Disney has also come under criticism for using child labor and accepting unsafe working conditions in some of the factories at which its toys and clothes are made overseas. After one such expose on 20/20 (a show on ABC, owned by Disney), Disney chose to terminate its contract with the company named in the expose rather than risk the negative publicity.

Finally, the number of pages in Disney’s annual report that are dedicated to the social good that it does is a good indicator of how much of a role social concerns play in Disney’s day-to-day decision making.

Source: Annual report; Various news stories;

Project Suggestion: You will not find much information on this aspect of your firm unless your firm falls into one of the extremes — for example, the tobacco firms or Exxon, or at the other extreme, companies like Levi Strauss. You can check out the annual report, and you can see how the company has responded to public or social criticism.

To analyze Disney’s stockholders, we began with an analysis of who the stockholders at the firm were at the end of last year. The pie chart breaks down the stock holdings in Disney into mutual funds, other institutional investors (pension funds), individual investors and insiders.

Source: Value Line CD-ROM

Most of these investors are still domestic investors, though they may be diversified into other markets. Finally, Disney’s stockholdings are fairly dispersed. The largest institutional investor, Investment Company of America, owns about 1.1% of the outstanding stock. The following table lists out the 10 largest stockholders in Disney.

Holder	Shares Owned	% of Disney	% of Fund
Investment Company of America	5505	1.10%	1.23%
Growth Fund of America	3852	0.77%	2.85%
Vanguard Index 500	3638	0.73%	0.83%
Fidelity Contrafund	2123	0.42%	0.61%
AMCAP Fund	2113	0.42%	4.12%
20th Century Ultra	1970	0.39%	0.84%
Sequoia	1561	0.31%	3.93%
Vanguard Institutional Index	1361	0.27%	0.82%
Fidelity Magellan	1300	0.26%	0.17%
Vanguard Windsor	1293	0.26%	0.58%

Source: Value Line

Note that Disney is not a disproportionate share of any of these fund’s total assets, suggesting that these funds are well diversified. In addition, a comparison of Disney’s insider and institutional holdings to the other entertainment firms suggests that Disney has far lower insider holdings and far greater institutional holdings than other companies in its peer group.

	Disney	Other Entertainment Companies
Insider Holdings	3.50%	9.73%
Institutional Holdings	57%	37%

Source: Insider and Institutional Holdings Data set on my web site

Conclusions

In conclusion, these facts suggest that:

• The average stockholder in Disney is a domestic institutional investor, more likely to be a pension fund than a mutual fund.

• Since no stockholder is large enough to dominate the holdings, that the marginal stockholder is also likely to be a domestic institutional investor, again more likely to be a pension fund than a mutual fund.

Project Suggestion: The average stockholder may not always be the marginal stockholder. For instance, in a firm which has a significant insider holding (Microsoft, Dell etc.), the average investor may be the owner/manager of the company (Gates, Dell etc.), but the marginal investor (who is the investor who trades on a regular basis and sets prices) may be a large institutional investor or individual.

Overall Risk Profile

Source: Bloomberg for prices over last 5 years and annual earnings per share.

A Market Analysis of Risk and Return

To analyze how much of this volatility can be attributed to market forces, we ran a regression of Disney stock prices against the S&P 500:

Source: Bloomberg Beta Page

In terms of the diagnostics on this regression, we concluded the following:

(a) Slope of the regression = 1.40. This is Disney's beta, based on returns from 1992 to 1996. Using a different time period for the regression or different return intervals (weekly or daily) for the same period can result in a different beta.

(b) Intercept of the regression = -0.01%. This is a measure of Disney's performance, when it is compared with Rf (1-b). The monthly risk-free rate (since the returns used in the regression are monthly returns) between 1992 and 1996 averaged 0.4%, resulting in the following estimate for the performance:

Rf (1-b) = 0.4% (1-1.40) = -0.16%

Intercept - Rf (1-b) =-0.01% - (-0.16%) = 0.15%

This analysis suggests that Disney performed 0.15% better than expected, when expectations are based on the CAPM, on a monthly basis between January 1992 and December 1996. This results in an annualized excess return of approximately 1.81%.

