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tourists, who are likely to stay away if the based upon
dollar strengthens tourist make up.


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3. Affected by success of movie and
broadcasting divisions.
Consumer Projects are likely to be short to medium term Debt should be
Products and linked to the success of the movie a. Medium term
division. Most of Disney™s product offerings b. Dollar debt.
are derived from their movie productions.

A Quantitative Approach
A quantitative approach estimates Disney™s sensitivity to changes in a number of
macro-economic variables, using two measures: Disney™s firm value (the market value of
debt and equity) and its operating income.
Value Sensitivity to Factors: Past Data
The value of a firm is the obvious choice when it comes to measuring its
sensitivity to changes in interest rates, inflation rates, or currency rates, because firm
value reflects the effect of these variables on current and future cash flows as well as on
discount rates. We begin by collecting past data on firm value, operating income and the
macroeconomic variables against which we want to measure its sensitivity. In the case of
the Disney, we choose four broad measures (See Table 9.12):
Long-term treasury bond rate, since the sensitivity of firm value to changes in interest

rates provides a measure of the duration of the projects. It also provides insight into
whether the firm should use fixed or floating rate debt; a firm whose operating
income changes with interest rates should consider using floating rate loans.
Real GDP, since the sensitivity of firm value to this variable provides a measure of

the cyclicality of the firm.
Currency rate, since the sensitivity of firm value to the currency rate provides a

measure of the exposure to currency rate risk and thus helps determine what the
currency mix for the debt should be.
Inflation rate, since the sensitivity of firm value to the inflation rate helps determine

whether the interest rate on the debt should be fixed or floating rate debt.
Table 9.12: Disney™s Firm Value and Macroeconomic Variables
%
Operating Firm T.Bond Change GDP % Chg in Change in Weighted Change in
Period Income CPI
value Rate in rate (Deflated) GDP CPI Dollar $
2003 $2,713 $68,239 4.29% 0.40% 10493 3.60% 2.04% 0.01% 88.82 -14.51%
2002 $2,384 $53,708 3.87% -0.82% 10128 2.98% 2.03% -0.10% 103.9 -3.47%


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2001 $2,832 $45,030 4.73% -1.20% 9835 -0.02% 2.13% -1.27% 107.64 1.85%
2000 $2,525 $47,717 6.00% 0.30% 9837 3.53% 3.44% 0.86% 105.68 11.51%
1999 $3,580 $88,558 5.68% -0.21% 9502 4.43% 2.56% 1.05% 94.77 -0.59%
1998 $3,843 $65,487 5.90% -0.19% 9099 3.70% 1.49% -0.65% 95.33 0.95%
1997 $3,945 $64,236 6.10% -0.56% 8774 4.79% 2.15% -0.82% 94.43 7.54%
1996 $3,024 $65,489 6.70% 0.49% 8373 3.97% 2.99% 0.18% 87.81 4.36%
1995 $2,262 $54,972 6.18% -1.32% 8053 2.46% 2.81% 0.19% 84.14 -1.07%
1994 $1,804 $33,071 7.60% 2.11% 7860 4.30% 2.61% -0.14% 85.05 -5.38%
1993 $1,560 $22,694 5.38% -0.91% 7536 2.25% 2.75% -0.44% 89.89 4.26%
1992 $1,287 $25,048 6.35% -1.01% 7370 3.50% 3.20% 0.27% 86.22 -2.31%
1991 $1,004 $17,122 7.44% -1.24% 7121 -0.14% 2.92% -3.17% 88.26 4.55%
1990 $1,287 $14,963 8.79% 0.47% 7131 1.68% 6.29% 1.72% 84.42 -11.23%
1989 $1,109 $16,015 8.28% -0.60% 7013 3.76% 4.49% 0.23% 95.10 4.17%
1988 $789 $9,195 8.93% -0.60% 6759 4.10% 4.25% -0.36% 91.29 -5.34%
1987 $707 $8,371 9.59% 2.02% 6493 3.19% 4.63% 3.11% 96.44 -8.59%
1986 $281 $5,631 7.42% -2.58% 6292 3.11% 1.47% -1.70% 105.50 -15.30%
1985 $206 $3,655 10.27% -1.11% 6102 3.39% 3.23% -0.64% 124.56 -10.36%
1984 $143 $2,024 11.51% -0.26% 5902 4.18% 3.90% -0.05% 138.96 8.01%
1983 $134 $1,817 11.80% 1.20% 5665 6.72% 3.95% -0.05% 128.65 4.47%
1982 $141 $2,108 10.47% -3.08% 5308 -1.61% 4% -4.50% 123.14 6.48%
Firm Value = Market Value of Equity + Book Value of Debt
Once these data have been collected, we can then estimate the sensitivity of firm value to
changes in the macroeconomic variables by regressing changes in firm value each year
against changes in each of the individual variables.

