I confess. I send out a lot of emails and I am sure that you don't read some of them. Since they sometimes contain important information as well as clues to my thinking (deranged though it might be), I will try to put all of the emails into this file. They are in chronological order, starting with the earliest one. So, scroll down to your desired email and read on...
January 12, 2009
Hi!
Happy new year! I hope you have have a wonderful break and that you will come
back tanned, rested and ready to go.... This is the first of many, many emails
that you will get for me. You can view that either as a promise or a threat...
I am delighted that you have decided to take the corporate finance class this
spring with me and especially so if you are not a finance major and have never
worked in finance. I am an evangelist when it comes to the importance of corporate
finance and I will try very hard to convert you to my faith. I also know that
some of you may be worried about the class and the tool set that you will bring
to it. I cannot alleviate all your fears now, but here are a few things that
you can do to get an early jump.
a. Get a financial calculator and do not throw away the manual.
b. The only prior knowledge that I will draw on will be in basic accounting,
statistics and present value. If you feel insecure about any of these areas,
I have short primers on my web site that you can download by going to
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/primer.html
c. If you are taking the Foundations in Finance class simultaneously, don't panic.
There will be 150 others in the same position and you will not be at any special
disadvantage.
d. If you are taking Valuation with me as well, you will be sick and tired of
me by the time the semester ends...
And trust me... We will get through this together...
Having got these thoughts out of the way, let me get down to business. You can
find out all you need to know about the class (for the moment) by going to the
web site for the class:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/corpfin.html
The syllabus has been updated and you will be getting a hard copy of it on the
first day of class but the quiz dates are specified online. If you click on the
calendar link, you will be taken to a Google calendar of everything related to
this class. You will note references to a project which will be consuming your
lives for the next four months. This project will essentially require you to
do a full corporate financial analysis of a company. While there is nothing you
need to do at the moment for the project, you can start thinking about a company
you would like to analyze and a group that you want to be part of.
Now for the material for the class. The lecture notes for the class are available
as a pdf file that you can download and print.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/cflect.htm
If you prefer a copied package, the first part (of two) should be in the bookstore
in about a week. The book for the class is "Applied Corporate Finance",
the second edition. I believe the bookstore already has copies.
One final point. I know that the last three months have led you to question the
reach of finance (and your own career paths). I must confess that I have gone
through my own share of soul searching, trying to make sense of what is going
on. I will try to incorporate what I think the lessons learned, unlearned and
relearned over this period are for corporate finance. There are assumptions that
we have made for decades that need to be challenged and foundations that have
to be reinforced. In other words, the time for cookbook finance (which is what
too many firms, investment banks and consultants have indulged in) is over.
That is about it. I am looking forward to this class. It has always been one
of my favorite classes to teach and I would like to make it the best class you
have ever, ever taken... I know that this is going to be tough to pull off but
I will really try. I hope to see you in a few weeks in class. Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
January 21, 2009
Hi!
By now, most of you have probably made your way back to New York. While the rest
of the country counts down to the Super Bowl, I want to start the countdown
to the first corporate finance class. Here we go:
1. How do I know if I am registered for the class? If you are getting this email,
you are in the class (at least according to the computer). if you were not supposed
to be in this class, think of it as destiny... If you think you should be registered
in this class, but are not getting this email (here it an interesting logical
question: how are you reading it then?), do something about it. I don't quite
know what... but don't just sit there.
2. What is this class all about? I cannot give away the secret yet, but you will
find out soon enough. The last email should have given you a flavor of what was
coming... What last email you ask? You are already behind in the class and it
has not even started. You can read the last email by going to
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/cfemail.html.
3. Can I take a peek at the syllabus? Of course! I aim to please. In fact, you
can browse through the entire syllabus by clicking on the link below. It describes
in excruciating detail my plans to take over your life and dominate your weekends
for the next 15 weeks (insert devilish laugh track in here...). Read and enjoy!!
http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/cfsyll.pdf
4. I have heard that there is a group project for this class. What is that all
about? Since you asked so nicely, i think I should oblige. I have attached the
description of this project. Warning: As you read this, you may feel a massive
sense of inadequacy. "I cannot do this. I am not even a Finance major" may
be your wail. Never fear. You too can do it. This class will be to CFD (corporate
finance disfunction) what Viagra is to ED.... just more effective, without the
warning about four hours and an emergency room ( Your have no idea what I am
talking about right... go back and watch the commercial).
http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/cfproj.pdf
Just a note. You will be getting hard copies of both the syllabus and the project
in class. Please, please don't print these documents off. The rainforests (there
are a couple in the malls.. though I think they are restaurants) of New Jersey
cannot take any more wasted paper...
5. Who else will be in this class? I have some good news. All those people you
liked in your block are in this class. I have some bad news. All those people
you despised are also in as well. As for that loser block you could not stand,
the whole block is in there. As of last count, there were 423 students registered
in the class, 95% of whom were first year full time MBAs. Since there were only
about 430 first time MBAs, everyone who is anyone will be in the class. This
will be like the Oscars... Party, party, party..
6. What do I have to do before the class? I would spend the weekend, doing silent
meditation or participating in a triathlon. If you think these do not sound like
good ideas, let me suggest some things that you should not do. Do not consume
more than a keg of alcohol, get less than 2 hours of sleep of stand in the line
at the Starbucks across the street just before class (since you will never make
it to class). Please do get the lecture note packet (or print off the packet)
and the book before class. I want to make sure that your net worth becomes negative
before the class starts. For those of you who have never been in Schimmel, this
will be an eye opening experience. Think of it as Carnegie Hall without the acoustics,
the charm and the history, and you pretty much have it.
Enough said... See you in a couple of days... Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
January 26, 2009
Hi!
I promised you with a ton of emails and I always deliver on my promises... Here
is the first of many, many missives that you will receive for me.....
1. Please pick a group as soon as you can and get started on picking companies
(Avoid money losing companies, financial service firms and firms with capital
arms like GE and GM). Once you have your group nailed down, let me know the names
of the people in your group and, if possible, the companies you have picked.
I will set up a Blackboard group account for you and you can exchange data and
files. In picking a company, pick a theme that is fairly broad and pick companies
that match this. Thus, if your theme is entertainment, you can analyze Sony,
Time Warner, Netflix and even Apple. I would encourage getting diverse companies
in your group - large and small, focused and diversified, and non-US companies.
(In other words, you don't want five companies that are carbon copies of each
other. There is little that you will interesting to say about differences across
companies, if there are none)
2. Once you pick your company, you can start collecting the data. You should
begin by accessing basic data on your company . Much of it comes from the Bloomberg
terminals (there is one on the second floor in the reading room and there should
be one downstairs in the computer room) and if you have never used a Bloomberg
before, it can be daunting.... Let me know if you get stuck (You can also get
a manual on using Bloomberg data written by yours truly u on my web site.)
http://pages.stern.nyu.edu/~adamodar/pdfiles/Bloombergfull.pdf
Look under Collecting Data... it is towards the top of the page.
3. If you do pick a company by Wednesday, print off the HDS page (just page 1)
for your company and visit the SEC site at
http://www.sec.gov
and print off the latest 14-DEF for your firm. If you cannot pick a company by
then, just pick a company that you are interested in and print these two items
off for the class...
4. The web cast for the first class is not up yet, but it should be soon. When
it is, you should be able to find it at:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr09.htm
Try it out and let me know what you think. I have been told that it come through
best if you have a 50 inch flat panel TV and surround sound. You will also find
the syllabus and project description in pdf format to download and print on this
page. The lecture note packet is also on this page.
5. I know this is a large class but I would really like to meet you at some point
in time personally. So, drop by when you get chance... I don't bite....
6. As for the book for the class, I really meant it when I said it was supplementary.
For this class, you don't need the book but I think it will be useful, if you
can afford it. In fact, please try to read chapter 2 for class on Wednesday.
Until next time...
P.S: If you have registered late for this class and did not get the previous
emails, you can see all past emails under email chronicles
on my web site
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/corpfin.html
Aswath Damodaran
adamodar@stern.nyu.edu
January 28, 2009
Hi!
I will try to keep this short but there are four items that I would like to draw
your attention to before class today:
1. Lecture notes for class: Please bring the first lecture note packet to class
tomorrow. Obviously, this is not an issue if you are printing off the pdf file.
If you are planning on buying the packet, I do not know whether it has made it
to the book store. If it has, great. If it has not, could you please print off
the first 25 pages of the packet for class tomorrow?
2. Group stuff: I hope that the process of forming groups and picking companies
is moving smoothly.... If you are having trouble finding kindred spirits, I will
start tomorrow's class with a call for the groupless... I will also send an email
this Friday listing those who are not in a group yet. If you are truly having
trouble connecting, let me know and I will add you to the orphan list (the list
has two on it already)....
3. Companies: I know you will not believe me on this one but try, anyway. There
are no good or bad companies to pick for the project. Every company is interesting
(on one dimension or the other). Pick a company, as soon as you can and get the
process rolling. If you truly have buyer's remorse, you can change your company
any time in the next few weeks.
4. Class attendance/participation: While I do not require attendance or grade
based on participation, I would like to see you in class, if you can make it.
I know there is a webcast of the class but... I will try my best not to bore
you!]
See you in class! Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
January 28, 2009
Hi!
