The Weighted Average Cost of Capital ICFI By : Else Fernanda, SE.Ak., M.Sc.

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: Price Earning Ratio; PER 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 (1+Re2)n (Re – G) (1+Re1)n Mature & stable Transition Preliminary D2n Value 2 : ------------ (1+Re2)n DPS Value 3 : ----------- (Re – G) D1n Value 1 : ------------ (1+Re1)n

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; 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) Analyze historical Performance Calculate Invested Capital (including debt); Calculate Value Driver (revenue, cost, etc); 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: 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 to Equity 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 Definition 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) Calculation (1) 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 (2) 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;

Profit & Loss

Balance Sheet

Cash Flow

Valuation (1)

Valuation (2)