Annualized Excess Return = (1 + Monthly Excess Return)¹² - 1

= 1.0015¹² -1 = 1.0181 - 1 = 0.0181 or 1.81%

By this measure of performance, Disney did slightly better than expected during the period of the regression. Note, however, that this does not imply that Dsiney would be a good investment looking forward. It also does not provide a breakdown of how much of this excess return can be attributed to ‘industry-wide’ effects, and how much is specific to the firm. To make that breakdown, the excess returns would have to be computed over the same period for other firms in the entertainment industry and compared with Disney’s excess return. The difference would be then attributable to firm-specific actions. In this case, for instance, the average annualized excess return on other entertainment firms between 1992 and 1996 was 3.5%, suggesting that the firm-specific component of performance for Disney is actually -1.7%. (Firm-specific Jensen’s alpha = 1.8% - 3.5%)

Source: The monthly riskfree rate can be obtained by adding up the T.Bill rates each year for the last 5 years (available in the Historical returns dataset on my web site), averaging them out, and then dividing by 5.For 1993-97, you can use 0.4% a month.

(c) R squared of the regression = 32.41%. This statistic suggests that 32.41% of the risk (variance) in Disney comes from market sources (interest rate risk, inflation risk etc.), and that the balance of 67.59% of the risk comes from firm-specific components. The latter risk should be diversifiable, and therefore unrewarded in the CAPM.

We also compared Disney’s regression statistics to those of the market over the same period, and came up with the following estimates:

	Disney	Entertainment Companies
Beta	1.40	0.91
Jensen’s Alpha	1.81%	3.51%
R Squared of Regression	32%	47%

Source: Industry Regression Statistics (My web site/new stuff)

Disney seems riskier than the comparable firms, and has done less well these firms in recent periods. It also gets a smaller portion of its risk from market factors (which are not diversifiable).

Project Suggestion: If you are comparing these statistics across multiple companies, you can consign the scatter plot (from Bloomberg or your own regression to the end of the report, and focus on only the output from the regression in this part of the report. Thus, the table shown above for Disney and entertainment firms can be expanded to include the other companies that you are analyzing.

A Bottom-up Beta Estimate

While the regression of Disney on the S&P 500 suggests a beta of 1.40, I would be concerned about using this beta because of

• the high standard error on the estimate (the standard error of 0.26 suggests a wide range for the true beta of Disney
• the changing business mix of Disney over the period, with its acquisition of Cap Cities in 1995
• the changing financial leverage at Disney over the period, with the $10 billion borrowed in 1995

To estimate a bottom-up beta for Disney, we broke it up into five different businesses and estimated the betas for each business based upon comparable firms. The table below provides the business mix, comparable firms used and the weights attached to each business:

Business	Estimated Value	Comparable Firms	Unlevered Beta	Division Weight	Weight*Beta
Creative Content	$ 22,167	Motion Picture and TV program producers	1.25	35.71%	0.4464
Retailing	$ 2,217	High End Specialty Retailers	1.5	3.57%	0.0536
Broadcasting	$ 18,842	TV Broadcasting companies	0.9	30.36%	0.2732
Theme Parks	$ 16,625	Theme Park and Entertainment Complexes	1.1	26.79%	0.2946
Real Estate	$ 2,217	REITs specializing in hotel and vacation properties	0.7	3.57%	0.0250
Firm	$ 62,068			100.00%	1.0929

In the first column, we list the businesses that Disney is involved in. In the second, we list the estimated value of each business to Disney, based upon the operating income (EBIT) of each business and an average multiple of EBIT (based upon comparable firms) for each business. In the third, we report the unlevered beta of comparable companies in each business, obtained by averaging out the betas of firms in each of the businesses and unlevering at their average debt/equity ratio. In the fourth column, we report the companies we used as comparable firms and in the last two columns we compute the weighted average beta. The unlevered beta, based upon the bottom-up calculation, for Disney is 1.09.

Project Suggestion: When estimating the bottom-up beta, try not to disaggregate too much or you will have trouble finding comparable firm betas. If your firm reports operating income by segment, use that to weight the unlevered betas. If not, use revenues.

To get Disney’s levered beta, we used the current estimated market values of equity and debt.

Market Value of Equity = Share Price * Number of Shares = 75.38 * 675.13 = 50.88 Billion

To get the market value of debt, we used the book value of debt of $ 12.342 billion, the interest expenses of $ 479 million and the face-value weighted average maturity of 3 years, in conjunction with a current cost of borrowing of 7.50% (see debt section below) to arrive at an estimated market value of debt of $ 11.18 billion.

Source: The face-value weighted maturity comes from the footnotes to the balance sheet.

Estimated Market Value of Debt =

Using these estimated market values for debt and equity, we estimated a debt/equity ratio of 21.97% for Disney as a company, and used it in conjunction with the bottom-up unlevered beta of 1.09 to estimate an unlevered beta of 1.25

From Betas to Costs of Equity

To get from the beta to the cost of equity, we needed two other inputs. For the riskfree rate, we used a long term treasury bond rate (which at the time of the analysis was 7%). For the risk premium we will use the geometric historical risk premium for stocks over long term treasury bonds of 5.5%.