First, on the question of picking companies for your group, some (unsolicited)
advice: (1) Define your theme broadly: In other words, don't pick five money-losing
airlines as your group. Pick Continental Airlines, Southwest, Ryan Air, Travelocity
and Embraer.... Three very different airline firms, a travel service and a
company that supplies aircraft to the airlines.
(2) Do not worry about making a mistake: If you pick a company that you regret
picking later, you can go back and change your pick.... If you do it in the first
5 weeks, it will not be the end of the world.
(3) If you are leery about picking a foreign company, pick one that has ADRs
listed in the US. It will make your life a little easier. You should still use
the information related to the local listing (rather than the ADR).
(4) If you want to sound me out on your picks, go ahead. I have to tell you up
front that I think that there is some aspect that will be interesting no matter
what company you pick. So, do not avoid a company simply because it pays no dividends
or has no debt.
(5) If you want to kill two birds with one stone, pick a company that you already
own stock in or plan to work for or with .....
Second, once you have picked your company, start by assessing the board of directors
(and making judgments on how effective or ineffective it is likely to be). To
help in this process, I am attaching the original article in 1997 that covered
the best and the worst boards as well as a more recent article detailing what
Business Week looks at in assessing boards.
There are a number of interesting sites that keep track of directors and their
workings. I have listed a few below:
http://www.corpgov.net/links/links.html : This is a general site listing corporate
governance links
http://www.ecgi.org/ : Covers corporate governance in Europe
Yahoo! finance reports corporate governance scores for individual companies...
http://finance.yahoo.com/
Type in the symbol for the company that you want to look up and check under profile.
Here is a fun site that allows you to look at individuals who sit on multiple
boards.
http://www.theyrule.net/
Type in George Mitchell, for instance, and see which boards of directors he sits
on...
You can find out more about your company by going to the SEC site (http://www.sec.gov)
and looking up the 14-DEF for your company.. As I noted in class today, you may
not be able to find a 14-DEF (or its equivalent) for a foreign company, but the
difficulty of finding this information may be more revealing than any information
that you may have unearthed.
Until next time...
P.S: If you have trouble with the attachments, check under readings (under the corporate finance class) for the articles. (Even if you can read the articles, check under readings for more articles...)
Aswath Damodaran
adamodar@stern.nyu.edu
January 30, 2009
So, are you in a group? Have you picked a company? Assessed the board? (I
told you I was a nag....) Anyway, the first order of business is the orphan
list. There poor, lost souls would like to be a part of a group. Show some
compassion:
Chia Chou Hung, cch313@stern.nyu.edu
Lidia Rekas, lidia.rekas@stern.nyu.edu
Meredith Somers, mls471@stern.nyu.edu
Brendan Hurley, brendan.hurley@stern.nyu.edu
gregory.agati@stern.nyu.edu
Matt Pecori <matthew.pecori@stern.nyu.edu>
Actually, I have a thought. Since there are 6 people on the list, they could
form their own group... I know.. I know.. Astoundingly brilliant, but that's
why they pay me.
Here is the second order of business. I am attaching the first weekly newsletter
for the class. It has never been mentioned before, you say? True, but I had hold
back something. If you have the time, take a look at the newsletter. It contains
nothing earth shattering, but it will keep you up to date with what is going
on in the class:
You should get a newsletter every Friday for the duration of the class. The
newsletters will also be available online at
http://www.stern.nyu.edu/~adamodar/New_Home_Page/newsletters.html
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 1, 2009
I am sure that you have seen more than your share of Super Bowl Previews
already, but here is one more with a uniquely corporate finance twist :
1. Who will win?
I am sure that there are some diehard Steeler fans in the audience (and you
guys scare me...) and perhaps even a few Cardinal fans (Do they exist? I have
yet to run into one..).... You can listen to experts go on about the Steel
Curtain and Kurt Warner's capacity to find the open guy, but here are some
market perspectives on who will win:
Vegas odds: Pittsburgh by 7.... For updated prices, go to
http://sports.us.newsfutures.com/group/group.html?groupId=2037
Market versus Maven.. Let's see who wins.
2. What will the market do next year?
This is an easy one, right? If the Cards (the NFC team) win, the market will
go up and if the Steelers (the AFC team) win, we are sunk... Before you Steelers
fans chase me down and kill me, here are the facts. In 32 out of the last 42
Super Bowls, this indicator has worked. Of course, anyone who thought they
could make money on this trend last year would have lost their shirt (the Giants,
the NFC team, won and the market did anything but go up...) But here's some
good news if Steelers' fans... In the six years that the Steelers have made
it to the Super Bowl, the market has been up 25%... So, no matter who wins,
we should do well. I think I am going to buy some index futures.
3. What should I be watching for?
ESPN announced the results of a poll, where they asked people what part of
the Super Bowl they were most looking forward - 63% said the game, 21% were
looking forward to the commercials, 15% mentioned the party and 3% specified
the half-time show (perhaps hoping for a wardrobe malfunction with Bruce Springsteen...)
I would suggest all of the above, with a corporate finance twist. As you watch
the game, think about the importance of corporate governance.. Think of the
Steelers being owned by Jerry Jones and you will get the picture. As you watch
the commercials, think about the company that you have or have not picked for
class yet... This may be your company... As you party, think about those poor
orphans without groups and see if you can find a spot for them in your group.
Some final thoughts. If you are in a group and have found a company and have
been able to print off the HDS page from Bloomberg for your company, please
bring it to class with you. So, have fun... Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: My orphan list seems to have created a few new orphans... I will start off tomorrow's class with a call to the lonely and the unwanted....
February 2, 2009
Hi!
There is almost no chance that you will get this email before class but I may
do a little extra with the HDS page today. These are the slides that I will
be using.... So, print them off when you get a chance (or just keep them on
your computer).
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 2, 2009
Hi!
Just a couple of notes about class today. First, the webcast is up and running
and I hope you got the holdings presentation that I emailed to you earlier
today. If not, it is also on the webcast page. Second, I will stop harassing
you about finding a group and picking a company but do it.... and I would really,
really like you to do the analysis of the top 17 holdings in your company,
using the framework we developed in class today.
As for the next class, I have a couple of items on the agenda and neither requires
extensive reading or research. I would like you to think about market efficiency
without any preconceptions. You may believe that markets are short term, volatile
and over react, but I would like you to consider the basis of these beliefs.
Is it because you have anecdotal evidence or because you have been told it is
so or is it based upon something more concrete? How have the last four months
changed that view? We will start the next class with this question. I would also
like you to consider the delicate balance between social and financial responsibility
that every firm faces in making decisions and how you would settle this balance.
Final notes. T the email chronicles have been updated (they will be every Monday
from now on..)
Aswath Damodaran
adamodar@stern.nyu.edu
February 4, 2009
I went back and forth on the subject and I think "whom" is the grammatically correct word to use. Enough about grammar, though! As those of you who have been scanning the newspapers have already noted, everything in the paper seems relevant to corporate finance (thus making my point that everything is a subset of corporate finance). Many of have emailed me articles that you have come across and I appreciate the links (it does help... I am not being facetious). This article is from the FT from almost a year ago but I cannot resist passing on to you because it dovetails so perfectly with the question that I left you with at the end of the class - who should you trust: markets or managers?- that is almost eerie. Anyway, take a look at the article and forgive the author for his incapacity to decide who to trust. He is a lawyer... and hopelessly wrong, in hindsight...
The gamble of short-term pain for long-term gain
By Frank Partnoy
Published: February 4 2008 02:00 | Last updated: February 4 2008 02:00
Last Thursday night, when Steve Ballmer, chief executive officer of Microsoft,
signed a letter announcing its proposal to acquire Yahoo, he probably knew
the markets would punish his company's shares. When bold acquisitions are announced,
the acquirer's shares typically decline. Indeed, although the markets were
up on Friday, Microsoft shares tumbled 6.6 per cent, or more than $20bn. Mr
Ballmer's personal stake in Microsoft lost nearly $900m.
Why would a smart leader agree to sacrifice so much of Microsoft's, and his own, share value? Although the deal raises many interesting antitrust, economic and technology issues, it also illustrates the central conundrum of modern business strategy: should corporations focus more on short-term share prices or long-term value? Put another way, the question is: should we trust markets or managers?
Whereas finance theory posits that managers should focus on share prices, today's managers see radical stock price volatility as a source of danger, not discipline.
According to this view, modern CEOs are like sailors in Greek mythology: they must shoot the gap between a high perch of mania and a whirlpool of panic. To maximise the long-term value, they must steer clear of short-term price pressures.
Last year, many managers sought private equity buyers, in part to avoid market over- and under-reaction. Now that the credit crisis has decimated those deals, the tables have been turned: fully-financed strategic buyers are hovering over companies, ready to pounce when prices fall. Microsoft's move is just the start. For example, consider MBIA, the multibillion dollar insurance company whose share price recently swung through a one-week trapeze act from $16 down to $7 and back to $16 again. What if an acquirer had offered to pay double for MBIA's shares when they hit $7?
As for Microsoft, its managers have cited an opportunity "to drive long-term economic value for our shareholders". Mr Ballmer wrote that: "Microsoft's consistent belief has been that the combination of Microsoft and Yahoo clearly represents the best way to deliver maximum value to our respective shareholders." Yet market reaction was that this belief is wrong, and that Microsoft is digging a massive financial hole by overpaying for Yahoo. Microsoft's chief financial officer has alluded to an "opportunity to drive at least $1bn of synergies". Even $1bn of synergies would recoup just 5 per cent of Friday's loss.
