The Tools of Corporate Finance

Present Value
Financial Statement Analysis
Fundamentals of Valuation

Aswath Damodaran
 Present Value
Aswath Damodaran

Aswath Damodaran
 Intuition Behind Present Value

 There are three reasons why a dollar tomorrow is worth less than a dollar today
• Individuals prefer present consumption to future consumption. To induce people to
give up present consumption you have to offer them more in the future.
• When there is monetary inflation, the value of currency decreases over time. The
greater the inflation, the greater the difference in value between a dollar today and a
dollar tomorrow.
• If there is any uncertainty (risk) associated with the cash flow in the future, the less
that cash flow will be valued.
 Other things remaining equal, the value of cash flows in future time periods
will decrease as
• the preference for current consumption increases.
• expected inflation increases.
• the uncertainty in the cash flow increases.

Aswath Damodaran
 Discounting and Compounding

• The mechanism for factoring in these elements is the discount rate.

• Discount Rate: The discount rate is a rate at which present and future cash
flows are traded off. It incorporates -
(1) Preference for current consumption (Greater ....Higher Discount Rate)
(2) expected inflation (Higher inflation .... Higher Discount Rate)
(3) the uncertainty in the future cash flows (Higher Risk....Higher Discount Rate)
• A higher discount rate will lead to a lower value for cash flows in the
future.
• The discount rate is also an opportunity cost, since it captures the returns
that an individual would have made on the next best opportunity.
 Discounting future cash flows converts them into cash flows in present
value dollars. Just a discounting converts future cash flows into present
cash flows,
 Compounding converts present cash flows into future cash flows.

Aswath Damodaran
 Present Value Principle 1

 Cash flows at different points in time cannot be compared and

aggregated. All cash flows have to be brought to the same point in
time, before comparisons and aggregations are made.

Aswath Damodaran
 Time Lines

Figure 3.1: A Time Line for Cash Flows: $ 100 in Cash Flows Received

at the End of Each of Next 4 years

Cash Flows

$ 100 $ 100 $ 100 $ 100

0 1 2 3

Year

Aswath Damodaran
 Cash Flow Types and Discounting Mechanics

 There are five types of cash flows -

 simple cash flows,
 annuities,
 growing annuities
 perpetuities and
 growing perpetuities

Aswath Damodaran
 I.Simple Cash Flows

 A simple cash flow is a single cash flow in a specified future time

period.
Cash Flow: CFt
_______________________________________________|
Time Period: t
 The present value of this cash flow is-

PV of Simple Cash Flow = CFt / (1+r)t

 The future value of a cash flow is -
FV of Simple Cash Flow = CF0 (1+ r)t

Aswath Damodaran
 Application: The power of compounding -
Stocks, Bonds and Bills

 Between 1926 and 1998, Ibbotson Associates found that stocks on the
average made about 11% a year, while government bonds on average
made about 5% a year.
 If your holding period is one year,the difference in end-of-period
values is small:
• Value of $ 100 invested in stocks in one year = $ 111
• Value of $ 100 invested in bonds in one year = $ 105

Aswath Damodaran
 Holding Period and Value

Figure 3.3: Effect of Compounding Periods: Stocks versus T.Bonds

$7,000.00

$ 100 invested in stocks, earning

11% a year, is worth more than seen

$6,000.00

times as much at the end of 40 years

than $ 100 invested in bonds, earning

5% a year.

$5,000.00

$4,000.00

Stocks

T. Bonds

$3,000.00

$2,000.00

The compounding effect increases

as the time horizon increases.

