DefaultSpreads–January2016
DefaultSpreadsfor10-yearCorporateBonds:January2015vsJanuary2016
25.00%
20.00%
20.00%
16.00%
15.00%
12.00%
10.00%
9.00%
7.50%
6.50%
5.50%
5.00%
4.25%
3.25%
0.75%
1.00%
1.10%
1.25%
1.75%
2.25%
0.00%
Aaa/AAA
Aa2/AA
A1/A+
A2/A
A3/A-
Baa2/BBB Ba1/BB+
Spread: 2016
Aswath Damodaran
Ba2/BB
B1/B+
B2/B
B3/B-
Caa/CCC
Ca2/CC
C2/C
D2/D
Spread: 2015
182
Applica9onTest:Es9ma9ngaCostofDebt
183
¨ 
Baseduponyourfirm’scurrentearningsbefore
interestandtaxes,itsinterestexpenses,es9mate
¤  Aninterestcoveragera9oforyourfirm
¤  Asynthe9cra9ngforyourfirm(usethetablesfromprior
pages)
¤  Apre-taxcostofdebtforyourfirm
¤  AnaKer-taxcostofdebtforyourfirm
AswathDamodaran
183
CostsofHybrids
184
¨ 
Preferredstocksharessomeofthecharacteris9csof
debt-thepreferreddividendispre-specifiedatthe9me
oftheissueandispaidoutbeforecommondividend--
andsomeofthecharacteris9csofequity-thepayments
ofpreferreddividendarenottaxdeduc9ble.Ifpreferred
stockisviewedasperpetual,thecostofpreferredstock
canbewriSenasfollows:
¤ 
¨ 
kps=PreferredDividendpershare/MarketPriceper
preferredshare
Conver9bledebtispartdebt(thebondpart)andpart
equity(theconversionop9on).Itisbesttobreakitup
intoitscomponentpartsandeliminateitfromthemix
altogether.
AswathDamodaran
184
WeightsforCostofCapitalCalcula9on
185
¨ 
¨ 
Theweightsusedinthecostofcapitalcomputa9onshould
bemarketvalues.
Therearethreespeciousargumentsusedagainstmarket
value
¤ 
¤ 
¤ 
Bookvalueismorereliablethanmarketvaluebecauseitisnotas
vola9le:Whileitistruethatbookvaluedoesnotchangeasmuchas
marketvalue,thisismoreareflec9onofweaknessthanstrength
Usingbookvalueratherthanmarketvalueisamoreconserva9ve
approachtoes9ma9ngdebtra9os:Formostcompanies,usingbook
valueswillyieldalowercostofcapitalthanusingmarketvalue
weights.
Sinceaccoun9ngreturnsarecomputedbaseduponbookvalue,
consistencyrequirestheuseofbookvalueincompu9ngcostof
capital:Whileitmayseemconsistenttousebookvaluesforboth
accoun9ngreturnandcostofcapitalcalcula9ons,itdoesnotmake
economicsense.
AswathDamodaran
185
Disney:Frombookvaluetomarketvalue
forinterestbearingdebt…
¨ 
¨ 
¨ 
InDisney’s2013financialstatements,thedebtdueover9mewasfootnoted.
Time due
Amount due
Weight
0.5
2
3
4
6
8
9
19
26
28
29
$1,452
$1,300
$1,500
$2,650
$500
$1,362
$1,400
$500
$25
$950
$500
$12,139
11.96%
10.71%
12.36%
21.83%
4.12%
11.22%
11.53%
4.12%
0.21%
7.83%
4.12%
Weight
*Maturity
0.06
0.21
0.37
0.87
0.25
0.9
1.04
0.78
0.05
2.19
1.19
7.92
The debt in this table does
not add up to the book value
of debt, because Disney
does not break down the
maturity of all of its debt.
Disney’stotaldebtdue,inbookvalueterms,onthebalancesheetis$14,288
millionandthetotalinterestexpensefortheyearwas$349million.Using3.75%
asthepre-taxcostofdebt:
"
%
1
$ (1− (1.0375) '
14, 288
Es9matedMVofDisneyDebt= 349 $
'+
= $13, 028 million
7.92
$
$#
Aswath Damodaran
.0375
7.92
' (1.0375)
'&
186
Opera9ngLeasesatDisney
The“debtvalue”ofopera9ngleasesisthepresent
valueoftheleasepayments,ataratethatreflects
theirrisk,usuallythepre-taxcostofdebt.
