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CHAPTER 2

THEORETICAL OVERVIEW

2.1 MERGER TERMINOLOGY

A merger occurs when two or more companies combines and the resulting firm

maintains the identity of one of the firms. One or more companies may merger with

an existing company or they may merge to form a new company. Usually the assets

and liabilities of the smaller firms are merged into those of larger firms. (Weston,

Mitchell and Mulherin , 2004, pp.5 ). However, in practice, one firm in a merger

might be stronger and might dominate the transaction.

2.2 TYPES OF MERGERS FROM AN ECONOMIC

STANDPOINT

Based on http://www.investopedia.com/articles/stocks/09/merger-acquisitions-

types.asp  and  Weston, Mitchell and Mulherin (2004, pp.6-10), those are types of

merger from an economic standpoint :

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• HORIZONTAL MERGERS

Horizontal mergers are those mergers where the company’s manufacturing

similar kinds of commodities or running similar type of businesses merge

with each other. The principal objective behind this type of mergers is to

achieve economies of scale in the production procedure through carrying off

duplication of installations, services and functions, widening the line of

products, decrease in working capital and fixed assets investment, getting rid

of competition, minimizing the advertising expenses, enhancing the market

capability and to get more dominance on the market.

Nevertheless, the horizontal mergers do not have the capacity to ensure the

market about the product and steady or uninterrupted raw material supply.

Horizontal mergers can sometimes result in monopoly and absorption of

economic power in the hands of a small number of commercial entities.

According to strategic management and microeconomics, the expression

horizontal merger delineates a form of proprietorship and control. It is a plan,

which is utilized by a corporation or commercial enterprise for marketing a

form of commodity or service in a large number of markets. In the context of

marketing, horizontal merger is more prevalent in comparison to horizontal

merger in the context of production or manufacturing.

For example, the acquisitions in 1999 of Mobil by Exxon and merger of

Hewlett-Packard (NYSE:HPQ) and Compaq Computer was a horizontal

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merger. Forming a larger firm may have the benefit of economies of scale.

They decrease the number of firms in an industry, possibly making it easier

for the industry members to collude for monopoly profits and enabling it to

engage in anticompetitive practices such transactions are heavily regulated by

antitrust legislation

Horizontal Integration

Sometimes, horizontal merger is also called as horizontal integration. It is

totally opposite in nature to vertical merger or vertical integration.

Horizontal Monopoly

A monopoly formed by horizontal merger is known as a horizontal monopoly.

Normally, a monopoly is formed by both vertical and horizontal mergers.

Horizontal merger is that condition where a company is involved in taking

over or acquiring another company in similar form of trade. In this way, a

competitor is done away with and a wider market and higher economies of

scale are accomplished. In the process of horizontal merger, the downstream

purchasers and upstream suppliers are also controlled and as a result of this,

production expenses can be decreased.

Horizontal Expansion

An expression which is intimately connected to horizontal merger is

horizontal expansion. This refers to the expansion or growth of a company in

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a sector that is presently functioning. The aim behind a horizontal expansion

is to grow its market share for a specific commodity or service.

• VERTICAL MERGERS

Its occur when two firms, each working at different stages in the production of

the same good, combine. For example, One of the most well-known examples

of a vertical merger took place in 2000 when internet provider America

Online combined with media conglomerate Time Warner (NYSE:TWX). The

merger is considered a vertical one because Time Warner supplied content to

consumers through properties like CNN and Time Magazine, while AOL

distributed such information via its internet service.

Firms might want to be vertically integrated for many reasons such as

transactions within a firm may eliminate the costs of searching for price,

contracting, payment collecting, advertising and also might reduce the costs of

communicating and coordinating production. The efficiency and affirmative

rationale of vertical integration rests primarily on the costliness of market

exchange and contracting.

• CONGLOMERATE MERGERS

Conglomerate merger is the combination of two or more unrelated business

units in respect of technology, production process or market and management.

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In other words, firms engaged in the different or unrelated activities are

combined together.  Diversification of risk constitutes the rational for such

merger moves.