$1,000.00

$0.00

Compounding Periods

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 Concept Check

 Most pension plans allow individuals to decide where their pensions

funds will be invested - stocks, bonds or money market accounts.
 Where would you choose to invest your pension funds?
 Predominantly or all equity
 Predominantly or all bonds and money market accounts
 A Mix of Bonds and Stocks
 Will your allocation change as you get older?
 Yes
 No

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 The Frequency of Compounding

 The frequency of compounding affects the future and present values

of cash flows. The stated interest rate can deviate significantly from
the true interest rate –
• For instance, a 10% annual interest rate, if there is semiannual
compounding, works out to-
Effective Interest Rate = 1.052 - 1 = .10125 or 10.25%
Frequency Rate t Formula Effective Annual Rate
Annual 10% 1 r 10.00%
Semi-Annual 10% 2 (1+r/2)2-1 10.25%
Monthly 10% 12 (1+r/12)12-1 10.47%
Daily 10% 365 (1+r/365)365-1 10.5156%
Continuous 10% expr-1 10.5171%

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 II. Annuities

 An annuity is a constant cash flow that occurs at regular intervals for a

fixed period of time. Defining A to be the annuity,
A A A A
| | | |
0 1 2 3 4

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 Present Value of an Annuity

 The present value of an annuity can be calculated by taking each cash

flow and discounting it back to the present, and adding up the present
values. Alternatively, there is a short cut that can be used in the
calculation [A = Annuity; r = Discount Rate; n = Number of years]

⎡ 1 ⎤
1 -
⎢ (1 + r)n ⎥
PV of an Annuity = PV(A,r, n) = A
⎢ r ⎥
⎣ ⎦

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 Example: PV of an Annuity

 The present value of an annuity of $1,000 at the end of each year for
the next five years, assuming a discount rate of 10% is -
⎡1 - 1 ⎤
5
⎢ (1.10) ⎥
PV of $1000 each year for next 5 years = $1000 = $3,791
⎢ .10 ⎥
⎣ ⎦

 The notation that will be used in the rest of these lecture notes for the
present value of an annuity will be PV(A,r,n).

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 Annuity, given Present Value

 The reverse of this problem, is when the present value is known and
the annuity is to be estimated - A(PV,r,n).

⎡ ⎤
⎢ r ⎥
Annuity given Present Value = A(PV, r, n) = PV 1
⎢1 - ⎥
⎣ (1 + r)n ⎦

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 Computing Monthly Payment on a Mortgage

 Suppose you borrow $200,000 to buy a house on a 30-year mortgage

with monthly payments. The annual percentage rate on the loan is 8%.
The monthly payments on this loan, with the payments occurring at
the end of each month, can be calculated using this equation:
• Monthly interest rate on loan = APR/ 12 = 0.08/12 = 0.0067

⎡ ⎤
⎢ 0.0067 ⎥
Monthly Payment on Mortgage = $200,000 = $1473.11
⎢1 - 1 ⎥
⎣ (1.0067)360 ⎦

Aswath Damodaran 1
 Future Value of an Annuity

 The future value of an end-of-the-period annuity can also be

calculated as follows-
n

⎡ ( 1 + r ) - 1 ⎤

FV of an Annuity = FV ( A , r , n ) = A

⎢ ⎥
r
⎣ ⎦

Aswath Damodaran 1
 An Example

 Thus, the future value of $1,000 at the end of each year for the next
five years, at the end of the fifth year is (assuming a 10% discount
rate) -
5
⎡(1.10) - 1 ⎤
FV of $1,000 each year for next 5 years = $1000 = $6,105
⎢
⎣ .10 ⎥
⎦

 The notation that will be used for the future value of an annuity will
be FV(A,r,n).

Aswath Damodaran 1
 Annuity, given Future Value

 if you are given the future value and you are looking for an annuity -
A(FV,r,n) in terms of notation -

⎡ r ⎤
Annuity given Future Value = A(FV, r, n) = FV ⎢
⎣(1+ r)n - 1 ⎥
⎦

Aswath Damodaran 2
 Application : Saving for College Tuition

 Assume that you want to send your newborn child to a private college
(when he gets to be 18 years old). The tuition costs are $ 16000/year
now and that these costs are expected to rise 5% a year for the next 18
years. Assume that you can invest, after taxes, at 8%.
• Expected tuition cost/year 18 years from now = 16000*(1.05)18 = $38,506
• PV of four years of tuition costs at $38,506/year = $38,506 * PV(A ,8%,4
years)= $127,537
 If you need to set aside a lump sum now, the amount you would need
to set aside would be -
• Amount one needs to set apart now = $127,357/(1.08)18 = $31,916
 If set aside as an annuity each year, starting one year from now -
• If set apart as an annuity = $127,537 * A(FV,8%,18 years) = $3,405

Aswath Damodaran 2
 Application : How much is an MBA worth?