¨  Thepre-taxcostofdebtatDisneyis3.75%.
¨ 
¨ 
Year Commitment Present Value @3.75%
1
$507.00
$488.67
2
$422.00
$392.05
3
$342.00
$306.24
4
$272.00
$234.76
5
$217.00
$180.52
6-10
$356.80
$1,330.69
Debt value of leases
$2,932.93
Disney reported $1,784 million
in commitments after year 5.
Given that their average
commitment over the first 5
years, we assumed 5 years @
$356.8 million each.
DebtoutstandingatDisney=$13,028+$2,933=$15,961million
Aswath Damodaran
187
Applica9onTest:Es9ma9ngMarketValue
188
¨ 
Es9matethe
¤  MarketvalueofequityatyourfirmandBookValueof
equity
¤  Marketvalueofdebtandbookvalueofdebt(Ifyoucannot
findtheaveragematurityofyourdebt,use3years):
Remembertocapitalizethevalueofopera9ngleasesand
addthemontoboththebookvalueandthemarketvalue
ofdebt.
¨ 
Es9matethe
¤  Weightsforequityanddebtbaseduponmarketvalue
¤  Weightsforequityanddebtbaseduponbookvalue
AswathDamodaran
188
CurrentCostofCapital:Disney
¨ 
Equity
CostofEquity=Riskfreerate+Beta*RiskPremium
=2.75%+1.0013(5.76%)=8.52%
¤  MarketValueofEquity= $121,878million
¤  Equity/(Debt+Equity)= 88.42%
¤ 
¨ 
Debt
AKer-taxCostofdebt=(Riskfreerate+DefaultSpread)(1-t)
=(2.75%+1%)(1-.361)=
2.40%
¤  MarketValueofDebt=$13,028+$2933= $15,961million
¤  Debt/(Debt+Equity)=
11.58%
¤ 
¨ 
CostofCapital=8.52%(.8842)+2.40%(.1158)=7.81%
Aswath Damodaran
121,878/ (121,878+15,961)
189
DivisionalCostsofCapital:DisneyandVale
Disney
Cost!of!
Cost!of!
Marginal!tax!
After6tax!cost!of!
Debt!
Cost!of!
!!
equity!
debt!
rate! debt!
ratio!
capital!
Media!Networks!
9.07%!
3.75%!
36.10%!
2.40%!
9.12%!
8.46%!
Parks!&!Resorts!
7.09%!
3.75%!
36.10%!
2.40%! 10.24%!
6.61%!
Studio!
Entertainment!
9.92%!
3.75%!
36.10%!
2.40%! 17.16%!
8.63%!
Consumer!Products!
9.55%!
3.75%!
36.10%!
2.40%! 53.94%!
5.69%!
Interactive!
11.65%!
3.75%!
36.10%!
2.40%! 29.11%!
8.96%!
Disney!Operations!
8.52%!
3.75%!
36.10%!
2.40%! 11.58%!
7.81%!
Vale
Business
Metals &
Mining
Iron Ore
Fertilizers
Logistics
Vale Operations
Aswath Damodaran
Cost of
equity
After-tax cost of
debt
Debt
ratio
Cost of capital (in
US$)
Cost of capital (in
$R)
11.35%
11.13%
12.70%
10.29%
11.23%
2.67%
2.67%
2.67%
2.67%
2.67%
35.48%
35.48%
35.48%
35.48%
35.48%
8.27%
8.13%
9.14%
7.59%
8.20%
15.70%
15.55%
16.63%
14.97%
15.62%
190
CostsofCapital:TataMotors,Baiduand
Bookscape
¨ 
Toes9matethecostsofcapitalforTataMotorsinIndian
rupees:
Costofcapital=14.49%(1-.2928)+6.50%(.2928)=12.15%
¨ 
ForBaidu,wefollowthesamepathtoes9mateacostof
equityinChineseRMB:
Costofcapital=12.91%(1-.0523)+3.45%(.0523)=12.42%
¨ 
ForBookscape,thecostofcapitalisdifferentdependingon
whetheryoulookatmarketortotalbeta:
Market Beta
Total Beta
Aswath Damodaran
Cost of
equity
7.46%
11.98%
Pre-tax Cost of debt
4.05%
4.05%
After-tax cost of
debt
D/(D+E) Cost of capital
2.43%
17.63%
6.57%
2.43%
17.63%
10.30%
191
Applica9onTest:Es9ma9ngCostofCapital
192
¨ 
¨ 
¨ 
UsingtheboSom-upunleveredbetathatyoucomputedfor
yourfirm,andthevaluesofdebtandequityyouhave
es9matedforyourfirm,es9mateaboSom-upleveredbeta
andcostofequityforyourfirm.
