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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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