Valuation

The Big Picture

Aswath Damodaran
[Link]

Aswath Damodaran
 DCF Choices: Equity Valuation versus Firm
Valuation
Firm Valuation: Value the entire business

Assets Liabilities

Existing Investments Fixed Claim on cash flows

Assets in Place Debt

Generate cashflows today Little or No role in management

Includes long lived (fixed) and Fixed Maturity

short-lived(working Tax Deductible

capital) assets

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

created by future investments Significant Role in management

Perpetual Lives

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran
 Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are

cashflows from assets,

after debt payments and

after making reinvestments

Discount rate reflects only the

needed for future growth

cost of raising equity financing

Growth Assets Equity

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

Aswath Damodaran
 Firm Valuation

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are

cashflows from assets,

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

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

all claims on the firm.

Aswath Damodaran
+isk isPremium
DISCOUNTED
Country
Cashflow
Expected
Firm
Forever
Terminal
FCFF
.........
Cost
Weights
Discount
Value
Riskfree
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R
X
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Base of
of
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2
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n Equity
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Firm
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FCFF CASHFLOW
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/(r-g
Equity VALUATION
n) (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
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-+
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same of in
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same of terms
Equity(real or
nominal as cash flows

Aswath Damodaran
+
Embraer:
$
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
Riskfree
Beta
M
Unlevered
Firm’s
Reinvestment
Return
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Avg
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Lambda
+
C
Country
R
X
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g
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ountry
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ature
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Yr
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on
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Debt
Equity
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Cashflow
Value
at
Rate
Capital
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Beta
$$
(4.17%+1%+4%)(1-.34)
E
+
$
1.07
premium
Sectors:
Ratio:
21.85%
rate
EBIT(1-t)
0.27
Premium
Spread
Mkt
Embraer
25.08%
=
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Cash:
=549
EBIT
4.17%;
84%
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=% 25.08%
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D
Price
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: Rate=
Status
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5Rate
=Beta
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:2003
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288/(.0876-.0417)
= 795
ofto
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=4.17%
Firm
1.00;
426
$ 404
(WACC)
2 ==6272
449
10.52% 3(.84) + 6.05%4(0.16) = 9.81%
474 500
5
527
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Country
-=
4
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%
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CpXPremium= 717
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5.48
-Cost
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288
FCFF
%ofWC
capital
Int. = 8.76%
12319 9 336 355 374 395
= FCFF8.76%; Tax
ROC=
=Equity 5,349
rate=34%
$ 372
Reinvestment Rate=g/ROC
-Options Rate28 = 32/404= 7.9%
Value/Share
=4.17/8.76= $7.47 47.62%
R$ 21.75

Aswath Damodaran
+
Ambev:
$
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
Riskfree
Beta
M
Unlevered
Firm’s
Reinvestment
Return
Term
Lambda
+
C
Country
R
X
On
1.21 ountry
el
ature
Cashflows
May
Equity
Assets
EBIT(1-t)
in
g
11.41
Spread
Mkt
Ambev
53.7%
=
Yr
ofD/E
Growth
on
market
Equity
Debt
Equity
Year
(4.70%+2%+4%)(1-.34)
E
+
$
0.87
premium
Sectors:
Ratio:
16.24%
0.41
Premium
Riskfree
1217
Cash:
=EBIT
4.70%;
84%
Vol
%19.4%
Common
(1-t)
EBIT0.77
Status
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24,
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Value
at
Rate
Capital
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Beta
$$
2004
Cost
5Rate
:6546
D: Rate=
=Beta
16%
(1-t)
Risk
=for Quo ($)2= 12,249
641/(.0994-.047)
oftoCapital
743
=
4.70%
Firm
R$1140
1.00;
1 (WACC) = 11.41%
3 4(.84) + 57.06%6(0.16) 7= 10.70%
504 $548 $595 $647 $704 $765 $832 $904 $983
8 9
$1069
10
$1162
.537*.1624=.0872
Country
-=
4
7.87%
6.50%
Ambev
-Debt
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%
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576
CpX -Pref
Premium=
= 500 1848
Reinvestment 5% 146 $294 $320 $348 $378 $411 $447 $486 $528 $574 $624
8.72
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= Chg
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641
%
ofWCcapital
Int.
FCFF = 137
9.94% 124 $253 $276 $300 $326 $354 $385 $419 $455 $495 $538
= FCFF9.94%; Tax
ROC=
=Equity 5304rate=34%
$ 233
Reinvestment Rate=g/ROC
-Options Rate0= 270/504= 53.7%
Value/Sh =4.70/9.94=
$137.6247.31%
R$ 433/sh

Aswath Damodaran
 I. The Cost of Capital

Aswath Damodaran
 The Cost of Capital is central to both corporate
finance and valuation

 In corporate finance, the cost of capital is important because

• It operates as the hurdle rate when considering new investments
• It is the metric that allows firms to choose their optimal capital structure
 In valuation, it is the discount rate that we use to value the operating
assets of the firm.

Aswath Damodaran
 I. The Cost of Equity

or to
Cost
Has
Preferably,
Historical
Impliedofbe
Equity
Premium
inathe
Premiumbottom-up
= same Riskfree
beta, Rate + Beta * (Risk Premium)
currency
based
1. Mature
Based upon
on as
Equity
how cash
other Market
equityflows,
firms inPremium:
the
and defined
business,
Average
market premium
andin firm’s
is priced same earned
today own
termsfinancial
by
(reala or
leverage
stocks
and over
nominal)
simple [Link]
as the
valuation in U.S.
cash
2. Country
model flows risk premium =
Country Default Spread* ( σEquity/σ Country bond)

Aswath Damodaran 1
 A Simple Test

 You are valuing Ambev in U.S. dollars and are attempting to estimate
a risk free rate to use in the analysis. The risk free rate that you should
use is
 The interest rate on a nominal real denominated Brazilian government
bond
 The interest rate on an inflation-indexed Brazilian government bond
 The interest rate on a dollar denominated Brazilian government bond
(11.20%)
 The interest rate on a U.S. treasury bond (4.70%)

Aswath Damodaran 1
 Everyone uses historical premiums, but..

 The historical premium is the premium that stocks have historically earned
over riskless securities.
 Practitioners never seem to agree on the premium; it is sensitive to
• How far back you go in history…
• Whether you use [Link] rates or [Link] rates
• Whether you use geometric or arithmetic averages.
 For instance, looking at the US:
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period [Link] [Link] [Link] [Link]
1928-2004 7.92% 6.53% 6.02% 4.84%
1964-2004 5.82% 4.34% 4.59% 3.47%
1994-2004 8.60% 5.82% 6.85% 4.51%

Aswath Damodaran 1
 Two Ways of Estimating Country Risk
Premiums… September 2003

 Default spread on Country Bond: In this approach, the country risk premium
is based upon the default spread of the bond issued by the country (but only if
it is denominated in a currency where a default free entity exists.
• Brazil was rated B2 by Moody’s and the default spread on the Brazilian dollar
denominated [Link] at the end of September 2003 was 6.01%. (10.18%-4.17%)
 Relative Equity Market approach: The country risk premium is based upon the
volatility of the market in question relative to U.S market.
Country risk premium = Risk PremiumUS* Country Equity / US Equity
Using a 4.53% premium for the US, this approach would yield:
Total risk premium for Brazil = 4.53% (33.37%/18.59%) = 8.13%
Country risk premium for Brazil = 8.13% - 4.53% = 3.60%
(The standard deviation in weekly returns from 2001 to 2003 for the Bovespa was
33.37% whereas the standard deviation in the S&P 500 was 18.59%)

Aswath Damodaran 1
 And a third approach

 Country ratings measure default risk. While default risk premiums and
equity risk premiums are highly correlated, one would expect equity
spreads to be higher than debt spreads.
 Another is to multiply the bond default spread by the relative volatility
of stock and bond prices in that market. In this approach:
• Country risk premium = Default spread on country bond* Country Equity /
Country Bond
– Standard Deviation in Bovespa (Equity) = 33.37%
– Standard Deviation in Brazil C-Bond = 26.15%
– Default spread on C-Bond = 6.01%
• Country Risk Premium for Brazil = 6.01% (33.37%/26.15%) = 7.67%

Aswath Damodaran 1
 Can country risk premiums change? Updating
Brazil in January 2005

 Brazil’s financial standing and country rating improved dramatically

towards the end of 2004. Its rating improved to B1. In January 2005,
the interest rate on the Brazilian C-Bond dropped to 7.73%. The US
treasury bond rate that day was 4.22%, yielding a default spread of
3.51% for Brazil.
• Standard Deviation in Bovespa (Equity) = 25.09%
• Standard Deviation in Brazil C-Bond = 15.12%
• Default spread on C-Bond = 3.51%
• Country Risk Premium for Brazil = 3.51% (25.09%/15.12%) = 5.82%