Baseduponthecostsofequityanddebtthatyouhave
es9mated,andtheweightsforeach,es9matethecostof
capitalforyourfirm.
Howdifferentwouldyourcostofcapitalhavebeen,ifyou
usedbookvalueweights?
AswathDamodaran
192
ChoosingaHurdleRate
193
Eitherthecostofequityorthecostofcapitalcanbe
usedasahurdlerate,dependinguponwhetherthe
returnsmeasuredaretoequityinvestorsortoall
claimholdersonthefirm(capital)
¨  Ifreturnsaremeasuredtoequityinvestors,the
appropriatehurdlerateisthecostofequity.
¨  Ifreturnsaremeasuredtocapital(orthefirm),the
appropriatehurdlerateisthecostofcapital.
¨ 
AswathDamodaran
193
BacktoFirstPrinciples
194
AswathDamodaran
194
AswathDamodaran
195
MEASURINGINVESTMENTRETURNS
I:THEMECHANICSOFINVESTMENT
ANALYSIS
“Showmethemoney”
fromJerryMaguire
FirstPrinciples
196
AswathDamodaran
196
Measuresofreturn:earningsversuscashflows
197
¨ 
PrinciplesGoverningAccoun9ngEarningsMeasurement
¤ 
¤ 
¨ 
AccrualAccoun9ng:Showrevenueswhenproductsandservicesare
soldorprovided,notwhentheyarepaidfor.Showexpenses
associatedwiththeserevenuesratherthancashexpenses.
Opera9ngversusCapitalExpenditures:Onlyexpensesassociatedwith
crea9ngrevenuesinthecurrentperiodshouldbetreatedasopera9ng
expenses.Expensesthatcreatebenefitsoverseveralperiodsare
wriSenoffovermul9pleperiods(asdeprecia9onoramor9za9on)
Togetfromaccoun9ngearningstocashflows:
¤ 
¤ 
¤ 
youhavetoaddbacknon-cashexpenses(likedeprecia9on)
youhavetosubtractoutcashouplowswhicharenotexpensed(such
ascapitalexpenditures)
youhavetomakeaccrualrevenuesandexpensesintocashrevenues
andexpenses(byconsideringchangesinworkingcapital).
AswathDamodaran
197
MeasuringReturnsRight:TheBasicPrinciples
198
Usecashflowsratherthanearnings.Youcannotspend
earnings.
¨  Use“incremental”cashflowsrela9ngtotheinvestment
decision,i.e.,cashflowsthatoccurasaconsequenceof
thedecision,ratherthantotalcashflows.
¨  Use“9meweighted”returns,i.e.,valuecashflowsthat
occurearliermorethancashflowsthatoccurlater.
TheReturnMantra:“Time-weighted,IncrementalCash
FlowReturn”
¨ 
AswathDamodaran
198
Seqngthetable:Whatisaninvestment/
project?
199
¨ 
Aninvestment/projectcanrangethespectrumfrombig
tosmall,moneymakingtocostsaving:
Majorstrategicdecisionstoenternewareasofbusinessornew
markets.
¤  Acquisi9onsofotherfirmsareprojectsaswell,notwithstanding
aSemptstocreateseparatesetsofrulesforthem.
¤  Decisionsonnewventureswithinexis9ngbusinessesor
markets.
¤  Decisionsthatmaychangethewayexis9ngventuresand
projectsarerun.
¤  Decisionsonhowbesttodeliveraservicethatisnecessaryfor
thebusinesstorunsmoothly.
¤ 
¨ 
Putinbroaderterms,everychoicemadebyafirmcan
beframedasaninvestment.
