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The Weighted Average Cost of CapitalPowerPoint Presentation

The Weighted Average Cost of Capital

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Valuation Method

Valuation Method

Market

Comparable

Dividend Discount

Model

DCF: Discounted

Cash Flow Method

Other

Method

- Comparing the firms with public company in the related industry, comparable size and relevant firms characteristic;
- Examples:
- PBV: Price to Book Value
- EV/EBITDA: Enterprise value to EBITDA
- PER: Price Earning Ratio

- Discounting the future expected dividend;
- Only recommended for company who has stable operation and stable dividend in the past history;

- Most commonly used in corporate finance;
- Based on comprehensive financial model;
- Value is derived from future free cash flow...
- ...discounted with cost of capital;
- Value is very sensitive toward cost of capital & growth;

- EVA: Economic Value Added. Used to be very popular in the 90s;
- In principle, similar with DCF method;

Valuation Method

Market

Comparable

Dividend Discount

Model

DCF: Discounted

Cash Flow Method

- See through the eyes of investors;
- Simple and straight forwards;

- Simple;

- Detail and tailor-made;
- Accommodate uniqueness, future strategy, and corporate action;

Advantage

- Can not be used if there is no comparable public companies;
- Neglect firms uniqueness;

- Oversimplify the real condition;
- Only applicable for mature firm with stable income and operate under stable economic landscape;

- Lengthy process;
- Open ended bias.....wrong assumption on growth rate and discount factor;

Drawback

Market Comparables

PER

- PER: Price Earning Ratio;
- Very fluctuate, but easy to calculate and to understand;
- Subject to financial engineering;

Market comparable, normally only used for sanity check, to ensure if the valuation using DCF valuation is make sense or inline with market practice

PBV

- PBV: Price to Book Value; Very stable;
- Less forward looking, doesn’t take into account future prospect;
- Suitable for company who rely on assets as well as has less variability of profit margin in compare to peers in the sector;

EV/EBITDA

- EV/EBITDA: Ratio between Enterprise Value & EBITDA;
- EBITDA is relatively difficult to manipulate;
- Taking into account future prospect;

Market Comparable - Example

Company D is excluded, since the number is so much difference with the others. It is an outlier.

AVERAGE comes from A, B, and E only

Value of XXX is:

Rp 1,681 – Rp 2,196 bn

Personally, I prefer to use EV/EBITDA

- 1,681 = 3.36 x 500

- 1,838 = 6.13 x 300

- 2,196 = 2.20 x 1,000

Dividend Discount Model (DDM)

- Valuing a firm, using dividend as free cash flow;
- The drawback of DDM: (1) DPS is difficult to measure and tend to fluctuate; (2) Sensitive to Discount Rate;

DDM

DPS

Value of Stock: --------

R - G

DPS: Expected Dividend during next year;

R: Required rate of return for equity investors;

G: Growth rate in dividend forever;

R: is equivalent with Re (Return on equity)

Re = Rf + β(Rm – Rf)

Rf = Risk free rate;

β = Betha, slope between Rm and Re

Rm = Return market

DDM: Multi Stages

Mature & stable

Transition

Preliminary

DPS

Value 3 : -----------

(Re – G)

D2n

Value 2 : ------------

(1+Re2)n

D1n

Value 1 : ------------

(1+Re1)n

Dividend Discount Model (DDM)

DDM

- Valuing a firm, using dividend as free cash flow;
- The drawback of DDM: (1) DPS is difficult to measure and tend to fluctuate; (2) Sensitive to Discount Rate;

DPS

Value of Stock: --------

R - G

DPS: Expected Dividend during next year;

R: Required rate of return for equity investors;

G: Growth rate in dividend forever;

R: is equivalent with Re (Return on equity)

Re = Rf + β(Rm – Rf)

Rf = Risk free rate;

β = Betha, slope between Rm and Re

Rm = Return market

G: calculated as (1-DPR) x ROE

DPR = Dividend Payout Ratio

Discounted Cash Flow (DCF)

- Calculate Invested Capital (including debt);
- Calculate Value Driver (revenue, cost, etc);

Analyze historical Performance

Forecast Performance

- Understand strategic position, market share, cost composition; Calculate Free Cash Flow;
- Check overal forecast reasonableness, using common size analysis;

Estimate Cost of Capital (WACC)

- Calculate cost of debt, cost of equity and WACC;
- Be careful on debt to equity ratio...should be reasonable;

Estimate Perpetual Value

- Select appropriate technique and estimate horizon;
- Discount perpetual value to present;

Calculate and interpret Result

- Run the calculation, double check if it is unreasonable;
- Compare with market comparable valuation method;

Discounted Cash Flow (DCF)

