GCC WACC H A Toolkit for Corporate Financiers. Kuwait Financial Centre Markaz R E S E A R C H. February 2016

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1 Kuwait Financial Centre Markaz R E S E A R C H Markaz Research is available on Bloomberg - Type MRKZ <Go> Thomson Research, Reuters Knowledge Nooz Zawya Investor ISI Emerging markets Capital IQ FactSet Research Connect TheMarkets.com M.R. Raghu CFA, FRM Head of Research RMandagolathur@markaz.com N. C. Karthik Ramesh Assistant Vice President Ext : 4611 KRamesh@markaz.com Rajesh Dheenathayalan Senior Analyst Ext: 4608 RDheenathayalan@markaz.com Irfan A. Naheem Analyst Ext: 4607 Inaheem@markaz.com GCC WACC H A Toolkit for Corporate Financiers Weighted Average Cost of Capital (WACC) assumes importance in corporate finance decision making. In the GCC, unlisted companies outnumber listed companies by miles and hence most of the deals involve unlisted companies in one way or other. Corporate finance professionals face twin problem while valuing an unlisted company. They have to estimate future cash flows and also estimate the appropriate discount rate at which these cash flows can be discounted to the present. Such a discount rate is nothing but the cost of capital adjusted for the weights of capital in the capital structure. In this research, we propose to compute country wise WACC using three different methodologies with appropriate assumptions. GCC WACC, Q WACC (Implied ERP) WACC (Country Risk Premium) WACC (Ratings) Bahrain 7.16% 9.63% 8.98% Abu Dhabi 7.08% 7.17% 6.92% Dubai 6.51% 8.43% 7.33% Kuwait 6.27% 7.17% 6.92% 6.10% 7.58% 6.98% Oman 5.99% 8.48% 8.03% Qatar 6.27% 7.23% 6.93% Source: Damodaran, Markaz Research; Note: 10yr U.S T-Yield of 2.21% Other Assumptions: D/E ratio of 0.5, Beta of 1 The broad methodology of our computation can be illustrated as: Kuwait Financial Centre K.P.S.C Markaz P.O. Box 23444, Safat 13095, Kuwait Tel: Fax: markaz.com Source: Markaz Research; Note: D stands for Debt and E stands for Equity.

2 In order to compute the cost of capital, we start by finding the cost of each capital component that the firm utilizes. WACC Methodology Cost of capital represents the opportunity cost of all financial capital, primarily debt and equity, invested in an enterprise. Opportunity cost is what you give up as a consequence of your decision to use a scarce resource, such as financial capital, in a particular way 1. Opportunity cost also referred to as hurdle cost or discount rate is of primary importance in valuation and helps the management in identifying projects which add value to the enterprise. Given the importance of this metric in creating value for shareholders, it is essential to understand how it is computed. Though in reality it s surprising to note that not much effort is divereted towards the calculation of cost of capital; while a significant amount of time is focussed on forecasting uncertain future cash flows. Improper capital cost assumptions could lead to type-i error (accepting projects that don t add shareholder value) or type-ii error (rejecting projects that add shareholder value). In order to compute the cost of capital, we start by finding the cost of each capital component that the firm utilizes. Cost of capital primarily consists of equity and debt costs, weighed according to the proportions of debt and equity capital in the capital structure. The cost of debt can be inferred easily as it entails specific cost in the form of interest payments made in cash. The entire debt mix including money market debt in the form of commercial papers/notes, bank debt in the form of loans/overdraft, financial leases and bonds raised is aggregated. The interest payments made as a proportion of interest bearing debt instruments provides us with the debt cost. Unlike debt holders, equity holders do not demand an explicit return on their capital. However, equity holders incur an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with similar risk profile 2. Equity cost involves various factors such as risk free asset, beta, market risk premium, country risk premium among others. Beta a measure of priced risk, is arrived by regressing the past price returns on an index. As private firms do not trade, estimation of beta becomes problematic for private firms. Beta a measure of priced risk, is arrived by regressing the past price returns on an index. In order to estimate the value of beta for a private firm, we create a list of comparable public firms from the same line of industry. Firms with similar line of business and asset size would typically be considered as a good comparable. To ensure we have zeroed down on appropriate comparable enterprise, a simple regression test between the revenues could be done. Firms which are affected by similar economic and industry factors, in general, would exhibit higher correlation. Once the publicly listed comparables list is drawn, we may average their beta values and leverage ratios to arrive at levered beta for the particular sector or industry. This levered beta is then unlevered to arrive at the beta for the industry/sector. The unlevered beta could then be levered based on the debt to equity (D/E) ratio for the private firm. One may either use the management target set for debt to equity ratio or the industry average to relever the unlevered beta. Considering this as beta for the private firm, we proceed with the calculation of cost of equity using the Capital Asset Pricing Model (CAPM) 3. 1 Prof. Aswath Damodaran 2 ibid 3 We have illustrated the cost of equity calculation using CAPM methodology as its is popular and widely used. Other available methods include Aribtrage Pricing Theory and Fama French three factor model Kuwait Financial Centre Markaz 2