Microsoft shareholders must trust these words, and hope the directors' big ownership stakes are enough to align their incentives. Because Microsoft is much larger than Yahoo, the proposal was not significant enough to require shareholder approval. More-over, the board's decision to make the proposal will probably be protected by the business judgment rule, a judicial presumption that courts will not scrutinise the actions of directors unless they involve gross negligence or self-dealing.
Yahoo's shareholders are in a different boat. The markets say Microsoft's $31-per-share offer is a good one. On Friday morning, that offer was at a 62 per cent premium to Yahoo's then share price. A year, or even three months ago, when Yahoo's price was much higher, $31 per share would have been laughable. Yet even after traders digested the offer, Yahoo's closing price on Friday was below $29, reflecting an expectation that Microsoft's proposal might be the best Yahoo could do. Risk arbitrageurs have bought Yahoo and shorted Microsoft, expressing their belief that Microsoft will succeed.
Interestingly, Yahoo's board already has parroted Microsoft's "long-term" mantra, saying it will "pursue the best course of action to maximise long-term value for shareholders".
The language is stan-dard, but also ironic. If Yahoo's directors are so inclined, they can reject Microsoft's proposal as inadequate to maximise long-term value. Indeed, if "long-term" means what Microsoft says it means, Yahoo should hold out.
Its board has adopted a "poison pill" shareholder rights plan, which provides defensive leverage against unwelcome acquisitions, and its shareholders have the right to vote against Microsoft's proposal, if they believe the board can do better. Moreover, because the proposal is life-changing for Yahoo, its directors will be held to a higher standard than Microsoft's. They will feel pressure to get a better deal.
The most likely outcome is that the companies will combine, perhaps with Microsoft paying an even higher price. As other strategic ac-qui-rers opportunistically seek targets with depressed share prices, they also will suffer short-term declines in exchange for potential long-term gains. The markets will punish them, just as they reward targets. Meanwhile, shareholders will continue to be baffled about who they should trust.
The writer is a law professor at the University of San Diego and author of The Match King: One Bullet and the Financial Scandal of the Century, forthcoming from Profile Books
Aswath Damodaran
adamodar@stern.nyu.edu
February 5, 2009
Hi!
Let me start off by fulfilling my "nagging" responsibilities. Have
you found a group yet? Picked a company? Cleaned your room? Made your bed? Called
your mother? (Even if you have not done the last three, do the first two..) The
objective function matters, and there are no perfect objectives. That is the
message of the last two classes. Once you have absorbed that, I am willing to
accept the fact that you still don't quite buy into the "maximize value" objective.
That is fine and I would like you to keep thinking about a better alternative
with three caveats. First, you cannot cop out and give me multiple objectives
- I too would like to maximize stockholder wealth, maximize customer satisfaction,
maximize social welfare and employee benefits at the same time but it is just
not doable. Second, your objective function has to be measurable. In other words,
if you define your objective as maximizing the social good, how would you measure
social good? I have attached an article on stock price maximization and alternatives
to it. Third, take your objective (and the measurement device you have developed)
and ask yourself a cynical question: How might managers game this system for
maximum benefit, while hurting you as an owner? In the long term, you may almost
guarantee that this will happen.
Building on the theme of social good and stockholder wealth a little more, there
are a number of fascinating moral and ethical issues that arise when you are
the manager in a publicly traded firm. Is your first duty to society (to which
we all belong) or to the stockholders (who are your ultimate employers)? If you
have to pick between the two and you choose the former, do you have an obligation
to be honest and let the latter know? What if you believed that the market was
overvaluing your stock? Should you sit back and let it happen, since it is good
for your stockholders, or should you try to talk the stock price down?
If you have picked a company, there are two orders of business you have for this
weekend:
a. How much power do you as an individual stockholder have over the management
of this company?
To make this assessment, you want to start by looking at the board of directors
and examining it for independence and competence. I know that there are lots
of unknowns here, but work with at least what you know - the size of the board,
the appearance of independence, the (perceived) quality of these directors. With
US companies, you can get more information about the directors from the DEF14
(a filing with the SEC that you can get from the SEC website). With non-US companies,
you may sometimes find yourself lacking information about potential conflicts
of interests, but what you cannot find is often more revealing than what you
can find out; it points to how little power stockholders have in these companies.
Also look at subtle ways in which power is shifted to managers at the expense
of stockholders including anti-takeover amendments (poison pills, golden parachutes),
if you can find reference to them.
b. Are there other potential conflicts of interests between inside stockholders
and outside stockholders?
In some companies, you will find that there are large stockholders in the company
who also play a role in running the company. While this may make you feel a little
more at ease about managers being held in check (by these large stockholders),
consider who these large stockholders are and whether their interests may diverge
from yours. In particular, the largest stockholder in your company can be a founder/CEO,
a family holding, the government or even employees in the company. What they
might want managers to do may be very different from what you would want managers
to do... Look for ways in which these inside stockholders may leverage their
holdings to get even more power (voting and non-voting shares for inside stockholders,
veto powers for the government...)
While it may seem like we are paying far too much attention to these minor issues,
I think that understanding who has the power to make decisions in a company will
have significant consequences for how the company approaches every aspect of
corporate finance - which projects it takes, how it funds them and how much it
pays in dividends. So, give it your best shot... On a different note, we will
be beginning our discussion of risk on Monday. As part of that discussion, we
will confront the question of who the marginal investor in your company is. Assuming
that you have picked your company, could you please take a couple of minutes
and go to Yahoo! Finance and look up the percent of stock in your company held
by institutions:
http://finance.yahoo.com
Enter the symbol for your firm and click on major holders. Please take note of
the percent of stock in your firm held by institutions and insiders and bring
it to class with you on Monday. If you have a non-US company, you may not be
able to get this information but that is okay.
P.S: I had mentioned a paper that related stock prices to corporate governance
scores in class today. You can find the link to the paper below:
http://pages.stern.nyu.edu/~adamodar/pdfiles/articles/corpgovstockprice.pdf
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 6, 2009
Hi!
First, I seem to have touched a nerve with whatever I said about Russia in the
last class. My problem with Russia (or should I say Putin?) is simple. Any
system where ownership at the firm is subject to the whims of a central authority
is suspect. Taking a look at BP's travails on its Russian investments or Khodorkovsky's
tribulations with Yukos does not exactly fill me with confidence as a prospective
investor in Russia, that my ownership rights will be respected. In the short
term, there may be gain to Russians but in the long term, this will prevent
outsiders from investing in Russian businesses.
Second, I have attached the excel spreadsheet for the groups and companies. I
held off as long as I could on this, to make sure that every one is part of a
group and has had a chance to pick a company. I might not have waited long enough,
but if your group is ready, please send me your information in the attached excel
spreadsheet.
When you do reply, it would help if you sent one excel spreadsheet for each
group and entered "CF Group" in the subject.
Finally, the latest newsletter is attached. I hope you get a chance to browse
through it.
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 8, 2009
Hi!
We will wrap up the objective function tomorrow in the first few minutes and
put it behind us.. Not that we have resolved every question and decided every
issue... Far from it.. But rather than beat it to death, better to leave and
return to it at regular intervals over the next weeks. This week, we will start
on the meat and potatoes (or rice and beans, if you are a vegan) of corporate
finance. We will define risk and assess how best to adjust for it, when doing
analysis. There are some things that you can do to make my life and yours a
little easier:
1. If your statistics basics are rusty (even though you took the class just last
semester), try the primer that I have on statistics on my website. (It is short..
and should not take more than 30 minutes to browse through)
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/StatFile/statistics.htm
2. If you have the applied corporate finance book, you can start reading through
chapter 3. Chapter 4 is long and dense.. Put it off until the weekend.
3. Now, let's get to the fun stuff you can do before class:
a. Get a sense of how risk averse you are by taking one of these tests:
http://www.humanmetrics.com/rot/rotqd.asp (This is a long test, and I lost patience
after a while.. Tells me something about myself, I guess)
http://moneycentral.msn.com/investor/calcs/n_riskq/main.asp (Much quicker to
get through..)
http://njaes.rutgers.edu/money/riskquiz/default.asp (Not a bad test, though I
have no idea why the Rutgers Agricultural people are hosting it..)
http://www.bankrate.com/brm/news/investing/20011127a.asp (an 8 question test....
)
b. Assuming you have picked a company for your project:
i. Visit the Reuters site (http://www.reuters.com/finance/stocks), enter your
company's symbol and click on chart. You can add the S&P 500 index as well
as your sector returns. (It will not answer any questions, but it will give you
a sense of how volatile your stock has been and how well it has performed. While
you are on the site, click on ratios and you should see the beta (according to
Reuters for your company and the sector).. No idea what it tells you..Don't freak
out.. we'll get there.
ii. Try this site (http://www.riskgrades.com/). It compares the standard deviation
of your stock to the standard deviation of an index and it does have non-US stocks
in it as well. Again, don't read too much into the numbers.
See you in class tomorrow! Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 9, 1009
Hi!
Some of you may be regretting the shift from the soft stuff (objectives, social
welfare etc.) to the hard stuff, but trust me that it is still fun.. If it
is not, keep telling yourself that it will become fun. Anyway, here are a few
thoughts about today's class.
