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ICFI. The Weighted Average Cost of Capital. By : Else Fernanda, SE.Ak., M.Sc. Valuation Method. Valuation Method. Market Comparable. Dividend Discount Model. DCF : Discounted Cash Flow Method. Other Method.

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the weighted average cost of capital

ICFI

The Weighted Average Cost of Capital

By : Else Fernanda, SE.Ak., M.Sc.

valuation method
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 method1
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
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
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
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
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 ddm1
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
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 dcf1
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
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: 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
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
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
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 wacc1
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

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 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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