Aswath Damodaran 1
 From Country Spreads to Corporate Risk
premiums

 Approach 1: Assume that every company in the country is equally

exposed to country risk. In this case,
E(Return) = Riskfree Rate + Country Spread + Beta (US premium)
Implicitly, this is what you are assuming when you use the local
Government’s dollar borrowing rate as your riskfree rate.
 Approach 2: Assume that a company’s exposure to country risk is
similar to its exposure to other market risk.
E(Return) = Riskfree Rate + Beta (US premium + Country Spread)
 Approach 3: Treat country risk as a separate risk factor and allow
firms to have different exposures to country risk (perhaps based upon
the proportion of their revenues come from non-domestic sales)
E(Return)=Riskfree Rate+ (US premium) + Country Spread)

Aswath Damodaran 1
 Estimating Company Exposure to Country
Risk: Determinants

 Source of revenues: Other things remaining equal, a company should

be more exposed to risk in a country if it generates more of its
revenues from that country. A Brazilian firm that generates the bulk
of its revenues in Brazil should be more exposed to country risk than
one that generates a smaller percent of its business within Brazil.
 Manufacturing facilities: Other things remaining equal, a firm that has
all of its production facilities in Brazil should be more exposed to
country risk than one which has production facilities spread over
multiple countries. The problem will be accented for companies that
cannot move their production facilities (mining and petroleum
companies, for instance).
 Use of risk management products: Companies can use both
options/futures markets and insurance to hedge some or a significant
portion of country risk.

Aswath Damodaran 1
 Estimating Lambdas: The Revenue Approach

 The easiest and most accessible data is on revenues. Most companies break
their revenues down by region. One simplistic solution would be to do the
following:
% of revenues domesticallyfirm/ % of revenues domesticallyavg firm
 Consider, for instance, Embraer and Embratel, both of which are incorporated
and traded in Brazil. Embraer gets 3% of its revenues from Brazil whereas
Embratel gets almost all of its revenues in Brazil. The average Brazilian
company gets about 77% of its revenues in Brazil:
• LambdaEmbraer = 3%/ 77% = .04
• LambdaEmbratel = 100%/77% = 1.30
 There are two implications
• A company’s risk exposure is determined by where it does business and not by
where it is located
• Firms might be able to actively manage their country risk exposures

Aswath Damodaran 1
 Estimating Lambdas: Earnings Approach

Figure 2: EPS changes versus Country Risk: Embraer and Embratel

1.5 40.00%

1 30.00%

0.5 20.00%

0 10.00%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003

-0.5
Quarterly EPS 0.00%

% change in C Bond Price

-1 -10.00%

-1.5 -20.00%

-2 -30.00%
Quarter

Embraer Embratel C Bond

Aswath Damodaran 1
 Estimating Lambdas: Stock Returns versus C-
Bond Returns
ReturnEmbraer = 0.0195 + 0.2681 ReturnC Bond ReturnEmbratel = -0.0308 + 2.0030 ReturnC Bond
ReturnAmbev = 0.0290+ 0.4136 ReturnC Bond ReturnPetrobras= -0.0308 + 0.6600 ReturnC Bond
ReturnVale = 0.02169 + [Link] Bond

E m b r a e r v e r s u s C B o n d : 2 0 0 0 - 2 0 0 3 E m b r a te l v e rs u s C B o n d : 2 0 0 0 - 2 0 0 3

4 0 1 0 0

8 0

2 0
6 0

r l
e 4 0
e t
a a
r r
b 0 b
m m 2 0
E E
n n
o o
n n
0
r r
u - 2 0 u
t t
e e
R R - 2 0

- 4 0
- 4 0

- 6 0

- 6 0 - 8 0

- 3 0 - 2 0 - 1 0 0 1 0 2 0 - 3 0 - 2 0 - 1 0 0 1 0 2 0

R e tu r n o n C - B o n d R e tu r n o n C - B o n d

Aswath Damodaran 2
 Estimating a US Dollar Cost of Equity for
Embraer - September 2003

 Assume that the beta for Embraer is 1.07, and that the riskfree rate used is
4.17%. The historical risk premium from 1928-2002 for the US is 4.53% and
the country risk premium for Brazil is 7.67%.
 Approach 1: Assume that every company in the country is equally exposed to
country risk. In this case,
E(Return) = 4.17% + 1.07 (4.53%) + 7.67% = 16.69%
 Approach 2: Assume that a company’s exposure to country risk is similar to
its exposure to other market risk.
E(Return) = 4.17 % + 1.07 (4.53%+ 7.67%) = 17.22%
 Approach 3: Treat country risk as a separate risk factor and allow firms to
have different exposures to country risk (perhaps based upon the proportion of
their revenues come from non-domestic sales)
E(Return)= 4.17% + (4.53%) + %) = 11.09%

Aswath Damodaran 2
 Implied Equity Premiums

 We can use the information in stock prices to back out how risk averse the market is and how much
January
In
Analysts
After
52.85
48.71
44.89
41.37
38.13
2004,
year
1,
dividends
expect
5,
2005 of atorisk
we earnings
will
& assume
stock thatpremium
grow it is
8.5% a year fordemanding.
the next 5 years .
earnings
S&P
buybacks
500 on
iswere
at
the1211.92
2.90%
index will
of grow at
the index,
4.22%, thegenerating
same rate as
35.15
the entire
in cashflows
economy

 If you pay the current level of the index, you can expect to make a return of 7.87% on stocks (which
is obtained by solving for r in the following equation)
38.13 41.37 44.89 48.71 52.85 52.85(1.0422)
1211.92 = + + + + +
(1 + r) (1 + r) 2 (1 + r) 3 (1+ r) 4 (1 + r) 5 (r − .0422)(1 + r) 5
 Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.87% - 4.22% =
3.65%
€

Aswath Damodaran 2
 Implied Premiums in the US

Implied Premium for US Equity Market

7.00%

6.00%

5.00%

4.00%

3.00%
Implied Premium

2.00%

1.00%

0.00% 196019611962196319641965196619671968196919701971197219731974197519761977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004

Year

Aswath Damodaran 2
 An Intermediate Solution

 The historical risk premium of 4.84% for the United States is too high
a premium to use in valuation. It is much higher than the actual
implied equity risk premium in the market
 The current implied equity risk premium requires us to assume that the
market is correctly priced today. (If I were required to be market
neutral, this is the premium I would use)
 The average implied equity risk premium between 1960-2004 in the
United States is about 4%. We will use this as the premium for a
mature equity market.

Aswath Damodaran 2
 Implied Premium for Brazil: June 2005

 Level of the Index = 26196

 Dividends on the Index = 6.19% of 16889
 Other parameters (all in US dollars)
• Riskfree Rate = 4.08%
• Expected Growth (in dollars)
– Next 5 years = 8% (Used expected growth rate in Earnings)
– After year 5 = 4.08%
 Solving for the expected return:
• Expected return on Equity = 11.66%
• Implied Equity premium = 11.66% - 4.08% = 7.58%
• Implied Equity premium for US on same day = 3.70%
• Implied country premium for Brazil = 7.58% - 3.70% = 3.88%

Aswath Damodaran 2
 Estimating Beta

 The standard procedure for estimating betas is to regress stock returns

(Rj) against market returns (Rm) -
Rj = a + b Rm
• where a is the intercept and b is the slope of the regression.
 The slope of the regression corresponds to the beta of the stock, and
measures the riskiness of the stock.
 This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the regression, not
the current mix
• It reflects the firm’s average financial leverage over the period rather than
the current leverage.