1. The Essence of Risk: There has been risk in investments as long as there have
been investments. If you have the time, pick up a copy of Against the Gods by
Peter Bernstein, John Wiley and Sons. It is a great book and an easy read. If
you want more, you should also pick up a copy of Capital Ideas by Peter as well...
That traces out the development of the CAPM....
2. More on Models: If you want to read more about the CAPM, you can begin with
the chapter in the book on risk and return models and then move on to the readings
at the end of the chapter. As you read the critiques of the CAPM, remember again
that all you have to do is outrun the guy in the sleeping bag.
3. Diversifiable versus non-diversifiable risk: The best way to understand diversifiable
and non-diversifiable risk is to take your company and consider all of the risks
that it is exposed to and then categorize these risks into whether they are likely
to affect just your company, your company and a few competitors, the entire sector
or the overall market.
One final note. If you can, try to make your assessment of whether the marginal
investors in your companies are likely to be diversified. Look at both the percent
of stock held in your company and the top 17 investors to make this judgment.
If your assessment leads you to conclude that the marginal investor is an institution
or a diversified investor, you are home free in the sense that you can now feel
comfortable using traditional risk and return models in finance. If, on the other
hand, you decide that the marginal investor is not diversified, we will come
back in a few sessions and talk about some adjustments you may want to make to
your beta calculations. Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: There are two TAs for this class and here are their office hours.
Justin Magner, justin.magner@stern.nyu.edu, Tuesday 3-4
Abhi Gupta, abhimanyu.gupta@stern.nyu.edu, Thursday TBA
I am not trying to shunt you off to the TAs. Please do come in or email me
first, if you have a question.....
February 10, 2009
I hope that this does not get to you too late. It is a very quick test to bring home the difference between firm specific and market risk, using Monday's WSJ business news summary section. If you have a chance, please give it a shot and we will talk about it at the start of class tomorrow.
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 10, 2009
Hi!
I am sorry but it looks like the attachment I sent may not be that readable...
So, let's take another shot at this. I have attached the front page from the
WSJ on Monday. Keep your attention on the Business and Finance news column
on the left. With each news item, ask yourself two questions:
1. Is this firm specific or market news?
2. is this good news of bad news?
February 11, 2009
HI!
I hope that you are gearing up for an extended weekend of fun (and catching up
on corporate finance.. but the two are not mutually exclusive). I have several
orders of business:
1. Improved webcast: If you get a chance, check out the webcast from today's
session. It looks like a new technology (called Echo 360 that we have been using
in 2-60 for my valuation class) has caught up with Schimmel. Not only is the
webcast much better (you see slides instead of pointless video of me scurrying
around) but you can download the webcast as a vodcast (to watch on your iPhone
or computer) but also as an audio cast. Let me know what you think.
2. Riskfree rates: The riskfree rate should be the easiest of all inputs to get,
but as I noted in class this morning, it is not that easy to get in markets like
Brazil and Russia. I had mentioned the riskfree rate in Euros and how different
governments issues ten-year bonds denominated in Euros, but with different rates.
The Financial Times has these numbers and I have attached the numbers from this
morning:
If you are truly interested in delving deeper on the topic (you must be sick),
I have a paper (I know that I need some psychological counseling) on risk free
rates that you can read this weekend:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317436
This is a truly spell binding piece, one that will keep you up at nights.....
or put you to sleep... Close call!
3. Risk premiums: We started on our discussion of risk premiums today, I had
mentioned survey premiums in class and two in particular - one by Merrill of
institutional investors and one of CFOs. I have attached the links to both:
Merrill survey: http://www.finfacts.ie/irishfinancenews/article_1015741.shtml
CFO survey: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162809
Until next time!
If you are working with
Aswath Damodaran
adamodar@stern.nyu.edu
February 13, 2009
Hi!
In the last email, I had mentioned that the easiest of all inputs - the riskfree
rate- may not be that easy to get, if you are working with an emerging market,
where there is default risk in the government. If you are working with such
a company (or interested in finding out, just in case), here are the steps:
1. Find a government bond, issued in the local currency. This is not easy to
find, since Bloomberg and most data sources carry only dollar denominated or
euro denominated emerging market bonds. I have found that searching online (Type
in "rupee denominated Indian government bond") often yields the best
results.
2. Once you have found the bond, you will have to check and see what the local
currency rating for the country is. You can find the ratings from January 2009
in the attached file:
if your country has a Aaa local currency rating, you can breathe easy. You
can use the local government bond rate as your riskfree rate. If not, read
on...
3. Once you have the rating, you need to come up with a default spread based
on the rating. At the start of every year, I compute these spreads, using bonds
issued by emerging markets in dollars or euros, and put them in a look up table.
Feel free to use it...
Take heed of these spreads, even if you are not working with an emerging market
company. Next week, we will consider equity risk premiums in emerging markets,
and revisit these spreads.
I hope you have a wonderful weekend. I will see you on Wednesday but trust
me, there will be more emails between now and then. Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 13, 2009
Hi!
I know.. I know.. I just emailed you a few minutes ago but I just got this article
in my email just now and I thought you may find it interesting (Of course,
I could be completely misjudging where your mind is on a Friday afternoon,
prior to a long weekend...) It relates to corporate governance, but has particular
relevance to what we were talking about with Tata Chemicals being part of a
group of companies controlled by a family.
PHAROAH CAPITALISM
Feb 12th 2009
The costs and benefits of "pyramid" business groups
LIKE a blot on corporate India's copybook, the Satyam scandal is still
spreading. Two auditors from PricewaterhouseCoopers are in police
custody, where they are trying to explain why they signed off on the
outsourcing company's cooked books. The chief minister of Satyam's home
state is trading furious accusations of negligence and worse with his
predecessor. And on February 6th the government revealed that its
serious fraud office is investigating no fewer than 325 companies
wrapped up in the scam perpetrated by Satyam's founder, B. Ramalinga
Raju, and at least one of his brothers.
In India, as in many emerging markets, companies rarely stand or fall
alone. Tarun Khanna of Harvard Business School and Yishay Yafeh of the
Hebrew University of Jerusalem report*[1] that a third of Indian firms
in the 1990s belonged to wider business groups, controlled by wealthy
families or corporate "promoters". These clubable firms were typically
4.4 times bigger than stand-alone companies.
Elsewhere in Asia, business groups are equally prevalent. In Hong Kong
15 families control corporate assets worth 84% of GDP, according to a
2000 article**[2] by Stijn Claessens, now at the University of
Amsterdam, Simeon Djankov of the World Bank and Larry Lang, now at the
Chinese University of Hong Kong. In Malaysia the figure is 76%.
These families exercise far more control than they pay for; their
corporate reach exceeds their financial stake. This is sometimes
because they hold a privileged class of shares that carry more votes
than common equity. Sometimes they appoint a loyal relative as chief
executive. But the most ambitious strategy for projecting control is to
build a corporate "pyramid".
The geometry works like this: the family holds a controlling stake (say
51%) in a company at the top of the pyramid. This firm then holds
similar stakes in a second tier of companies, which will in turn
maintain stakes in a third tier. In this way, the family controls the
entire pyramid from top to bottom, even though its financial commitment
to the second tier is only 26% (51% of 51%) and its stake in the third
tier is only about 13%.
Pyramids solve what Yoshisuke Aikawa, the founder of the Nissan group
in pre-war Japan, once called the "capitalist's quandary": how to
raise
money from outsiders without ceding control. Students of corporate
governance view them less benignly. To them, pyramids combine the twin
dangers of entrenched management and diffuse ownership.
In a closely held company, the manager is hard to oust because he owns
most of the firm. But at least he will want to make a good return on
equity, given that he owns most of it. In widely held companies,
managers are easier to replace--they are hired help. But, by the same
token, they have less skin in the game.
Pyramids combine the "worst of both worlds", point out Randall
Morck#[3] of the University of Alberta and Daniel Wolfenzon and Bernard
Yeung of New York University. They are tightly controlled by families,
who have only a paltry stake in the companies at their base. When this
gap between control and ownership grows too large, the pharaohs have an
incentive to divert resources from companies at the bottom of the
pyramid (where they might claim only 13 cents on the dollar) to the top
(where their claim is 51 cents).
In a study of eight East Asian economies (Hong Kong, Indonesia, South
Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand), Mr
Claessens and his co-authors show that a family's "control rights"
often exceed their equity claim by a wide margin. When this gap grows
to 35 percentage points or more, the market value of firms drops to
only 80% of their book value.
Satyam may not have been part of a pyramid, but it is a good example of
control exceeding ownership. The Raju family's stake had dwindled to 5%
or less on the eve of Mr Raju's January 7th confession. What started
out as a small family firm had become a widely held corporation, to
which 218,000 shareholders had entrusted their money. But as subsequent
revelations have made clear, it was still firmly in Mr Raju's grip. Its
market value has since plummeted. No one knows its book value.
PHARAONIC SACRIFICES
If pyramids are such a threat to minority shareholders, Mr Khanna asks,
why does anybody ever buy shares in them? One answer is that the danger
is reflected in the price small investors are willing to pay for their
shares. In some countries, the cost per share for a minority stake is
40% lower than the share price for a controlling block.
Another answer is that the pyramid can be a source of stability as well
as exploitation. Mr Khanna shows that firms in heavily diversified
Indian business groups outperform their free-standing rivals. Perhaps
firms in a pyramid can prop each other up, offering "mutual insurance"
that may be hard to buy on the market.