Among conglomerate mergers, three type have been distinguished.

o Product extension mergers broaden the product lines of firms. These

are mergers between firms in related business activity they can also be

called concentric mergers.

o A geographic market extension merger involves two firm whose

operations have been conducted in non overlapping geographic areas.

o Finally, the other conglomerate mergers that are often referred to as

pure conglomerate mergers involve unrelated business activity. These

would not qualify as product extension or market extension mergers.

Procter & Gamble (NYSE:PG), a consumer goods company, engaged

in just such a transaction with its 2005 merger with Gillette. At the

time, Procter & Gamble was largely absent from the men's personal

care market, a sector led by Gillette. The companies' product portfolios

were complimentary, however, and the merger created one of the

world's biggest consumer product companies.

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2.3 THE DIFFERENCE BETWEEN A MERGER AND A

TAKEOVER

Based on http://www.investopedia.com/ask/answers/05/mergervstakeover.asp, In a general

sense, mergers and takeovers (or acquisitions) are very similar corporate actions -

they combine two previously separate firms into a single legal entity. Significant

operational advantages can be obtained when two firms are combined and, in fact, the

goal of most mergers and acquisitions is to improve company performance and

shareholder value over the long term. The motivation to pursue a merger or

acquisition can be considerable; a company that combines itself with another can

experience boosted economies of scale, greater sales revenue and market share in its

market, broadened diversification and increased tax efficiency.

However, the underlying business rationale and financing methodology for mergers

and takeovers are substantially different. Those difference are

( http://www.investopedia.com/ask/answers/05/mergervstakeover.asp ) :

• A merger involves two relatively equal companies, which combine to

become one legal entity with the goal of producing a company that is worth

more than the sum of its parts. In a merger of two corporations, the

shareholders usually have their shares in the old company exchanged for an

equal number of shares in the merged entity.  Both companies' stocks are

surrendered and new company stock is issued in its place. For example, both

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Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a

new company, DaimlerChrysler, was created.

• A takeover, or acquisition, on the other hand, is characterized by the purchase

of a smaller company by a much larger one. This combination of "un equals"

can produce the same benefits as a merger, but it does not necessarily have to

be a mutual decision. From a legal point of view, the target company ceases to

exist, the buyer "swallows" the business and the buyer's stock continues to be

traded.

• In an takeover, the acquiring firm usually offers a cash price per share to

the target firm's shareholders or the acquiring firm's share's to the shareholders

of the target firm according to a specified conversion ratio. Either way, the

purchasing company essentially finances the purchase of the target company,

buying it outright for its shareholders. An example of an acquisition would be

how the Walt Disney Corporation bought Pixar Animation Studios in 2006. In

this case, this takeover was friendly, as Pixar's shareholders all approved the

decision to be acquired.

• In merger, the method of payment is generally cash, stock, debt or some

combination of the three.

• A purchase deal will also be called a merger when both CEOs agree that

joining together is in the best interest of both of their companies. But when

the deal is unfriendly - that is, when the target company does not want to be

purchased - it is always regarded as an acquisition.

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• Whether a purchase is considered a merger or an acquisition really depends on

whether the purchase is friendly or hostile and how it is announced. In other

words, the real difference lies in how the purchase is communicated to and

received by the target company's board of directors, employees and

shareholders.

• In a merger, the seller’s shareholders receive shares of the survivor or cash,

and in asset acquisition, the seller receives stock or cash of the buyer

( Romanek and Krus, 2002, pp.8).

• In an asset acquisition, the seller’s liabilities may remain with the seller. In a

cash-out merger transaction, the buyer does not want the shareholders of the

seller to end up holding voting common stock in the buyer. The buyer wants

to pay cash for the seller or if cash is not available, to pay the seller’s

shareholders nonvoting investments in the buyer such as debentures or non-

voting preferred shares ( Romanek and Krus, 2002, pp.8).

2.4 FORM OF PAYMENT

According to Weston, Mitchell and Mulherin (2004, pp.96), the method of payment

in a merger or acquisition is generally cash, stock, debt or some combination of the

three. The cash or stock combination includes mergers in which target shareholders

receive cash and stock in the merger or have a choice of receiving either cash or

stock. Cash as the form of payment occurs in cash tender offers and cash mergers. At

the closing of the merger, the stockholders in the target firm receive cash in

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substitution for their shares, after which time the share carry no value. In a stock

merger, the merging parties negotiate a fixed number of acquire shares that will be

exchanged for each target share .The fixed-exchanged ratio will be made available in

the press release announcing the merger.  The stock may be common or preferred.

