Session8:WeightsandCostofCapital

Dynamics

Aswath Damodaran

WeightsforCostofCapitalCalculation

Theweightsusedinthecostofcapitalcomputationshouldbemarket
values.
Therearethreespeciousargumentsusedagainstmarketvalue

Aswath Damodaran

Bookvalueismorereliablethanmarketvaluebecauseitisnotasvolatile:Whileit
is true that book value does not change as much as market value, this is more a
reflectionofweaknessthanstrength
Using book value rather than market value is a more conservative approach to
estimatingdebtratios: Formostcompanies,usingbookvalueswillyieldalower
costofcapitalthanusingmarketvalueweights.
Since accounting returns are computed based upon book value, consistency
requires the use of book value in computing cost of capital: While it may seem
consistent to use book values for both accounting return and cost of capital
calculations,itdoesnotmakeeconomicsense.

Disney:Frombookvaluetomarketvaluefordebt

InDisneys2008financialstatements,thedebtdueovertimewas
footnoted.
Nomaturitywasgivenfordebt
dueafter5years.Iassumed10
years.

Disneystotaldebtdue,inbookvalueterms,onthebalancesheetis
$16,003millionandthetotalinterestexpensefortheyearwas$728
million.Assumingthatthematuritythatwecomputedabovestillholds
andusing6%asthepretaxcostofdebt:
EstimatedMVofDisneyDebt=
Aswath Damodaran

1
(1
(1.06)5.38
728
.06

16,003

$14,962 million
5.38
(1.06)

Andoperatingleases

ThepretaxcostofdebtatDisneyis6%.
Year
1
2
3
4
5

Commitment
$392.00
$351.00
$305.00
$265.00
$198.00

PresentValue
$369.81
$312.39
$256.08
$209.90
$147.96

6&7
DebtValueof
leases=

$309.50

$424.02

$1,720.17

Disneyreported$619millionin
commitmentsafteryear5.Given
thattheiraveragecommitment
overthefirst5yearsof$302
million,weassumedtwoyears@
$309.5millioneach.

DebtoutstandingatDisney
=MVofInterestbearingDebt+PVofOperatingLeases
=$14,962+$1,720=$16,682million

Aswath Damodaran

CurrentCostofCapital:Disney

Equity

Debt

CostofEquity=Riskfreerate+Beta*RiskPremium
=3.5%+0.9011(6%)=8.91%
MarketValueofEquity=
$45.193Billion
Equity/(Debt+Equity)=
73.04%
AftertaxCostofdebt=(Riskfreerate+DefaultSpread)(1t)
=(3.5%+2.5%)(1.38)=
3.72%
MarketValueofDebt=
$16.682Billion
Debt/(Debt+Equity)=
26.96%

CostofCapital=8.91%(.7304)+3.72%(.2696)=7.51%
45.193/(45.193+16.682)

Aswath Damodaran

DealingwithHybridsandPreferredStock

Whendealingwithhybrids(convertiblebonds,forinstance),breakthe
securitydownintodebtandequityandallocatetheamounts
accordingly.Thus,ifafirmhas$125millioninconvertibledebt
outstanding,breakthe$125millionintostraightdebtandconversion
optioncomponents.Theconversionoptionisequity.
Whendealingwithpreferredstock,itisbettertokeepitasaseparate
component.Thecostofpreferredstockisthepreferreddividendyield.

Aswath Damodaran

Decomposingaconvertiblebond

Assumethatthefirmthatyouareanalyzinghas$125millioninfacevalueof
convertibledebtwithastatedinterestrateof4%,a10yearmaturityanda
marketvalueof$140million.IfthefirmhasabondratingofAandthe
interestrateonAratedstraightbondis8%,youcanbreakdownthevalueof
theconvertiblebondintostraightdebtandequityportions.

Aswath Damodaran

Straightdebt=(4%of$125million)(PVofannuity,10years,8%)+125
million/1.0810=$91.45million
Equityportion=$140million$91.45million=$48.55million

Debtratiosforprivatebusinesses

Whilethetemptationistogowithbookvaluesfordebtandequity,
youshouldsteerawayfromthem.Therearethreealternativesyoucan
employ.

Aswath Damodaran

Usetheindustryaveragemarketdebtratio,obtainedbylookingatpubliclytraded
companiesinthesector,toestimatethecostofequityandcapital.
Useanestimatedmarketvalueofequity,baseduponapplyingamultiple(sayaPE
ratio)toyourprivatecompanysearningstoarriveatadebttoequityratio.
UseyourDCFestimatesofequityanddebtvaluetocomputeyourcostofcapital.
Sinceyouwillneedthecostofcapitaltoarriveattheseestimates,thiswillcreate
circularityinyourvaluation.Ifyouarewillingtousetheiterationfunctionin
Excel,youshouldbestillabletoworkwiththecircularity.

TargetversusActualDebtRatios

Theactualdebtratioforafirmreflectswhatthecurrentmanagement
ofthefirmhaschosenastheappropriatedebtratio.Totheextentthat
themanagershaveeitherbeentooconservativeortooextremeinthe
useofdebt,therightdebtratioforthefirmmaybedifferentfrom
theactual.
Toestimatethisrightortargetdebtratio,analystsuseoneofthree
choices:

Aswath Damodaran

Anarbitrarynumber,basedupongutfeelingandexperience
Anindustryaveragefortheindustryinwhichyourcompanyoperates
Anoptimaldebtratiothatminimizesyourcostofcapital

Computinganoptimaldebtratio

Aswath Damodaran

10

Shouldyouvalueyourbusinessusingthetargetoroptimal?

Ifyouarevaluingabusinessforasaleoracquisition,itdoesmake
sensetousethetargetdebtratio,sincetheacquirercanresetthedebt
ratioatthetimeoftheacquisition.
Ifyouarevaluingabusinessasapassiveinvestororobserver,you
maybebetteroffusingtheactualdebtratio,sincetheexisting
managerswillcontinuetorunthefirm(andpresumablykeepintact
theirviewsofdebt).
Ifyouareuncertainaboutwhowillberunningthebusinessinthe
future(existingmanagersoranewowner),youcaneither

Aswath Damodaran

Changethedebtratiograduallyovertimefromtheactualtotheoptimal
Dotwovaluations,onewiththeactualandonewiththeoptimal,andtakean
expectedvalue.

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Changingriskprofiles&changingcostsofcapital

Whenvaluingyoung,growthfirms,thecostofcapitalatthestartof
yourvaluationshouldreflectthehighriskofthefirms(highcostsof
equity)andtheirinabilitytoborrowmoney(lowornodebt).Asa
result,yourcostofcapitalwillbehigh.
Asyoubringdownthegrowthrateofthefirmovertimeandmakeita
morematurebusiness(withhigherrevenues&profits),youshould
expect

Aswath Damodaran

Thecostofequitytochangeovertime,asyourriskmovestowardstheaveragefor
thesectororthemarket.
Thedebtratiotorise,asearningsandcashflowsgoup
Thecostofcapitaltodriftdowntowardstheaverageforthemarket(orthesector).

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Backtothebeginning

Assets
Value of investments already
made by the company over it's
history. The value is updated to
reect their current cash ow
potential.
Value of investments the
company is expected to take into
the future. This value rests on
perceptions of growth
opportunities.

Aswath Damodaran

Liabilities
Assets in Place

Debt

Lenders, both short and long

term, get rst claim whatever
cash ow is generated by the
rm.

Growth Assets

Equity

Equity investors get whatever is

left over, after meeting the debt
obligations.

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