 Assume that you were earning $40,000/year before entering program

and that tuition costs are $16000/year. Expected salary is $
54,000/year after graduation. You can invest money at 8%.
For simplicity, assume that the first payment of $16,000 has to be made at
the start of the program and the second payment one year later.
• PV Of Cost Of MBA = $16,000+16,000/1.08 + 40000 * PV(A,8%,2
years) = $102,145
 Assume that you will work 30 years after graduation, and that the
salary differential ($14000 = $54000-$40000) will continue through
this period.
• PV of Benefits Before Taxes = $14,000 * PV(A,8%,30 years) = $157,609
• This has to be discounted back two years - $157,609/1.082 = $135,124
• The present value of getting an MBA is = $135,124 - $102,145 = $32,979

Aswath Damodaran 2
 Some Follow-up Questions

1. How much would your salary increment have to be for you to break
even on your MBA?
2. Keeping the increment constant, how many years would you have to
work to break even?

Aswath Damodaran 2
 Application: Savings from Refinancing Your
Mortgage

 Assume that you have a thirty-year mortgage for $200,000 that carries
an interest rate of 9.00%. The mortgage was taken three years ago.
Since then, assume that interest rates have come down to 7.50%, and
that you are thinking of refinancing. The cost of refinancing is expected
to be 2.50% of the loan. (This cost includes the points on the loan.)
Assume also that you can invest your funds at 6%.
Monthly payment based upon 9% mortgage rate (0.75% monthly rate)
= $200,000 * A(PV,0.75%,360 months)
= $1,609
Monthly payment based upon 7.50% mortgage rate (0.625% monthly rate)
= $200,000 * A(PV,0.625%,360 months)
= $1,398
 Monthly Savings from refinancing = $1,609 - $1,398 = $211

Aswath Damodaran 2
 Refinancing: The Trade Off

 If you plan to remain in this house indefinitely,

Present Value of Savings (at 6% annually; 0.5% a month)
= $211 * PV(A,0.5%,324 months)
= $33,815
• The savings will last for 27 years - the remaining life of the existing mortgage.
• You will need to make payments for three additional years as a consequence of the
refinancing -
Present Value of Additional Mortgage payments - years 28,29 and 30
= $1,398 * PV(A,0.5%,36 months)/1.0627
= $9,532
 Refinancing Cost = 2.5% of $200,000 = $5,000
 Total Refinancing Cost = $9,532 + $5,000 = $14,532
 Net Effect = $ 33,815 - $ 14,532 = $ 19,283: Refinance

Aswath Damodaran 2
 Follow-up Questions

1. How many years would you have to live in this house for you break
even on this refinancing?
2. We've ignored taxes in this analysis. How would it impact your
decision?

Aswath Damodaran 2
 Valuing a Straight Bond

 You are trying to value a straight bond with a fifteen year maturity and a
10.75% coupon rate. The current interest rate on bonds of this risk level is
8.5%.
PV of cash flows on bond = 107.50* PV(A,8.5%,15 years) + 1000/1.085 15 = $
1186.85
 If interest rates rise to 10%,
PV of cash flows on bond = 107.50* PV(A,10%,15 years)+ 1000/1.10 15 =
$1,057.05
Percentage change in price = -10.94%
 If interest rate fall to 7%,
PV of cash flows on bond = 107.50* PV(A,7%,15 years)+ 1000/1.07 15 = $1,341.55
Percentage change in price = +13.03%
 This asymmetric response to interest rate changes is called convexity.