To estimate the levered beta by division, we used the same debt/equity ratio for all divisions except real estate, which raises its own debt based upon its properties.

Business	Unlevered Beta	D/E Ratio	Levered Beta	Riskfree Rate	Risk Premium	Cost of Equity
Creative Content	1.25	20.92%	1.42	7.00%	5.50%	14.80%
Retailing	1.50	20.92%	1.70	7.00%	5.50%	16.35%
Broadcasting	0.90	20.92%	1.02	7.00%	5.50%	12.61%
Theme Parks	1.11	20.92%	1.26	7.00%	5.50%	13.92%
Real Estate	0.70	50.00%	0.92	7.00%	5.50%	12.08%
Disney	1.09	21.97%	1.25	7.00%	5.50%	13.85%

Using the same riskfree rate of 7% (based upon the long term treasury bond rate) and a risk premium of 5.5% (based upon historical data) yields us the costs of equity by division.

Source: Use the latest long-term government bond rate as your riskless rate, and a 5.5% premium (if it is a US stock, or the country premium (based upon rating) if it is a foreign stock.

Disney’s Cost of Debt

To estimate Disney’s cost of debt, we obtained the current bond rating of the company. Standard and Poor’s assigns a rating of AA to Disney’s traded debt. Based upon the long term treasury bond rate of 7% and an estimated default spread of 0.50%, we estimate a pre-tax cost of borrowing of 7.50%. The after-tax cost of debt for Disney reflects the tax savings accruing to interest:

After-tax Cost of Debt = 7.50% (1 - .36) = 4.80%

We will also assume that all of Disney’s divisions face the same cost of borrowing.

Source: Bloomberg corporate bond page for Disney. If it does not exist, use a synthetic rating.

Project Suggestion: If your company has multiple bonds outstanding, it might also have multiple ratings. Use the rating on a recently issued straight bond. If you cannot find a rating, use the synthetic rating spreadsheet to estimate a rating. If you are capitalizing operating leases, be consistent, and treat these expenses like interest expenses.

Disney’s Weights for Debt and Equity

Using the market values of debt and equity, estimated earlier in the section on levered betas to be $ 50.88 billion for equity and $ 11.18 billion for debt, we estimate the following weights for debt and equity in the capital structure calculation:

Equity Ratio = 50.88/62.06 = 82%

Debt Ratio = 11.18 /62.06 = 18%

Disney’s Cost of Capital

Having estimated a cost of equity of 13.85% and an after-tax cost of debt of 4.80%, the cost of capital for Disney can be computed as follows:

Cost of Capital = 13.85% (0.82) + 4.80% (0.18) = 12.22%

The divisional costs of capital can also be estimated similarly, using the divisional costs of equity and the same debt ratio for all divisions except for real estate.

Business	E/(D+E)	Cost of Equity	D/(D+E)	After-tax Cost of Debt	Cost of Capital
Creative Content	82.70%	14.80%	17.30%	4.80%	13.07%
Retailing	82.70%	16.35%	17.30%	4.80%	14.36%
Broadcasting	82.70%	12.61%	17.30%	4.80%	11.26%
Theme Parks	82.70%	13.92%	17.30%	4.80%	12.32%
Real Estate	66.67%	12.08%	33.33%	4.80%	9.65%
Disney	81.99%	13.85%	18.01%	4.80%	12.22%

The costs of capital for the divisions range from a high of 14.36% for retailing to 9.65% for real estate.

Relevance of Costs of Equity and Capital

The costs of equity and capital become hurdle rates for Disney as a company, with different rates applying for different divisions. In using these rates,

• The cost of equity is the appropriate hurdle rate, when returns are measured to equity investors in the company. Thus, a new store has to earn a return on equity of more than 16.35% to be considered a good investment.
• The cost of capital is the appropriate hurdle rate, when returns are measured to all investors in the firm (debt as well as equity). Thus, a new theme park will have to earn a return on all capital invested of greater than 12.22% to be considered a good investment

A Typical Project

Given the diversity of Disney’s business mix, it is difficult to identify one typical project. Instead, we will identify the likely characteristics of projects in each of Disney’s divisions:

Business	Project Cash Flow Characteristics
Creative Content	Projects are likely to be short term have cash outflows are primarily in dollars (since Disney makes most of its movies and T.V programs in the U.S.) but cash inflows could have a substantial foreign currency component (because of overseas sales) have net cash flows which are heavily driven by whether the movie or T.V series is a "hit", which is often difficult to predict.
Retailing	Projects are likely to be 1. medium term (tied to store life) 2. primarily in dollars (most of the stores are still in the United States) 3. cyclical
Broadcasting	Projects are likely to be 1. short term 2. primarily in dollars, though foreign component is growing 3. driven by advertising revenues and show success
Theme Parks	Projects are likely to be very long term primarily in dollars, but a significant proportion of revenues come from foreign tourists, who may be impacted by exchange rate movements. affected by success of movie and broadcasting divisions.
Real Estate	Projects are likely to be long term primarily in dollars. affected by real estate values in the area

Project Suggestion: This might be difficult to do for companies which do not have typical projects. Give it your best shot. If a firm has multiple divisions, try to look at each division separately.