Aswath Damodaran 2
 Beta Estimation : The Index Effect

Aswath Damodaran 2
 Determinants of Betas

Beta
Beta ofof
service
Costs
Other
1.
Highly
of
Implciations
Nature
Operating
Financial
Implications
Cyclical
Firmsthings
as
levered
Equity
Leverage:
product
FirmLeverage
offered
with
percent
companies
remaining
high
firms
(Levered
or(Fixed
(Unlevered
byinfrastructure
ofshould
total
should
equal,
Beta) Beta)
have
thehighe betas
company
costs):
greater
have
needs
than firms
higher
and
the:with
rigid
proportion
betas
less
costthan
debt.
structures
ofnon-
capital that
Other
a
cyclical
should
Equity
firm raises
things
Beta
have
companies.
(Levered
higher
remaining
from debt,the
betas
beta)
equal,
equal
than
higher
= its
theLuxury
equity
2.
firms
Unlev more
greater
with
Beta
beta
discretionary
goods
flexible
the
(1
will+proportion
be
(1-
firms
cost
t) (Debt/Equity
should
structures.
theof Ratio))
product
the
have
2. Smaller
costs
higher
orthat
firms
service,
betas
areshould
fixed,
than
the higher
have
basic
the higher
the beta.
higher
goods.
betas than
the beta
larger offirms.
the
company.
3. Young
High priced
firms goods/service
should have higher
firms should
betas than more havemature
higherfirms.
betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran 2
 The Solution: Bottom-up Betas

Possible
While
Step
If you5:1:expect
2:
3:
4:
can,
revenues
Find
Estimate
Compute
Refinements
adjust
the
publicly
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yourbusiness
business
how
athis
debt
operating
weighted
levered
traded
beta
much
to equity
or
mix
for
beta
firms
value
businesses
income
average
differences
of(equity
ratio
your
in
your
each
to
offirm
beta)
the
that
of derives
these
unlevered
your
for your
firm
businesses
fromfirm,
operates
betas
each
using
ofand
ofthe
in.
obtain
between
are
different
the
firm
changedifferent
market
often
to their
change
over
businesses
your
used
debt
regression
businesses
time,
firm
over
as
toweights,
and
the
equity
time,
(from
levered
the
betas.
itratio
you
is
step
comparable
it in.
isCompute
can
beta
for
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2) your
using
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the
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weights average
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Bottom-up
Levered
change
try on
to
regression
the
over
estimate
operating
bottom-up
Unlevered
weights
[Link]
the
leverage
beta
onvalue
beta
ato=year-to-year
arrive
Unlevered
for
ofand each
your
at
product
an
firm
beta
average
= Weighted
(1+ (1-t)
beta (Debt/Equity))
for
average
theseof
publicly
the
traded firms.
characteristics.
business.
unlevered
basis. betas
Unlever
of thethisindividual
averagebusiness
beta using the average debt to
equity ratio across the publicly traded firms in the sample.
Unlevered beta for business = Average beta across publicly traded
firms/ (1 + (1- t) (Average D/E ratio across firms))

Aswath Damodaran 2
 Bottom-up Betas: Embraer, Ambev, Vale and
Petrobras

Company Business Unlevered beta D/E Ratio Weights Levered Beta

Embraer Aerospace 0.95 18.95% 100% 1.07
Ambev Alcoholic beverages 0.75 19.43% 80% 0.85
Soft Drinks 0.85 19.43% 20% 0.96
Company 0.77 19.43% 0.87
Vale Mining 0.98 25.66% 71% 1.15
Aluminum 0.72 25.66% 9% 0.84
Steel 0.63 25.66% 14% 0.74
Transportation 0.73 25.66% 5% 0.85
Other 0.74 25.66% 1% 0.87
Company 0.89 25.66% 100% 1.04
Petrobras Integrated Oil 0.60 49.58% 100% 0.79

Aswath Damodaran 3
 Gross Debt versus Net Debt Approaches:
Embraer in September 2003

 Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity
= (1953-2320)/ 11,042 = -3.32%
 Levered Beta for Embraer = 0.95 (1 + (1-.34) (-.0332)) = 0.93
 The cost of Equity using net debt levered beta for Embraer will be
much lower than with the gross debt approach. The cost of capital for
Embraer, though, will even out since the debt ratio used in the cost of
capital equation will now be a net debt ratio rather than a gross debt
ratio.

Aswath Damodaran 3
 From Cost of Equity to Cost of Capital

Cost of equity
Marginal
Weights Capital
borrowing
should
tax rate,
=bereflecting
should
market
Cost beofvalue
Equity
based
weights
(Equity/(Debt
upon + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity))
(1) synthetic
tax
based
benefits
upon ofbottom-up
ordebt
actual bond rating
(2) default spread
beta
Cost of Borrowing = Riskfree rate + Default spread

Aswath Damodaran 3
 Estimating Synthetic Ratings

 The rating for a firm can be estimated using the financial characteristics of the
firm. In its simplest form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
 For Embraer’s interest coverage ratio, we used the interest expenses and EBIT
from 2002.
Interest Coverage Ratio = 2166/ 222 = 9.74
 For Ambev’s interest coverage ratio, we used the interest expenses and EBIT
from 2003.
Interest Coverage Ratio = 2213/ 570 = 3.88
 For Vale’s interest coverage ratio, we used the interest expenses and EBIT
from 2003 also
Interest Coverage Ratio = 6371/1989 = 3.20

Aswath Damodaran 3
 Interest Coverage Ratios, Ratings and Default
Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2003) Default Spread(2004)
> 8.50 (>12.50) AAA 0.75% 0.35%
6.50 - 8.50 (9.5-12.5) AA 1.00% 0.50%
5.50 - 6.50 (7.5-9.5) A+ 1.50% 0.70%
4.25 - 5.50 (6-7.5) A 1.80% 0.85%
3.00 - 4.25 (4.5-6) A– 2.00% 1.00%
2.50 - 3.00 (4-4.5) BBB 2.25% 1.50%
2.25- 2.50 (3.5-4) BB+ 2.75% 2.00%
2.00 - 2.25 ((3-3.5) BB 3.50% 2.50%
1.75 - 2.00 (2.5-3) B+ 4.75% 3.25%
1.50 - 1.75 (2-2.5) B 6.50% 4.00%
1.25 - 1.50 (1.5-2) B– 8.00% 6.00%
0.80 - 1.25 (1.25-1.5) CCC 10.00% 8.00%
0.65 - 0.80 (0.8-1.25) CC 11.50% 10.00%
0.20 - 0.65 (0.5-0.8) C 12.70% 12.00%
< 0.20 (<0.5) D 15.00% 20.00%
The first number under interest coverage ratios is for larger market cap companies and the second in brackets is for
smaller market cap companies. For Embraer and Ambev , I used the interest coverage ratio table for smaller/riskier
firms (the numbers in brackets) which yields a lower rating for the same interest coverage ratio.

Aswath Damodaran 3
 Estimating the cost of debt

Company EBIT Interest Interest Rating Company Country Cost of

Expense Coverage Spread Spread Debt($)
Embraer (2003) 2166 222 9.76 AA 1.00% 4% 9.17%
Ambev 2213 570 3.88 BB+ 2.00% 4% 10.70%
Vale 6371 1989 3.20 BB 2.50% 4% 11.20%
Petrobras 14974 3195 4.69 A- 1% 4% 9.70%

Riskfree Rate = 4.17% for Embraer in 2003, 4.70% for all other firms
Cost of debt ($) = Riskfree Rate + Company Spread + Country Spread
(I have assumed that all of these companies will have to bear only a portion of the total country
default spread of Brazil which is 4.50%)

Aswath Damodaran 3
 Weights for the Cost of Capital Computation

 The weights used to compute the cost of capital should be the market
value weights for debt and equity.
 There is an element of circularity that is introduced into every
valuation by doing this, since the values that we attach to the firm and
equity at the end of the analysis are different from the values we gave
them at the beginning.
 As a general rule, the debt that you should subtract from firm value to
arrive at the value of equity should be the same debt that you used to
compute the cost of capital.

Aswath Damodaran 3
 Estimating Cost of Capital: Embraer

 Equity
• Cost of Equity = 4.17% + 1.07 (4%) + 0.27 (7.67%) = 10.52%
• Market Value of Equity =11,042 million BR ($ 3,781 million)
 Debt
• Cost of debt = 4.17% + 4.00% +1.00%= 9.17%
• Market Value of Debt = 2,093 million BR ($717 million)
 Cost of Capital
Cost of Capital = 10.52 % (.84) + 9.17% (1- .34) (0.16)) = 9.81%
The book value of equity at Embraer is 3,350 million BR.
The book value of debt at Embraer is 1,953 million BR; Interest expense is 222
mil; Average maturity of debt = 4 years
Estimated market value of debt = 222 million (PV of annuity, 4 years, 9.17%) +
$1,953 million/1.09174 = 2,093 million BR

Aswath Damodaran 3
 Estimating Cost of Capital: Ambev

 Equity
• Cost of Equity = 4.7% + 0.87 (4%) + 0.41 (7.87%) = 11.41%
• Market Value of Equity = 29,886 million BR ($ 9,508 million)
 Debt
• Cost of debt = 4.7% + 4.00% +2.00%= 10.70%
• Market Value of Debt = 5,808 million BR ($1,848 million)
 Cost of Capital
Cost of Capital = 11.41 % (.837) + 10.7% (1- .34) (0.163)) = 10.70%
The book value of equity at Ambev is 4,209 million BR.
The book value of debt at Ambev is 5,980 million BR; Interest expense is 570
mil; Average maturity of debt = 3 years
Estimated market value of debt = 570 million (PV of annuity, 3 years, 10.7%) +
$5,980 million/1.1073 = 5,808 million BR

