Financial Analysis of Home Depot and Boeing: Debt Costs, Ratios, and Ratings, Study notes of Reasoning

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The Free Cashflow to Firm Model

Aswath Damodaran

DaimlerChrysler: Rationale for Model

n DaimlerChrysler is a mature firm in a mature industry. We will

therefore assume that the firm is in stable growth.

n Since this is a relatively new organization, with two different cultures

on the use of debt (Daimler has traditionally been more conservative

and bank-oriented in its use of debt than Chrysler), the debt ratio will

probably change over time. Hence, we will use the FCFF model.

Daimler/Chrysler: Analyzing the Inputs

n Expected Reinvestment Rate = g/ ROC = 3%/7.15% = 41.98%

n Cost of Capital

• Bottom-up Levered Beta = 0.61 (1+(1-.4694)(64.5/62.3)) = 0.
• Cost of Equity = 4.87% + 0.945 (4%) = 8.65%
• After-tax Cost of Debt = (4.87% + 0.20%) (1-.4694)= 2.69%
• Cost of Capital = 8.65%(62.3/(62.3+64.5))+ 2.69% (64.5/(62.3+64.5)) =

Daimler Chrysler Valuation

n Estimating FCFF

Expected EBIT (1-t) = 9324 (1.03) (1-.4694) = 5,096 mil DM

Expected Reinvestment needs = 5,096(.42) = 2,139 mil DM

Expected FCFF next year = 2,957 mil DM

n Valuation of Firm

Value of operating assets = 2957 / (.056-.03) = 112,847 mil DM

+ Cash + Marketable Securities = 18,068 mil DM

Value of Firm = 130,915 mil DM

• Debt Outstanding = 64,488 mil DM

Value of Equity = 66,427 mil DM

Value per Share = 72.7 DM per share

Stock was trading at 62.2 DM per share on August 14, 2000

Tube Investment: Rationale for Using 2-Stage

FCFF Model

n Tube Investments is a diversified manufacturing firm in India. While

its growth rate has been anemic, there is potential for high growth over

the next 5 years.

n The firm’s financing policy is also in a state of flux as the family

running the firm reassesses its policy of funding the firm.

Current Cashflow to Firm EBIT(1-t) : 4,

• Nt CpX 843
• Chg WC 4, = FCFF - 568 Reinvestment Rate =112.82%

Expected Growth in EBIT (1-t) .60*.092-=. 5.52 %

Stable Growth g = 5%; Beta = 1.00; Debt ratio = 44.2% Country Premium= 3% ROC= 9.22% Reinvestment Rate=54.35% Terminal Value 5= 2775/(.1478-.05) = 28,

Cost of Equity 22.80%

Cost of Debt (12%+1.50%)(1-.30) = 9.45%

Weights E = 55.8% D = 44.2%

Discount at Cost of Capital (WACC) = 22.8% (.558) + 9.45% (0.442) = 16.90%

Firm Value: 19,

• Cash: 13,

• Debt: 18, =Equity 15, -Options 0 Value/Share 61.

Riskfree Rate : Real riskfree rate = 12%

Beta 1.17 X

Risk Premium 9.23%

Unlevered Beta for Sectors: 0.

Firm’s D/E Ratio: 79%

Mature risk premium 4%

Country Risk Premium 5.23%

Tube Investments: Status Quo (in Rs)

Reinvestment Rate 60%

Return on Capital 9.20%

Term Yr 6, 3, 2,

EBIT(1-t) $4,670 $4,928 $5,200 $5,487 $5,

• Reinvestment $2,802 $2,957 $3,120 $3,292 $3, FCFF $1,868 $1,971 $2,080 $2,195 $2,

The Effects of Return Improvements on Value

n The firm is considering changes in the way in which it invests, which

management believes will increase the return on capital to 12.20% on

just new investments (and not on existing investments) over the next 5

years.

n The value of the firm will be higher, because of higher expected

growth.

Current Cashflow to Firm EBIT(1-t) : 4,

• Nt CpX 843
• Chg WC 4, = FCFF - 568 Reinvestment Rate =112.82%

Expected Growth in EBIT (1-t) .60*.122-=. 7.32 %

Stable Growth g = 5%; Beta = 1.00; Debt ratio = 44.2% Country Premium= 3% ROC=12.22% Reinvestment Rate= 40.98% Terminal Value 5= 3904/(.1478-.05) = 39.

Cost of Equity 22.80%

Cost of Debt (12%+1.50%)(1-.30) = 9.45%

Weights E = 55.8% D = 44.2%

Discount at Cost of Capital (WACC) = 22.8% (.558) + 9.45% (0.442) = 16.90%

Firm Value: 25,

• Cash: 13,

• Debt: 18, =Equity 20, -Options 0 Value/Share 84.

