81% 8.76% Expected Growth Rate 5.48% 4.17% Reivestmet Rate 25.04% 4.17%/8.76% = 47.62% Amazo.com Beta Debt Ratio 1.20% 15% Retur o Capital Negative 20% Expected Growth Rate NMF 6% Reivestmet Rate >100% 6%/20% = 30% Aswath Damodara 60

61 Dealig with Cash ad Marketable Securities The simplest ad most direct way of dealig with cash ad marketable securities is to keep them out of the valuatio - the cash flows should be before iterest icome from cash ad securities, ad the discout rate should ot be cotamiated by the iclusio of cash. (Use betas of the operatig assets aloe to estimate the cost of equity). Oce the firm has bee valued, add back the value of cash ad marketable securities. If you have a particularly icompetet maagemet, with a history of overpayig o acquisitios, markets may discout the value of this cash. Aswath Damodara 61

62 Dealig with Cross Holdigs Whe the holdig is a majority, active stake, the value that we obtai from the cash flows icludes the share held by outsiders. While their holdig is measured i the balace sheet as a miority iterest, it is at book value. To get the correct value, we eed to subtract out the estimated market value of the miority iterests from the firm value. Whe the holdig is a miority, passive iterest, the problem is a differet oe. The firm shows o its icome statemet oly the share of divideds it receives o the holdig. Usig oly this icome will uderstate the value of the holdigs. I fact, we have to value the subsidiary as a separate etity to get a measure of the market value of this holdig. Propositio 1: It is almost impossible to correctly value firms with miority, passive iterests i a large umber of private subsidiaries. Aswath Damodara 62

63 Embraer s Cash ad Cross Holdigs Embraer has a 60% iterest i a equipmet compay ad the fiacial statemets of that compay are cosolidated with those of Embraer. The miority iterests (represetig the equity i the subsidiary that does ot belog to Embraer) are show o the balace sheet at 23 millio BR. Estimated market value of miority iterests = Book value of miority iterest * P/BV of sector that subsidiary belogs to = *1.5 = millio BR Preset Value of FCFF i high growth phase = $1, Preset Value of Termial Value of Firm = $3, Value of operatig assets of the firm = $5, Value of Cash, Marketable Securities = $ Value of Firm = $6, Market Value of outstadig debt = $ Miority Iterest i cosolidated holdigs =34.68/2.92 = $11.88 Market Value of Equity = $5, Value of Equity i Optios = $27.98 Value of Equity i Commo Stock = $5, Market Value of Equity/share = $7.47 Market Value of Equity/share i BR =7.47 *2.92 BR/$ = R$ Aswath Damodara 63

64 Amazo: Estimatig the Value of Equity Optios Details of optios outstadig Average strike price of optios outstadig = $ Average maturity of optios outstadig = 8.4 years Stadard deviatio i l(stock price) = 50.00% Aualized divided yield o stock = 0.00% Treasury bod rate = 6.50% Number of optios outstadig = 38 millio Number of shares outstadig = millio Value of optios outstadig (usig dilutio-adjusted Black-Scholes model) Value of equity optios = $ 2,892 millio Aswath Damodara 64

65 NOL: 500 m Curret Reveue $ 1,117 EBIT -410m Curret Margi: % Sales Turover Ratio: 3.00 Reveue Growth: 42% Reivestmet: Cap ex icludes acquisitios Workig capital is 3% of reveues Competitive Advatages Expected Margi: -> 10.00% Stable Reveue Growth: 6% Stable Growth Stable Operatig Margi: 10.00% Stable ROC=20% Reivest 30% of EBIT(1-t) Termial Value= 1881/( ) =52,148 Value of Op Assets $ 14,910 + Cash $ 26 = Value of Firm $14,936 - Value of Debt $ 349 = Value of Equity $14,587 - Equity Optios $ 2,892 Value per share $ Reveues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 EBIT -$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 - Reivestmet $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1, Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50% Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00% AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55% Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61% Term. Year $41, % 35.00% $2,688 $ 807 $1,881 Forever Cost of Equity 12.90% Cost of Debt 6.5%+1.5%=8.0% Tax rate = 0% -> 35% Weights Debt= 1.2% -> 15% Riskfree Rate : T. Bod rate = 6.5% + Beta > 1.00 X Risk Premium 4% Amazo.com Jauary 2000 Stock Price = $ 84 Iteret/ Retail Operatig Leverage Curret D/E: 1.21% Base Equity Premium Coutry Risk Premium Aswath Damodara 65