They may be registered, meaning they may be freely resold to the public, or they may

be restricted, meaning they cannot be offered for public sale. Stock transactions may

offer the seller’s shareholders certain tax benefits that cash transactions do not

provide. However, securities transactions require the parties to agree on the value of

the securities. This may create some uncertainty and may give cash an advantage over

securities transactions from a seller’s point of view ( Romanek and Krus, 2002, pp.8).

2.5 REASONS FOR MERGER

• SIZE AND RETURNS TO SCALE

According to Weston, Mitchell and Mulherin (2004, pp.132), a common feature

of all mergers is an increase in firm size. Consequently, a standard reason offered

for a merger is that the union of the two firms will create economies of scale or

synergies. Economies of scale are the reductions in per-unit costs that come as the

size of a company’s operations, in terms of revenues or units production, increase.

One aspect of scale economies comes from technical and engineering relations

such as those between volume and surface area. Another natural economy of scale

occurs in holding inventories when demand is subject to random influences. The

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statistical law of large numbers maintains that the larger the scale of operations is

the lower the required investment in inventories is in relation to the average

quantity sold. Another important source of returns to scale is specialization. Firms

of larger size might be able to organize production into specialist groups that

emphasize a single task. Returns to scale can be distinguished from improved

capacity utilization that spreads fixed costs over a larger number of units. In

industry such as steel and autos, consolidating mergers have taken place to reduce

industry capacity.

While according to Gaughan (2007, pp.117-118,145-165), there are some motives

of mergers such as :

• GROWTH

One of the most fundamental motives for M&As is growth. Companies that desire

rapid growth in size or market share or diversification in the range of their

products may find that a merger can be used to fulfill the objective instead of

going through the tome consuming process of internal growth or diversification.

The firm may achieve the same objective in a short period of time by merging

with an existing firm. Growth through M&As may be a much more rapid process

and often less costly than the alternative of developing the necessary production

capability and capacity because a company can acquire others that has the

resources such as established offices and facilities, management and others in

place to increase their strength over competitors.

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• HORIZONTAL INTEGRATION

Through horizontal integration, a company is able to increase its market share .It

could be the case that even with a substantial increase in market share, the lack of

significant product differentiation or barriers to entry could prevent a firm from

being able to raise its price significantly above marginal cost. Horizontal

integration increase buyer power of the merging firms in instances where the

suppliers are concentrated. This was theoretically demonstrated by Synder as well

as by Stole and Zweibel, Fee and Thomas and also by Shahrur, who theorized that

merged buyers could lower their costs of inputs that they purchase from

concentrated suppliers industries.

• VERTICAL INTEGRATION

A firm might consider vertically integrating for several reasons such as to lower

inventory costs, lower transaction costs, the need to have specialized inputs. By

acquiring a supplier and establishing a long term source of supply at prearranged

costs, the acquiring firm may avoid potential disruptions that might occur when

agreements with independent suppliers end. When the buyer owns the supplier, it

may be better able to predict future supply costs and avoid uncertainty that

normally is associated with renegotiation of supply agreements

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• IMPROVED MANAGEMENT, RESEARCH AND DEVELOPMENT,

DISTRIBUTION AND TECHNOLOGY

Some mergers are motivated by a belief that the acquiring firm’s management can

better manage the target’s resources. This lead the acquirer to pay a value for the

target in excess of the target’s current price. For large public firms, a merger may

be the most cost-efficient way to bring about a management change.

Research and development (R&D) is critically important to the future growth of

many companies particularly pharmaceutical companies. This was one of the

reasons for the consolidation that occurred in the pharmaceutical industry in the

fifth merger wave.

Vertical mergers between manufacturers and distributors or retailers often give

competitor manufacturer cause for concern in that they worry about being cut off

from distribution channel. Locking in dependable distribution channels can be

critical to a firm’s success.

Mergers also enabled companies to spread the risk inherent in developing new

technologies, particularly those engaged in significant research and development.

