The operating income that should be used to arrive at

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The operating income that should be used to arrive at an optimal debt ratio is a “normalized” operating income n A normalized operating income is the income that this firm would make in a normal year. For a cyclical firm, this may mean using the average operating income over an economic cycle rather than the latest year’s income For a firm which has had an exceptionally bad or good year (due to some firm-specific event), this may mean using industry average returns on capital to arrive at an optimal or looking at past years For any firm, this will mean not counting one time charges or profits
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Aswath Damodaran 62 Analyzing a Private Firm n 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 do not trade 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.
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Aswath Damodaran 63 Estimating the Optimal Debt Ratio for a Private Software Firm n We first estimate the market value of the firm using the average Value/EBITDA multiple of 21.8 for the software industry and the EBITDA for InfoSoft of $ 3 million: Firm Value = $ 3 million * 21.8 = $ 65.4 million n We then estimate a synthetic rating for the firm, using its current interest coverage ratio and the ratings table designed for smaller and riskier firms. The current interest coverage ratio for InfoSoft was: Interest Coverage Ratio = EBIT / Interest Expense = $ 2 million/$ 315,000 = 6.35
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Aswath Damodaran 64 Interest Coverage Ratios, Spreads and Ratings: Small Firms Interest Coverage Ratio Rating Spread over T Bond Rate > 12.5 AAA 0.20% 9.50-12.50 AA 0.50% 7.5 - 9.5 A+ 0.80% 6.0 - 7.5 A 1.00% 4.5 - 6.0 A- 1.25% 3.5 - 4.5 BBB 1.50% 3.0 - 3.5 BB 2.00% 2.5 - 3.0 B+ 2.50% 2.0 - 2.5 B 3.25% 1.5 - 2.0 B- 4.25% 1.25 - 1.5 CCC 5.00% 0.8 - 1.25 CC 6.00% 0.5 - 0.8 C 7.50% < 0.5 D 10.00%
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Aswath Damodaran 65 Optimal Debt Ratio for InfoSoft Debt Ratio Beta Cost of Equity Rating Interest rate Cost of Debt (After-tax) Cost of Capital 0% 1.43 12.87% AAA 5.20% 3.02% 12.87% 10% 1.52 13.38% A- 6.25% 3.63% 12.40% 20% 1.64 14.01% B- 9.25% 5.37% 12.28% 30% 1.82 15.02% CC 11.00% 7.00% 12.61% 40% 2.16 16.86% C 12.50% 9.50% 13.91% 50% 2.63 19.48% D 15.00% 12.60% 16.04% 60% 3.29 23.10% D 15.00% 13.00% 17.04% 70% 4.39 29.13% D 15.00% 13.29% 18.04% 80% 6.58 41.20% D 15.00% 13.50% 19.04% 90% 13.16 77.40% D 15.00% 13.67% 20.04%
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Aswath Damodaran 66 Determinants of Optimal Debt Ratios n Firm Specific Factors 1. Tax Rate Higher tax rates - - > Higher Optimal Debt Ratio Lower tax rates - - > Lower Optimal Debt Ratio 2. Cash flow generation = EBITDA / MV of Firm Higher Pre-tax Returns - - > Higher Optimal Debt Ratio Lower Pre-tax Returns - - > Lower Optimal Debt Ratio 3. Variance in Earnings [ Shows up when you do 'what if' analysis] Higher Variance - - > Lower Optimal Debt Ratio Lower Variance - - > Higher Optimal Debt Ratio n Macro-Economic Factors 1. Default Spreads Higher - - > Lower Optimal Debt Ratio Lower - - > Higher Optimal Debt Ratio
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Aswath Damodaran 67 6 Application Test: Your firm’s optimal financing mix n Using the optimal capital structure spreadsheet provided: Estimate the optimal debt ratio for your firm Estimate the new cost of capital at the optimal
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