3 Part I. Cost of Equity Capital Asset Pricing Model (CAPM) states that the equity investors in addition to risk free rate demand a premium for bearing the extra risk of enterprise operations. The additional risk is referred to as Equity risk Premium (ERP). ERP for a company is dependent on the beta which measures how risky the company is relative to the entire market. Not all GCC countries have instruments which can be considered risk free. CAPM can be expressed mathematically as, Cost of Equity, Ke = Risk free-rate, Rf + Beta * (ERP) The easy way out to calculate ERP is to find the difference between historic long-term return of equity index and the risk-free investment, such as government bonds. Though it appears simple, the methodology has its drawbacks especially for emerging and frontier countries like the GCC region 1. Not all GCC countries have instruments which can be considered risk free. This is either because sovereign bonds were not issued (Ex. Kuwait) or because governments may have default risk (Ex. Dubai). In our case, we find the nominal yield of 10-yr US treasury and add inflation differential for the country compared to U.S. Thus, Risk-free rate, Rf for Oman equals the sum of 10-yr US bond yield (2.21%) and the inflation differential between Oman and U.S (2.04%). Risk-free rate, Rf for Oman = 4.25% Local bond yield minus the sovereign risk premium (default spread based on ratings) can beused to derive the risk-free rate. Alternatively, we take the local bond yield and deduct the sovereign risk premium (default spread based on ratings) to derive the risk-free rate. For instance, riskfree rate of Bahrain can be calculated as difference between 6.86% (local bond yield) and 2.20% (sovereign risk premium). Risk-free rate, Rf for Bahrain = 4.66% 2. Equity markets are volatile and risk premiums calculated with short historical data experience significant estimation errors. 3. Almost all GCC exchanges are still undergoing a lot of transformation in terms of regulations, trading platforms, instrument availability, and corporate disclosures. This coupled with nascent secondary market for bonds will make the risk premiums calculated with historical numbers inaccurate. While the traditional way of calculating ERP has many obstacles due to lack of data and volatile nature of equity markets in the region, Markaz computes Equity Risk Premium data using alternate methods such as: Kuwait Financial Centre Markaz 3