66 Amazo.com: Break Eve at $84? 6% 8% 10% 12% 14% 30% $ (1.94) $ 2.95 $ 7.84 $ $ % $ 1.41 $ 8.37 $ $ $ % $ 6.10 $ $ $ $ % $ $ $ $ $ % $ $ $ $ $ % $ $ $ $ $ % $ $ $ $ $ Aswath Damodara 66

67 NOL: 1,289 m Curret Reveue $ 2,465 EBIT -853m Curret Margi: % Sales Turover Ratio: 3.02 Reveue Growth: 25.41% Reivestmet: Cap ex icludes acquisitios Workig capital is 3% of reveues Competitive Advatages Expected Margi: -> 9.32% Stable Reveue Growth: 5% Stable Growth Stable Operatig Margi: 9.32% Termial Value= 1064/( ) =$ 28,310 Stable ROC=16.94% Reivest 29.5% of EBIT(1-t) Value of Op Assets $ 7,967 + Cash & No-op $ 1,263 = Value of Firm $ 9,230 - Value of Debt $ 1,890 = Value of Equity $ 7,340 - Equity Optios $ 748 Value per share $ Reveues $4,314 $6,471 $9,059 $11,777 $14,132 $16,534 $18,849 $20,922 $22,596 $23,726 $24,912 EBIT -$703 -$364 $54 $499 $898 $1,255 $1,566 $1,827 $2,028 $2,164 $2,322 EBIT(1-t) -$703 -$364 $54 $499 $898 $1,133 $1,018 $1,187 $1,318 $1,406 $1,509 - Reivestmet $612 $714 $857 $900 $780 $796 $766 $687 $554 $374 $445 FCFF -$1,315 -$1,078 -$803 -$401 $118 $337 $252 $501 $764 $1,032 $1, Debt Ratio 27.27% 27.27% 27.27% 27.27% 27.27% 24.81% 24.20% 23.18% 21.13% 15.00% Beta Cost of Equity 13.81% 13.81% 13.81% 13.81% 13.81% 12.95% 12.09% 11.22% 10.36% 9.50% AT cost of debt 10.00% 10.00% 10.00% 10.00% 9.06% 6.11% 6.01% 5.85% 5.53% 4.55% Cost of Capital 12.77% 12.77% 12.77% 12.77% 12.52% 11.25% 10.62% 9.98% 9.34% 8.76% Term. Year $24,912 $2,322 $1,509 $ 445 $1,064 Forever Cost of Equity 13.81% Cost of Debt 5.1%+4.75%= 9.85% Tax rate = 0% -> 35% Weights Debt= 27.38% -> 15% Riskfree Rate : T. Bod rate = 5.1% + Beta 2.18-> 1.10 X Risk Premium 4% Amazo.com Jauary 2001 Stock price = $14 Iteret/ Retail Operatig Leverage Curret D/E: 37.5% Base Equity Premium Coutry Risk Premium Aswath Damodara 67

