The Weighted Average Cost of CapitalThe Weighted Average Cost of Capital

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

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Valuation 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

Valuation Method

Market Comparable

Dividend DiscountModel

DCF: DiscountedCash Flow Method

OtherMethod

•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;

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Valuation Method

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

Market Comparable

Dividend DiscountModel

DCF: DiscountedCash Flow Method

• 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

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Market Comparables

PER: Price Earning Ratio; Very fluctuate, but easy to calculate and to

understand; Subject to financial engineering;

PER

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;

PBV

EV/EBITDA: Ratio between Enterprise Value & EBITDA;

EBITDA is relatively difficult to manipulate; Taking into account future prospect;

EV/EBITDA

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

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Market Comparable - ExampleValuing Company XXXData on the Performance of Company XXX and Comparable Firms (F2010)

1 Company A 2,000 500 1,000 300 150 500 2 Company B 500 2,400 1,200 400 210 575 4 Company D 1,500 200 300 300 200 700 5 Company E 2,500 300 750 200 125 300

6 Company XXX 500 300 1,000

Market Comparable Data (F2010)

1 Company A 3.33 6.67 2.00 2 Company B 3.00 5.71 2.09 4 Company D 1.00 1.50 0.43 5 Company E 3.75 6.00 2.50

AVERAGE: 3.36 6.13 2.20

Valuation of XXXValue of XXX (Rp bn) 1,681 1,838 2,196

Net Income

Book Value (Rp

EV/EBITDA (x)

PER (x) PBV (x)No Company

# Stock (mn)

CompanyNoStock Price

(Rp) EV (Rp bn)EBITDA (Rp bn)

• 1,681 = 3.36 x 500

• 1,838 = 6.13 x 300 • 2,196 = 2.20 x 1,000

Value of XXX is:Rp 1,681 – Rp 2,196 bnPersonally, I prefer to use EV/EBITDA

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

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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

DPSValue 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

ReRm = Return market

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DDM: Multi Stages

D1nValue 1 : ------------ (1+Re1)n

D2nValue 2 : ------------ (1+Re2)n

DPSValue 3 : ----------- (Re – G)

Preliminary

TransitionMature & stable

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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

DPSValue 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

ReRm = Return market

G: calculated as (1-DPR) x ROEDPR = Dividend Payout Ratio

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Discounted Cash Flow (DCF)

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

Analyze historical

Performance

Forecast Performance

Estimate Cost of Capital (WACC)

Estimate Perpetual

Value

Calculate and interpret

Result

Understand strategic position, market share, cost composition; Calculate Free Cash Flow;

Check overal forecast reasonableness, using common size analysis;

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

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

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

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Discounted Cash Flow (DCF)

FCF1 FCF2 FCF3 FCF4 FCF5 FCF6 FCF7 FCF8 FCF9 FCF10

Perpetual Valueor

Terminal ValuePresent Valueof FCF

Present Value

of Terminal

Value

Firm Value

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

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Component of DCF

Enterprise 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);

Financial Projection Calculate WACC

(Weighted Average Cost of Capital);

WACC is the discount rate to calculate Present Value of Free Cash Flow and Terminal Value

WACC Calculate Terminal

Value or Perpetual Value....

....using market comparable at year XX (say 10), or assuming the company operate perpetually;

Terminal Value

We have learned this

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WACC: Cost of Financing & Risk Free

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)

WACC:

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;

Cost of Debt

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

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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

Rm

1

β

Rf

Re = Rf + β (Rm – Rf)

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WACC: Calculating ß

Re

Rm

1β = 1.86

Return: IHSG vs. Stock A

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

Usually, Betha is calculated using 3 years historical data;

Market Stock A Market Stock AJan-09 1,800 1,980 1.1% 3.0%Feb-09 1,820 2,020 1.1% 2.0%Mar-09 1,840 2,080 1.1% 3.0%Apr-09 1,850 2,035 0.5% -2.2%