A. Measuring Past Returns

To measure returns on Disney’s existing projects, we begin with a couple of assumptions. We assume that the current earnings of the firm are earnings attributable to existing projects. Consequently, we adjust earnings by adding back one-time charges and amortization of goodwill (on the Capital Cities acquisition). We also assume that the current book value of assets and equity reflect the current capital and equity invested in existing projects. Using the net income and book value of equity, we compute a return on equity of:

Return on Equity = Net Income₁₉₉₆ / Average BV of Equity for 1995 and 1996 = $2,836 million / $ 11,368 million = 24.95%

The average book value of equity was obtained by adding up the book values of equity for 1995 and 1996 and dividing by two.

Using the after-tax operating income and book value of capital, we estimate a return on capital of

Return on Capital = EBIT₁₉₉₆ (1-t)/ Average BV of Capital from 1995 to 1996 = $5,559 (1-.36)/ (19,031) = 18.69%

[Book value of capital = Book Value of Equity + Book Value of Debt; the average is obtained by summing up the book values for the two years and dividing by two.]

Both the net income and earnings before interest and taxes were cleansed of one-time charges and any extraordinary items.

Project Suggestion: For book value of equity, use only common equity. If your company’s book value of equity, do not compute the return on equity, since it is meaningless. You can also use the book value of equity and capital from the end of the last year to compute returns on equity and capital. The more your company has grown in the last year, the more I would be inclined towards using the average.

B. Evaluation Of Past Returns

To evaluate whether these returns measure up to requirements, we compare the return on equity to the cost of equity from the previous section.

Return on Equity = 24.95%

Cost of Equity = 13.85%

Equity Return Spread = 24.95% - 13.85% = 11.10%

This spread, when multiplied by the book value of equity, yields a measure of the surplus value created by existing projects (called the Equity EVA).

Equity EVA = (Return on Equity — Cost of Equity) (BV of Equity) = (.2495 — 1385) ($11,368 million) = $1,262 million

A similar analysis, comparing return on capital to cost of capital, yields the following numbers.

Return on Capital = 18.69%

Cost of Capital = 12.22%

EVA = (.1869 — .1222) ( 19,031 million) = $1,232 million

On both measures, it looks like Disney is creating about $1.2 billion in surplus value each year because of the excess returns it makes on its existing projects. While we have a measure of operating income at the division level, we do not have a breakdown of book value at the division level. If we did, we could compute the returns on capital, on a division level, and compare them to costs of capital, on a division level, to estimate divisional EVA.

Finally, we compare Disney’s equity and firm EVA to those created by entertainment firms as a whole in the most recent year in the table below:

	Disney	Entertainment Firms
Equity EVA	$1,262 million	- $ 52 million
Firm EVA	$1,232 million	- $ 40 million

Source: My web site/datasets/EVA

In contrast to other entertainment firms, Disney is creating significant surplus value from existing projects.

C. Assessments for the Future

We believe that the theme parks, creative content, retailing and real estate divisions are likely to continue generating surplus value into the future, because of several barriers to entry, including:

• Disney’s strong brand name value is likely to allow them to charge higher prices, earn higher margins and maintain healthy returns on capital into the future.
• The bulk of the investment, especially in the theme parks, has been made already. Disney will continue to enjoy the benefits of this investment in the form of earnings at these parks.
• The potential for excess returns in the creative content (movie) division will continue to be greater for Disney Studios (where the brand name counts) than for Touchstone Studios, where the brand name value counts for less.

Current Financing Mix

Disney currently has the following debt on its books:

Type of Financing	Dollar Amount	Interest Rate on Books	Maturity
Commercial Paper	$4,185 million	5.5%	1
Debentures	$4,399 million	6.6%	2-6 years
Dual Currency and Foreign Notes	$1,987 million	5.4%	1-4 years
Senior Participating Notes	$ 1,099 million	6.3%	3-4 years
Other	$ 672 million	5.6%	1-15 years
Total	$ 12,342 million		Approximately 3 years

Source: Footnotes to Balance Sheet on Borrowings

Disney’s commercial paper reflects the money borrowed by Disney in its acquisition of Capital Cities, and Disney has replaced almost $ 4 bilion of its original commercial paper borrowing with longer term notes. The Company foreign currency notes are mostly in three currencies — British Pounds ( $ 520 million), Japanese Yen ( $1.4 billion) and Italian Lira ( $ 190 million).