Aswath Damodaran 2
 Contrasting Short Term and Long Term Bonds

Price Changes as a function of Bond Maturities

20.00%

15.00%

10.00%

% Change if rate drops

5.00% to 7%

0.00% % Change if rate

increases to 10%

-5.00%

% Change in Price

-10.00%

-15.00%

1 5 15 30

Bond Maturity

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 Bond Pricing Proposition 1

 The longer the maturity of a bond, the more sensitive it is to changes

in interest rates.

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 Contrasting Low-coupon and High-coupon
Bonds

Bond Price Changes as a function of Coupon Rates

25.00%

20.00%

15.00%

10.00%
% Change if rate

drops to 7%
5.00%

0.00%
% Change if rate

increases to 10%
-5.00%

% Price Change

-10.00%

-15.00%

-20.00%

0% 5% 10.75% 12%

Coupon Rate

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 Bond Pricing Proposition 2

 The lower the coupon rate on the bond, the more sensitive it is to
changes in interest rates.

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 III. Growing Annuity

 A growing annuity is a cash flow growing at a constant rate for a

specified period of time. If A is the current cash flow, and g is the
expected growth rate, the time line for a growing annuity looks as
follows –

Figure 3.8: A Growing Annuity

A(1+g) 2 3 n
A(1+g) A(1+g) A(1+g)

0 1 2 3 ........... n

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 Present Value of a Growing Annuity

 The present value of a growing annuity can be estimated in all cases,

but one - where the growth rate is equal to the discount rate, using the
following model:
⎡ (1+g)
n⎤
⎢1 - n
⎥
⎢ (1+ r) ⎥
PV of an Annuity = PV(A,r, g,n) = A(1 + g) ⎢ ⎥
⎢ (r - g) ⎥
⎢
⎣ ⎥⎦

 In that specific case, the present value is equal to the nominal sums of
the annuities over the period, without the growth effect.

Aswath Damodaran 3
 The Value of a Gold Mine

 Consider the example of a gold mine, where you have the rights to the
mine for the next 20 years, over which period you plan to extract
5,000 ounces of gold every year. The price per ounce is $300
currently, but it is expected to increase 3% a year. The appropriate
discount rate is 10%. The present value of the gold that will be
extracted from this mine can be estimated as follows –

⎡ (1.03)20 ⎤
1 -
⎢ (1.10)20 ⎥
PV of extracted gold = $300* 5000 * (1.03) = $16,145,980
⎢ .10 - .03 ⎥
⎢⎣ ⎥⎦

Aswath Damodaran 3
 PV of Extracted Gold as a Function of
Expected Growth Rate

Present Value of Extracted Gold as a function of Growth Rate

$50,000,000

$45,000,000

$40,000,000

$35,000,000

$30,000,000

$25,000,000

$20,000,000

$15,000,000

Present Value of Extracted Gold

$10,000,000

$5,000,000

$-

0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

10% 11% 12% 13% 14% 15%

Growth Rate in Gold Prices

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 Concept Check

 If both the growth rate and the discount rate go up by 1%, will the
present value of the gold to be extracted from this mine increase or
decrease?

Aswath Damodaran 3
 IV. Perpetuity

 A perpetuity is a constant cash flow at regular intervals forever. The

present value of a perpetuity is-
A
PV of Perpetuity =
r

Aswath Damodaran 3
 Valuing a Console Bond

 A console bond is a bond that has no maturity and pays a fixed

coupon. Assume that you have a 6% coupon console bond. The value
of this bond, if the interest rate is 9%, is as follows -
Value of Console Bond = $60 / .09 = $667

Aswath Damodaran 3
 V. Growing Perpetuities

 A growing perpetuity is a cash flow that is expected to grow at a

constant rate forever. The present value of a growing perpetuity is -
CF1
PV of Growing Perpetuity =
(r - g)

where
• CF1 is the expected cash flow next year,
• g is the constant growth rate and
• r is the discount rate.