In a recent working paper, Yan-Leung Cheung@[4] of the City University
of Hong Kong and his co-authors look at over 290 related-party
transactions between listed Chinese firms and their controlling
shareholders. They found that 132 of these transactions ended up
benefiting minority shareholders. In August 2001, for example, Luoyang
Glass, which is listed on the Shanghai stock exchange, received a $28m
loan from its unlisted state-owned godfather. In the days after the
announcement, its shares beat the market by 8.1%.
In his confession, Mr Raju said he had personally raised 12.3 billion
rupees ($250m) in loans to help keep Satyam afloat. He may even be
telling the truth. But pharaohs like to be buried in their pyramids,
not for them. According to the INDIAN EXPRESS, a newspaper, he is now
asking Satyam for the money back.
Sources:
*"Business groups in emerging markets: paragons or parasites?[5]",
by
Tarun Khanna and Yishay Yafeh
**"The separation of ownership and control in East Asian
corporations[6]", by Stijn Claessens, Simeon Djankov and Larry H.P.
Lang. JOURNAL OF FINANCIAL ECONOMICS, October 2000
#"Corporate governance, economic entrenchment and growth[7]", by
Randall Morck, Daniel Wolfenzon and Bernard Yeung. JOURNAL OF ECONOMIC
LITERATURE, September 2005
"Disentangling the incentive and entrenchment effects of large
shareholdings[8]", by Stijn Claessens, Simeon Djankov, Joseph P.H. Fan
and Larry H. P. Lang. JOURNAL OF FINANCE, December 2002
@"Tunneling and propping up: an analysis of related party transactions
by Chinese listed companies[9]", by Yan-Leung Cheung, Lihua Jing, Tong
Lu, P. Raghavendra Rau and Aris Stouraitis
Aswath Damodaran
adamodar@stern.nyu.edu
February 13, 2009
Hi!
Okay... Okay.. This is it.. No more.. but Fabio Noronha forwarded this message
to me that just begged for a wider audience. It relates specifically to the
entire question of what exactly comprises a riskfree rate. Read it and weep!
Life just got a little more complicated - we now have three layers of AAA,
resistant, resilient and vulnerable.
Triple-A Dividing Line
By RICHARD BARLEY
When is a triple-A no longer triple-A? As countries compete for trillions of dollars worth of funding, markets are questioning long-held assumptions about the risk-free status of government bonds – and whether their ratings can weather the storm. Moody's has waded into the debate by dividing its 18 triple-A countries into three categories.
At the top are 14 "resistant" triple-As, whose ratings aren't being tested by the crisis, including Germany, France and Canada. The U.S. and the U.K. rank second as "resilient" triple-As. They face shocks to their economic model and very large contingent liabilities, but Moody's thinks they can adjust. Spain and Ireland are "vulnerable," based on their lack of ability to rebound. Ireland's rating already has a negative outlook, and Standard & Poor's has already downgraded Spain.
All of the sovereigns face mounting debt-to-gross-domestic-product ratios, as debt issuance balloons and economic output declines. But rather than simply the amount of debt, it is affordability that is key to ratings. This metric measures a government's room for maneuver. A downgrade could be caused by a combination of three factors: a material deterioration in the absolute affordability of debt; a deterioration in affordability relative to other sovereigns; and an inability to correct the problem.
There are already worries about what surging debt issuance will do to funding costs. So far, governments have benefited from the rush to safe-haven bonds, but long-term yields have risen this year, and there is a growing mountain of short-term debt to be refinanced.
Under Moody's stress scenario, involving a further growth shock and permanently higher interest rates, interest payments for the U.S., U.K. and Ireland as a share of general government revenues would rise above 10% by the end of 2011 from 6.1%, 5.3% and 2.8%, respectively, at the end of 2007. Spain's indicator would rise to more than 5% from 3.9%.
The 10% barrier is crucial, as above this level debt service costs start to limit governments' social and political options. Double-A-rated Italy's indicator was 10.7% at the end of 2007. Its government has acknowledged it can only respond in a limited way to the crisis due to its debt burden.
The last factor – the ability to rebound – is harder to judge. The capacity of a national economy to recover and reinvent itself is driving ratings. Fears about Irish and Spanish competitiveness – exacerbated by their inability to use exchange rates to boost their economies – put them at risk of downgrades, with Ireland under greater pressure in Moody's eyes. The ratings of the U.S. and U.K. seem safe, with the U.S. in particular seen to be in a good position to rebound.
So downgrades will be limited. But even if countries remain triple-A, investors should dig deeper and differentiate between the top rated credits.
Write to Richard Barley at richard.barley@dowjones.com
Aswath Damodaran
adamodar@stern.nyu.edu
February 15, 2009
Hi!
I hope your weekend is going well (I know it is going too fast...). I am attaching
the newsletter for the week, if you are craving more stuff on corporate finance.
I also saw this article in the New York Times about risk aversion, which relates to what we were talking about in class on Wednesday. (I was actually skimming my way through the paper to get to the sports pages, which is about the only section I read in depth... )
Until next time!!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: The project awaits....
February 17, 2009
Hi!
I hope you had a wonderful weekend. It is my job to break the spell. Some notes
ahead of tomorrow's class:
1. Risk premiums: We ended the last session with a discussion of the historical
risk premium. Tomorrow's class will begin with an alternative approaches to estimating
equity risk premiums. First, we will look at a historical risk premium by looking
at how stocks have done relative to the treasuries between 1928 and 2008. We
will then back out the premium from the current level of the S&P 500 index.
If you want to get a jump on the process, try the attached spreadsheet. The only
numbers you will have to update is the current level of the S&P 500 index
and the treasury bond rate today (in red). I have updated all the other numbers
for you. Bring the output with you to class, if you do it.
2. Betas: We will also begin our discussion of the conventional approach to estimating betas - running a regression of stock returns against a market index. If you can get to a Bloomberg, find your stock and print off the BETA page (you might already have done this, in which case you are all set) for it and bring it to class, it would be immensely useful. In fact, you can get part of the project done if you enter the numbers from your company's BETA page into the attached risk diagnostics sheet.
I know... I know.. You are still in weekend mode... So, do what you can and I will see you in class tomorrow! Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 18, 2009
Hi!
I hope you have had a chance to absorb the discussion of implied equity risk
premiums. I know that the concept is complex but it is well worth understanding.
If you are up to it, try computing today's implied equity risk premium in the
attached chart. Change only the index and the riskfree rate (and leave the
other inputs untouched). Then, go into "Goal seek" function in Excel
and set B24 to the current level of the index by changing cell C18. (If you
have no idea what I am talking about, open the goal seek in Excel and it should
become clearer).
If you can, please do print off the Beta page for your company and fill out the excel spreadsheet that I sent out in my last email (riskchecker.xls). Just in case you did not get it, I am attaching it again:
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 19, 2009
Hi!
I seem to be getting a lot of emails about the equity risk premium. You are either
doing it to make me feel good or because you are really interested in the topic
or completely brainwashed. In case you are interested in getting a more complete
handle on equity risk premiums, you may want to take a look at this paper that
I wrote for practitioners (primarily) last October.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1274967
I would tell you that the paper will answer every question you will have about
equity risk premiums but I would be guilty of unforgivable hubris... But it did
answer every question I had on the topic... obviously...
On a different note, a few of you have asked me about setting the growth rate
(in the implied equity risk premium formula) beyond year 5 equal to the risk
free rate. Here is the rationale in steps:
1. Since we are looking at the entire index, the earnings on the stocks in the
index should grow at roughly the same rate as the economy in the long term.
2. Since the valuation is being done in dollar terms, that growth rate should
reflect the expected inflation rate in US dollars and the real growth rate in
the economy.
Nominal GDP growth = Expected inflation + Expected real growth rate in economy
(If it is in rupees, it will reflect the expected inflation in rupees)
3. Neither number is observable, since we are talking about the future. We could
ask economists, but let's not waste our time. They have a tough enough time telling
us what happened last quarter, let alone what will happen over the next 10 years.
4. The nominal riskfree rate = Expected inflation + Expected real interest rate
Here comes the clincher. In the long term, the expected real interest rate =
expected real growth rate in the economy (After all, to deliver a real interest
rate of 2% you have produce 2% more in goods and services... which is the growth
rate in the eoonomy)
Ergo (I love that word, whatever it means.. Makes me sound learned...), the riskfree
rate is a good proxy for the nominal growth rate in the economy in the long term...
Of course, none of this may have troubled you in the first place, in which case
you should ignore everything you read in this paragraph. Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 20, 2009
Hi!
I know that you were just waiting for this with bated breath, but here it is...
Fresh of the press.. the newsletter for the week...
Nothing more to add... Hope you have a great weekend! Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 23, 2009
Hi!
Hope you have had a chance to print off the beta page from Bloomberg for your
company. If you have, do try to work through the regression diagnostics that
we did for Disney in class today. I know that I send the excel spreadsheet
to you last week, but I am attaching it again, just in case....As you take
a look at the output, consider the following:
1. The Slope of the regression and the standard error: for the beta and the range
on your estimate
2. The intercept: To convert it into a Jensen's alpha, you will need an average
T.Bill rate over your regression period. The spreadsheet has the T.Bill rates
at the end of each year. You can use the average annual rate over your regression
period as an approximation.