68 Avg Reivestmet rate = 25.08% Curret Cashflow to Firm EBIT(1-t) : $ Nt CpX 23 - Chg WC 9 = FCFF $ 372 Reivestmet Rate = 32/404= 7.9% Embraer: Status Quo ($) Reivestmet Rate 25.08% Expected Growth i EBIT (1-t).2185*.2508= % Retur o Capital 21.85% Stable Growth g = 4.17%; Beta = 1.00; Coutry Premium= 5% Cost of capital = 8.76% ROC= 8.76%; Tax rate=34% Reivestmet Rate=g/ROC =4.17/8.76= 47.62% Op. Assets $ 5,272 + Cash: Debt Mior. It. 12 =Equity 5,349 -Optios 28 Value/Share $7.47 R$ $ Cashflows Year EBIT(1-t) Reivestmet = FCFF Discout at $ Cost of Capital (WACC) = 10.52% (.84) % (0.16) = 9.81% Termial Value5= 288/( ) = 6272 Term Yr = 288 Cost of Equity 10.52% Cost of Debt (4.17%+1%+4%)(1-.34) = 6.05% Weights E = 84% D = 16% O October 6, 2003 Embraer Price = R$15.51 Riskfree Rate: $ Riskfree Rate= 4.17% + Beta 1.07 X Mature market premium 4 % + Lambda 0.27 X Coutry Equity Risk Premium 7.67% Ulevered Beta for Sectors: 0.95 Firm s D/E Ratio: 19% Coutry Default Spread 6.01% Aswath Damodara 68 X Rel Equity Mkt Vol 1.28

69 Value Ehacemet: Back to Basics Aswath Damodara Aswath Damodara 69

70 Price Ehacemet versus Value Ehacemet Aswath Damodara 70

71 The Paths to Value Creatio Usig the DCF framework, there are four basic ways i which the value of a firm ca be ehaced: The cash flows from existig assets to the firm ca be icreased, by either icreasig after-tax earigs from assets i place or reducig reivestmet eeds (et capital expeditures or workig capital) The expected growth rate i these cash flows ca be icreased by either Icreasig the rate of reivestmet i the firm Improvig the retur o capital o those reivestmets The legth of the high growth period ca be exteded to allow for more years of high growth. The cost of capital ca be reduced by Reducig the operatig risk i ivestmets/assets Chagig the fiacial mix Chagig the fiacig compositio Aswath Damodara 71

72 A Basic Propositio For a actio to affect the value of the firm, it has to Affect curret cash flows (or) Affect future growth (or) Affect the legth of the high growth period (or) Affect the discout rate (cost of capital) Propositio 1: Actios that do ot affect curret cash flows, future growth, the legth of the high growth period or the discout rate caot affect value. Aswath Damodara 72

73 Value-Neutral Actios Stock splits ad stock divideds chage the umber of uits of equity i a firm, but caot affect firm value sice they do ot affect cash flows, growth or risk. Accoutig decisios that affect reported earigs but ot cash flows should have o effect o value. Chagig ivetory valuatio methods from FIFO to LIFO or vice versa i fiacial reports but ot for tax purposes Chagig the depreciatio method used i fiacial reports (but ot the tax books) from accelerated to straight lie depreciatio Major o-cash restructurig charges that reduce reported earigs but are ot tax deductible Usig poolig istead of purchase i acquisitios caot chage the value of a target firm. Decisios that create ew securities o the existig assets of the firm (without alterig the fiacial mix) such as trackig stock caot create value, though they might affect perceptios ad hece the price. Aswath Damodara 73

74 I. Ways of Icreasig Cash Flows from Assets i Place More efficiet operatios ad cost cutttig: Higher Margis Divest assets that have egative EBIT Reduce tax rate - movig icome to lower tax locales - trasfer pricig - risk maagemet Reveues * Operatig Margi = EBIT - Tax Rate * EBIT = EBIT (1-t) + Depreciatio - Capital Expeditures - Chg i Workig Capital = FCFF Live off past overivestmet Better ivetory maagemet ad tighter credit policies Aswath Damodara 74

75 II. Value Ehacemet through Growth Reivest more i projects Icrease operatig margis Reivestmet Rate * Retur o Capital = Expected Growth Rate Do acquisitios Icrease capital turover ratio Aswath Damodara 75