Aswath Damodaran 3
 Estimating Cost of Capital: Vale

 Equity
• Cost of Equity = 4.7% + 1.04 (4%) + 0.37 (7.87%) = 11.77%
• Market Value of Equity = 56,442 million BR ($ 17,958 million)
 Debt
• Cost of debt = 4.7% + 4.00% +2.50%= 11.20%
• Market Value of Debt = 14,484 million BR ($ 4,612 million)
 Cost of Capital
Cost of Capital = 11.77 % (.796) + 11.2% (1- .34) (0.204)) = 10.88%
The book value of equity at Vale is 15,937 million BR.
The book value of debt at Vale is 13,709 million BR; Interest expense is 1,989
mil; Average maturity of debt = 2 years
Estimated market value of debt = 1,989 million (PV of annuity, 2 years, 11.2%) +
13,709 million/1.1122 = 14,484 million BR

Aswath Damodaran 3
 Estimating Cost of Capital: Petrobras

 Equity
• Cost of Equity = 4.70% + 0.79 (4%) + 0.66(7.87%) = 12.58%
• Market Value of Equity = 85,218 million BR ($ 27,114 million)
 Debt
• Cost of debt = 4.7% + 4.00% + 1.00%= 9.70%
• Market Value of Debt = 39,367 million BR ($ 12,537 million)
 Cost of Capital
Cost of Capital = 12.58 % (.684) + 9.7% (1- .34) (0.316)) = 10.63%
The book value of equity at Petrobras is 50.987 million BR.
The book value of debt at Petrobras is 42,248 million BR; Interest expense is
1,989 mil; Average maturity of debt = 4 years
Estimated market value of debt = 3,195 million (PV of annuity, 4 years, 9.7%) +
42,248 million/1.0974 = 39,367 million BR

Aswath Damodaran 4
 If you had to do it….Converting a Dollar Cost of
Capital to a Nominal Real Cost of Capital -
Ambev

 Approach 1: Use a BR riskfree rate in all of the calculations above. For

instance, if the BR riskfree rate was 12%, the cost of capital would be
computed as follows:
• Cost of Equity = 12% + (4%) + %) = 18.71%
• Cost of Debt = 12% + 2% = 14%
• (This assumes the riskfree rate has no country risk premium embedded in it.)
 Approach 2: Use the differential inflation rate to estimate the cost of capital.
For instance, if the inflation rate in BR is 8% and the inflation rate in the U.S.
is 2%
⎡1+ Inflation ⎤
Cost of capital= (1+ Cost of Capital$ )⎢ BR
⎥
⎣ 1+ Inflation$ ⎦
= 1.107 (1.08/1.02)-1 = 17.21%

Aswath Damodaran 4
 II. Valuing Control and Synergy
Acquisition Valuation
It is not what you buy but what you pay for it….

Aswath Damodaran 4
 Issues in Acquisition Valuation

 Acquisition valuations are complex, because the valuation often

involved issues like synergy and control, which go beyond just
valuing a target firm. It is important on the right sequence, including
• When should you consider synergy?
• Where does the method of payment enter the process.
 Can synergy be valued, and if so, how?
 What is the value of control? How can you estimate the value?

Aswath Damodaran 4
 The Value of Control

 Control has value because you think that you can run a firm better
than the incumbent management.
Value of Control = Value of firm, run optimally - Value of firm, status quo
 The value of control should be inversely proportional to the
perceived quality of that management and its capacity to maximize
firm value.
 Value of control will be much greater for a poorly managed firm
that operates at below optimum capacity than it is for a well managed
firm. It should be negligible or firms which are operating at or close
to their optimal value

Aswath Damodaran 4
 Price Enhancement versus Value
Enhancement

Aswath Damodaran 4
+
Ambev:
$
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
Riskfree
Beta
M
Unlevered
Firm’s
Reinvestment
Return
Term
Lambda
+
C
Country
R
X
On
1.21 ountry
el
ature
Cashflows
May
Equity
Assets
EBIT(1-t)
in
g
11.41
Spread
Mkt
Ambev
53.7%
=
Yr
ofD/E
Growth
on
market
Equity
Debt
Equity
Year
(4.70%+2%+4%)(1-.34)
E
+
$
0.87
premium
Sectors:
Ratio:
16.24%
0.41
Premium
Riskfree
1217
Cash:
=EBIT
4.70%;
84%
Vol
%19.4%
Common
(1-t)
EBIT0.77
Status
Default
24,
Cashflow
Value
at
Rate
Capital
Growth
Beta
$$
2004
Cost
5Rate
:6546
D: Rate=
=Beta
16%
(1-t)
Risk
=for Quo ($)2= 12,249
641/(.0994-.047)
oftoCapital
743
=
4.70%
Firm
R$1140
1.00;
1 (WACC) = 11.41%
3 4(.84) + 57.06%6(0.16) 7= 10.70%
504 $548 $595 $647 $704 $765 $832 $904 $983
8 9
$1069
10
$1162
.537*.1624=.0872
Country
-=
4
7.87%
6.50%
Ambev
-Debt
Nt
%
7.06%
576
CpX -Pref
Premium=
= 500 1848
Reinvestment 5% 146 $294 $320 $348 $378 $411 $447 $486 $528 $574 $624
8.72
-Cost
= Chg
Minor.
641
%
ofWCcapital
Int.
FCFF = 137
9.94% 124 $253 $276 $300 $326 $354 $385 $419 $455 $495 $538
= FCFF9.94%; Tax
ROC=
=Equity 5304rate=34%
$ 233
Reinvestment Rate=g/ROC
-Options Rate0= 270/504= 53.7%
Value/Sh =4.70/9.94=
$137.6247.31%
R$ 433/sh

Aswath Damodaran 4
 The Paths to Value Creation

 Using the DCF framework, there are four basic ways in which the value of a
firm can be enhanced:
• The cash flows from existing assets to the firm can be increased, by either
– increasing after-tax earnings from assets in place or
– reducing reinvestment needs (net capital expenditures or working capital)
• The expected growth rate in these cash flows can be increased by either
– Increasing the rate of reinvestment in the firm
– Improving the return on capital on those reinvestments
• The length of the high growth period can be extended to allow for more years of
high growth.
• The cost of capital can be reduced by
– Reducing the operating risk in investments/assets
– Changing the financial mix
– Changing the financing composition

Aswath Damodaran 4
 I. Ways of Increasing Cash Flows from Assets
in Place

Better
Revenues
Divest
More
Reduce
Live off
efficient
inventory
assets
past
tax rate
over-
that
have
-operations
investment
management
moving
negative
income
and and
EBIT
to lower tax locales
* transfer
-cost
tighter
Operating
cuttting:
credit
pricing
Margin
policies
-Higher
risk management
Margins
= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF

Aswath Damodaran 4
 II. Value Enhancement through Growth

Reinvestment
Reinvest
Do
Increase
acquisitions
operating
capital
moreRate
inturnover ratio
projects
margins
* Return on Capital

= Expected Growth Rate

Aswath Damodaran 4
 III. Building Competitive Advantages: Increase
length of the growth period

Cost new
Increase
Build
Find
Brand
Legal
Switching
on existing
length of growth period
competitive
name
Protection
Costs
advantages
advantages

Aswath Damodaran 5
 Illustration: Valuing a brand name: Coca Cola

Coca Cola Generic Cola

Company
AT Operating Margin 18.56% 7.50%
Sales/BV of Capital 1.67 1.67
ROC 31.02% 12.53%
Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)
Expected Growth 20.16% 8.15%
Length 10 years 10 yea
Cost of Equity 12.33% 12.33%
E/(D+E) 97.65% 97.65%
AT Cost of Debt 4.16% 4.16%
D/(D+E) 2.35% 2.35%
Cost of Capital 12.13% 12.13%
Value $115 $13

Aswath Damodaran 5
 Gauging Barriers to Entry

 Which of the following barriers to entry are most likely to work for
Embraer?
 Brand Name
 Patents and Legal Protection
 Switching Costs
 Cost Advantages
 What about for Ambev?
 Brand Name
 Patents and Legal Protection
 Switching Costs
 Cost Advantages

Aswath Damodaran 5
 Reducing Cost of Capital

Swaps
Cost
Change
Make
Reduce
Match
Changing
More
Flexible
Outsourcing
Hybrids
Derivatives
ofproduct
debt
Equity
wage
operating
financing
to or
contracts
(E/(D+E)
service
mix + & Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital
less discretionary
leverage
assets,
product
effective
cost structure
reducing to
customers
default
characteristics
advertising
risk