May-09 1,870 2,120 1.1% 4.2%Jun-09 1,885 2,200 0.8% 3.8%Jul-09 1,905 2,200 1.1% 0.0%

Aug-09 1,925 2,120 1.0% -3.6%Sep-09 1,945 2,100 1.0% -0.9%Oct-09 1,960 2,150 0.8% 2.4%Nov-09 1,975 2,180 0.8% 1.4%Dec-09 1,990 2,120 0.8% -2.8%Jan-10 2,005 2,250 0.8% 6.1%Feb-10 2,035 2,300 1.5% 2.2%Mar-10 2,055 2,400 1.0% 4.3%

Return 11.68% 15.38%

Index ReturnMonth

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WACC: Calculating WACC

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

Re Rf β Rm Rf

•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%

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WACC: Calculating 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

WACC:

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)

Data

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Free Cash Flow

FCF To Firm = EBIT (1-Tax rate) + Depreciation – Capital Expenditure – Increase in inventory – Increase in receivable+ Increase in payable

Free Cash Flow to Firm Free Cash Flow to Equity

FCF To Equity = Free Cash Flow To Firm– Interest (1 – Tax Rate)– Principal repaid+ 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

FCF To Equity = Net Income+ Depreciation– Capital Expenditure– Increase in inventory – Increase in receivable+ Increase in payable– Principal repayment+ New Debt isssue– Preferred Dividend

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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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Profit & LossProfit & LossProject INITIAL

unit 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Revenue Rp mn - - - 5,000,000 7,800,000 8,640,000 9,520,000 10,440,000 11,400,000 12,400,000 12,800,000

COGSMaterial, Labor, Energy Rp mn - - - 3,700,000 5,850,000 6,560,000 7,310,000 8,100,000 8,930,000 9,800,000 10,200,000 Depreciation Rp mn 27,778 55,556 66,667 66,667 66,667 66,667 66,667 66,667 66,667 66,667 66,667

Sub total: Rp mn 27,778 55,556 66,667 3,766,667 5,916,667 6,626,667 7,376,667 8,166,667 8,996,667 9,866,667 10,266,667

Gross Profit Rp mn (27,778) (55,556) (66,667) 1,233,333 1,883,333 2,013,333 2,143,333 2,273,333 2,403,333 2,533,333 2,533,333 Gross Profit Margin % 0.0% 0.0% 0.0% 24.7% 24.1% 23.3% 22.5% 21.8% 21.1% 20.4% 19.8%

Operating ExpensesHead office Rp mn 15,000 15,000 15,000 25,000 35,000 45,000 55,000 65,000 75,000 85,000 95,000 Marketing & Promotion Rp mn - - 100,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 Depreciation Rp mn 5,556 13,611 17,361 22,361 28,611 33,611 38,611 43,611 48,611 53,611 58,611

Sub total: Rp mn 20,556 28,611 132,361 197,361 213,611 228,611 243,611 258,611 273,611 288,611 303,611

Operating Profit (EBIT) Rp mn (48,333) (84,167) (199,028) 1,035,972 1,669,722 1,784,722 1,899,722 2,014,722 2,129,722 2,244,722 2,229,722 EBITDA Rp mn (15,000) (15,000) (115,000) 1,125,000 1,765,000 1,885,000 2,005,000 2,125,000 2,245,000 2,365,000 2,355,000

Operating Margin %

Non Operating ExpensesInterest expenses Rp mn 18,750 67,500 120,000 141,000 109,500 39,750 - - - - -

Earning Before Tax Rp mn (67,083) (151,667) (319,028) 894,972 1,560,222 1,744,972 1,899,722 2,014,722 2,129,722 2,244,722 2,229,722

Taxable Income Rp mn - - - 357,194 1,560,222 1,744,972 1,899,722 2,014,722 2,129,722 2,244,722 2,229,722