I. Sensitivity to changes in interest rates
As we discussed earlier, the duration of a firm™s projects provides useful
information for determining the maturity of its debt. While bond-based duration measures
may provide some answers, they will understate the duration of assets or projects if the
cash flows on these assets or projects themselves vary with interest rates. Regressing
changes in firm value against changes22 in interest rates over this period yields the
following result (with t statistics in brackets):
Change in Firm Value = 0.2081 - 4.16 (Change in Interest Rates)
(2.91) (0.75)
Based upon this regression, the duration of Disney™s projects collectively is about 4.16
years. If this were a reliable estimate, Disney should try to keep the duration of its bond




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issues to at least 3.71 years. Unfortunately, though, there is significant noise in the
estimate, and the coefficient is not a reliable estimate of duration.
II. Sensitivity to Changes in the Economy
Is Disney a cyclical firm? One way to answer this question is to measure the
sensitivity of firm value to changes in economic growth. Regressing changes in firm
value against changes in the real Gross Domestic Product (GDP) over this period yields
the following result:
Change in Firm Value = 0.2165 + 0.26 (GDP Growth)
(1.56) (0.07)
Disney™s value as a firm has not been affected significantly by economic growth. Again,
to the extent that we trust the coefficients from this regression, this would suggest that
Disney is not a cyclical firm.
III. Sensitivity to Changes in the Inflation Rates
We earlier made the argument, based upon asset/liability matching, that firms
whose values tend to move with inflation should be more likely to issue floating rate
debt. To examine whether Disney fits this pattern, we regressed changes in firm value
against changes in the inflation rate over this period with the following result:
Change in Firm Value = 0.2262 + 0.57 (Change in Inflation Rate)
(3.22) (0.13)
Disney˜s firm value is unaffected by changes in inflation since the coefficient on
inflation is not statistically different from zero. Since interest payments have to be made
out of operating cash flows, we will also have to look at how operating income changes
with inflation before we can make a final decision on this issue.

IV. Sensitivity to Changes in the Dollar
We can answer the question of how sensitive Disney™s value is to changes in
currency rates by looking at how the firm™s value changes as a function of changes in
currency rates. Regressing changes in firm value against changes in the dollar over this
period yields the following regression:


22 To ensure that the coefficient on this regression is a measure of duration, we compute the change in the
interest rate as follows: (rt “ rt-1)/(1+rt-1). Thus, if the long term bond rate goes from 8% to 9%, we compute



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Change in Firm Value = 0.2060 -2.04 (Change in Dollar)
(3.40) (2.52)
Statistically, this yields the strongest relationship. Disney™s firm value decreases
as the dollar strengthens.. If this pattern continues, Disney should consider using non-
dollar debt. If it had not been very sensitive to exchange rate changes, Disney could have
issued primarily dollar debt.
Cash Flow Sensitivity to Factors: Past Data
In some cases, it is more reasonable to estimate the sensitivity of operating cash
flows directly against changes in interest rates, inflation, and other variables. This is
particularly the case when we are designing interest payments on debt, since these
payments to be made out of operating income. For instance, while our regression of firm
value against inflation rates showed a negative relationship and led to the conclusion that
Disney should not issue floating rate debt, we might reverse our view if operating income
were positively correlated with inflation rates. For Disney, we repeated the analysis using
operating income as the dependent variable, rather than firm value. Since the procedure
for the analysis is similar, we summarize the conclusions below:
Regressing changes in operating cash flow against changes in interest rates over this

period yields the following result “
Change in Operating Income = 0.2189 + 6.59 (Change in Interest Rates)
(2.74) (1.06)
Disney™s operating income, unlike its firm value, has moved with interest rates.
Again, this result has to be considered in light of the low t statistics on the
coefficients. In general, regressing operating income against interest rate changes
should yield a lower estimate of duration than the firm value measure, for two
reasons. One is that income tends to be smoothed out relative to value, and the other
is that the current operating income does not reflect the effects of changes in interest
rates on discount rates and future growth.
Regressing changes in operating cash flow against changes in Real GDP over this

period yields the following regression “



the change to be (.09-.08)/1.08.