Aswath Damodaran 3
 Valuing a Stock with Growing Dividends

 Southwestern Bell paid dividends per share of $2.73 in 1992. Its

earnings and dividends have grown at 6% a year between 1988 and
1992, and are expected to grow at the same rate in the long term. The
rate of return required by investors on stocks of equivalent risk is
12.23%.
Current Dividends per share = $2.73
Expected Growth Rate in Earnings and Dividends = 6%
Discount Rate = 12.23%
Value of Stock = $2.73 *1.06 / (.1223 -.06) = $46.45

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 Financial Statement Analysis

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 Questions we would like answered…

Assets Liabilities

What are the assets in place? What is the value of the debt?

Assets in Place Debt

How valuable are these assets? How risky is the debt?

How risky are these assets?

What are the growth assets? Growth Assets Equity What is the value of the equity?

How valuable are these assets? How risky is the equity?

Aswath Damodaran 4
 Basic Financial Statements

 The balance sheet, which summarizes what a firm owns and owes at a
point in time.
 The income statement, which reports on how much a firm earned in
the period of analysis
 The statement of cash flows, which reports on cash inflows and
outflows to the firm during the period of analysis

Aswath Damodaran 4
 The Balance Sheet

Figure 4.1: The Balance Sheet

Assets Liabilities

Current Short-term liabilities of the firm

Long Lived Real Assets Fixed Assets

Liabilties

Short-lived Assets Current Assets Debt Debt obligations of firm

Investments in securities & Financial Investments Other

Other long-term obligations

assets of other firms Liabilities

Assets which are not physical, Intangible Assets

Equity Equity investment in firm

like patents & trademarks

Aswath Damodaran 4
 A Financial Balance Sheet

Assets Liabilities

Existing Investments Fixed Claim on cash flows

Assets in Place Debt

Generate cashflows today Little or No role in management

Includes long lived (fixed) and Fixed Maturity

short-lived(working Tax Deductible

capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows

created by future investments Significant Role in management

Perpetual Lives

Aswath Damodaran 4
 The Income Statement
Figure 4.2: Income Statement

Gross revenues from sale

Revenues
of products or services

Expenses associates with

- Operating Expenses
generating revenues

Operating income for the = Operating Income

period

Expenses associated with - Financial Expenses

borrowing and other financing

Taxes due on taxable income - Taxes

Earnings to Common &

= Net Income before extraordinary items

Preferred Equity for

Current Period

Profits and Losses not - (+) Extraordinary Losses (Profits)

associated with operations

Profits or losses associated - Income Changes Associated with Accounting Changes

with changes in accounting

rules

Dividends paid to preferred - Preferred Dividends

stockholders

= Net Income to Common Stockholders

Aswath Damodaran 4
 Modifications to Income Statement

 There are a few expenses that consistently are miscategorized in

financial statements.In particular,
• Operating leases are considered as operating expenses by accountants but
they are really financial expenses
• R &D expenses are considered as operating expenses by accountants but
they are really capital expenses.
 The degree of discretion granted to firms on revenue recognition and
extraordinary items is used to manage earnings and provide
misleading pictures of profitability.

Aswath Damodaran 4
 Dealing with Operating Lease Expenses

 Debt Value of Operating Leases = PV of Operating Lease Expenses at

the pre-tax cost of debt
 This now creates an asset - the value of which is equal to the debt
value of operating leases. This asset now has to be depreciated over
time.
 Finally, the operating earnings has to be adjusted to reflect these
changes:
• Adjusted Operating Earnings = Operating Earnings + Operating Lease
Expense - Depreciation on the leased asset
• If we assume that depreciation = principal payment on the debt value of
operating leases, we can use a short cut:
Adjusted Operating Earnings = Operating Earnings + Debt value of
Operating leases * Cost of debt

Aswath Damodaran 4
 Operating Leases at Boeing and The Home
Depot in 1998

Boeing Home Depot

Year Operating Lease Expense Present Value at Operating Present Value
5.5% Lease Expense at 5.8%
1 $ 205 $ 194.31 $ 294 $ 277.88
2 $ 167 $ 150.04 $ 291 $ 259.97
3 $ 120 $ 102.19 $ 264 $ 222.92
4 $ 86 $ 69.42 $ 245 $ 195.53
5 $ 61 $ 46.67 $ 236 $ 178.03
Yr 6 -15 $ - $ - $ 270 $ 1,513.37
PV of Operating Lease Expenses $ 562.64 $ 2,647.70