4 a) Sovereign Rating Taking the US market equity risk premium, of 6.12% 4, the ERP of GCC countries are arrived at by adding the default spread based on their credit rating: Rating agencies are generally considered to be slow in updating their ratings. ERP for GCC Countries based on Credit Rating US Eq. Risk Default Total Equity Rating Country Premium Spread Risk Premium Bahrain 6.12% Baa3 2.20% 8.3% Kuwait 6.12% Aa2 0.50% 6.6% Oman 6.12% A1 0.70% 6.8% Qatar 6.12% Aa2 0.50% 6.6% Saudi Arabia 6.12% Aa3 0.60% 6.7% UAE 6.12% Aa2 0.50% 6.6% Abu Dhabi 6.12% Aa2 0.50% 6.6% Source: Moody s, Aswath Damodaran, Markaz Research b) CDS Spreads Rating agencies are generally considered to be slow in updating their ratings. So, instead of arriving at default spread based on rating, we can use CDS spreads as a proxy. In this method, the CDS spread of a country s bond (adjusted for spread of risk free country) is considered as default spread instead of looking at the yield differentials of similarly rated bonds. The adjusted CDS for Bahrain (3.5%) is the difference between the 10Yr CDS for Bahrain (3.8) and US (0.3). Since 10 Yr CDS spread for Kuwait is not available, an average of Qatar and Abu Dhabi spread was taken as proxy for Kuwait due to similar ratings. The adjusted CDS for Bahrain (3.5%) is the difference between the 10Yr CDS for Bahrain (3.8) and US (0.3). ERP for GCC Countries on CDS Spread US Eq. Risk Adjusted Total Equity Country Premium 10Yr CDS CDS Risk Premium Bahrain 6.12% 3.8% 3.5% 9.6% Kuwait 6.12% 1.3% 1.0% 7.1% Oman 6.12% 1.9% 1.6% 7.7% Qatar 6.12% 1.3% 1.0% 7.2% 6.12% 2.1% 1.8% 7.9% Abu Dhabi 6.12% 1.3% 1.0% 7.1% Dubai 6.12% 2.9% 2.6% 8.8% Source: Aswath Damodaran, Thomson Reuters Eikon, Markaz Research c) Implied ERP Implied equity risk premium is an alternative approach to estimating risk premiums. Assuming that stocks are correctly priced in, if we can estimate the expected cash flows from buying stocks, then we can estimate the expected rate of return on stocks by computing an internal rate of return (IRR). Subtracting out the risk free rate from IRR should yield an implied equity risk premium. The inputs required for calculation of Implied ERP were not readily available for GCC countries. Absence of sovereign bonds for some countries made the estimation of risk free rate and perpetual growth rate difficult. Also, the lack of consensus earnings 4 Aswath Damodaran- 6 th January 2016 Kuwait Financial Centre Markaz 4

5 growth estimate makes it hard to determine the market s view on growth for the next 5 years. The inputs required for calculation of Implied ERP were not readily available for GCC countries. Implied Risk Premium for GCC Countries Country Index Level * Implied Equity Risk Premium 6, % Kuwait 5, % Qatar 10, % Abu Dhabi 4, % Dubai 3, % Oman 5, % Bahrain 1, % Source: Thomson Reuters Eikon, Zawya, Markaz Research * As of 31-Dec-2015 Part II. Cost of Debt The cost of debt can be inferred easily as it entails specific cost in the form of interest payments made in cash. To compute the cost of debt, entire debt mix including money market debt in the form of commercial papers/notes, bank debt in the form of loans/overdraft, financial leases and bonds raised is aggregated. The interest payments made as a proportion of interest bearing debt instruments provides us with the debt cost. For instance, consider ABC Ltd. which has SAR 500mn in the form of long-term bonds and SAR 100mn in the form of bank loans. Annual interest payments include SAR 36mn and the tax rate for the firm is 5%. Total Debt = Short-term Debt (money market/commercial papers/notes payable) + Long-term debt (bonds) + bank debt (loans/overdraft/working capital finance) + financial lease obligations The interest payments made as a proportion of interest bearing debt instruments provides us with the debt cost. Thus, on a total debt of SAR 600mn ABC Ltd. pays an annual charge of SAR 36mn. From this we can infer that the interest charged for ABC Ltd. 6%. As interest payments are tax deductible, we may find the after tax cost of debt as: Cost of Debt, after-tax = (Interest charge incurred/total Debt) * (1- Tax rate) = (36/600) * (1-0.05) = 5.7% Part III. Cost of Capital Having found out the cost of debt and cost of equity, we could compute the cost of capital as weighted average cost of capital as WACC = (Proportion of Debt * Cost of debt, after-tax) + (Proportion of Equity * Cost of Equity) Kuwait Financial Centre Markaz 5