For some companies, developing technology through mergers and acquisitions is

viewed as necessary to survive in their rapidly changing industries

• TAX MOTIVES

Certain studies have concluded that acquisitions may be an effective means to

secure tax benefits. Gilson, Scholes, and Wolfson assert that for a certain small

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fraction of mergers, tax motives could have played a significant role. Hayn,

however, has empirically analyzed this relationship and has found that potential

tax benefits stemming from net operating loss carry forward and unused tax credit

positively affect announcement period returns of firms involving tax-free

acquisitions, and capital gains and the step-up in the acquired assets basis affect

returns of firms involved in taxable acquisitions. Moreover, whether the

transaction can be structured as a tax-free exchange may be a prime determining

factor in whether to go forward with a deal. Sellers sometimes require tax-free

status as a prerequisite of approving a deal.

A profitable company can buy a loss maker to use the target's loss as their

advantage by reducing their tax liability. Example, assume that a firm A has

earnings before taxes of about ten billion rupiahs per year and firm B now break

even, has a loss carry forward of rupees twenty billion rupiahs accumulated from

profitable operations of previous years. The merger of A and B will allow the

surviving corporation to utility the loss carries forward, thereby eliminating

income taxes in future periods.

For the case of Niaga Bank and Lippo Bank, the main motive for merge is to gain

size and return to scale and improve growth in term of sales and market coverage as a

mean to reach CIMB Group’s broad objectives and targets which are become top 3

bank in South East Asia by assets and integrated ASEAN universal bank and to be

one of the top 5 banks in Indonesia.  To achieve this goal, both banks have

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individually and aggressively focused on innovating new product lines and

penetrating untapped customer segments for organic business expansion, while

simultaneously seeking potential merger and acquisition opportunities as part of an

inorganic growth strategy. Bank CIMB Niaga combines the best of Bank Niaga

(strong corporate presence and mortgage) and Bank Lippo  (leadership in SME loan

and payment processing system), enhanced by scale synergies and CIMB Group’s

regional platform.

2.6. VALUING FINANCIAL FIRMS – BANKS

2.6.1 MARKET INDICES

According to Feibel (2003, pp.107), Practitioners have come to accept that a peer

group universe does not fulfill all of the requirements for a good measure of

relative performance. Jeffrey Bailey set out the criteria of a good performance

comparison benchmark, which is “unambiguous, investable, measurable,

appropriate, and specified in advance”. Peer group universes do not enjoy all of

these ideal characteristics. For example, we cannot invest in an asset called “the

median manager return. But we still need to understand whether our investments

have done as well as they should have, given the returns provided by the capital

markets during the period. A performance benchmark is the standard by which

we judge the success or failure of an investment strategy. We usually benchmark

a fund against the performance of a market index. We can compare not only the

return, but also the risk experienced by the investor in the fund against that of the

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index. An index represents the average price level of a particular asset class or

market. Periodic changes in the index represent the average performance of the

underlying securities. An appropriate index for a particular fund represents the

performance of the universe of assets that are eligible for portfolio construction

according to the manager’s mandate and specific strategy. For example, the

IHSG index represents the performance of Indonesian large capitalization stocks.

We could use the IHSG as the benchmark to judge the performance of funds that

invest in the Indonesian large-cap stock asset class.The appropriate market index

return is the return that can be earned by the investor at low cost where there are

index funds that parallel the performance of the index. It therefore makes a good

benchmark of active manager performance.

2.6.2 REGRESSION ANALYSIS

We can gain insight into the degree of association between two variables by

plotting the observations. A graph plotting the periodic fund-benchmark return

pairs allows us to visualize the relationship between the fund and benchmark

returns (Feibel, 2003, pp.171-172). Exhibit below is a scatter diagram plotting

the relationship between the fund and benchmark returns.

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Feibel J.Bruce, 2003, Investment Performance Measurement,

John Wiley & Sons, Inc.