The company’s senior debt is rated AA, and the market interest rate on AA bonds at the time of this analysis is 7.50%. Disney’s medium term notes were trading at a yield to maturity of roughly 6.9%. Given that these notes are shorter term, we will continue to use the 7.50% as our cost of debt.

Project Suggestion: Some companies provide more information than other companies on their borrowing. If you are working with a foreign company, you might be able to get far less information on this component.

Trade Off on Debt versus Equity

Looking at the advantages and disadvantages of debt, and Disney’s specific characteristics yields the following:

Factor	Disney
Tax Benefit	Disney has a marginal tax rate of about 40%. It has an effective tax rate of 43.58%.
Added Discipline of Debt	Disney is a widely held firm. While institutional stockholders own a significant percentage of the firm, no individual stockholder or institution is large enough to have much say in management. The firm has significant cash flows and should gain from the use of debt.
Bankruptcy Risk	Some of Disney’s earnings are volatile, but a significant portion of the cash flows are stable (especially cash flows from theme parks). The bankruptcy risk should be low, given this factor and the size of the company
Agency Costs	The agency costs are likely to be large for borrowings by the creative content and broadcasting divisions, where it is difficult to track the funds. It is likely to be smaller in the real estate, retailing and theme park divisions.
Future Flexibility	The need for financing flexibility is increasing as the media business changes technologically and becomes more global.

Project Suggestion: This is a subjective analysis and is meant to be so. If you are comparing across companies, use this table to compare the companies on each of these factors. You can then make statements about which of the companies should have the highest debt ratio and which should have the lowest debt ratio.

A Qualitative Judgment

Current Cost of Capital / Financing Mix

To estimate the current cost of capital, we used the market value of equity and estimated market value of debt from the earlier section on hurdle rates. Using the market value of equity of $ 50.88 billion, the market value of debt of $ 11.18 billion, the cost of equity of 13.85% (based upon the bottom-up beta) and the after-tax cost of borrowing of 4.80%, we estimate a cost of capital as follows:

Project Suggestion: Since the optimal capital structure analysis forces you to pick between only debt and equity, those of you who have preferred stock in your capital structures will have to do some fancy footwork at this stage. The simplest way of dealing with this is to calculate the cost of capital without preferred stock at this stage. To be consistent then, when you calculate the EBIT to use in the optimal capital structure analysis below, use (EBIT — Preferred Dividends).

Costs of Capital at Different Financing Mixes

We estimated the costs of equity and debt at different debt ratios — using betas for costs of equity and estimated ratings for costs of debt.

Debt Ratio	Cost of Equity	AT Cost of Debt	Cost of Capital
0.00%	13.00%	4.61%	13.00%
10.00%	13.43%	4.61%	12.55%
20.00%	13.96%	4.99%	12.17%
30.00%	14.65%	5.28%	11.84%
40.00%	15.56%	5.76%	11.64%
50.00%	16.85%	6.56%	11.70%
60.00%	18.77%	7.68%	12.11%
70.00%	21.97%	7.68%	11.97%
80.00%	28.95%	7.97%	12.17%
90.00%	52.14%	9.42%	13.69%

Based upon the objective of minimizing the cost of capital, the optimal debt ratio for Disney was 40%.

Project Suggestion: If you are analyzing multiple companies, just show the cost of capital (and not the costs of debt and equity) for each company at each debt ratio in this table (instead of having a table for each company). Then highlight the optimal cost of capital box for each company separately. You need not include the capital structure spreadsheet output in your project.

Firm Value at Optimal

To estimate firm value at the optimal debt, we estimated the dollar savings we would have from moving from the current cost of capital of 12.22% to the cost of capital at the optimal (11.64%), and converted it into present value terms:

Firm Value before the change = 50,888+11,180= $ 62,068

Assuming an implied growth rate (of 7.13%) in firm value over time,

• Increase in firm value = $357 * 1.0713 /(.1164-.0713) = $ 8,474
• Change in Stock Price = $8,474/675.13 = $12.55 per share

The implied growth rate is based upon the assumption that the market value of Disney as a company reflects a market expectation of future growth. To estimate it, we used the following perpetual growth formula

Substituting today’s market value for Disney as a firm (debt + equity) of $ 62,068 million, the free cash flow to the firm of $3,255 million and the current cost of capital of 12.22%, we solved for the expected growth rate of 7.13%.

