Valuation : WACC

Discount rate

If you recall the introductory principle, Valuation (NPV) = Sum of all the cashflows weighted by a factor for time value of the money (aka Discount factor)

Where Wi = 1/(1+r)ⁱ

Theoretically, the Discount factor is a rate (similar to Interest Rate) which is a function of the risk of a project (Expected Rate of Return). For eg A low risk project will carry a discount rate of say 10% while a high risk project will carry a discount rate of 15%.

Practically the estimate of Discount Rate (expected rate of return) is drawn on the basis of Weighted Average Cost of Capital (WACC). WACC is simply weighted average cost of Debt and Equity

• Cost of Debt is rate of interest on loans of the company
• Cost of Equity is the rate of return “expected” by the shareholders of the company
• To sum it up simply, the determining the valuation or the Net Present Value(NPV) is only a matter of forecasting the cashflows from the Mine and then discounting it with the WACC of the company.

The cost of debt is the easier of the two factors to determine and can be estimated from

1. Interest rate on the debt which the company already has or other companies with similar projects have
2. Yield (based on the Market price) of the debt held by the company. Say Company has a bond of USD100 maturing after one year, which is currently trading at 88 USD. It would imply a yield of (100-88)/88 = 13.6% which can be then considered a cost of debt

The Cost of equity is determined by a formula called Capital Asset pricing mechanism (CAPM)

E(R) = Rf +Beta*(E(Rm) -Rf)

E(R)is the expected return on the capital asset

Rf is the risk-free rate of interest such as interest arising from government bonds

Beta (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or also ,

Rm is the expected return of the market

(Rm - Rf ) is sometimes known as the market premium (the difference between the expected market rate of return and the risk-free rate of return). and is also known as the risk premium

Typically, beta is calculated over a 5-year period (A number of websites will provide you the Beta information) and usually an average of companies in the industry is considered.

Risk premium is considered by different entities at different levels such as 4.5%-5%. A good reference for Beta and Risk premium information is Aswath Damodarans webpage (Damodaran is a prof at stern business school, NYU).

Rf is taken as yield on the 10 year government bond.