76 III. Buildig Competitive Advatages: Icrease legth of the growth period Icrease legth of growth period Build o existig competitive advatages Fid ew competitive advatages Brad ame Legal Protectio Switchig Costs Cost advatages Aswath Damodara 76

77 3.1: The Brad Name Advatage Some firms are able to sustai above-ormal returs ad growth because they have well-recogized brad ames that allow them to charge higher prices tha their competitors ad/or sell more tha their competitors. Firms that are able to improve their brad ame value over time ca icrease both their growth rate ad the period over which they ca expect to grow at rates above the stable growth rate, thus icreasig value. Aswath Damodara 77

78 Illustratio: Valuig a brad ame: Coca Cola Coca Cola Geeric Cola Compay AT Operatig Margi 18.56% 7.50% Sales/BV of Capital ROC 31.02% 12.53% Reivestmet Rate 65.00% (19.35%) 65.00% (47.90%) Expected Growth 20.16% 8.15% Legth 10 years 10 yea Cost of Equity 12.33% 12.33% E/(D+E) 97.65% 97.65% AT Cost of Debt 4.16% 4.16% D/(D+E) 2.35% 2.35% Cost of Capital 12.13% 12.13% Value $115 $13 Aswath Damodara 78

79 3.2: Patets ad Legal Protectio The most complete protectio that a firm ca have from competitive pressure is to ow a patet, copyright or some other kid of legal protectio allowig it to be the sole producer for a exteded period. Note that patets oly provide partial protectio, sice they caot protect a firm agaist a competitive product that meets the same eed but is ot covered by the patet protectio. Liceses ad govermet-sactioed moopolies also provide protectio agaist competitio. They may, however, come with restrictios o excess returs; utilities i the Uited States, for istace, are moopolies but are regulated whe it comes to price icreases ad returs. Aswath Damodara 79

80 3.3: Switchig Costs Aother potetial barrier to etry is the cost associated with switchig from oe firm s products to aother. The greater the switchig costs, the more difficult it is for competitors to come i ad compete away excess returs. Firms that devise ways to icrease the cost of switchig from their products to competitors products, while reducig the costs of switchig from competitor products to their ow will be able to icrease their expected legth of growth. Aswath Damodara 80

81 3.4: Cost Advatages There are a umber of ways i which firms ca establish a cost advatage over their competitors, ad use this cost advatage as a barrier to etry: I busiesses, where scale ca be used to reduce costs, ecoomies of scale ca give bigger firms advatages over smaller firms Owig or havig exclusive rights to a distributio system ca provide firms with a cost advatage over its competitors. Owig or havig the rights to extract a atural resource which is i restricted supply (The udeveloped reserves of a oil or miig compay, for istace) These cost advatages will show up i valuatio i oe of two ways: The firm may charge the same price as its competitors, but have a much higher operatig margi. The firm may charge lower prices tha its competitors ad have a much higher capital turover ratio. Aswath Damodara 81

82 Gaugig Barriers to Etry p p p p p p p p Which of the followig barriers to etry are most likely to work for Embraer? Brad Name Patets ad Legal Protectio Switchig Costs Cost Advatages What about for Amazo.com? Brad Name Patets ad Legal Protectio Switchig Costs Cost Advatages Aswath Damodara 82

83 Reducig Cost of Capital Outsourcig Flexible wage cotracts & cost structure Reduce operatig leverage Chage fiacig mix Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital Make product or service less discretioary to customers Match debt to assets, reducig default risk Chagig product characteristics More effective advertisig Swaps Derivatives Hybrids Aswath Damodara 83