Each marker represents one monthly return. Its distance from the vertical or Y-

axis, measured along the horizontal scale, represents the benchmark return. The

distance of the marker from the horizontal or X axis, measured on the vertical

axis in the middle, represents the fund return. The arrangement of the plotted

returns on the chart shows that there is a strong correlation between the two sets

of returns. Most of the return pairs are located in the top right and bottom left

quadrants of the chart. This dispersion occurred because when we had high

benchmark returns, we also had high fund returns, and vice versa. The scatter

plot is a visual indicator of the high degree of fund and benchmark return

correlation. If the returns were less correlated, the scatter plot would show more

returns in the other two quadrants. Assuming that the fund is comprised of

holdings selected from an underlying universe represented by the benchmark,

we expect a high degree of correlation between the fund and benchmark

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returns. To identify the degree to which the fund returns vary given the

variability in the benchmark returns we can calculate a statistic called Beta.

Beta isolates the degree of benchmark, or market-related risk inherent in the

fund, where risk is defined as the total variability in returns. A fund with a

higher Beta than another indicates that it has taken on more benchmark relative

risk than the other.We calculate the Beta through regression analysis.

If the returns are strongly correlated, we can imagine a clear line about which

the fund-benchmark returns cluster. We can draw a straight,upward sloping line

over the scatter plot from the bottom left to the top right quadrant that comes

closest to representing the trend in the actual data. This line of best fit

represents a linear relation between the return pairs. We can use the line of best

fit to interpolate the fund return if we were given the benchmark return.

2.6.3 BETA

The Beta represents the proportion of the covariance in fund/benchmark returns

that is related to the variance in benchmark returns (Feibel, 2003, pp.174-175).

Beta measures the degree of variability in fund returns around the mean fund

return that is correlated with the degree of market return differences to the mean

market return

• If the fund returns varied exactly in proportion to the benchmark returns,

this would be equivalent to replacing the fund deviations in the

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numerator (right hand expression) with the benchmark deviations. Beta

will be equal to 1 if the fund returns vary from the mean fund return in

the same direction and degree as the benchmark returns vary from the

mean benchmark return.

• If Beta is less than 1, then the numerator is smaller than the

denominator. This indicates that the fund returns have been less variable

than the benchmark returns over the period, in relation to their means.

• If Beta is greater than one, the numerator would be greater than the

denominator so the fund returns have varied to a greater degree relative

to the mean during the period, than the benchmark returns.

• Covariance close to zero indicates that there was little relationship

between the fund and benchmark returns during the period. This will

cause the numerator of the Beta calculation to be close to zero, which

divided by the variance in index returns will yield a result close to zero.

So, a Beta close to zero indicates that there is little relation between the

fund and benchmark returns.

• If the covariance was negative, the Beta will be negative because we

cannot have a negative variance. So the negative Beta indicates that

there is an opposite relationship between the fund and benchmark

returns for the period.”

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2.6.4 THE RISK FREE RETURN

The risk-free return is the return that we can earn on an investment with little or

no market or credit risk, like a SBI. It is the return over the risk-free return that

we expect to earn for bearing the market and credit risk that accompanies most

investments (Feibel, 2003, pp.186). The risk-free rate is a hurdle rate, or

benchmark for risk, in that we can earn this rate without taking on risk. A risk-

free investment is one where the actual return equals the expected return, i.e.,

there is no variance around the expected return. In practice, we use the rates on

short term government securities to represent the risk-free investment because

they do not suffer from credit risk. The return on a risk-free investment

represents the pure time value of money. All other investments that incur other

risks, such as the risk of default or risk of losing principal, should return a

premium to the risk-free rate ( Feibel, 2003, p.188)

The risk free rate used to come up with expected returns should be measured

consistently with how the cash flows are measured. If the cash flows are

nominal, the risk free rate should be in the same currency in which the cash

flows are estimated. This also implies that its is not where a project or firm is

located that determines the choice of a risk free rate, but the currency in which

the cash flows on the project or firm are estimated. To select the risk-free rate,

we choose an instrument with a time to maturity that has no reinvestment risk,

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i.e., we use the return on a 30-day SBI for comparison to one-month returns on

risky securities or funds ( Feibel, 2003, p.188).

2.6.5. MEASURING RETURN

The return defined so far is the capital appreciation return, which ignores the

income payment on the asset. Define the dividend or coupon as Dt, spot price as

St and past spot price as St-1 (Jorion,2005, pp.68)

So, the total return on the asset is :

Rt TOT = ( St + Dt – St-1 ) St-1

When the horizon is very short, the income return is typically very small

compared with the capital appreciation return.