Aswath Damodaran 5
 Embraer : Optimal Capital Structure

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 0.95 10.05% AAA 8.92% 34.00% 5.89% 10.05% $3,577
10% 1.02 10.32% AAA 8.92% 34.00% 5.89% 9.88% $3,639
20% 1.11 10.67% AA 9.17% 34.00% 6.05% 9.75% $3,690
30% 1.22 11.12% A 9.97% 34.00% 6.58% 9.76% $3,686
40% 1.37 11.72% A- 10.17% 34.00% 6.71% 9.72% $3,703
50% 1.58 12.56% B 14.67% 34.00% 9.68% 11.12% $3,218
60% 1.89 13.81% CCC 18.17% 34.00% 11.99% 12.72% $2,799
70% 2.42 15.90% CC 19.67% 34.00% 12.98% 13.86% $2,562
80% 3.48 20.14% CC 19.67% 33.63% 13.05% 14.47% $2,450
90% 6.95 34.05% CC 19.67% 29.90% 13.79% 15.81% $2,236

Aswath Damodaran 5
 Ambev: Optimal Capital Structure
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 0.85 11.33% AAA 9.20% 34.00% 6.07% 11.33% $33,840
10% 0.91 11.58% AA 9.20% 34.00% 6.07% 11.03% $35,530
20% 0.99 11.89% A- 9.70% 34.00% 6.40% 10.79% $36,966
30% 1.09 12.29% B- 14.70% 34.00% 9.70% 11.52% $32,873
40% 1.23 12.83% CC 18.70% 34.00% 12.34% 12.63% $28,005
50% 1.49 13.87% C 20.70% 25.24% 15.48% 14.67% $21,930
60% 1.95 15.71% D 28.70% 14.22% 24.62% 21.05% $12,721
70% 2.59 18.30% D 28.70% 12.19% 25.20% 23.13% $11,098
80% 3.89 23.49% D 28.70% 10.67% 25.64% 25.21% $9,804
90% 7.78 39.06% D 28.70% 9.48% 25.98% 27.29% $8,748

Aswath Damodaran 5
 Vale: Optimal Capital Structure

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 0.89 11.17% AAA 9.20% 34.00% 6.07% 11.17% $67,576
10% 0.95 11.43% AA 9.20% 34.00% 6.07% 10.89% $70,723
20% 1.04 11.76% A+ 9.40% 34.00% 6.20% 10.65% $73,819
30% 1.14 12.18% A- 9.70% 34.00% 6.40% 10.44% $76,537
40% 1.28 12.73% BB 11.20% 34.00% 7.39% 10.60% $74,451
50% 1.48 13.52% B- 14.70% 34.00% 9.70% 11.61% $63,058
60% 1.77 14.69% CC 18.70% 34.00% 12.34% 13.28% $50,122
70% 2.35 17.01% CC 18.70% 29.68% 13.15% 14.31% $44,418
80% 3.90 23.20% D 28.70% 15.46% 24.26% 24.05% $20,372
90% 7.79 38.79% D 28.70% 13.74% 24.76% 26.16% $18,043

Aswath Damodaran 5
+
Ambev:
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
Riskfree
Beta
M
Unlevered
Firm’s
Reinvestment
Return
Term
Lambda
+
C
Country
R
X
On
1.21
$
Year ountry
el
ature
Cashflows
May
Equity
Assets
EBIT(1-t)
in
g
11.53
Yr
ofD/E
Growth
on
market
Equity
Debt
Equity
(4.70%+1%+4%)(1-.34)
E
+
$
0.90
premium
Sectors:
Ratio:
60%
18%
0.41
Premium
Spread
Mkt
Ambev
EBIT =
Riskfree
1470
Cash:
=EBIT
4.70%;
80%
Vol%
25%
Common
(1-t)
(1-t)0.77
Restructured
Default
24,
Cashflow
Value
at
Rate
Capital
Growth
Beta
$$
2004
Cost
15Rate
D: Rate=
=Beta
20%
:7567
$558
Risk
=for
766/(.0994-.047)
ofto
743
=
2Capital
4.70%
($)
Firm3 (WACC)
R$1140
1.00;
4= 14.990
= 11.53%
5 6(.80) + 76.40%8(0.20) 9= 10.50%
504 $685 $759 $841 $932 $1,032 $1144 $1,267 $1,404
$618
10

.60*.18=.108
Country
-=
4
7.87%
6.50%
Ambev
--Debt
Nt
%
6.40%
704
CpXPref
Premium=
= 500
Reinvestment$335 18485% 146 $411 $455 $505 $559 $619 $686 $760 $843
$371
10.80
-Cost
= Chg
Minor.
FCFF 766
of%
WCcapital
Int. $223 = 137
9.94% 124 $274 $304 $336 $373 $413 $458 $507 $562
$247
= FCFF9.94%; Tax
ROC=
=Equity 6277rate=34%
$ 233
Reinvestment Rate=g/ROC
-Options Rate0= 270/504= 53.7%
Value/Sh =4.70/9.94=
$162.8947.31%
R$ 512/sh

Aswath Damodaran 5
 Value of stock in a publicly traded firm

 When a firm is badly managed, the market still assesses the

probability that it will be run better in the future and attaches a value
of control to the stock price today:
Status Quo Value + Probability of control change (Optimal - Status Quo Value)
Value per share =
Number of shares outstanding
 With voting shares and non-voting shares, a disproportionate share of
the value of control will go to the voting shares. In the extreme
€ scenario where non-voting shares are completely unprotected:
Status Quo Value
Value per non - voting share =
# Voting Shares + # Non - voting shares

Probability of control change (Optimal - Status Quo Value)

Value per voting share = Value of non - voting share +
# Voting Shares
€

Aswath Damodaran 5
 Valuing Ambev voting and non-voting shares

 Status Quo Value = $5,304 million* 3.14 = 16,655 million BR

 Optimal Value = $6,277 million *3.14 = 19,710 million BR
 Number of shares
• Voting =15.735
• Non-voting =22.801
• Total = 38.536
 Value/ non-voting share = 16,655/38.536 = 433 BR/share
 Value/ voting share = 433 + (19710-16655)/15.735 = 626 BR/share

Aswath Damodaran 5
 Sources of Synergy

MayBenefits
Synergy
Operating
Financial
Cost
Tax
Added
Diversification?
Strategic
Economies
Longer
More
Lower
Higherreduce
Savings
new
sustainable
taxes
Debt
returns
ROC
Reinvestment
Margin
debt
Growth
is
Advantages
Synergy
Synergy
created
ofon
in
Scale
on when
accrues
twotofirms
the combined
are combined
firm as
and can be
eitherof
new
Investments
current
Capacity
Period
excess
earnings
raito
cost investments
and
financial
equity
returns
operations
due
lower toor operating
-Higher
cost
for
higher
private
of capital
Growth
Base-or Rate
Rate EBIT
year
depreciaiton
closely held
- operating loss
firm
carryforwards

Aswath Damodaran 6
 A procedure for valuing synergy

(1) the firms involved in the merger are valued independently, by

discounting expected cash flows to each firm at the weighted average
cost of capital for that firm.
(2) the value of the combined firm, with no synergy, is obtained by
adding the values obtained for each firm in the first step.
(3) The effects of synergy are built into expected growth rates and
cashflows, and the combined firm is re-valued with synergy.
Value of Synergy = Value of the combined firm, with synergy - Value of
the combined firm, without synergy

Aswath Damodaran 6
Aswath Damodaran 6
 J.P. Morgan’s estimate of annual operating
synergies in Ambev/Labatt Merger

Aswath Damodaran 6
 J.P. Morgan’s estimate of total synergies in
Labatt/Ambev Merger

Aswath Damodaran 6
 Evidence on Synergy

o A stronger test of synergy is to evaluate whether merged firms improve their

performance (profitability and growth), relative to their competitors, after takeovers.
o McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for
evidence on two questions -
o Did the return on the amount invested in the acquisitions exceed the cost of
capital?
o Did the acquisitions help the parent companies outperform the competition?
o They concluded that 28 of the 58 programs failed both tests, and 6 failed at least
one test.
o KPMG in a more recent study of global acquisitions concludes that most mergers (>80%)
fail - the merged companies do worse than their peer group.
o Large number of acquisitions that are reversed within fairly short time periods. bout
20.2% of the acquisitions made between 1982 and 1986 were divested by 1988. In studies
that have tracked acquisitions for longer time periods (ten years or more) the divestiture
rate of acquisitions rises to almost 50%.