Aswath Damodaran 4
 Imputed Interest Expenses on Operating
Leases

Boeing The Home Depot

PV of Operating Leases $ 562.64 $ 2647.70
Interest rate on Debt 5.50% 5.80%
Imputed interest expense on PV of operating leases $ 30.95 $ 153.57

Aswath Damodaran 5
 The Effects of Capitalizing Operating Leases

 Debt : will increase, leading to an increase in debt ratios used in the

cost of capital and levered beta calculation
 Operating income: will increase, since operating leases will now be
before the imputed interest on the operating lease expense
 Net income: will be unaffected since it is after both operating and
financial expenses anyway
 Return on Capital will generally decrease since the increase in
operating income will be proportionately lower than the increase in
book capital invested

Aswath Damodaran 5
 R&D Expenses: Operating or Capital Expenses

 Accounting standards require us to consider R&D as an operating

expense even though it is designed to generate future growth. It is
more logical to treat it as capital expenditures.
 To capitalize R&D,
• Specify an amortizable life for R&D (2 - 10 years)
• Collect past R&D expenses for as long as the amortizable life
• Sum up the unamortized R&D over the period. (Thus, if the amortizable
life is 5 years, the research asset can be obtained by adding up 1/5th of the
R&D expense from five years ago, 2/5th of the R&D expense from four
years ago...:

Aswath Damodaran 5
 Capitalizing R&D Expenses: Boeing

Yea r R&D Una mo rt ize d Value

Por t io n
1 9 89 $ 7 54 0 .1 0 $75
1 9 90 $ 8 27 0 .2 0 $ 1 65
1 9 91 $ 1 ,4 17 0 .3 0 $ 4 25
1 9 92 $ 1 ,8 46 0 .4 0 $ 7 38
1 9 93 $ 1 ,6 61 0 .5 0 $ 8 31
1 9 94 $ 1 ,7 04 0 .6 0 $ 1 ,0 22
1 9 95 $ 1 ,3 00 0 .7 0 $ 9 10
1 9 96 $ 1 ,6 33 0 .8 0 $ 1 ,3 06
1 9 97 $ 1 ,9 24 0 .9 0 $ 1 ,7 32
1 9 98 $ 1 ,8 95 1 .0 0 $ 1 ,8 95
Ca pita lize d Value of R& D Expe ns e s = $ 9 ,1 00

Aswath Damodaran 5
 Boeing’s Corrected Operating Income

Boeing
Operating Income $1,720
+ Research and Development Expenses $1,895
- Amortization of Research Asset $1,382
+ Imputed Interest Expense on Operating $ 31
Leases
= Adjusted Operating Income $2,264

Aswath Damodaran 5
 The Effect of Capitalizing R&D

 Operating Income will generally increase, though it depends upon

whether R&D is growing or not. If it is flat, there will be no effect
since the amortization will offset the R&D added back. The faster
R&D is growing the more operating income will be affected.
 Net income will increase proportionately, depending again upon how
fast R&D is growing
 Book value of equity (and capital) will increase by the capitalized
Research asset
 Capital expenditures will increase by the amount of R&D;
Depreciation will increase by the amortization of the research asset;
For all firms, the net cap ex will increase by the same amount as the
after-tax operating income.

Aswath Damodaran 5
 The Statement of Cash Flows

Figure 4.3: Statement of Cash Flows

Net cash flow from operations,

after taxes and interest expenses Cash Flows From Operations

Includes divestiture and acquisition

of real assets (capital expenditures)

+ Cash Flows From Investing

and disposal and purchase of

financial assets. Also includes

acquisitions of other firms.