2.6.6 Economic Value Added (EVA)

EVA is the value added to shareholders by management during a given year.EVA

focuses on managerial effectiveness in a given year. The basic formula for EVA

is as follows by Arzac (2008, pp.84) :

EVA = NOPAT – wC > 0

w : wacc

c : after tax cost of invested

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based on Tim MarkPlus and Co.(2001, pp.30-31) ,the formula for NOPAT and

Capital are :

NOPAT = Net Operating Profit After tax

= (Total Operating Income + Other Operating Incomes - Other Interest

Expense) x (1-t)

Capital = Acceptances payable + subordinated loans + fund borrowings + stock

equity

While according to Brigham and Ehrhardt (2005, pp.110), the basic formula for

Eva is as follows :

EVA = EBIT(1-Tax rate) – (Total Net Operating Capital)(WACC)

That calculation of EVA do not add back depreciation because them assumes

that the true economic depreciation of the company’s fixed assets exactly equals

the depreciation used for accounting and tax purposes.

Based on those formula above, the writer decide to use the Brigham’s EVA

formula and Tim MarkPlus and Co.’s formula for calculate capital because its

more practical and suitable for banks industry.

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According to Iramani and Febrian (2005), Firm’s goal are to achieve an positif

EVA and make it increase because :

• EVA > 0 : there is a economical increment in the firm

• EVA = 0 : in economically,the firm has no gain or loss because

all the profits has used to paid to the funding.

• EVA < 0 : there is no a economical increment for the firm because

the profits don’t fulfill the shareholders’s expectations.

According to Brigham&Houston (2004,p.55-57), “EVA is an estimate of a

business’s true economic profit for the year, and it differs sharply form

accounting profit. The most important reason is that the cost of equity capital is

deducted when EVA is calculated. Others factors that could lead to differences

include adjustments that might be made to depreciation, to research and

development costs, to inventory valuations and so on.EVA represents the residual

income that remains after the cost of all capital, including equity capital, has been

deducted, whereas accounting profit is determined without imposing a charge for

equity capital. Equity capital has a cost because funds provided by shareholders

could have been invested elsewhere where they would have earned a return.

Shareholders give up the opportunity to invest funds elsewhere when they provide

capital to firm. The return they could earn elsewhere in investments of equal risk

represents the cost of equity capital.

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EVA provide a good measure of the extent to which the firm has added to

shareholders value. So it can be determined for divisions as well as for the

company.EVA can be determined for divisions as well as for the company as a

whole, so it provides a useful basis for determining managerial performance at all

levels.

1. Advantages and Disadvantages of EVA

According  to  http://pages.stern.nyu.edu/~adamodar/pdfiles/eva.pdf  ,  there  are 

some of advantages and disadvantages of using EVA as measurement. 

Advantages of EVA are :

1. EVA is closely related to NPV. It is closest in spirit to corporate

finance theory that argues that the value of the firm will increase if you

take positive NPV projects.

2. It avoids the problems associates with approaches that focus on

percentage spreads between ROE and Cost of Equity and ROC and

Cost of Capital. These approaches may lead firms with high ROE to

turn away good projects to avoid lowering their percentage spreads.

3. It makes top managers responsible for a measure that they have

more control over - the return on capital and the cost of capital are

affected by their decisions - rather than one that they feel they cannot

control as well the market price per share.

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4. It is influenced by all of the decisions that managers have to make

within a firm the investment decisions and dividend decisions affect

the return on capital and the financing decision affects the WACC

Disadvantages of EVA are :

1. High growth firms, where the bulk of the value can be attributed to

future growth.

2. Firms where neither the leverage not the risk profile of the firm is

stable, and can be changed by actions taken by the firm.

3. Firms where the current market value has imputed in it expectations of

significant surplus value or excess return projects in the future.

• Note that all of these problems can be avoided if we restate the objective

as maximizing the present value of EVA over time. If we do so, however,

some of the perceived advantages of EVA - its simplicity and

observability - disappear.