Aswath Damodaran 6
 Labatt DCF valuation

 Labatt is the Canadian subsidiary of Interbrew and is a mature firm with sold
brand names. It can be valued using a stable growth firm valuation model.
 Base Year inputs
• EBIT (1-t) = $411 million
• Expected Growth Rate = 3%
• Return on capital = 9%
• Cost of capital = 7%
 Valuation
• Reinvestment Rate = g/ ROC = 3/9= 33.33%
• Value of Labatt = 411 (1-.333)/ (.07-.03) = $6.85 billion
 Ambev is paying for Labatt with 23.3 billion shares (valued at about $5.8
billion) and is assuming $ 1.5 billion in debt, resulting in a value for the firm
of about $ 7.3 billion.

Aswath Damodaran 6
 Who gets the benefits of synergy?

$1.55Synergy
Total
Premium
Voting
Non-voting
billion
Shares
paid
to=to
be
$ 2shared?
billion
Labatt
in
Shares
Ambev Stockholders
in Ambev
= $7.3 billion - $6.85
billion = $ 450 million

Aswath Damodaran 6
 III. Valuing Equity in Cyclical firms
and firms with negative earnings :
The Search for Normalcy

Aswath Damodaran
[Link]

Aswath Damodaran 6
 Begin by analyzing why the earnings are not
not normal
Use
Why
Temporary
Cyclicality:
Life
Leverage
Long-term
Normalize
Value
Average
If
Afirm’s Cycle
firm’s
are
the
Frameworksize
Dollar
the
firm
related
average
Earnings
has
earnings
bychanged
not
doing
forROE negative
detailed
(if
Analyzing orcash
abnormally
Companies low?with Negative or Abnormally Low Earnings
Problems
Eg.
reasons:
Problems:
Operating
flow
changed
Earnings
over
valuingAuto
forecasts
timeequity)
firm
Young
significantly
(Net
Eg. Income
starting
or average with revenues and
inEquity
firms
An
Problems:
reduce
ifover
ROC recession
otherwise
time
and
(ifor
valuing
andfirms
eliminate
[Link]
Awith
firm)
firm
if the
onproblem
current over
infrastructure
healthy
with
time.:
Firm
BV ofsignificant
made
equity
firmby with
(if ROE) or current
problems
too
production
(a)
the
BV Ifof
much
firm
problem
capital
overdebt.
ortime
(if
cost
is ROC)
structura l: Target for
problems. margins of stable firms in the
operating
sector.
(b) If problem is leverage: Target for a
debt ratio that the firm will be comfortable
with by end of period, which could be its
own optimal or the industry average.
(c) If problem is operating: Target for an
industry-average operating margin.

Aswath Damodaran 6
 1. If the earnings decline or increase is
temporary and will be quickly reversed…
Normalize

 You can normalize earnings in three ways:

• Company’s history: Averaging earnings or operating margins over time
and estimating a normalized earning for the base year
• Industry average: You can apply the average operating margin for the
industry to the company’s revenues this year to get a normalized earnings.
• Normalized prices: If your company is a commodity company, you can
normalize the price of the commodity across a cycle and apply it to the
production in the current year.

Aswath Damodaran 7
 Aracruz in 2001: The Effect of Commodity
Prices

Aracruz Celulose: Revenues, Profits and the Price of Paper

$1,600.00 115

$1,400.00
110

$1,200.00

105
$1,000.00

100
$800.00
Revenues
Operating Income
$600.00 Price of pulp
95

Price of paper (1992: 100)

Revenues & Operating Income
$400.00
90

$200.00

85
$0.00
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

-$200.00 80
Year

Aswath Damodaran 7
 Normalizing Earnings

Revenues Operating Income Operating Margin Price of pulp

1991 $131.19 $19.54 14.89% 100
1992 $447.84 $125.45 28.01% 113.18
1993 $301.93 -$34.86 -11.55% 102.89
1994 $614.05 $131.34 21.39% 112.54
1995 $703.00 $271.00 38.55% 98.71
1996 $493.00 $15.00 3.04% 94.86
1997 $536.83 $39.12 7.29% 92.93
1998 $535.98 -$4.93 -0.92% 99.20
1999 $989.75 $403.35 40.75% 102.09
2000 $1,342.35 $665.85 49.60% 109.39
Normalized 2000 $1,342.35 $324.59 24.18%
Normalized 2000 $1,258.78 $582.28 102.58

Aswath Damodaran 7
Aracruz
EBIT
Normalized
Expected
Stable
Terminal
Cost
Weights
Discount
Op.
Reinvestment
Normalized
Term
$ Cashflows
Actual
in
g
13.97
Assets
(1-t)
Yr
ofGrowth
(7.50%(1-.34)
E
+
10.55%
-80%
=
Cash:
Reinvestment
=EBIT
691
3%;
73%%EBIT
(1-t)
$(2000):
Equity
Debt
Value
atGrowth
$ROC
Earnings
Cost
5Rate
D ==27%
5332
$665.85
Normalized
= 457/(.0885-.03)
of $425
Capital
847$242
(WACC)
million
=$470
7,805 Earnings
= 13.97%
$267
$519 ($) $574
(.73) + 4.95%
$295
(0.27) = 11.52%
$326
$635
$361
Normalized
80%
Cost
-= =-Debt
4.95%
FCFF
234
*of10%
capital
=EBIT
8%
=1395
8.85
= $582
$183 million $203 $224 $248 $274
Tax457
ROC=
=Equity
= Rate8.85%
= 34%4785
Reinvestment Rate=g/ROC
=3/8.85= 33.90%

Aswath Damodaran 7
 2. If the earnings are negative because the firm
is early in its life cycle…

 When operating income is negative or margins are expected to change

over time, we use a three step process to estimate growth:
• Estimate growth rates in revenues over time
– Use historical revenue growth to get estimates of revenue growth in the near
future
– Decrease the growth rate as the firm becomes larger
– Keep track of absolute revenues to make sure that the growth is feasible
• Estimate expected operating margins each year
– Set a target margin that the firm will move towards
– Adjust the current margin towards the target margin
• Estimate the capital that needs to be invested to generate revenue growth
and expected margins
– Estimate a sales to capital ratio that you will use to generate reinvestment
needs each year.

Aswath Damodaran 7
+iskRate
Discounted
Terminal
Forever
FCFF
.........
Cost
Weights
Discount
Value
Riskfree
Beta
R
X
Type
Operating
Financial
Base
Country
Current
Sales
Reinvestment
Competitive
Revenue
Expected
Stable
Tax
EBIT Premium
of
1
2
3
4
5
nof
Equity
of
Turnover
=Growth
Revenue*
Equity
Debt
Risk Cash
Operating
Value=
at
RateWACC=
: FCFF
Op Flow
Assets
Cost
Margin
n+1of Valuation:
/(r-g
Equity
(1-t) High Growth
n) - (Equity/(Debt
Reinvestment with
+ Equity)) Negative
+ Cost Earnings Equity))
of Debt (Debt/(Debt+
(Riskfree
Based
+
Business
Leverage
Premium
Ratio
Advantages
Growth
Revenue
Operating
-Reinvestment
No
Measures
Premium
NOLs
Cash
default
on
& Rate
Non-op
Market
for
market
risk
average
Value
Assets
risk
+No
-=
risk
Growth
Margin
Default
Value
investment
reinvestment
ofSpread)
Firm (1-t) risk
- In
Value
same of currency
Debt and
= Value
in same of terms
Equity
(real or
- Equity Options
nominal as cash flows
= Value of Equity in Stock

