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

2. 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;

3. 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

4. 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;

5. 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

6. 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

7. 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

8. 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

9. 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;

10. 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

11. 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

12. 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%;

13. 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

14. WACC: Calculating ß Return: IHSG vs. Stock A β = 1.86 Re 1 Rm
The slope between Rm and Re is This slope is called Betha
Usually, Betha is calculated using 3 years historical data;

15. WACC: Calculating WACCRe 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 %
Risk Free Rate;
Using SBI;
Around 6.4%
16.2%
6.4%
1.86
11.68%
6.4%

16. 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

17. 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

18. 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;

19. Profit & Loss

20. Balance Sheet

21. Cash Flow

22. Valuation (1)

23. Valuation (2)