Tax 30% Rp mn - - - 107,158 468,067 523,492 569,917 604,417 638,917 673,417 668,917

Net Income Rp mn (67,083) (151,667) (319,028) 787,814 1,092,156 1,221,481 1,329,806 1,410,306 1,490,806 1,571,306 1,560,806

Retained Earning Rp mn (67,083) (218,750) (537,778) 250,036 1,342,192 2,563,672 3,893,478 5,303,783 6,794,589 8,365,894 9,926,700 Dividend Rp mn - - - 236,344 327,647 366,444 398,942 423,092 447,242 471,392 468,242

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Balance Sheet

Balance SheetProject INITIAL

unit 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Cash Rp mn 16,250 123,750 173,750 24,248 39,034 308,348 1,177,490 2,096,982 3,066,823 4,087,015 5,189,857 Account Receivable Rp mn - - - 1,250,000 1,950,000 2,160,000 2,380,000 2,610,000 2,850,000 3,100,000 3,200,000 Inventory Rp mn - - - 500,000 780,000 864,000 952,000 1,044,000 1,140,000 1,240,000 1,280,000 Net Fixed Assets Value Rp mn 566,667 1,107,500 1,238,472 1,169,444 1,099,167 1,028,889 958,611 888,333 818,056 747,778 677,500

Assets Rp mn 582,917 1,231,250 1,412,222 2,943,692 3,868,201 4,361,237 5,468,101 6,639,315 7,874,879 9,174,793 10,347,357

Account Payable Rp mn - - - 1,000,000 1,560,000 1,728,000 1,904,000 2,088,000 2,280,000 2,480,000 2,560,000 Loan Rp mn 250,000 650,000 950,000 930,000 530,000 - - - - - -

Paid up Capital Rp mn 400,000 800,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Retained Earning Rp mn (67,083) (218,750) (537,778) 13,692 778,201 1,633,237 2,564,101 3,551,315 4,594,879 5,694,793 6,787,357

Liabilities & Equities Rp mn 582,917 1,231,250 1,412,222 2,943,692 3,868,201 4,361,237 5,468,101 6,639,315 7,874,879 9,174,793 10,347,357

Check Balance Rp mn - - - - - - - - - - -

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Cash FlowCash FlowProject INITIAL

unit 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Cash Flow from OperationNet Income Rp mn (67,083) (151,667) (319,028) 787,814 1,092,156 1,221,481 1,329,806 1,410,306 1,490,806 1,571,306 1,560,806 Add back

Depreciation Rp mn 33,333 69,167 84,028 89,028 95,278 100,278 105,278 110,278 115,278 120,278 125,278 Inventory Rp mn - - - (500,000) (280,000) (84,000) (88,000) (92,000) (96,000) (100,000) (40,000) Account Payable Rp mn - - - 1,000,000 560,000 168,000 176,000 184,000 192,000 200,000 80,000 Account Receivable Rp mn - - - (1,250,000) (700,000) (210,000) (220,000) (230,000) (240,000) (250,000) (100,000)

Sub total: Rp mn (33,750) (82,500) (235,000) 126,842 767,433 1,195,758 1,303,083 1,382,583 1,462,083 1,541,583 1,626,083

Cash Flow from InvestmentProduction Facility Rp mn (500,000) (500,000) (200,000) - - - - - - - - Office Building Rp mn (100,000) (100,000) - - - - - - - - - Car & Office Equipment Rp mn - (10,000) (15,000) (20,000) (25,000) (30,000) (35,000) (40,000) (45,000) (50,000) (55,000)

Sub Total: Rp mn (600,000) (610,000) (215,000) (20,000) (25,000) (30,000) (35,000) (40,000) (45,000) (50,000) (55,000)

Cash Flow from FinancingPaid up Capital Rp mn 400,000 400,000 200,000 - - - - - - - - Dividend Payment Rp mn - - - (236,344) (327,647) (366,444) (398,942) (423,092) (447,242) (471,392) (468,242) Loan