Aswath Damodaran 7
+
[Link]
Terminal
Forever
Cost
Weights
Value
Riskfree
Beta
R
X
Internet/
Operating
Base
Country
Current
Reinvestment:
Sales
Competitive
Revenue
Expected
Stable
EBIT
NOL:
iskofYear
$41,346
Term.
9
8
6
5
1
3
4
2
C
7
Revenues
0ost
10.00%
Cost
EBIT of
Premium
of
Equity
of
Turnover
Growth
Equity
Debt
Risk
Op
Value=
Rate
Equity Assets : 1881/(.0961-.06)
12.90%
$2,793 $12.90%
14,910
5,585 12.90%
9,774 12.90%
14,661 19,059
12.90% 23,862
12.42% 28,729
12.30% 33,211
12.10% 36,798
11.70% 39,006
10.50%
January
=52,148
12.90%
4%
Retail
Leverage
D/E:
Premium
Ratio: ->Debt
6.5%+1.5%=8.0%
Debt=
+
T.
1.60
Advantages
Growth:
Margin:
Revenue
Operating
ROC=20%
-410m
500
Cap Cash
Bond
m
ex1.21%
3.00
1.2%
rate
1.00
includes =-$373
2000
-> 8.00%
15% -$94
6.5% 8.00%
$
acquisitions 8.00% $1,038
$407
26 8.00% 8.00%
$1,628 7.80%
$2,212 7.75%
$2,768 7.67%
$3,261 7.50%
$3,646 7.00%
$3,883
35.00%
AT
EBIT cost
Working (1-t)
ofcapital
debt 8.00%
-$373
is 3% of -$94
8.00% 8.00% $871
$407
revenues 6.71% 5.20%
$1,058 5.07%
$1,438 5.04%
$1,799 4.98%
$2,119 4.88%
$2,370 4.55%
$2,524
Stock
Tax
=
$
-36.71%
42%
Growth:
Margin:
Reinvest
->1,117
Value
$2,688
Cost
10.00%
rate Price
of
6%
- Reinvestment
=30%
0%
Firm=
of Capital $559
$ 35%
-> 84
12.84% $931
$14,936
12.84% $1,396
12.84% $1,629
12.83% 12.81%
$1,466 12.13%
$1,601 11.96%
$1,623 11.69%
$1,494 11.15%
$1,196 9.61%
$736
-of
10.00%
Value
EBIT(1-t)
$ 807
FCFF
of Debt
-$931
$ 349
-$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1,788
= Value
$1,881 of Equity $14,587
- Equity Options $ 2,892
Value per share $ 34.32

Aswath Damodaran 7
 3. If earnings are negative because the firm
has structural/ leverage problems…

 Survival Scenario: The firm survives and solves its structural problem
(brings down its financial leverage). In this scenario, margins improve
and the debt ratio returns to a sustainable level.
 Failure Scenario: The firm does not solve its structural problems or
fails to make debt payments, leading to default and liquidation.

Aswath Damodaran 7
+
Terminal
Forever
Cost
Weights
Value
Riskfree
Beta
R
X
Internet/
Operating
Base
Country
Current
Revenue
EBITDA/Sales
Stable
EBIT
NOL:
Revenues
$13,902 Cap
7G
24315689Term.
Beta
=$
0isk
16.80%
ex
lobalPremium
of
Equity
of
Growth
Year
4.8%+8.0%=12.8%
Debt=
+
T.
3.00>
4%
Retail
Leverage
D/E:
Premium
Margin:
Growth:
Revenue
EBITDA/
ROC=7.36%
-1895m
2,076m
and-> Cash
Bond
28,683
$November
Cost
EBITDA 30%
of441%
net
4,187
Equity
Debt
Risk
Op
Value=
Rate
growth
74.91%
1.10
&rate
cap
Equity
Assets
Non-op
: 677(.0736-.05)
slows
Crossing
3.00
$3,804
ex=($95)
4.8%
$$5,326
-> 40%
16.80%
5,530$6,923
3.00
$ 0 2,260
$16.80%
3.00 3.00
$8,308
16.80% $831
$346
3.00
$9,139
16.80% $1,371
16.80%
$10,053 $11,058
2.60 2.20
15.20% $2,322
$1,809
$11,942
1.80
13.60% $2,508
$12,659
1.40 $13,292
12.00% $3,038
1.00
10.40% $3,589
8.80%
2001
Tax
=
$
-49.82%
13.33%
Growth:
Sales
Reinvest
3,804
Value
decreases
$ 3,248
Cost
EBIT rate
of Debtof
5%
= 0%
Firm -> 35%
12.80%
($1,675) $ 7,790
12.80%
($1,738) 12.80% ($1,272)
($1,565) 12.80% $320
12.80% 11.84% $1,550
$1,074 10.88% $1,697
9.92% $2,186
8.96% $2,694
6.76%
Stock
$ Value
-EBIT
30%
67.93%
Debt 2,111
price =($1,675)
(1-t)of Debt
Ratio
$1.86($1,738)
74.91% $ 4,923
74.91% 74.91% ($1,272)
($1,565) 74.91% $320
74.91% 67.93% $1,550
$1,074 60.95% $1,697
53.96% $2,186
46.98% $2,276
40.00%
$+ Value
=
Cost of Equity
Depreciation
939
of Capital 13.80% $
$1,580 2867$1,911
13.80%
$1,738 13.80% $2,102
13.80% $1,051
13.80% 12.92% $773
$736 11.94% $811
10.88% $852
9.72% $894
7.98%
-$- Equity
Cap Ex Options
2,353 $3,431 $ $1,716 14$1,201 $1,261 $1,324 $1,390 $1,460 $1,533 $1,609 $1,690
Value
$- Chg
20 WCper share $0 $46 3.22$48
$ $42 $25 $27 $30 $27 $21 $19
$ 677
FCFF ($3,526) ($1,761) ($903) ($472) $22 $392 $832 $949 $1,407 $1,461

Aswath Damodaran 7
 The Going Concern Assumption

 Traditional valuation techniques are built on the assumption of a going

concern, I.e., a firm that has continuing operations and there is no
significant threat to these operations.
• In discounted cashflow valuation, this going concern assumption finds its
place most prominently in the terminal value calculation, which usually is
based upon an infinite life and ever-growing cashflows.
• In relative valuation, this going concern assumption often shows up
implicitly because a firm is valued based upon how other firms - most of
which are healthy - are priced by the market today.
 When there is a significant likelihood that a firm will not survive the
immediate future (next few years), traditional valuation models may
yield an over-optimistic estimate of value.

Aswath Damodaran 7
 DCF Valuation + Distress Value

 A DCF valuation values a firm as a going concern. If there is a

significant likelihood of the firm failing before it reaches stable
growth and if the assets will then be sold for a value less than the
present value of the expected cashflows (a distress sale value), DCF
valuations will understate the value of the firm.
 Value of Equity= DCF value of equity (1 - Probability of distress) +
Distress sale value of equity (Probability of distress)

Aswath Damodaran 8
 Bond Price to estimate probability of distress

 Global Crossing has a 12% coupon bond with 8 years to maturity trading at $ 653. To
estimate the probability of default (with a treasury bond rate of 5% used as the riskfree
rate):
t= 8
120(1− π Distress )t 1000(1− π Distress )8
653 = ∑ t
+ N
t=1 (1.05) (1.05)
 Solving for the probability of bankruptcy, we get
• With a 10-year bond, it is a process of trial and error to estimate this value. The solver
function in excel accomplishes the same in far less time.
Distress = Annual probability of default = 13.53%
€  To estimate the cumulative probability of distress over 10 years:
 Cumulative probability of surviving 10 years = (1 - .1353) 10 = 23.37%
 Cumulative probability of distress over 10 years = 1 - .2337 = .7663 or 76.63%

Aswath Damodaran 8
 Valuing Global Crossing with Distress

 Probability of distress
• Cumulative probability of distress = 76.63%
 Distress sale value of equity
• Book value of capital = $14,531 million
• Distress sale value = 25% of book value = .25*14531 = $3,633 million
• Book value of debt = $7,647 million
• Distress sale value of equity = $ 0
 Distress adjusted value of equity
• Value of Global Crossing = $3.22 (1-.7663) + $0.00 (.7663) = $ 0.75

Aswath Damodaran 8
 Real Options: Fact and Fantasy

Aswath Damodaran

Aswath Damodaran 8
 Underlying Theme: Searching for an Elusive
Premium

 Traditional discounted cashflow models under estimate the value of

investments, where there are options embedded in the investments to
• Delay or defer making the investment (delay)
• Adjust or alter production schedules as price changes (flexibility)
• Expand into new markets or products at later stages in the process, based
upon observing favorable outcomes at the early stages (expansion)
• Stop production or abandon investments if the outcomes are unfavorable
at early stages (abandonment)
 Put another way, real option advocates believe that you should be
paying a premium on discounted cashflow value estimates.

Aswath Damodaran 8
 Three Basic Questions

 When is there a real option embedded in a decision or an asset?

 When does that real option have significant economic value?
 Can that value be estimated using an option pricing model?

Aswath Damodaran 8
 When is there an option embedded in an
action?

 An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.
 There has to be a clearly defined underlying asset whose value
changes over time in unpredictable ways.
 The payoffs on this asset (real option) have to be contingent on an
specified event occurring within a finite period.

Aswath Damodaran 8
 Payoff Diagram on a Call

Net Payoff
on Call

Strike
Price

Price of underlying asset

Aswath Damodaran 8
 Example 1: Product Patent as an Option

PV of Cash Flows
from Project

Initial Investment in
Project

Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section

Aswath Damodaran 8
 Example 2: Undeveloped Oil Reserve as an
option

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran 8
 Example 3: Expansion of existing project as an
option

PV of Cash Flows
from Expansion

Additional Investment
to Expand

Present Value of Expected

Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section

Aswath Damodaran 9
 When does the option have significant
economic value?