In summary, we are arguing that increasing debt ratio to the optimal will increase the stock price approximately $12.55 per share, which translates into a 16.65 % change in the current stock price of $ 75.38. This is also based upon the assumption that the stock repurchase will occur at the higher price (thus, allowing investors who sell their stock back to the firm to also share in the spoils).

Project Suggestion: If you are comparing the optimal debt ratios of two or more firms in a sector, estimate EBITDA as a percentage of firm value for each firm. The magnitude of this ratio will be highly correlated with the optimal debt ratio.

Constraints

I. Operating Income Variability: What If Analysis

We examined the sensitivity of the optimal debt ratio to changes in the operating income. Looking at the last two decades of operating income changes, we estimated a standard deviation in operating income of 39%. In conjunction with Disney’s worst year of operating income (-26%) and the behavior of its operating income during the last two recessions (-22% in 1990-91 recession and no change duringthe 1980-82 recession), this lead us to use a worst case scenario drop in the operating income of 40%. The optimal debt ratio with this lower operating income was between 20 and 30%.

II. Rating Constraints

To provide a cushion against downside risk, we also considered a rating constraint of BBB or higher. Using the same table as the one used for the optimal debt ratio, we obtained the following ratings at different debt ratios:

While the unconstrained optimal debt ratio for Disney is 40%, the optimal debt ratio is 30%, when we introduce a BBB constraint.

In Summary

Both the operating income worst-case scenario and the rating constraints suggest to us that Disney’s excess debt capacity is not an artifact of just a good operating year. The analyses present a powerful argument that Disney is under levered and should use more debt in its financing mix.

Sector Analysis

We did the sector analysis in two parts. In the first part, we compared Disney’s debt ratio to its largest competitors in the entertainment industry.

Source: Bloomberg using RV screen or Value Line

Disney’s debt ratio is pretty comparable to the averages on both a book value and a market value basis. Since these companies vary significantly on fundamentals, we ran a regression of debt ratios against fundamentals for all entertainment firms (about 30) and arrived at the following regression:

The R squared of the regression is 27.16%. This regression can be used to arrive at a predicted value for Disney of:

Based upon the debt ratios of other firms in the entertainment industry, Disney should have a market value debt ratio of 23.14%.

Project Suggestion: If you are doing this for a number of firms in the same sector, you can do one regression and apply it to all the firms to get predicted debt ratios for the firms. You do not need to use the same or all of the variables that I used. Work with what you can get information on, and think about the variables in the trade off to decide what variables you need to measure bankruptcy cost, agency costs and tax benefits.

Market Analysis

This analysis was extended to cover all firms listed on the US markets, to yield the following regression of debt ratio against the variance in market prices (as a proxy for bankruptcy risk), the percent of shares that are closely held (as a proxy for debt as a disciplinary mechanism), capital expenditures as a percent of total assets (as a proxy for the need for flexibility) and free cash flows as a percent of the market value of the firm (as a proxy for the cash flow potential of the firm).

(6.06a) (1.96b) (1.05a) (5.73a) (3.89a)

Plugging in the values for these variables for Disney yields a predicted debt ratio of:

Looking at the analysis, we have four estimates of the optimal debt ratio — 40% from the unconstrained optimal, 20-30% from the constrained optimal (with ratings and operating income constraints), 23.14% from the sector-based relative analysis and 29.95% from the market —based relative analysis. We do not believe, given Disney’s unique business mix and characteristics, that the sector-based analysis should carry much weight. We also accept the need for reasonable ratings and operating income constraints, which leaves us with the conclusion that Disney has excess debt capacity and a "recommended" debt ratio of 30%. If Disney does move to this debt ratio, it will be in line with the debt ratios of other firms in the market, with similar characteristics.

A Path to the Optimal

The Right Financing For Disney

Intuitive Analysis

Business	Project Cash Flow Characteristics	Type of Financing
Creative Content	Projects are likely to be short term have cash outflows are primarily in dollars (since Disney makes most of its movies and T.V programs in the U.S.) but cash inflows could have a substantial foreign currency component (because of overseas sales) have net cash flows which are heavily driven by whether the movie or T.V series is a "hit", which is often difficult to predict.	Debt should be short term primarily dollar if possible, tied to the success of movies. (Lion King Bonds?)
Retailing	Projects are likely to be 1. medium term (tied to store life) 2. primarily in dollars (most of the stores are still in the United States) 3. cyclical	Debt should be in the form of operating leases.
Broadcasting	Projects are likely to be 1. short term 2. primarily in dollars, though foreign component is growing 3. driven by advertising revenues and show success	Debt should be short term primarily dollar debt if possible, linked to network ratings.
Theme Parks	Projects are likely to be very long term primarily in dollars, but a significant proportion of revenues come from foreign tourists, who may be impacted by exchange rate movements. affected by success of movie and broadcasting divisions.	Debt should be long term mix of currencies, based upon tourist make up.
Real Estate	Projects are likely to be long term primarily in dollars. affected by real estate values in the area	Debt should be long term dollars real-estate linked (Mortgage Bonds)