FCF1

FCF2

FCF3

FCF4

FCF5

FCF6

FCF7

FCF8

FCF9

FCF10

Perpetual Value

or

Terminal Value

Present Value

of FCF

- Firm/Enterprise value is the accumulation of Present Value of Free Cash Flow (FCF) and Present Value of Perpetual Value;
- Equity Value = Enterprise Value – Debt
- Market Capitalization = Enterprise Value

Present Value

of Terminal Value

Firm Value

Component of DCF

Enterprise Value

Financial Projection

WACC

Terminal Value

- Create financial projection, could be full model or cash flow only;
- Determine Free Cash Flow To Firm for the next 10 years (could be more or less);

- Calculate WACC (Weighted Average Cost of Capital);
- WACC is the discount rate to calculate Present Value of Free Cash Flow and Terminal Value

- Calculate Terminal Value or Perpetual Value....
- ....using market comparable at year XX (say 10), or assuming the company operate perpetually;

We have learned this

WACC: Cost of Financing & Risk Free

WACC:

- WACC: Weighted Average Cost of Capital;
- Capital = Debt + Equity
- Wd = proportion of debt = Debt / Total Capital
- We = proportion of equity = Equity / Total Capital
- Cost of Debt (Rd) = Interest Rate of the Debt x (1 – tax rate);
- Cost of Equity (Re) = Rf + β (Rm – Rf)

Cost of Debt

- Debt is cheaper than equity. Rd < Re;
- Why we should multiply Rd with (1- Tax Rate)?....
- .....because the interest we paid will reduce the taxable income (interest is part of non operating income)....
- .....the higher the interest rate, the lower the tax we should pay;

Risk Free Rate

- Risk Free Rate: using SBI rate;
- Current rate is around 6.5%;

WACC: Cost of Equity

- Cost of Equity (Re) = Rf + β (Rm – Rf)
- Rf = Risk free rate.....the return of risk free investment, such as government bond, SBI, etc;
- Rm = Return market, in this case....we use IHSG return;
- β is the association or slope of return between Rm and Re.....
- ....pls refer to CAPM principle

Cost of Equity

Re

β

Re = Rf + β (Rm – Rf)

1

Rf

Rm

WACC: Calculating ß

Return: IHSG vs. Stock A

β = 1.86

Re

1

Rm

The slope between Rm and Re is 1.86. This slope is called Betha

Usually, Betha is calculated using 3 years historical data;

WACC: Calculating WACC

Re

Rf

β

Rm

Rf

- Risk Free Rate;
- Using SBI;
- Around 6.4%

- The slope between Rm & Re
- Depend on industry or sector or companies;
- For our discussion, we use 1.86 (see previous slides)

- Market return;
- The annual return of IHSG;
- For this case we us 11.68%

- Risk Free Rate;
- Using SBI;
- Around 6.4%

16.2%

6.4%

1.86

11.68%

6.4%

WACC: Calculating WACC

Data

- Cost of Equity = 16.2% (Re)
- Cost of Debt = 12% (Rd)
- Tax rate = 30%
- Debt amount = Rp 400 bn; proportion = 40% (Wd)
- Equity amount = Rp 600 bn; proportion = 60% (We)

WACC:

- WACC = We x Re + Wd x Rd x (1 – Tax)
- WACC = 60% x 16.2% + 40% x 12% x (1 – 30%)
- WACC = 9.7% + 3.4%
- WACC = 13.1%
- We use 13.1% as the discount factor

Free Cash Flow

Free Cash Flow to Firm

Free Cash Flow to Equity

FCF To Firm =

EBIT (1-Tax rate)

+ Depreciation

– Capital Expenditure

– Increase in inventory

– Increase in receivable

+ Increase in payable

FCF To Equity =

Free Cash Flow To Firm

– Interest (1 – Tax Rate)

– Principal repaid

+ New Debt isssue

– Preferred Dividend

FCF To Equity =

Net Income

+ Depreciation

– Capital Expenditure

– Increase in inventory

– Increase in receivable

+ Increase in payable

– Principal repayment

+ New Debt isssue

– Preferred Dividend

Present Value of (FCFF + Terminal Value) = EV

Present Value of (FCFE + Terminal Value) = Equity Value

Enterprise Value = Debt + Equity Value

Perpetual of Terminal Value

- Perpetual Value or Terminal Value is the Value of Continuing Firm;
- We assume that the firm will survive forever....
- ....or will be sold at a certain year (i.e. year 11)

Definition

- Free Cash Flow (year 11)
- Perpetual Value (year 11) = ---------------------------------
- (WACC – G)
- G = Perpetual Growth = (1 – DPR) x ROE
- DPR = Dividend Payout Ratio = Dividend / Net Income
- ROE = Return on Equity = Net Income / Equity

Calculation

(1)

- Assuming the company will be sold at year 11;
- Perpetual Value = EBITDA x (EV/EBITDA)
- EBITDA....use EBITDA at year 11;
- EV/EBITDA.....use market comparable;

Calculation

(2)

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