Net cash flow from the issue and

repurchase of equity, from the + Cash Flows from Financing

issue and repayment of debt and after

dividend payments

= Net Change in Cash Balance

Aswath Damodaran 5
 The Financial perspective on cash flows

 In financial analysis, we are much more concerned about

• Cash flows to the firm or operating cash flows, which are before cash
flows to debt and equity)
• Cash flows to equity, which are after cash flows to debt but prior to cash
flows to equity

Aswath Damodaran 5
 Fundamentals of Valuation

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 Discounted Cashflow Valuation: Basis for
Approach

t = n CF
Value = ∑ t
t
t = 1 (1 + r)

• where,
• n = Life of the asset
• CFt = Cashflow in period t
• r = Discount rate reflecting the riskiness of the estimated cashflows

Aswath Damodaran 5
 Two Measures of Cash Flows

 Cash flows to Equity: Thesea are the cash flows generated by the
asset after all expenses and taxes, and also after payments due on the
debt. This cash flow, which is after debt payments, operating expenses
and taxes, is called the cash flow to equity investors.
 Cash flow to Firm: There is also a broader definition of cash flow
that we can use, where we look at not just the equity investor in the
asset, but at the total cash flows generated by the asset for both the
equity investor and the lender. This cash flow, which is before debt
payments but after operating expenses and taxes, is called the cash
flow to the firm

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 Two Measures of Discount Rates

 Cost of Equity: This is the rate of return required by equity investors

on an investment. It will incorporate a premium for equity risk -the
greater the risk, the greater the premium.
 Cost of capital: This is a composite cost of all of the capital invested
in an asset or business. It will be a weighted average of the cost of
equity and the after-tax cost of borrowing.

Aswath Damodaran 6
 Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are

cashflows from assets,

after debt payments and

after making reinvestments

Discount rate reflects only the

needed for future growth

cost of raising equity financing

Growth Assets Equity

Present value is value of just the equity claims on the firm

Aswath Damodaran 6
 Valuing Equity in a Finite Life Asset

 Assume that you are trying to value the Home Depot’s equity
investment in a new store.
 Assume that the cash flows from the store after debt payments and
reinvestment needs are expected will be $ 850,000 a year, growing at
5% a year for the next 12 years.
 In addition, assume that the salvage value of the store, after repaying
remaining debt will be $ 1 million.
 Finally, assume that the cost of equity is 9.78%.

⎛ (1.05)12 ⎞
850,000 (1.05) ⎜⎜1 - ⎟
12 ⎟
⎝ (1.0978) ⎠ 1,000,000
Value of Equity in Store = + = $8,053,999
(.0978 -.05) (1.0978)12

Aswath Damodaran 6
 Firm Valuation

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are

cashflows from assets,

Discount rate reflects the cost
prior to any debt payments
of raising both debt and equity
but after firm has
financing, in proportion to their
reinvested to create growth
use
assets
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of

all claims on the firm.

Aswath Damodaran 6
 Valuing a Finite-Life Asset

 Consider the Home Depot's investment in a proposed store. The store

is assumed to have a finite life of 12 years and is expected to have
cash flows before debt payments and after reinvestment needs of $ 1
million, growing at 5% a year for the next 12 years.
 The store is also expected to have a value of $ 2.5 million at the end of
the 12th year (called the salvage value).
 The Home Depot's cost of capital is 9.51%.

Aswath Damodaran 6
 Expected Cash Flows and present value
Yea r Expe c te d Cas h Flows V alue at End PV at 9 .5 1 %
1 $ 1 ,0 50 ,0 00 $ 9 58 ,8 1 7
2 $ 1 ,1 02 ,5 0 0 $ 9 19 ,3 2 9
3 $ 1 ,1 57 ,6 25 $ 8 81 ,4 6 8
4 $ 1 ,2 15 ,5 06 $ 8 45 ,1 6 6
5 $ 1 ,2 76 ,2 82 $ 8 10 ,3 5 9
6 $ 1 ,3 40 ,0 96 $ 7 76 ,9 8 6
7 $ 1 ,4 07 ,1 00 $ 7 44 ,9 8 7
8 $ 1 ,4 77 ,4 55 $ 7 14 ,3 0 6
9 $ 1 ,5 51 ,3 28 $ 6 84 ,8 8 8
10 $ 1 ,6 28 ,8 95 $ 6 56 ,6 8 2
11 $ 1 ,7 10 ,3 39 $ 6 29 ,6 3 8
12 $ 1 ,7 95 ,8 56 $ 2 ,5 00 ,0 00 $ 1 ,4 4 4 ,1 2 4
Value of St ore = $ 10 ,0 6 6 ,7 4 9