3. The R Squared: will give you a measure of the proportion of the risk in your
stock that comes from the market. (I do know that the concept that I tried to
explain with Shaq's weight and mine is a messy one, but the best way to see it
is to set up an example with two companies with different total risk and see
the effect of changing the R-squared)
If you truly have time on your hands and can find a vacant Bloomberg, try changing
some of the defaults on your Beta page and keep track of what happens to your
beta. Try different starting points, change the weekly default to daily or monthly
and change the market index.... and bring the pages with you to class on Wednesday.
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 25, 2009
Hi!
As we work our way through betas and hurdle rates, it is my dubious pleasure
to remind you that the first quiz is on Monday, March 2. As you gasp and claim
that you never saw this coming, let me hasten to add that the date has been
etched in stone from the start of the class (See syllabus and Google calendar,
if you are skeptical). Here are a few details about the quiz:
1. Quiz time: The quiz will be in the first 30 minutes of class on March 2, i.e.
from 10.30-11. It is open book, open notes but laptops are not allowed; fingers,
toes, slide rules, abacuses and calculators are all okay.. There will be three
rooms used for the quiz, and which one you will be in depends upon the first
letter of your last name. (if you are unsure about what your last name is, I
would strongly recommend that you skip the quiz and go to work at Bloomberg as
the beta calculation guy.)
Go to If your last name starts with
KMEC 2-65 A-B
KMEC 2-70 C-E
KMEC 3-65 F-G
Schimmel H-Z
There will be class after the quiz. So, please do come to Schimmel, if you are
in one of the other rooms, by 11.05.
2. Quiz will cover: Chapters 1, 2, 3 and much of 4 (until you get to the cost
of debt). In terms of the lecture note packet, up to slide 156 in the lecture
notes is fair game.
3. Pre-prep for the quiz:
Step 1: Review the lecture notes.
Step 2: Relive the excitement. Watch the webcasts, in case you missed a class
(either physically or mentally).
Step 3: Read the sections of the book, where you are still unclear about what
was said in class.
Step 4: If you are still confused, call me or or email me.
Step 5: Work through the problems at the end of chapters 2,3 and 4. You can skip
any problems that require you to compute a standard deviation, correlation, covariance
or a beta, but you do need to be able to use any of these number in analysis.
One unconventional way of preparing for the quiz is to get caught up on your
project.
4. Prepping for the quiz: All of the past quizzes I have ever given in this class
are online, in the website for the class. Just download quiz 1 and work through
as many as you can in real time conditions (give yourself 30 minutes and don't
cheat by looking at the solutions, which are also online). If you want to make
it really real, surround yourself with panicky, stressed out people (I would
suggest a really crowded dentist's office or Penn Station at the peak of commuter
hour) and then work through the quizzes.
5. Review session for the quiz: The review session will be in Schimmel on Friday,
from 12-1. Needless to say, the review session will be webcast and the webcast
should be available within a couple of hours of the session. There will be a
presentation for the review session that I will email separately.
6. Missing the quiz? If for reasons beyond your control, you are unable to take
the quiz, please, please let me know before the quiz. To do so, send me an email
with "Missing Quiz 1" as the subject and give me a reason. If you are
planning to miss this quiz for strategic reasons (rather than health or other
good reasons), remember that there is a cost to quiz-missing. You lose the option
of having your worst quiz score pushed up to the average score you had on the
rest of the exams (the other quizzes and the final).
I am sorry for the long email (not really, but seems like the polite thing to
say...).... Until tomorrow!
Aswath Damodaran
adamodar@stern.nyu.edu
February 26, 2009
If you remember, we finished the class on Wednesday with an analysis of the
beta for Disney after its acquisition of Cap Cities. The first step was assessing
the beta for Disney after the merger. That value is obtained by taking a weighted
average of the unlevered betas of the two firms using firm values (not equity)
as the weights. The resulting number was 1.026. The second step is looking
at how the acquisition is funded. We looked at an all equity and a $10 billion
debt option in class and I left you with the question of what would happen
if the acquisition were entirely funded with debt. (If you have not tried it
yet, you should perhaps hold off on reading the rest of this email right now)
Debt after the merger = 615+3186 + 18500 = $22,301 million ( Disney has to
borrow $18.5 billion to buy Cap Cities Equity and it assumes the debt that
Cap Cities used to have before the acquisition)
Equity after the merger = $31,100 (Disney's equity pre-merger does not change)
D/E Ratio = 22,301/31,100= 0.7171
Levered beta = 1.026 (1+ (1-.36) (0.7171)) = 1.497
Note that I used a marginal tax rate of 36% for both companies - that is where
the 0.64 on the page 143 comes from
2. As you start working through past quizzes, you will find that the last question
- about betas and what happens after firms restructure - is always the toughest
one. A couple of suggestions that may ease your passage. First, separate the
effects of changes in business mix from changes in financial leveral. For the
former, you work with unlevered betas and firm values. For the latter, you
look at debt to equity ratios. For instance, divesting a business changes your
business mix because it replaces an operating asset with cash. Paying that
cash out as a dividend will affect both your business mix (by taking cash out
of the business) and reducing your equity. We will spend a lot of time in the
review session tomorrow on this issue.
3. Finally, here are two other questions about past quizzes that seem to keep
coming up:
a. Why is 5.5% the risk premium in past quizzes and problems?: As you work
through a lot of the past exams, you have probably noticed that a 5.5% risk
premium magically pops up when you look at the solutions. This is why. If you
are not given a risk premium for equity in a problem, you should look it up
in your notes and use the historical premium or the implied equity premium
and specify what you did. If you were doing that today, you would be using
3.88% (which is the geometric premium for stocks over T.Bonds) or 6.5% (implied
equity premium); check your lecture notes to see where these numbers come from.
At the time that these quizzes were worked out, that historical premium was
closer to 5.5%.
b. Is it possible that some of the problems lend themselves to multiple interpretations?
If you read a problem and are not sure about something, make an assumption
and state it. When grading the quiz, I will consider your assumption.
I am also attaching the presentation for the review session tomorrow. If you
are coming to the session, please make a copy and bring it with you.
Have a great weekend (and I apologize if I have already ruined it)! Until
next time!
Aswath Damodaran
adamodar@stern.nyu.edu
February 27, 2009
Hi!
Hope the review session helped (the review is online). You can get to it by going
to
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/cfquizreview.htm
The review presentation is available there as well (and it was attached to yesterday's
email)
If you prefer direct links, here they are:
Rich Media (Streaming)
http://echo360.stern.nyu.edu:8080/ess/echo/presentation/9031c94e-2337-46e5-a925-a490c7e8573c
Vodcast (Downloadable)
http://echo360.stern.nyu.edu:8080/ess/echo/presentation/9031c94e-2337-46e5-a925-a490c7e8573c/media.m4v
Enhanced Podcast (Also downloadable, but I have no idea what makes it enhanced)
http://echo360.stern.nyu.edu:8080/ess/echo/presentation/9031c94e-2337-46e5-a925-a490c7e8573c/media.m4b
Podcast: (Downloadable, but just audio)
http://echo360.stern.nyu.edu:8080/ess/echo/presentation/9031c94e-2337-46e5-a925-a490c7e8573c/media.mp3
I know that Wednesday's class was dense and that I risked confusing you more,
especially with the unlevered betas corrected for cash. If you are still confused,
consider doing the following:
a. Review the class session where we estimated betas corrected for cash. Note
that we started with the regression betas for comparable firms and unlevered
those betas using the average (or median) debt to equity ratio for these firms:
Unlevered beta = Regression Beta/ (1 + (1- tax rate) (Debt/Equity))
and corrected for cash, using the following equation:
Unlevered beta for business = Unlevered beta for company / (1- Cash/Firm Value)
In this case, we were starting with regression betas which are levered betas
and worked to unleverered betas corrected for cash.
b. Take a look at the review session where we estimated the levered beta for
the tobacco company on page 21 as follows
Unlevered beta for the company = Unlevered beta for business (1 - Cash/Firm
Value)
For instance, the tobacco firm with $15 billion in tobacco assets and $ 10
billion in cash had an unlevered beta of 0.54. Correcting for the debt to equity
ratio of 100%, the levered beta was 0.864. In this case, we were starting with
the unlevered beta corrected for cash (0.90) and working to a levered beta
for the company.
To reconcile the two, assume that I had given you the regression beta for the
tobacco firm (which would have been the levered beta of 0.864) and asked you
for the beta of just the tobacco business. You would have done exactly what
we did in the Disney case, unlevering the beta (using the debt to equity ratio
of 100% which would have given you the unlevered beta of 0.54) and then dividing
by ( 1- Cash/ Firm Value) which would have given you the unlevered beta of
0.90 for the tobacco business.
In other words, we started with levered betas in the Disney case and backed into pure play or business betas, whereas we started with business betas in the review problem and worked to levered betas...
I know it is confusing to work with levered betas, unlevered betas and unlevered
betas corrected for cash. While there is no magic bullet, using the financial
balance sheet (with assets at market value on one side and debt and equity
in market value terms on the other) helps, as does the recognition that:
a. Divestitures and acquisitions, by themselves, don't affect debt or equity,
but can affect the business mix of the firm.
b. What you do with the cash from divestitures and how you raise the cash for
acquisitions can make a difference to your debt to equity ratio.
As a final note, I have attached the weekly newsletter for this week and the
answers to the last page of the review packet. Good luck and see you on Monday!