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Change in Operating Income = 0.1725 + 0.66 ( GDP Growth)
(1.10) (0.15)
Disney™s operating income, like its firm value, does not reflect any sensitivity to
overall economic growth, confirming the conclusion that Disney is not a cyclical
firm.
Regressing changes in operating cash flow against changes in the dollar over this

period yields the following regression “
Change in Operating Income = 0.1768 -1.76 ( Change in Dollar)
(2.42) (1.81)
Disney™s operating income, like its firm value, is negatively affected by a stronger
dollar.
Regressing changes in operating cash flow against changes in inflation over this

period yields the following result “
Change in Operating Income = 0.2192 +9.27 ( Change in Inflation Rate)
(3.01) (1.95)
Unlike firm value which is unaffected by changes in inflation, Disney™s operating
income moves strongly with inflation, rising as inflation increases. This would
suggest that Disney has substantial pricing power, allowing it to transmit inflation
increases into its prices and operating income. This makes a strong case for the use
of floating rate debt.
The question of what to do when operating income and firm value have different results
can be resolved fairly simply. For issues relating to the overall design of the debt, the
firm value regression should be relied on more; for issues relating to the design of interest
payments on the debt, the operating income regression should be used more. Thus, for the
duration measure, the regression of firm value on interest rates should, in general, give a
more precise estimate. For the inflation rate sensitivity, since it affects the choice of
interest payments (fixed or floating), the operating income regression should be relied on
more.

Bottom up Estimates for Debt Design
While this type of analysis yields quantitative results, those results should be
taken with a grain of salt. They make sense only if the firm has been in its current


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business for a long time and expects to remain in it for the foreseeable future. In today™s
environment, in which firms find their business mixes changing dramatically from period
to period as they divest some businesses and acquire new ones, it is unwise to base too
many conclusions on a historical analysis. In such cases, we might want to look at the
characteristics of the industry in which a firm plans to expand, rather than using past
earnings or firm value as a basis for the analysis. Furthermore, the small sample sizes
used tend to yield regression estimates that are not statistically significant (as is the case
with the duration estimate that we obtained for Disney from the firm value regression).
To illustrate, we looked at the sector estimates23 for each of the sensitivity
measures for the entertainment, theme park and consumer product businesses:
Coefficients on firm value regression
Interest Rates GDP Growth Inflation Currency Disney
Weights
Movies -3.70 0.56 1.41 -1.23 25.62%
Theme Parks -6.47 0.22 -1.45 -3.21 20.09%
Broadcasting -4.50 0.70 -3.05 -1.58 49.25%
Consumer
Products -4.88 0.13 -5.51 -3.01 5.04%
Disney -4.71 0.54 -1.71 -1.89 100%

These bottom-up estimates suggest that Disney should be issuing long term fixed-rate
debt with a duration of 4.71 years, and that firms in this sector are relatively unaffected
by both the overall economy. Like Disney, firms in these businesses tend to be hurt by a
stronger dollar, but,, unlike Disney, they do not seem have much pricing power (note the
negative coefficient on inflation. The sector averages also have the advantage of more
precision than the firm-specific estimates and can be relied on more.
Overall Recommendations
Based upon the analyses of firm value and operating income, as well as the sector
averages, our recommendations would essentially match those of the intuitive approach,




23These sector estimates were obtained by aggregating the firm values of all firms in a sector on a quarter-
by-quarter basis going back 12 years, and then regressing changes in this aggregate firm value against
changes in the macro-economic variable each quarter.


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but they would have more depth to because of the additional information we have
acquired from the quantitative analysis:
The debt issued should be long term and should have duration of between 4 and 5

years.
A significant portion of the debt should be floating rate debt, reflecting Disney™s

capacity to pass inflation through to its customers and the fact that operating income
tends to increase as interest rates go up.
Given Disney™s sensitivity to a stronger dollar, a portion of the debt should be in

foreign currencies. The specific currency used and the magnitude of the foreign
currency debt should reflect where Disney makes its revenues. Based upon 2003
numbers at least, this would indicate that about 20% of the debt should be in Euros
and about 10% of the debt in Japanese Yen reflecting Disney™s larger exposures in
Europe and Asia. As its broadcasting businesses expand into Latin America, it may

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