Aswath Damodaran 6
 Valuation with Infinite Life

DISCOUNTED
Length
Cash
Expected
Firm
Forever
Terminal
CF
Discount
.........
Value1 isflows
2
3
4
5
n inof
Value
stable
Rate
Growth
Period growth:CASHFLOW
of High Growth VALUATION
GrowsValue
Firm:Cost
Firm: Pre-debt
Growth
at constant
ofofCapital
inFirm
cashrate
flow
Operating
forever Earnings
Equity: After
Growth
Cost
Value debt
ofofEquity
inEquity
cashIncome/EPS
Net flows

Aswath Damodaran 6
 Valuing the Home Depot’s Equity

 Assume that we expect the free cash flows to equity at th Home Depot
to grow for the next 10 years at rates much higher than the growth rate
for the economy. To estimate the free cash flows to equity for the next
10 years, we make the following assumptions:
• The net income of $1,614 million will grow 15% a year each year for the
next 10 years.
• The firm will reinvest 75% of the net income back into new investments
each year, and its net debt issued each year will be 10% of the
reinvestment.
• To estimate the terminal price, we assume that net income will grow 6% a
year forever after year 10. Since lower growth will require less
reinvestment, we will assume that the reinvestment rate after year 10 will
be 40% of net income; net debt issued will remain 10% of reinvestment.

Aswath Damodaran 6
 Estimating cash flows to equity: The Home
Depot

Year Net Income Reinvestment Needs Net Debt FCFE PV of FCFE

Issued
1 $ 1,856 $ 1,392 $ (139) $ 603 $ 549
2 $ 2,135 $ 1,601 $ (160) $ 694 $ 576
3 $ 2,455 $ 1,841 $ (184) $ 798 $ 603
4 $ 2,823 $ 2,117 $ (212) $ 917 $ 632
5 $ 3,246 $ 2,435 $ (243) $ 1,055 $ 662
6 $ 3,733 $ 2,800 $ (280) $ 1,213 $ 693
7 $ 4,293 $ 3,220 $ (322) $ 1,395 $ 726
8 $ 4,937 $ 3,703 $ (370) $ 1,605 $ 761
9 $ 5,678 $ 4,258 $ (426) $ 1,845 $ 797
10 $ 6,530 $ 4,897 $ (490) $ 2,122 $ 835
Sum of PV of FCFE = $6,833

Aswath Damodaran 6
 Terminal Value and Value of Equity today

 FCFE11 = Net Income11 – Reinvestment11 – Net Debt Paid (Issued)11

= $6,530 (1.06) – $6,530 (1.06) (0.40) – (-277) = $ 4,430 million
 Terminal Price10 = FCFE11/(ke – g)
= $ 4,430 / (.0978 - .06) = $117,186 million
 The value per share today can be computed as the sum of the present
values of the free cash flows to equity during the next 10 years and the
present value of the terminal value at the end of the 10th year.
Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978)10
= $52,927 million

Aswath Damodaran 7
 Valuing Boeing as a firm

 Assume that you are valuing Boeing as a firm, and that Boeing has
cash flows before debt payments but after reinvestment needs and
taxes of $ 850 million in the current year.
 Assume that these cash flows will grow at 15% a year for the next 5
years and at 5% thereafter.
 Boeing has a cost of capital of 9.17%.

Aswath Damodaran 7
 Expected Cash Flows and Firm Value

 Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049 million

Year Cash Flow Terminal Value Present Value

1 $978 $895
2 $1,124 $943
3 $1,293 $994
4 $1,487 $1,047
5 $1,710 $43,049 $28,864
Value of Boeing as a firm = $32,743

Aswath Damodaran 7