 For an option to have significant economic value, there has to be a

restriction on competition in the event of the contingency. In a
perfectly competitive product market, no contingency, no matter how
positive, will generate positive net present value.
 At the limit, real options are most valuable when you have exclusivity
- you and only you can take advantage of the contingency. They
become less valuable as the barriers to competition become less steep.

Aswath Damodaran 9
 Exclusivity: Putting Real Options to the Test

 Product Options: Patent on a drug

• Patents restrict competitors from developing similar products
• Patents do not restrict competitors from developing other products to treat
the same disease.
 Natural Resource options: An undeveloped oil reserve or gold mine.
• Natural resource reserves are limited.
• It takes time and resources to develop new reserves
 Growth Options: Expansion into a new product or market
• Barriers may range from strong (exclusive licenses granted by the
government - as in telecom businesses) to weaker (brand name,
knowledge of the market) to weakest (first mover).

Aswath Damodaran 9
 Determinants of option value

 Variables Relating to Underlying Asset

• Value of Underlying Asset; as this value increases, the right to buy at a fixed price
(calls) will become more valuable and the right to sell at a fixed price (puts) will
become less valuable.
• Variance in that value; as the variance increases, both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
• Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reducing the value of calls and increasing the value of puts.
 Variables Relating to Option
• Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
• Life of the Option; both calls and puts benefit from a longer life.
 Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price
in the future becomes more (less) valuable.

Aswath Damodaran 9
 When can you use option pricing models to
value real options?

 All option pricing models rest on two foundations.

• The first is the notion of a replicating portfolio where you combine the underlying
asset and borrowing/lending to create a portfolio that has the same cashflows as the
option.
• The second is arbitrage. Since both the option and the replicating portfolio have the
same cashflows, they should trade at the same value.
 As a result, option pricing models work best when
• The underlying asset is traded - this yield not only observable prices and volatility
as inputs to option pricing models but allows for the possibility of creating
replicating portfolios
• An active marketplace exists for the option itself.
 When option pricing models are used to value real assets where neither
replication nor arbitrage are usually feasible, we have to accept the fact that
• The value estimates that emerge will be far more imprecise.
• The value can deviate much more dramatically from market price because of the
difficulty of arbitrage.

Aswath Damodaran 9
 Illustrating Replication: The Binomial Option
Pricing Model
K0=DD
25
35
50
Option
Stock
5
0
10
60
Call
100
Call
70 $=-40
-1.11
4.99
33.96
19.42
Details
1.11BB==33.96
1060
t =D
Price
25
50
35 2 - 1.11 B = 4.99
0
10
r ==11%
D 0.4,
1,
0.8278,
BB== 36.04
B9.01
= 21.61
Call = 0.8278
0.4
1 * 70
* 35
-*36.04
-50
9.01
- 21.61
==33.96
4.99
= 19.42

Aswath Damodaran 9
 The Black Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

where, 2
⎛S σ
ln ⎞ + (r + ) t
⎝K ⎠ 2
d1 =
σ t

• d2 = d1 -  √t
 The replicating portfolio is embedded in the Black-Scholes model. To
replicate this call, you would need to
• Buy N(d1) shares of stock; N(d1) is called the option delta
• Borrow K e-rt N(d2)

Aswath Damodaran 9
 The Normal Distribution
d N(d) d N(d) d N(d)
-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
N(d
d 1 1) -2.65
-2.60
0.0040
0.0047
-0.65
-0.60
0.2578
0.2743
1.40
1.45
0.9192
0.9265
-2.55 0.0054 -0.55 0.2912 1.50 0.9332
-2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.40 0.9918
-1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413

Aswath Damodaran 9
 1. Obtaining Inputs for Patent Valuation

Input Estimation Process

1. Value of the Underlying Asset • Present Value of Cash Inflows from taking project
now
• This will be noisy, but that adds value.
2. Variance in value of underlying asset • Variance in cash flows of similar assets or firms
• Variance in present value from capital budgeting
simulation.
3. Exercise Price on Option • Option is exercised when investment is made.
• Cost of making investment on the project
; assumed
to be constant in present value dollars.
4. Expiration of the Option • Life of the patent

5. Dividend Yield • Cost of delay

• Each year of delay translates into one less year of
value-creatingcashflows
1
Annual cost of delay=
n

Aswath Damodaran 9
 Valuing a Product Patent as an option: Avonex

 Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat

multiple sclerosis, for the next 17 years, and it plans to produce and
sell the drug by itself. The key inputs on the drug are as follows:
PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion
PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion
Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year [Link] rate)
Variance in Expected Present Values =2 = 0.224 (Industry average firm
variance for bio-tech firms)
Expected Cost of Delay = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512N(d2) = 0.2076
Call Value= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17) (0.2076)= $
907 million

Aswath Damodaran 9
 2. Valuing an Oil Reserve

 Consider an offshore oil property with an estimated oil reserve of 50

million barrels of oil, where the present value of the development cost
is $12 per barrel and the development lag is two years.
 The firm has the rights to exploit this reserve for the next twenty years
and the marginal value per barrel of oil is $12 per barrel currently
(Price per barrel - marginal cost per barrel).
 Once developed, the net production revenue each year will be 5% of
the value of the reserves.
 The riskless rate is 8% and the variance in ln(oil prices) is 0.03.

Aswath Damodaran 10
 Valuing an oil reserve as a real option

 Current Value of the asset = S = Value of the developed reserve

discounted back the length of the development lag at the dividend
yield = $12 * 50 /(1.05)2 = $ 544.22
 (If development is started today, the oil will not be available for sale
until two years from now. The estimated opportunity cost of this delay
is the lost production revenue over the delay period. Hence, the
discounting of the reserve back at the dividend yield)
 Exercise Price = Present Value of development cost = $12 * 50 =
$600 million
 Time to expiration on the option = 20 years
 Variance in the value of the underlying asset = 0.03
 Riskless rate =8%
 Dividend Yield = Net production revenue / Value of reserve = 5%

Aswath Damodaran 10
 Valuing Undeveloped Reserves

 Inputs for valuing undeveloped reserves

• Value of underlying asset = Value of estimated reserves discounted back for period
of development lag= 3038 * ($ 22.38 - $7) / 1.05 2 = $42,380.44
• Exercise price = Estimated development cost of reserves = 3038 * $10 = $30,380
million
• Time to expiration = Average length of relinquishment option = 12 years
• Variance in value of asset = Variance in oil prices = 0.03
• Riskless interest rate = 9%
• Dividend yield = Net production revenue/ Value of developed reserves = 5%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = 1.6548 N(d1) = 0.9510
d2 = 1.0548 N(d2) = 0.8542
 Call Value= 42,380.44 exp(-0.05)(12) (0.9510) -30,380 (exp(-0.09)(12) (0.8542)= $
13,306 million

Aswath Damodaran 10
 3. An Example of an Expansion Option

 Ambev is considering introducing a soft drink to the U.S. market. The

drink will initially be introduced only in the metropolitan areas of the
U.S. and the cost of this “limited introduction” is $ 500 million.
 A financial analysis of the cash flows from this investment suggests
that the present value of the cash flows from this investment to Ambev
will be only $ 400 million. Thus, by itself, the new investment has a
negative NPV of $ 100 million.
 If the initial introduction works out well, Ambev could go ahead with
a full-scale introduction to the entire market with an additional
investment of $ 1 billion any time over the next 5 years. While the
current expectation is that the cash flows from having this investment
is only $ 750 million, there is considerable uncertainty about both the
potential for the drink, leading to significant variance in this estimate.

Aswath Damodaran 10
 Valuing the Expansion Option

 Value of the Underlying Asset (S) = PV of Cash Flows from

Expansion to entire U.S. market, if done now =$ 750 Million
 Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000
Million
 We estimate the standard deviation in the estimate of the project value
by using the annualized standard deviation in firm value of publicly
traded firms in the beverage markets, which is approximately 34.25%.
• Standard Deviation in Underlying Asset’s Value = 34.25%
 Time to expiration = Period for which expansion option applies = 5
years
Call Value= $ 234 Million

Aswath Damodaran 10
 Opportunities and not Options…

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Aswath Damodaran 10
 Key Tests for Real Options

 Is there an option embedded in this asset/ decision?

• Can you identify the underlying asset?
• Can you specify the contigency under which you will get payoff?
 Is there exclusivity?
• If yes, there is option value.
• If no, there is none.
• If in between, you have to scale value.
 Can you use an option pricing model to value the real option?
• Is the underlying asset traded?
• Can the option be bought and sold?
• Is the cost of exercising the option known and clear?

Aswath Damodaran 10