Withdrawal Rp mn 250,000 400,000 300,000 - - - - - - - - Repayment Rp mn - - - (20,000) (400,000) (530,000) - - - - -

Sub total: Rp mn 650,000 800,000 500,000 (256,344) (727,647) (896,444) (398,942) (423,092) (447,242) (471,392) (468,242)

Net Cash Flow Rp mn 16,250 107,500 50,000 (149,503) 14,787 269,314 869,142 919,492 969,842 1,020,192 1,102,842

Cash FlowBeginning Rp mn - 16,250 123,750 173,750 24,248 39,034 308,348 1,177,490 2,096,982 3,066,823 4,087,015 Additional Rp mn 16,250 107,500 50,000 (149,503) 14,787 269,314 869,142 919,492 969,842 1,020,192 1,102,842 Ending Rp mn 16,250 123,750 173,750 24,248 39,034 308,348 1,177,490 2,096,982 3,066,823 4,087,015 5,189,857

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Valuation (1)

ValuationProject INITIAL

unit 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

EBIT (1-Tax) Rp mn (33,833) (58,917) (139,319) 725,181 1,168,806 1,249,306 1,329,806 1,410,306 1,490,806 1,571,306 1,560,806 Add Depreciation Rp mn 33,333 69,167 84,028 89,028 95,278 100,278 105,278 110,278 115,278 120,278 125,278 Deduct Capital Expenditure Rp mn (600,000) (610,000) (215,000) (20,000) (25,000) (30,000) (35,000) (40,000) (45,000) (50,000) (55,000) Deduct Increase in Inventory Rp mn - - - (500,000) (280,000) (84,000) (88,000) (92,000) (96,000) (100,000) (40,000) Deduct Increase in Receivable Rp mn - - - (1,250,000) (700,000) (210,000) (220,000) (230,000) (240,000) (250,000) (100,000) Add Increase in Payable Rp mn - - - (1,000,000) (560,000) (168,000) (176,000) (184,000) (192,000) (200,000) (80,000)

Free Cash Flow To Firm Rp mn (600,500) (599,750) (270,292) (1,955,792) (300,917) 857,583 916,083 974,583 1,033,083 1,091,583 1,411,083

Perpetual Value Rp mn 12,588,222 Free Cash Flow To Firm 1,439,305 Perpetual Growth 2%WACC 13.4%

1 2 3 4 5 6 7 8 9 10 11 12Present Value Rp mn (529,384) (466,107) (185,185) (1,181,282) (160,227) 402,553 379,087 355,534 332,242 309,481 352,686 2,773,685

EV Rp mn 2,383,084

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Valuation (2)

WACC CalculationDebt

Interest Rate % 15%Amount (D) Rp mn 950,000 Tax Rate % 30%

EquityAmount (E) Rp mn 1,000,000 Re = Rf + Betha (Rm - Rf)

Rf % 6.40%Betha 1.86Rm % 11.68%Re % 16.2%

Total Debt + Equity Rp mn 1,950,000 Wd % 48.7%We % 51.3%

WACC = Wd.D.(1-Tax) + We.E % 13.4%

Perpetual Growth 2%(1-DPR).ROEDPR % 30%ROE % -20% -26% -69% 78% 61% 46% 37% 31% 27% 23% 20%

Net Income Rp mn (67,083) (151,667) (319,028) 787,814 1,092,156 1,221,481 1,329,806 1,410,306 1,490,806 1,571,306 1,560,806 Equity Rp mn 332,917 581,250 462,222 1,013,692 1,778,201 2,633,237 3,564,101 4,551,315 5,594,879 6,694,793 7,787,357 Average ROE (Stable) Rp mn 28%

(1-30%).ROE % 19.4% Too High !!!In practice, we normally use 2 - 3% 2%