Riskfree Rate : Real riskfree rate = 12%

Beta 1.17 X

Risk Premium 9.23%

Unlevered Beta for Sectors: 0.

Firm’s D/E Ratio: 79%

Mature risk premium 4%

Country Risk Premium 5.23%

Tube Investments: Higher Marginal Return(in Rs)

Reinvestment Rate 60%

Return on Capital 12.20%

Term Yr 6, 2, 3,

EBIT(1-t) $4,749 $5,097 $5,470 $5,871 $6,

• Reinvestment $2,850 $3,058 $3,282 $3,522 $3, FCFF $1,900 $2,039 $2,188 $2,348 $2,

Current Cashflow to Firm EBIT(1-t) : 4,

• Nt CpX 843
• Chg WC 4, = FCFF - 568 Reinvestment Rate =112.82%

Expected Growth 60*.122 + .0581 =. 13.13 %

Stable Growth g = 5%; Beta = 1.00; Debt ratio = 44.2% Country Premium= 3% ROC=12.22% Reinvestment Rate= 40.98% Terminal Value 5= 5081/(.1478-.05) = 51,

Cost of Equity 22.80%

Cost of Debt (12%+1.50%)(1-.30) = 9.45%

Weights E = 55.8% D = 44.2%

Discount at Cost of Capital (WACC) = 22.8% (.558) + 9.45% (0.442) = 16.90%

Firm Value: 31,

• Cash: 13,

• Debt: 18, =Equity 27, -Options 0 Value/Share 111.

Riskfree Rate : Real riskfree rate = 12%

Beta 1.17 X

Risk Premium 9.23%

Unlevered Beta for Sectors: 0.

Firm’s D/E Ratio: 79%

Mature risk premium 4%

Country Risk Premium 5.23%

Tube Investments: Higher Average Return(in Rs)

Reinvestment Rate 60%

Return on Capital 12.20%

Term Yr 8, 3, 5,

EBIT(1-t) $5,006 $5,664 $6,407 $7,248 $8,

• Reinvestment $3,004 $3,398 $3,844 $4,349 $4, FCFF $2,003 $2,265 $2,563 $2,899 $3,

Improvement on existing assets { (1+(.122-.092)/.092) 1/5-1}

Tube Investments and Tsingtao: Should there

be a corporate governance discount?

n Stockholders in Asian, Latin American and many European companies

have little or no power over the managers of the firm. In many cases,

insiders own voting shares and control the firm and the potential for

conflict of interests is huge. Would you discount the value that you

estimated to allow for this absence of stockholder power?

q Yes

q No.

n The pre-tax cost of debt at the Home Depot is 5.80%

Other Adjustments from Operating Leases

Operating Lease Operating Lease

Expensed converted to Debt

EBIT $ 2,661mil $ 2,815 mil

EBIT (1-t) $1,730 mil $1,829 mil

Debt $1,433 mil $ 4,081 mil

Dealing with R&D: Bristol Myers

n Bristol Myers, like most pharmaceutical firms, has a significant

amount of research and development expenses. These expenses,

though treated as operating expenditures, by accountants, are really

capital expenditures.

n When R&D expenses are reclassified as capital expenditures, there is a

ripple effect on the following:

• Operating income
• Capital Expendiutures
• Depreciation and Amortization
• Reinvestment Rates
• Return on Capital

Converting R&D Expenses to Capital Expenses

• Operating Leases at The Home Depot in
  • 1 $ 294.00 $277. Year Commitment Present Value
  • 2 $ 291.00 $259.
  • 3 $ 264.00 $222.
  • 4 $ 245.00 $195.
  • 5 $ 236.00 $178.
  • 6 and beyond $ 270.00 $1,513.
  • n Debt Value of leases = $ 2,647.
• Current 1939.00 1.00 1939. Year R&D Expense Unamortized portion Amortization this year
• -1 1759.00 0.90 1583.10 $175.
• -2 1577.00 0.80 1261.60 $157.
• -3 1385.00 0.70 969.50 $138.
• -4 1276.00 0.60 765.60 $127.
• -5 1199.00 0.50 599.50 $119.
• -6 1108.00 0.40 443.20 $110.
• -7 1128.00 0.30 338.40 $112.
• -8 1083.00 0.20 216.60 $108.
• -9 983.00 0.10 98.30 $98.
• -10 881.00 0.00 0.00 $88.
• Value of Research Asset = $8,214.
• Amortization this year = $1,237.