Aswath Damodaran
adamodar@stern.nyu.edu
February 28, 2009
Well, I guess I have pretty much ruined your weekend and I am sorry.
Anyway, I hope that the quizzes a re getting a little easier as you
keep at them and that the skies are starting to open up.. In fact, the
theme for this song should be emerging:
http://www.youtube.com/watch?v=gIqLsGT2wbQ
I am just hoping that it is not this one:
http://www.youtube.com/watch?v=ZeZm7KQJT1o
Do hold out one exam and take it in real time (without the solutions
next to you). Relax and don't stress out too much! Until Monday!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: In case you still need a reminder, the quiz is in the first 30
minutes of class and your room assignments are as follows:
Go to If your last name starts with
KMEC 2-65 A-B
KMEC 2-70 C-E
KMEC 3-65 F-G
Schimmel H-Z
There will be class after the quiz...
March 1, 2009
Hi!
I know that this is late in the game but I did get a few questions repeatedly
yesterday and I think it makes sense to answer them publicly:
1. Why do we use past T.Bill rates for Jensen's alpha and the current treasury
bond rate for the expected return/cost of equity calculation?
The Jensen's alpha is the excess return you made on a monthly basis over a past
time period (2 years or 5 years, depending on the regression). Since you are
looking backwards and computing short-term (monthly or weekly) returns, you need
to use a past, short-term rate; hence, the use of past T.Bill rates. The cost
of equity is your expected return on an annual basis for the long term future.
Hence, we use today's treasury bond or long term government bond rate as the
riskfree rate.
2. When do you use the arithmetic average risk premium over T.Bills as your risk
premium?
Only when you are asked to compute the expected return over the next year (a
one-year number). You will never use it to compute a long term cost of equity.
3. Why do you use the US historical risk premium for European stocks?
The US historical risk premium is used as the premium for any mature market,
because the US has the longest uninterrupted historical data on stock and treasury
bond returns. Most European markets are categorized as mature markets. Hence,
it makes sense to use the US premium.
4. How do you adjust for the additional country risk in emerging market stocks?
If the country you are analyzing is not AAA, you should adjust for the risk by
adding an "extra" premium to your cost of equity. The simplest way
to do this is to add the default spread for the country bond to the US risk premium.
This will increase your equity risk premium and when multiplied by your beta
will increase the cost of equity. A slightly more sophisticated approach is to
adjust the default spread for the relative risk of equities versus bonds (look
at the Brazil example in the notes) and adding this amount to the US premium.
This will give you a higher cost of equity. (See the Mexico example in the review
session). If you are given enough information to do the latter, do it (rather
than use just the default spread).
5. How do you estimate a riskfree rate for a currency in an emerging market?
If you are doing your analysis in US dollars or Euros, you would use the riskfree
rates in those currencies. In the local currency, you should start with the government
bond rate in the local currency and take out of that number any default spread
that the market may be charging (see the Mexico example in the review packet)
6. Why do you use the average debt to equity ratio in the past to unlever betas?
The regression beta is based upon returns over the regression time period. Hence,
the debt to equity ratio that is built into the regression beta is the average
debt to equity ratio over the period.
7. What is the link between Debt to capital and debt to equity ratios?
If you have one, you can always get the other. For instance, the Fall 2006 quiz
gives you the average debt to capital ratio over the last 5 years of 20%. The
easiest way to convert this into a debt to equity is to set capital to 100. That
would give you debt of 20 and equity of 80, based upon the debt to capital ratio
of 20%. Divide 20 by 80 and you will get the debt to equity ratio of 25%.
8. How do you annualize non-annual numbers?
The most accurate thing to do is to compound. Thus, if 1% is your monthly rate,
the annual rate is (1.01)^12-1.... if 15% is your annual rate, the monthly rate
is (1.15)^(1/12) -1... If you have trouble or get stuck, just go with the simpler
computation; multiply or divide by 12.
That is about it... Hope I have not added to your confusion. Relax.. and I will
see you soon. Until next time!
March 3, 2009
The quizzes are done... Before you rush up, though, please do read the rest
of this email:
1. Pick up area and etiquette: The quizzes can be picked up on the ninth floor
of KMEC. As you come out of the elevator, please walk towards the door to the
department and look to your left, just before you get to the door. The quizzes
are in four NEAT piles, in alphabetical order. Please, please do not mess them
up, There are 430 quizzes and it took me a while to get them in the right order.
(If you asked me to hold your quiz, you will have to get it from me tomorrow)
2. Grading: The solutions to the quizzes are attached to this email and I have
included the grading guidelines that I followed. I have also made copies of
the solutions and left them with the quizzes.
3. Grievances: I am not a robot and I do mess up. If I have messed up, please
bring your quiz and I will fix my mistake. If you have an issue with one of
my solutions (and feel yours is better), I am willing to listen, though I may
not always respond favorably. I am also a very untidy grader; I am sorry.
4. Distribution for the quiz: I have also attached the distribution for the
quiz to this email. While I have tried to put letter grades on the quiz scores,
don't take them too seriously. After all, right now, 2 points may separate
a B+ from a C+....
Hope you get a chance to pick up your quiz soon. Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
March 3, 2009
Hi!
Now that you have had a chance to pick up your quiz (you have, haven't you?)
and gone through the requisit celebration/ mourning period, it is time to get
back to work. One small notes before I get into the topic for the day. First,
I hope you had a chance to read the Wall Street Journal's cover story on shareholder
activism in Japanese companies. It is well worth a look. Second, those of you
who have been reviewing Google calendar (for this class) have noticed that
your first case will be given to you next week. I have it almost ready and
I will email you the case on Monday. The due date is scheduled to be March
30. .. Bummer, because it hangs over your Spring break but you can always get
it done before. It is a group case and there is one grade per group.
Finally, lets talk about bottom-up betas. Here are the basis steps involved in
estimating them:
Step1: You have to get a breakdown of the businesses that your firm is in. You
can get this by downloading your firm's 10K from the SEC web site.
http://www.sec.gov/edgar/searchedgar/webusers.htm
Once you have it, browse through it (I would say read it but that would be a
painful exercise) to find the breakdown of your firm's business. Usually, the
company will give you at least revenue and operating income by business. If you
have a non-US company, you should be able to find this information in their annual
report.
Step 2: Estimate bottom-up unlevered betas for each business. There are four
routes you can follow, depending on how much time you are willing to spend on
the process-
a. The Easy Route (5 minutes): You can use the unlevered betas that I have computed
by business on my web site. You can get to it by going to updated data and looking
for levered and unlevered betas by business- I have them as separate datasets
for the US, Europe, Emerging Markets and Japan. The advantage is that it is easy
to do... The disadvantage is that you will not get the wonderful experience of
doing it yourself and the breakdown may not be detailed enough for you.
b. The Slightly more involved route (20-30 minutes): At the top of the updated
data page, you will find the complete excel datasets of the 20000+ companies
that I used to construct the industry average tables. You can download the datasets
(Do it on a high-speed line because it is a very large dataset) and then create
your own group of comparable firms. All of the raw data on the company is provided
- betas, debt, equity and cash - and you have to construct your own unlevered
beta. Try it if you have a chance.
c The online way (5 minutes): Go the Reuters web site;
http://www.reuters.com/finance/stocks
Enter the symbol for your firm and check the ratios (look under the symbol).
One of the numbers that they report is the beta for your company and the betas
for the industry and sector (they have their own categorization). The beta they
report is a levered beta but on the same page, they report a book debt to equity
ratio and a price to book ratio. You can compute an average debt to equity ratio
for the industry by dividing the book debt to equity by the price to book...
Market debt to equity = Total debt to equity/ Price to book ratio
Since the tax rate is reported for the industry, you can compute an unlevered
beta. The problem with this approach is it is difficult to do this for multiple
businesses but it works if you have a single business company.
d. The Bloomberg Way (30 minutes - 2 hours, depending): After all, real finance
mavens use Bloomberg. You can get the information to estimate unlevered betas
by getting on a Bloomberg terminal and typing QSRC. You can then screen across
markets and industries to pick firms in particular markets. Once you have your
sample ready, you can modify the output page to contain the information you need
- betas, debt, equity, cash and tax rates, for example. The advantage is that
you can do this for non-US stocks. The disadvantages is that Bloombergs are notoriously
user unfriendly and you can get only a paper printout. (We don't pay enough for
a download function)
Step 3: Compute the values of each of the businesses that your firm is in. I
would recommend using revenues as the starting point. If you are not comfortable
using pricing ratios, weight the businesses based on revenues. If you would like
a more precise estimate, go back to the comparable firms you pulled up in step
2 and compute the value to sales ratio for the industry
Enterprise Value to Sales = (Market value of Equity + Debt - Cash) / Revenues
Multiply the revenues from each of the businesses by these value to sales ratios
to get estimated values, and use them to compute weights.
Step 4: Compute a bottom-up unlevered beta for your company by taking a weighted
average of the betas in step 2 with the weights in step 3..
I have more to say about the cost of debt, but this email has reached critical
mass... So, have fun.. Until next time!
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
March 4, 2009
Hi!
Now that you have the bottom up beta (you cannot blame me for hopeful thinking),
I want to review some of what you will need to do to come up with a cost of
debt and perhaps come up with market values of debt and equity in advance of
Monday's class:
1. Get the raw data on interest bearing debt: In particular, take a look at the
balance sheet and identify the interest bearing debt. It is not always easy to
do since you will see ambiguous items such as long term liabilities. Include
both bank loans and corporate bonds, short term and long term debt. (It is possible
that your firm has no debt. Don't ruin your eyes looking for something that does
not exist. A clue that your firm has no debt will be in your income statement
if your interest expenses are zero).
