【正文】 and the revenues of the pany. This works if the firm is under performing the sector, but could be brought up to par with new management. ? Use conservative estimate: Compute the optimal debt ratio, based upon the portion of ine that you can count on. Aswath Damodaran 40 Modifying the Cost of Capital Approach for Aracruz ? The operating ine at Aracruz is a function of the price of paper and pulp in global markets. We puted Aracruz?s average pretax operating margin between 2020 and 2020 to be %. Applying this average margin to 2020 revenues of $R 3,697 million generates a normalized operating ine of R$ 1,007 million. We will pute the optimal debt ratio using this normalized value. ? In Chapter 4, we noted that Aracruz?s synthetic rating of BB+, based on the interest coverage ratio, is higher than its actual rating of BB and attributed the difference to Aracruz being a Brazilian pany, exposed to country risk. Because we pute the cost of debt at each level of debt using synthetic ratings, we run the risk of understating the cost of debt. To account for Brazilian country risk, we add the country default spread for Brazil (%) to Aracruz?s pany default spread in assessing the dollar cost of debt: $ Cost of Debt = US T Bond Rate + Default SpreadCountry+Default SpreadCompany. ?Aswath Damodaran 41 Aracruz’s Optimal Debt Ratio Aswath Damodaran 42 C. Analyzing a Private Firm ? The approach remains the same with important caveats ? It is far more difficult estimating firm value, since the equity and the debt of private firms are not traded. ? Most private firms are not rated. ? If the cost of equity is based upon the market beta, it is possible that we might be overstating the optimal debt ratio, since private firm owners often consider all risk. Aswath Damodaran 43 Bookscape’s current cost of capital ? We assumed that Bookscape would have a debt to capital ratio of %, similar to that of publicly traded book panies, and that the tax rate for the firm is 40%. We puted a cost of capital based on that assumption. We also used a total beta of to measure the additional risk that the owner of Bookscape is exposed to because of his lack of diversification. Cost of equity = RiskFree Rate + Total Beta * Risk Premium = % + * 6% = % Pretax Cost of Debt = 6% (based on synthetic rating of A) Cost of Capital = % () + 6% (1 – )() = % Aswath Damodaran 44 The Inputs: Bookscape ? Although Bookscape has no conventional debt outstanding, it does have one large operating lease mitment. Given that the operating lease has 25 years to run and that the lease mitment is $750,000 for each year, the present value of the operating lease mitments is puted using Bookscape?s pretax cost of debt of 6%: Present value of Operating Lease Commitments (in thousands) = $750 (PV of annuity, 6%, 25 years) = $ 9,587 ? Bookscape had operating ine before taxes of $3 million in the most recent financial year, after depreciation charges of $400,000 and operating lease expenses of $750,000. We add back the imputed interest expense on the present value of lease expenses to the EBIT to arrive at an adjusted EBIT. Adjusted EBIT (in ?000s) = EBIT + Pretax Cost of Debt * PV of Operating Lease Expenses = $3,000 + * $9,587 = $3,575 ? To estimate the market value of equity, we looked at publicly traded book retailers and puted an average price to earnings ratio of 10 for these firms. Applying this multiple of earnings to Bookscape?s ine of $ million in 2020 yielded the equity value: Estimated Market Value of Equity (in ?000s) = Net Ine for Bookscape * Average PE for Publicly Traded Book Retailers = 1,500 * 10 = $15,000 Aswath Damodaran 45 Interest Coverage Ratios, Spreads and Ratings: Small Firms Aswath Damodaran 46 Optimal Debt Ratio for Bookscape Aswath Damodaran 47 Limitations of the Cost of Capital approach ? It is static: The most critical number in the entire analysis is the operating ine. If that changes, the optimal debt ratio will change. ? It ignores indirect bankruptcy costs: The operating ine is assumed to stay fixed as the debt ratio and the rating changes. ? Beta and Ratings: It is based upon rigid assumptions of how market risk and default risk get borne as the firm borrows more money and the resulting costs. Aswath Damodaran 48 II. Enhanced Cost of Capital Approach ? Distress cost affected operating ine: In the enhanced cost of capital approach, the indirect costs of bankruptcy are built into the expected operating ine. As the rating of the firm declines, the operating ine is adjusted to reflect the loss in operating ine that will occur when customers, suppliers and investors react. ? Dynamic analysis: Rather than look at a single number for operating ine, you can draw from a distribution of operating ine (thus allowing for different outes). Aswath Damodaran 49 Estimating the Distress Effect Disney Rating Drop in EBITDA A or higher No effect A % BBB % BB+ % B % CCC % D % Indirect bankruptcy costs manifest themselves, when the rating drops to A and then start being larger as the rating drops below investment grade. Aswath Damodaran 50 The Optimal Debt Ratio with Indirect Bankruptcy Costs The optimal debt ratio drops to 30% from the original putation of 40%. Aswath Damodaran 51 Extending this approach to analyzing Financial Service Firms ? Interest coverage ratio spreads, which are critical in determining the bond ratings, have to be estimated separately for financial service firms。 Equity A recent article in an Asian business magazine argued that equity was cheaper than debt, because dividend yields are much lower than interest rates on debt. Do you agree with this statement? ? Yes ? No Can equity ever be cheaper than debt? ? Yes ? No Aswath Damodaran 8 Applying