A More Quantitative Analysis

To provide a more quantitative estimate of the right financing characteristics, we regressed changes in Disney’s hisorical operating income and firm value against four macro-economic variables — interest rates, inflation rates, the weighted dollar and real GNP. The following table summarizes our results and conclusions:

Macro Variable	Results of Regressions	Implications for Financing
Long Term Interest Rates	D FV = 0.22 - 7.43 ( D Interest Rates) (3.09) (1.69) D OI = 0.31 - 4.99 ( D Interest Rates) (2.90) (0.78)	Both firm value and operating income are sensitive to interest rate changes. The firm value regression suggests that the duration of Disney’s assets is roughly 7.5 years. The operating income regression yields a lower estimate.
Real GNP	D FV = 0.31 + 1.71 ( GNP Growth) (2.43) (0.45) D OI= 0.17 + 4.06 ( GNP Growth) (1.04) (0.80)	Disney is not a very cyclical firm. While is operating income is marginally cyclical, its firm value shows little evidence of being affected by overall economic growth.
Inflation Rates	D FV = 0.2 - 0.22 (D Inflation Rate) (3.36) (0.05) D OI = 0.32 + 10.51 (D Inflation Rate) (3.61) (2.27)	Disney’s firm value is not affected much by what happens to inflation rates, but its operating income tends to move with inflation, reflecting Disney’s pricing power. This would suggest that some of Disney’s debt be floating rate debt.
Weighted Dollar	D FV = 0.26 - 1.01 (D Dollar) (3.35) (0.98) D OI = 0.26 - 3.03 (D Dollar) (3.14) (2.59)	Disney’s operating income, again, is more negatively affected by a stronger dollar than the firm value. This would again suggest that some of Disney’s debt be in a foreign currency.

D FV = Change in Firm Value D OI = Change in Operating Income

Project Suggestions: The coefficients on these regressions are likely to be all over the place. If they are, look at the averages across firms in your group to get a sense of what financing mix is right for your type of firm. The data on the macro economic variables is available on the web under datasets. (macro.xls)

Overall Recommendations on Financing Mix

Based upon our analysis of Disney, we would recommend that Disney issued debt

• with an average duration of approximately 7.5 years
• in a mix of currencies, with the foreign currencies used reflecting, as closely as possible, the mix of tourists at the theme parks, and the mix of revenues from other business divisions
• in a mix of fixed and floating rate debt

Disney’s current debt satisfies the last two conditions, but is much too short term (with an average maturity of only 3 years). As the commercial paper gets refinanced, Disney should issue longer term debt.

Disney has used both dividends and stock buybacks over the last 5 years to return cash to its owners. The following table summarizes the earnings, dividends and stock buybacks at Disney from 1992 to 1996:

Year	1992	1993	1994	1995	1996
Dividends	$105.30	$128.60	$153.20	$180.00	$271.00
+ Equity Repurchases	$0.00	$31.60	$570.70	$348.70	$462.00
= Cash to Stockholders	$105.30	$160.20	$723.90	$528.70	$733.00

Source: Statements of Cash Flows (Bloomberg Financial Analysis)

Disney’s dividend yield is relatively modest. Based upon its current price of $ 75.375, its dividend yield is only 0.67%. It pays out 19.73% of its earnings as dividends. In the following table, we compare Disney’s dividend yield and payout to that of the entertainment industry:

	Disney	Entertainment Companies
Dividend Yield	0.67%	0.59%
Dividend Payout	19.73%	35.84%

Source: My web site/ datasets/dividend fundamentals

Disney pays out less of its earnings as dividends than the typical entertainment company, but has a higher dividend yield than other entertainment firms.

Trade Offs on Dividend Policy

Factor	Implications for Disney
Stockholder Tax Preferences	Given its history as a stock with low dividend yields, stockholders are much more likely to be attracted to capital gains than dividends. Equity Buybacks
Information Effects and Signaling Incentives	Disney is one of the more heavily followed stocks in the United States. It should not have to increase dividends to attract attention or send signals about future cash flows.
Effect on Flexibility	The technological changes in the media and entertainment business and uncertainty about global expansion needs increase the need for flexibility and are likely to work against paying more in dividends.
Bond Covenants and Ratings Agency Concerns	Neither is likely to be a serious impediment to Disney raising dividends.

