Discounted Cash Flow (DCF) valuation is one of the fundamental models in value investing. The model is used to calculate the present value of a firm by discounting the expected returns to their present value by using the weighted average cost of capital (WACC).

**How to perform a DCF valuation**

There are certain steps in performing a DCF valuation. These are:

*Calculate the WACC*

The weighted average cost of capital is fundamental to the capital asset pricing model (CAPM). The WACC is calculated as the weighted average of a firm’s cost of debt and cost of equity.

Assuming that you have invested in Novartis (NYSE: NVS), the steps for the calculation of WACC are the following:

**a) The first step is to find the cost of debt and the cost of equity.**

The cost of debt is derived as follows:

The company’s total debt is $16.33 billion and the interest expenses are $655.0 million. The interest expenses will save Novartis $655 x 30% (tax rate) = $196.50 million. So, the after-tax cost of debt Rd = ($655.0 – $196.5) / $16.33 = 2.81%

The cost of equity is calculated using the formula Rs = RRF + (RPM * b), where,

- RRF: the risk-free rate
- RPM: the return that the market expects
- b: the stock’s beta (systemic risk)

Therefore, for a risk-free rate of 5.00%, an expected market return of 5.10% and a b=0.75, the cost of equity is:

Rs = RRF + (RPM * b) = 5.00% + (5.10% x 0.75) = 8.83%

**b) The second step is to calculate the weights of debt and equity**

First, you need to find the Market value added (MVA) of the company, which represents the difference between the current market value of a firm and its book value. Novartis is currently trading at $75.21 and the number of shares outstanding is 2.37 billion. Therefore, the company’s market value is $75.21 x 2.37 = $178.25 billion. Given the company’s book value per share (BVPS) of $31.57, its book value is $31.57 x 2.37 = $74.82 billion. Therefore, the market value added is market value – book value = $178.25 – $74.82 = $103.43 billion.

Now that you know the MVA and the total debt, you added them to derive the weights of debt and equity. Therefore:

The book value of debt + MVA of equity = $16.33 + $103.43 = $119.76. Therefore, the weight of debt Wd = $16.33 / $119.76 = 13.63% and the weight of equity We = $103.43 / $119.76 = 86.37%.

**c) The final step is to calculate the WACC**

The formula for WACC is (Rd*Wd) + (Rs*We). Therefore:

WACC = (2.81% x 13.63%) + (8.83% x 86.37%) = 0.38% + 7.62% = 8.00%.

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