2. Collect lease commitment data: For US companies, the lease commitments (if
any) should be in a footnote. The current year's lease payment will be in close
proximity. These lease commitments are also called rental commitments....Again,
note that not all companies have lease commitments.... and you may not be able
to find this table for non-US companies.
3. Check to see if your company is rated by S&P or Moody's: If you have access
to a Bloomberg terminal, you can do this by clicking on CORP and then typing
in the name of your company. If nothing shows up, you don't have a rating. If
something does, you can click on any of the bonds and look up the actual rating.
4. Get a synthetic rating: For firms without a rating, this will be your primary
basis for estimating the cost of debt. For firms with an actual rating, it will
give you a basis for comparison. You can continue to use the actual rating, but
be aware of the synthetic rating as well. I have attached a spreadsheet that
will do dual duty - estimate the synthetic rating and convert lease commitments
into debt for you... It also gives you the default spread to use with the rating
and thus the pre-tax cost of debt for your firm. Just make sure that the riskfree
rate you are using is the same 10-year default free rate you used earlier on
your cost of equity (Thank you...thank you... I aim to please)
5. Get a marginal tax rate to use on your cost of debt: I have attached a link
to the page on my website that has the marginal tax rates by country
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/countrytaxrate.htm
Aswath Damodaran
adamodar@stern.nyu.edu
March 5, 2009
Hi!
I have attached the case for the class. It is due on March 30, but you can get
started whenever you want. There are still things that we do in class that
will lead to revisit the numbers and change them. It is a group case and there
will be only one submission per group.
On a completely different note, I have noticed a fair degree of confusion about what happens next, if you did badly (or well) on your first quiz or missed it.... I know.. I know.. I am supposed to tell you that grades don't matter and that learning does. I do believe the latter is true but the former is not true. Of course, you care about your grade, both for self esteem and for your resume. I know that it can be difficult figuring out where you stand in a class of this size or how the system works, if you have a bad quiz or a bad day. While I cannot set all your fears to rest, I have attached a spreadsheet that you can use to extrapolate your score on the class. Right now, all you have is one quiz score. Enter that score and your prospective scores on future quizzes, the exam, the project and the case. If nothing else, it will show you how your worst quiz score will be adjusted based upon the better quizzes/final. As you get additional real scores (as opposed to hypothetical scores), you can update the spreadsheet. Hope it helps... Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
March 7, 2009
Hi!
I hope you have a great weekend planned. In case you do have the time and the
inclination, please try to get the bottom up beta and the cost of debt done
for your firm. You can also take the case (sent on Thursday) with you as leisure
reading... I have attached the weekly newsletter for this week.
Aswath Damodaran
adamodar@stern.nyu.edu
March 8, 2009
Hi!
I have been getting lots of emails about bottom up betas this weekend, which
I take as a sign of psychological sickness or remarkable planning. Rather than
try to answer questions in pieces, I have put together a list of the top ten
questions on bottom up betas that answers some of the mechanical questions
you may have on the topic. Please do take a look at it, when you have a chance.
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
March 10, 2009
Hi!
I know that you have lots of other stuff on your plate right now and are not
really thinking about corporate finance (I find that hard to believe but then
again, I am biased..) In case your fascination with corporate finance leads
you to crack open the case, here are a few suggestions on dealing with the
issues. (In case, you are wondering "What case?". I will leave physical
copies of the case outside the front door to the finance department - the same
place where you picked up the quizzes) tomorrow.
a. Do the finite life (15-year) analysis first. It is more contained and easier
to work with. Then, try the longer life analysis. It is trickier...
b. If you find yourself lacking information, make reasonable assumptions. Ignoring
something because you don't have enough information is not a good choice.
c. I think the case is self contained. For your protection, I think you should
stay with what is in the case. You are of course not restricted from wandering
off the reservation and reading whatever you want on furniture retailing and
manufacturing, but you run the risk of opening up new fronts in a war (with other
Type A personalities in other groups who may be tempted to one up by bringing
in even more outside facts to the case) that you do not want to fight. And please
do not override any information that I have given you in the case. (I have given
you a treasury bond rate and a risk premium, for instance.)
d. There are accounting and tax rules that you violate at your own risk. For
instance, investing in production capacity is always a capital expenditure. At
the same time, make your life easy when it comes to issues like depreciation.
If nothing is specified about deprecation, use the simplest method (straight
line) over a reasonable life.
e. There is no one right answer to the case. In all my years of providing variations
of this case, I have never had two groups get the same NPV for a case. There
will be variations that reflect the assumptions you make at the margin. At the
same time, there are some wrong turns you can make (and i hope you do not) along
the way.
f. Much of the material for the estimation of cash flows will be covered in the
next couple of sessions. You can get a jump on the material by reviewing chapters
5 and 6 in the book. The material for the discount rate estimation is already
behind us and you should be able to apply what we did with Disney to this case
to arrive at the relevant numbers.
g. Do not ask what-if questions until you have your base case nailed down. In
fact, shoot anyone in the group who brings up questions like "What will
happen if the margins are different or the market share changes?" while
you are doing your initial run...
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: The last exhibit in the case has lots of data. I have attached an excel version of the exhibit.
Both the case and the exhibit are available online on the website for the class. Click on the case.
March 11, 2009
Hi!
I know that it has probably already been a fairly stressful semester, with the
financial work coming apart at the seams, summer internships fading and work
building up on every front. So, take a break and have a wonderful week. I will
see you in about 10 days... Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
March 15, 2009
Hi!
I know that you probably have one foot out of the door already, as you take for
other parts of the world. As a parting gift, I plan to make this email a general
one about computing capital invested, the meaning of return on capital and
the use of pre-debt versus after-debt cashflows. I am sure you will read the
sub-text for implications for the case...
Measuring Capital Invested: We looked at return on capital in two contexts yesterday.
One was to compute the return on capital for an entire firm and the other was
in computing return on capital for a prospective project. The way we compute
return on capital and how we use it is different under the two scenarios:
a. Return on capital for an individual project:
How it is computed: The return on capital for an individual project is computed
using the projected operating income after taxes in the numerator and the projected
capital invested in the project in the denominator. To compute the former, you
subtract out operating expenses, including depreciation and allocated expenses,
but not financial expenses (such as interest expenses on debt or lease expenses)
from revenues; you multiply this number by (1- Marginal tax rate), since the
project adds operating income at the margin to estimate the after tax operating
income. To compute the latter, you want to stay focused on only the capital investments
made in the project. In general, the capital invested in any year can be computed
by taking the capital invested at the beginning of the year and adding to it
any new capital expenditures made during the year and subtracting out the depreciation
expense for the year. If there are working capital investments made, I would
that to capital invested as well. For instance, take the Disney theme part example
from yesterday. We started with $ 2.5 billion in capital invested at the start
of year 1; during the year, we made an additional $ 1 billion in new capital
expenditures to arrive at an ending value of $3.5 billion. In year 2, things
get messier because depreciation and working capital make their entrance:
Capital invested at the beginning of year 2 = $ 3.5 billion
Capital invested at the end of year 2 = Capital at start + New Cap Ex (including
maintenance cap ex) - Depreciation + Change in WC = 3500 + 1269 - 537 + 63 =
4294 (New cap ex is 1000, maintenance cap ex is 50% of depreciation and thus
269; there is some rounding error)
Note that there is no retained earnings or traditional double entry stuff. Projects
don't have balance sheets. Any excess cash from the project goes to the company
and does not build up within the project.
You have a choice of computing return on capital based on just the capital invested
at the beginning of the year or the average for the year. I used the average
for the theme park.
How it is used: The return on capital is a return on the overall investment in
a project and is compared to the cost of capital for the project. If the return
is greater, the project looks good (at least on an accounting basis)
b. Return on capital for the entire firm
How it is computed: The return on capital for an entire firm is computed using
the after-tax operating income of the firm and the capital invested in all of
its existing assets. To measure the former, we usually start with the operating
income in the most recent year and apply a tax rate to it. Since this is the
entire operating income for the business (rather than income added at the margin),
using an effective tax rate is defensible albeit dangerous if the effective tax
rate is volatile; I prefer to use the marginal tax rate here as well to compute
the after-tax operating income. To measure capital invested in existing assets,
I go to the balance sheet and look up the book value of debt and equity in the
firm, making the assumption that this must be the capital invested in the assets
that generate the operating income. If the company had a substantial cash balance,
it makes sense to net this number out of the book value, because cash does not
generate operating income.
Return on capital for a firm = EBIT (1-t)/ (Book value of debt + Book value of
equity - Cash)
Here again, you have a choice of using the number from the beginning of the year
or an average.
How it is used: You can compare a company's return on capital to its overall
cost of capital. If it is higher, the company, on average, has taken good investments.
If lower, it has destroyed value. The caveat, though, is that you are trusting
accounting estimates of earnings and capital invested.
Until next time!
Aswath Damodaran
adamodar@stern.nyu.edu
P.S: If you want to see how depreciation in the Disney theme park was computed, you can access all of the examples in the book (in their full excel spreadsheet mode) by going to the website for the book (which is accessible through the website for the class). I have attached the theme park spreadsheet.