2.6.7 WEIGHTED AVERAGE COST OF CAPITAL

If a firm’s only investors were common stockholders, then the cost of capital

would be the required rate of return on equity. However, most firms employ

different types of capital and due to differences in risk, these different securities

46  

 

have different required rate of return. The required rate of return on each capital

component is called its component costs and the cost of capital used to analyze

capital budgeting decisions should be a weighted average of the various

components’ costs. That weighted average called weighted average cost of capital

(WACC)

Based on www.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch4.pdf, Calculation for

wacc is :

Wacc = kd [D/(D+E)] + ke [E/(D+E)]

Where:

ke = cost of equity

kd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

• for calculate weighted average cost of debt, according to Brigham &

Houston (2004,p.360) :

after tax cost of debt = interest rate (1 - tax rate)

• for calculate cost of equity (Rs), we using CAPM with the formula

according to Block and Hirt (2005, pp.318) :

Rs = rf + β(rm - rf)

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where :

Rs : cost of equity

rf : the risk free rate ( we using SBI rate as explained above)

rm: cost of equity of the market (market risk premium, which is the

expected market return)

expected market return by Berk and DeMarzo(2007, pp.69) is :

Expected return of a risky investment (in percentage)

= expected gain at end of year

Initial cost

For example : investors who buy the market index for its current

price of $1000 receive $1100 on the end of year, which is an

average gain of $100 or a 10% return on their investment.

Because we using IHSG for find out the market risk premium, so

the formula would be :

Rm = IHSGt - IHSGt-1

X 100% IHSGt-1

IHSG used to measure the accuracy of market return based on

Indonesian stock index in all industry

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β : the stock’s beta coefficient (we using regression to get the figure)

Steps for calculate beta :

First we must find out the return of stock then we be able to calculate the

beta :

� = Covariance (rs,rm) Variance rm

Where,

n Covariance = ∑ [ Rsi – Rs] [Rm – Rm] i= 1 n

n variance = ∑ [Rm – Rm]² i= 1 n

desc :

Rsi : return share price per year

Rm : return of IHSG per year

Rs : average return share price per year

Rm : average return IHSG per year

We using CAPM that found by William F.Sharpe because CAPM

specifies the relationship between risk and required rates of return on

assets when they are held in well-diversified portfolio. Based on Brigham

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& Ehrdardt (2005, pp.182), there are some of the assumptions underlying

the CAPM’s model. Those assumption are :

o All investors focus on a single holding period and they seek to

maximize the expected utility of their terminal wealth by choosing

amount alternative portfolios on the basis of each portfolio’s

expected return and standard deviation.

o All investors can borrow or lend an unlimited amount at a given

risk free rate of interest, rRF, and there are no restrictions on short

sales of any assets

o All investors have identical estimates of the expected returns,

variances, and covariances among all assets; that is, investors have

homogeneous expectations

o All assets are perfectly divisible and perfectly liquid (that is,

marketable at the going price)

o There are no transactions costs

o There are no taxes

o All investors are price takers(that is, all investors assume that their

own buying and selling activity will not affect stock price)

o The quantities of all assets are given and fixed

• for tax rate, we using tax rate of 30% based on the tax regulation in

Indonesia which is Perpajakan Pasal 17 No.10 tahun 1994 and pasal 17(1)

50  

 

huruf b tahun 2000. Undang- Undang Perpajakan Pasal 17 No.10 tahun

1994 is the change of Undang- Undang Perpajakan Pasal 7 tahun 1991

UU Perpajakan Pasal 17(1) huruf b tahun 2000 untuk tarif PPh wajib pajak badanPenghasilan Kena Pajak Tarif Pajak (%)Rp 0,- - Rp 50.000.000,- 10%Rp 51.000.000, - s/d Rp 100.000.000,- 15%> Rp 100.000.000,- 30%

www.pajak.go.id

• for calculate the β, we using regression analysis with the historical share

price per year, average return share price per year, historical IHSG per

year, average return IHSG per year. The regression done by excel based

on guidance from Mayes TR and Shank’s Financial Modeling book.