84 Amazo.com: Optimal Debt Ratio Debt Ratio Beta Cost of Equity Bod Ratig Iterest rate o debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G) 0% % AAA 6.80% 0.00% 6.80% 12.82% $29,192 10% % D 18.50% 0.00% 18.50% 14.02% $24,566 20% % D 18.50% 0.00% 18.50% 15.22% $21,143 30% % D 18.50% 0.00% 18.50% 16.42% $18,509 40% % D 18.50% 0.00% 18.50% 17.62% $16,419 50% % D 18.50% 0.00% 18.50% 18.82% $14,719 60% % D 18.50% 0.00% 18.50% 20.02% $13,311 70% % D 18.50% 0.00% 18.50% 21.22% $12,125 80% % D 18.50% 0.00% 18.50% 22.42% $11,112 90% % D 18.50% 0.00% 18.50% 23.62% $10,237 Aswath Damodara 84

85 Embraer : Optimal Capital Structure Debt Ratio Beta Cost of Equity Bod Ratig Iterest rate o debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G) 0% % AAA 8.92% 34.00% 5.89% 10.05% $3,577 10% % AAA 8.92% 34.00% 5.89% 9.88% $3,639 20% % AA 9.17% 34.00% 6.05% 9.75% $3,690 30% % A 9.97% 34.00% 6.58% 9.76% $3,686 40% % A % 34.00% 6.71% 9.72% $3,703 50% % B 14.67% 34.00% 9.68% 11.12% $3,218 60% % CCC 18.17% 34.00% 11.99% 12.72% $2,799 70% % CC 19.67% 34.00% 12.98% 13.86% $2,562 80% % CC 19.67% 33.63% 13.05% 14.47% $2,450 90% % CC 19.67% 29.90% 13.79% 15.81% $2,236 Aswath Damodara 85

86 Curret Cashflow to Firm EBIT(1-t) : $ Nt CpX 23 - Chg WC 9 = FCFF $ 372 Reivestmet Rate = 32/404= 7.9% Embraer: Restructured ($) Reivestmet Rate 40.00% Expected Growth i EBIT (1-t).40*.20= % Retur o Capital 20% Stable Growth g = 4.17%; Beta = 1.00; Coutry Premium= 5% Cost of capital = 7.87% ROC= 7.87%; Tax rate=34% Reivestmet Rate=g/ROC =4.17/7.87= 52.99% Op. Assets $ 6,096 + Cash: Debt Mior. It. 12 =Equity 6,196 -Optios 28 Value/Share $8.66 R$ $ Cashflows Year EBIT(1-t) Reivestmet = FCFF Discout at $ Cost of Capital (WACC) = 11.72% (.60) % (0.40) = 9.72% Termial Value5= 291/( ) = 7855 Term Yr = 291 Cost of Equity 11.72% Cost of Debt (4.17%+2%+4%)(1-.34) = 6.71% Weights E = 60% D = 40% O October 6, 2003 Embraer Price = R$15. Riskfree Rate: $ Riskfree Rate= 4.17% + Beta 1.37 X Mature market premium 4 % + Lambda 0.27 X Coutry Equity Risk Premium 7.67% Ulevered Beta for Sectors: 0.95 Firm s D/E Ratio: 19% Coutry Default Spread 6.01% Aswath Damodara 86 X Rel Equity Mkt Vol 1.28

87 The Value of Cotrol? If the value of a firm ru optimally is sigificatly higher tha the value of the firm with the status quo (or icumbet maagemet), you ca write the value that you should be willig to pay as: Value of cotrol = Value of firm optimally ru - Value of firm with status quo Implicatios: The value of cotrol is greatest at poorly ru firms. Votig shares i poorly ru firms should trade at a premium o o-votig shares if the votes associated with the shares will give you a chace to have a say i a hostile acquisitio. Whe valuig private firms, your estimate of value will vary depedig upo whether you gai cotrol of the firm. For example, 49% of a private firm may be worth less tha 51% of the same firm. 49% stake = 49% of status quo value 51% stake = 51% of optimal value Aswath Damodara 87

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