6 Country-wise Commentary Saudi Arabia Risk-free for Saudi Arabia is estimated by subtracting country premium for Saudi Arabia from 10-yr Saudi sovereign yield. There are multiple ways to compute the riskfree rate for a country. Risk-free for Saudi Arabia is estimated by subtracting country premium for Saudi Arabia from 10-yr Saudi sovereign yield. Rf for = 10-yr Sovereign Yield (2.85%) - Country Risk Premium (0.60%) = 3.25% Saudi Arabia sovereign bond rating stands at Aa3 (Moody s) and AA- (S&P ratings). Considering the US market equity risk premium, of 5.86% 5, the ERP for Saudi Arabia is arrived at by adding the default spread based on their credit rating. The implied ERP method provides the lowest equity risk premium for markets. The low ERP can be attributed to discounted levels at which the index is trading on anticipation of lower earnings growth. On the contrary, ERP estimated using the credit rating and CDS spread methodology provides relatively higher ERP of 6.7% and 7.9% respectively. This can be attributed to the inability of these methodologies to capture the prevailing negative investor sentiments towards equity instruments. Kuwait In the case of Kuwait, longterm government bond with maturity of 10 years lacks liquidity and is not actively traded. In the case of Kuwait, long-term government bond with maturity of 10 years lacks liquidity and is not actively traded. Thus, the yields obtained on local sovereign bonds might be stale and using them may not be effective. Few argue to the usage of central bank s discount rates (Repo rates) as a proxy for risk free rate. However, this may not be the right strategy since these are inter-bank rates that are used to lend money to banks over the short term (while WACC is generally computed for long term projects) and is fixed by the central bank. Further, they are not backed by an underlying instrument which the investors have access to unlike government treasuries which are traded in the public domains. To overcome this problem, we have taken proxies from countries with rating similar to Kuwait. In this case we have taken the average of 10 Yr CDS spreads for Abu Dhabi and Qatar as proxy for Kuwait. Kuwait s ERP based on credit rating and CDS spread is 6.6% and 7.1% respectively. Qatar & UAE ERP values of Qatar and UAE is also the same as that of Kuwait since their sovereign ratings are very similar. However, the marginal difference in 10 Yr CDS for Qatar and Abu Dhabi has resulted in the difference in ERP for Qatar (7.2%) and Abu Dhabi (7.1%). Dubai with the history of default has higher CDS spread of 2.9% and hence the high ERP of 8.8% relative to Abu Dhabi and Qatar. 5 Aswath Damodaran-1 st Apr 2015 Kuwait Financial Centre Markaz 6