Year	Net Income	(Cap Ex- Depr) (1-DR)	Chg in WC (1-DR)	FCFE
1992	$817	$173	($81)	$563
1993	$889	$328	$160	$722
1994	$1,110	$469	$498	$1,139
1995	$1,380	$325	$206	$1,261
1996	$1,214	$466	($470 )	$278
Average	$1,082	$352	$63	$793

Year	FCFE	Dividends + Stock Buybacks
1992	$563	$105
1993	$722	$160
1994	$1,139	$724
1995	$1,261	$529
1996	$278	$733
Average	$793	$450

In comparing Disney’s dividend policy to its peer group, we analyze the dividend yields and payout ratios of comparable firms in 1997 , as shown in in the table below:

Company Name	Price	Dividend Yield	Dividend Payout	Earnings Stability	Expected Growth
Belo (A.H.).	$ 44.50	0.99%	22.11%	55.00	2.50%
King World	$ 40.13	0.00%	0.00%	95.00	6.50%
Gaylord 'A'	$ 23.50	1.70%	45.98%	40.00	9.50%
Disney (Walt)	$ 79.56	0.67%	19.78%	80.00	15.00%
Chris-Craft	$ 50.00	0.00%	0.00%	30.00	19.00%
Clear Channel	$ 68.25	0.00%	0.00%	55.00	24.00%
Viacom 'A'	$ 31.63	0.00%	0.00%	5.00	24.00%
Westinghouse	$ 26.31	0.76%	10.50%	20.00	4.85%
Average		0.51%	12.30%	47.50	13.17%%

Source: Value Line

The earnings predictability estimates and forecasted growth rates are from Value Line; we would expect companies with less predictable earnings and higher expected growth rates to have lower earnings to have lower dividend yields and payout ratios than firms with more predictable earnings and lower growth. The problem with this comparison is that there is very little variability in dividend policy across firms in this group.They all have low dividend yields and payout ratios, with Disney’s yield and payout ratio being close to the average for the industry. We did try regressing dividend yield and payout ratios against expected growth rates:

Dividend Payout Ratio = 0.24 - 0.89 (Expected growth rate) R² = 21.37%

(1.28)

Dividend Yield = 0.0107 - 0.043 (Expected growth rate) R² = 33.65%

(1.74)

Using Disney’s expected growth rate of 15% in these regressions yields the following predicted values for the dividend measures.

Predicted Dividend Payout for Home Depot = 0.24 - 0.89 (.15)= 0.1066 or 10.66%

Predicted Dividend Yield for Home Depot = 0.0107 - 0.043(.15)= 0.0044 or .44%

Using data from 1996, we regressed dividend yields and payout ratios against all of these variables and arrived at the following regression equations.

where BETA = Beta of the stock

MKTCAP = Market Value of Equity + Book Value of Debt

DBTRATIO = Book Value of Debt / MKTCAP

ROE = Return on Equity in 1996

NCEX/TA = (Capital Expenditures - Depreciation) / Total Assets

Substituting into the regression equation for the dividend payout ratio, we predicted the following payout ratio for Disney:

Substituting into the regression equation for the dividend yield, we predict the following dividend yield for Disney:

For Disney = 0.0189 - 0.0121 (1.25) + 0.00000016 (62,068) + 0.0056 (.1952) + 0.0094 (.2495) - 0.0028 (.0117) = 1.71%

Choosing the Right Model

We valued Disney, using a

• a 3-stage model, because Disney has substantial barriers to entry and has high expected growth
• an FCFF model, because the leverage at Disney is expected to change.

Estimation Inputs

The inputs are summarized on the next page.

Project Suggestion: You are now looking at the future. There are no right answers, but there are some answers that are more reasonable than others. Make your best estimates of the inputs, and make sure that they are consistent. Use the most current data you can for each input.

Valuation

We valued Disney as follows:

The present values of the free cash flows to the firm and the present value of the terminal value are computed, and the sum is reported below:

Value of Disney = $ 57,817 million

If we subtract out the market value of existing debt of $ 11,180 million from this firm value, we arrive at the value of equity for Disney to be $ 46,637 million. The value of equity per share is computed by dividing by the number of shares outstanding:

Value of Equity per Share = $46,637/ 675.13 = $ 69.08

Thus, the valuation suggests that Disney was overvalued at $ 75.13 per share.

Project Suggestion: The debt you should be subtracting out at this stage of the process should be exactly the same debt that you used in computing your current cost of capital.