2.6.8 TOBIN’S Q

Chung and Pruitt(1994) said Tobin's q plays an important role in many

financial interactions. Defined as the ratio of the market value of a firm to the

replacement cost of its assets, q has been employed to explain a number of

diverse corporate phenomena, such as cross-sectional differences in

investment and diversification decisions (Jose, Nichols, and Stevens (1986)

and Malkiel, Von Furstenberg, and Watson (1979), the relationship between

managerial equity ownership and firm value (McConnell and Servaes (1990)

and Morck, Shleifer, and Vishny (1988), the relationship between managerial

performance and tender offer gains (Lang, Stulz, and Walkling (1989),

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investment opportunities and tender offer responses (Lang, Stulz, and

Walkling (1989), and financing, dividend, and compensation policies (Smith

and Watts (1992).

Lang, Stulz and Walkling (1989) avoid the drawbacks of ex post approaches

by focusing on a performance measure observed at a point in time that does

not require the use of a risk adjustment, Tobin's q. The advantage of Tobin's q

is that it incorporates the capitalized value of the benefits from diversification.

The problem with this is that Tobin's q reflects what the market thinks are the

benefits from diversification, whether illusory or not. Hence, for us to be able

to infer from Tobin's q the benefits from diversification, we have to assume

that financial markets are efficient and that a firm's market value is an

unbiased estimate of the present value of its cash flows. With this assumption,

the ratio of the market value of the firm to the replacement value of its assets

is a measure of the contribution of the firm's intangible assets to its market

value. A firm's intangible assets include its organizational capital, reputational

capital, monopolistic rents, investment opportunities,and so on. Management's

actions directly affect the value of the intangible assets, and managerial

entrenchment can be viewed as an intangible asset that has negative

value.Hence, management can add or subtract from the value of the firm's

tangible assets whose replacement value is the denominator of the q formula.

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Lang, Stulz and Walkling (1989) said ”To compute Tobin's q, we follow the

methods used by Lang and Litzenberger (1989), who build on Lindenberg and

Ross (1981). Tobin's q is defined as the ratio of the firm's market value to the

replacement cost of its assets. The firm's market value is taken to be equal to

the sum of the value of its common stock,debt, and preferred stock. A firm's

common stock and the number of shares outstanding.  The book value of

preferred stock is used as a surrogate for market value because of its relatively

trivial magnitude. When available, the prices of long-term bonds are obtained

from Moody's Bond Record and Standard and Poor's Bond Guide; otherwise,

we use book value. If the price of a nonconvertible bond is not reported, the

yield to maturity of another bond with a similar maturity and coupon rate

issued by the same firm is used to calculate the price of the bond. Bonds with

a remaining maturity of less than one year, short-term bonds, and debt with an

unknown coupon and/or maturity date are valued at book value. The

denominator of the q ratio is assumed to be equal to total book assets plus the

replacement costs of plant and inventories minus the book value of plant and

inventories.  To obtain the replacement costs for smaller firms that do not

report these replacement costs at all, we assume that the value of plant at the

start (1967) is equal to book value. Replacement cost is the sum of the book

values of common stock,preferred stock and long-term debt”

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According to Damodaran (2002, pp.538-539), Tobin’s Q is a practical

measure of value for a mature firm with most or all of its assets in place where

the replacement cost can be estimated for the assets.

Tobin’s Q = Market value of assets on place

Replacement cost of assets in place

Firm that earn negative excess returns and do not utilize their assets efficiently

will have a Tobin’s Q that is less than 1.Firm that utilize their assets more

efficiently will trade at a Tobin’s Q that exceeds 1. In practice, analysts often

to use shortcut to arrive at Tobin’s Q, using book value of assets as a proxy

replacement value and market value of debt and equity as a proxy for the

market value of assets. The market value of the this firm can be used a proxy

for the market value of its assets.

While Lindenberg and Ross (1981) said that if a firm's q is greater than one,

the market value of the firm is in excess of its replacement cost. If there is free

entry, other firms could enter the industry by purchasing the same capital

stock as the existing firm. Furthermore, they would anticipate an increase in

value over their investment because its market value would exceed its cost. 

Thus, in the absence of barriers to entry and exit, q will be driven down to one

as new firms enter (or existing firms expand if average and marginal q

coincide). The assets of a firm fall into three broad categories: (a) plant and

equipment, (b) inventories, and (c) other assets. Category c contains liquid

assets such as cash and securities as well as land.

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