7 The Implied ERP for Abu Dhabi is 6.92% compared to Dubai with implied ERP of 4.95% and Qatar with 5.28%. The higher ERP of Qatar relative to Dubai can be attributed to higher anticipated earnings growth rate for Qatar. The higher ERP of Qatar relative to Dubai can be attributed to higher anticipated earnings growth rate for Qatar. Sovereign Ratings of GCC Countries, 2015 Country Moody s Rating S&P Ratings Aa3 AA- Kuwait Aa2 AA Qatar Aa2 AA UAE Aa2 AA Oman A1 A Bahrain Baa3 BBB Source: Moody s S&P Oman Oman whose rating is lower than that of, Kuwait, Qatar and UAE has its ERP at 6.8% based on the credit rating methodology. Based on the CDS methodology, Oman s ERP is lower than s ERP, however, the implied ERP is lowest at 2.72% for Oman. This low implied ERP can pegged to lower long term growth rate (0.96%) anticipated. Bahrain ERP value of Bahrain, which has a rating of Baa3 (Moody s) and BBB (S&P) is at a premium value of 8.30% compared to its GCC peers. The excess CDS spread over U.S for Bahrain stands at 3.50% (highest among GCC countries). The implied ERP of 4.65% is better than Oman and Qatar. Final Note ERP of Bahrain, is at a premium value of 8.30% compared to its GCC peers. While the risk free rate and ERP vary due to differences in ratings, the interest rates which determine the cost of debt have more or less been similar across the GCC countries. Moreover, as their currencies are pegged to U.S dollar, the monetary policies of GCC countries follow the U.S Fed rates, which currently is at historical lows. For our WACC calculation, we have assumed an after-tax cost of debt at 5%. Cost of equity is subjective as different people use different methods to compute beta. Some use monthly data for past 5 years while others prefer weekly data for past 3 years. As beta is derived based on historical price data, few adjust it under the assumption that the beta value would revert towards the mean value of 1 over the long period 6. Difference in equity cost would lead to a range of values for cost of capital. Risk-free rate and equity risk premium values are dynamic in nature and change with time depending on the market perception of risk. In good times, ERP is compressed due to lack of risk events, which lowers the equity cost and subsequently capital costs. This would make most projects attractive as with a lower discount/hurdle rate, it would be value accretive. While in bad times, risk events erupt and the same gets 6 Blume Adjustment Kuwait Financial Centre Markaz 7

8 Risk-free rate and equity risk premium values change with time depending on the market perception of risk. priced in leading to expansion of ERP. Higher costs of capital could affect the ability to intiate projects, as they wouldn t add value when expected cashflows are discounted at higher discount rate. Stalled investments are usually a fall out of this. Given the challenging and dynamic nature of capital costs, it would be a good practice to have a range of values for capital costs, depending on different scenarios. Sensitivity and scenario analysis are particularly helpful in such circumstances to understand the implications of various capital cost assumptions and its potential impact on the project. Kuwait Financial Centre Markaz 8

9 Appendix Illustrative Example: Cost of Capital for a Private Firm To illustrate this concept, we shall try to arrive at the cost of capital for a private cement company (ABC Ltd.) operating out of Saudi Arabia. Assume ABC Ltd has yearly revenues of SAR 1.75billion and that the management has set a D/E target of 30%. Comparable companies would then include the following list of companies: Company Revenues D/E Beta (levered) Saudi Cement Co SAR 2.0bn Southern Province Cement Co SAR 1.8bn Arabian Cement Co SAR 1.7bn Yanbu Cement SAR 1.6bn Average Source: Reuters From the levered beta, for ABC Ltd. comparable we arrive at the unlevered beta, Risk premiums calculated with short historical data experience significant estimation errors. Unlevered Beta = Levered Beta / (1+ (1-tax rate) (Average D/E)) = 0.51/ (1+ (1-0.05) (0.18)) = 0.44 This is levered according to the Debt-to-Equity ratio of ABC Ltd. Levered Beta = Unlevered Beta * (1+ (1- tax rate)* (ABC Debt-to-Equity)) = 0.44 * (1+ (1-0.05) * (0.3)) = 0.57 Considering this as the value of beta for the private firm, ABC Ltd. Its cost of equity is computed as below: Cost of Equity for ABC Ltd. = Rf + * ( Equity Risk Premium) = 2.25% + (0.57 * 6.7%) = 6.07% Cost of Debt was computed earlier as 5.7%. With the values of cost of equity and cost of debt, we may arrive at the WACC Cost of Capital, WACC = 0.3 * (5.7%) * (6.07%) WACC, Cost of Capital for ABC Ltd. = 5.96% Thus, the cost of capital for cement company ABC Ltd. with a capital structure of 30% debt and 70% equity in Saudi Arabia works out to be 5.96%. Kuwait Financial Centre Markaz 9

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