AswathDamodaran
199
Herearefourexamples…
200
¨ 
¨ 
¨ 
¨ 
RioDisney:WewillconsiderwhetherDisneyshouldinvestinitsfirst
themeparksinSouthAmerica.Theseparks,whilesimilartothosethat
Disneyhasinotherpartsoftheworld,willrequireustoconsiderthe
effectsofcountryriskandcurrencyissuesinprojectanalysis.
NewironoremineforVale:ThisisanironoreminethatValeis
consideringinWesternLabrador,Canada.
AnOnlineStoreforBookscape:Bookscapeisevalua9ngwhetheritshould
createanonlinestoretosellbooks.Whileitisanextensionoftheirbasis
business,itwillrequiredifferentinvestments(andpoten9allyexpose
themtodifferenttypesofrisk).
Acquisi9onofHarmanbyTataMotors:Across-borderbidbyTatafor
HarmanInterna9onal,apubliclytradedUSfirmthatmanufactureshighendaudioequipment,withtheintentofupgradingtheaudioupgradeson
TataMotors’automobiles.Thisinvestmentwillallowustoexamine
currencyandriskissuesinsuchatransac9on.
AswathDamodaran
200
EarningsversusCashFlows:ADisneyTheme
Park
201
ThethemeparkstobebuiltnearRio,modeledon
EuroDisneyinParisandDisneyWorldinOrlando.
¨  Thecomplexwillincludea“MagicKingdom”tobe
constructed,beginningimmediately,andbecoming
opera9onalatthebeginningofthesecondyear,and
asecondthemeparkmodeledonEpcotCenterat
Orlandotobeconstructedinthesecondandthird
yearandbecomingopera9onalatthebeginningof
thefourthyear.
¨  Theearningsandcashflowsarees9matedin
nominalU.S.Dollars.
¨ 
AswathDamodaran
201
KeyAssump9onsonStartUpandConstruc9on
202
¨ 
¨ 
Disneyhasalreadyspent$0.5Billionresearchingtheproposaland
geqngthenecessarylicensesforthepark;noneofthisinvestment
canberecoverediftheparkisnotbuilt.Thisexpenditurehasbeen
capitalizedandwillbedepreciatedstraightlineovertenyearstoa
salvagevalueofzero.
Disneywillfacesubstan9alconstruc9oncosts,ifitchoosestobuild
thethemeparks.
¤ 
¤ 
¤ 
Thecostofconstruc9ngMagicKingdomwillbe$3billion,with$2billion
tobespentrightnow,and$1Billiontobespentoneyearfromnow.
Thecostofconstruc9ngEpcotIIwillbe$1.5billion,with$1billiontobe
spentattheendofthesecondyearand$0.5billionattheendofthethird
year.
Theseinvestmentswillbedepreciatedbaseduponadeprecia9on
scheduleinthetaxcode,wheredeprecia9onwillbedifferenteachyear.
AswathDamodaran
202
KeyRevenueAssump9ons
203
Revenuees9matesfortheparksandresortproper9es(inmillions)
Year
MagicKingdom EpcotII ResortProper9esTotal
1
$0
$0
$0
$0
2
$1,000 $0
$250 $1,250
3
$1,400 $0
$350 $1.750
4
$1,700 $300 $500 $2.500
5
$2,000 $500 $625 $3.125
6
$2,200 $550 $688 $3,438
7
$2,420 $605 $756 $3,781
8
$2,662 $666 $832 $4,159
9
$2,928 $732 $915 $4,575
10
$2,987 $747 $933 $4,667
¨ 
¨ 
AswathDamodaran
203
KeyExpenseAssump9ons
204
Theopera9ngexpensesareassumedtobe60%of
therevenuesattheparks,and75%ofrevenuesat
theresortproper9es.
¨  Disneywillalsoallocatecorporategeneraland
administra9vecoststothisproject,basedupon
revenues;theG&Aalloca9onwillbe15%ofthe
revenueseachyear.Itisworthno9ngthatarecent
analysisoftheseexpensesfoundthatonlyone-third
oftheseexpensesarevariable(andafunc9onof
totalrevenue)andthattwo-thirdsarefixed.
¨ 
AswathDamodaran
204
Deprecia9onandCapitalMaintenance
205
¨ 
Thecapitalmaintenanceexpendituresarelowinthe
earlyyears,whentheparksares9llnewbutincreaseas
theparksage.
AswathDamodaran
205