Cement Capacity Expansion: DDM or FCFF?
A listed cement producer has just commissioned a 2.0mtpa line, taking capacity to 3.5mtpa, funded with PKR 18bn of debt priced at KIBOR plus 250bp; KIBOR is 11.5%. Net debt to EBITDA has moved from 0.8x to 2.9x. The company has paid out 70% of earnings for eight consecutive years. FY24 EPS was PKR 14.20 and DPS PKR 10.00, and the share trades at PKR 118. The new line should lift volumes by about 45% over three years as it ramps, while cement demand grows 4-5%. A competitor is adding 3mtpa in the same northern region within 18 months, and your plant is in the north where freight protects the market. Long-run inflation is 7%, the 10-year PIB yields 13.5%, you use an equity risk premium of 6.5%, the stock's beta is 1.25, and the corporate tax rate is 29%. Your client asks whether the dividend discount model is the right tool and what value it implies.
1. Compute the cost of equity and the perpetual growth rate implied by the market price under a constant-growth DDM. Is that growth rate credible?
Read the worked answer
Cost of equity. r = 13.5% + 1.25 x 6.5% = 13.5% + 8.125% = 21.6%.
Implied growth. 118 = 10.00(1+g) / (0.2163 - g) 118 x 0.2163 - 118g = 10 + 10g 25.52 - 118g = 10 + 10g 15.52 = 128g g = 12.1%
Credibility test. A 12.1% perpetual nominal growth rate, against 7% inflation, implies about 5% real growth forever on top of 4-5% industry volume growth. That requires the company to compound market share indefinitely in a commodity with a competitor adding 3mtpa in the same region. It is not a forecast, it is the plug that reconciles a high cost of equity to the observed price.
Sensitivity. At g = 7% the value is 10.70 / 0.1463 = PKR 73. At g = 5% it is 10.50 / 0.1663 = PKR 63. A 5pp change in a single perpetuity assumption moves the value by 38% - the model is not measuring the business, it is measuring the terminal assumption.
Diagnosis. Either the market is capitalising something outside the dividend stream (asset revaluation, a land bank, an acquisition option), or the cost of equity is overstated. Before concluding the stock is expensive, check whether the 10-year PIB is contaminated by a liquidity premium and whether a lower beta is defensible.
2. Argue whether DDM is the appropriate model here. If you reject it, set out the FCFF framework and the WACC you would use.
Read the worked answer
Reject the DDM. Three reasons, in order of importance:
- Leverage changed the equity story. Net debt/EBITDA went from 0.8x to 2.9x in one year. FCFE is now debt-driven and will differ materially from dividends for several years; DDM ignores this entirely.
- The 70% payout is a policy, not a forecast. A company ramping a new line needs working capital and debt service. Eight years of history says nothing when the capital structure has just tripled in leverage; the payout is the first thing to be cut.
- DDM cannot value the growth being paid for. All of the 45% volume ramp and the associated capex sit outside a dividend model until they show up in DPS years later.
FCFF framework.
- FCFF = EBIT(1 - t) + D&A - capex - change in working capital.
- Explicit period: four years, with the ramp (45% volume), blended realisations assuming the competitor's 3mtpa lands, and a terminal EBIT margin of 18-20% rather than the peak-cycle 24%+.
- Cost of debt: 11.5% + 2.5% = 14.0% pre-tax, 9.94% after tax. At roughly 75/25 equity/debt weights: WACC = 0.75 x 21.6% + 0.25 x 9.94% = 18.7%.
- Terminal growth 6.5-7.0%, reflecting inflation and no share gain.
Check. Terminal value will exceed 75% of the total. Disclose that and show the value with the terminal growth at 5% and 8%.
3. The client asks for a buy/sell view. What is the most important assumption to stress, and how would you present the downside?
Read the worked answer
The assumption to stress is not the discount rate; it is the coexistence of a 45% volume ramp and a 3mtpa competitor in the same market within 18 months. Freight protection works when capacity is balanced; two plants commissioning into the same northern catchment turns the advantage into a shared cost burden and pushes pricing to variable cost.
Downside case. Ramp only reaches 20% instead of 45%, realised prices fall 5% in year two as the competitor commissions, and terminal EBIT margin drops 300bp to 15-17%. With the 18bn debt at KIBOR+250bp, interest is about 1.61bn a year before any rate move; combine that with lower EBITDA and the DSCR covenant becomes the binding constraint before the valuation does.
Presentation. Do not give a point estimate. Give a range: base case (ramp achieved, 19% terminal margin, g = 7%) against the downside above, and state at what price the downside is already discounted. The DDM-implied PKR 118 requires 12.1% perpetual growth, which resembles the base case of a fully de-risked, mature, high-payout utility rather than a leveraged capacity expansion.
What would make me more constructive. Evidence of pre-sales from the new line, a confirmed long-term coal contract, and a dividend policy restated as a percentage of free cash flow rather than earnings. Absent those, the correct output is a valuation range for discussion with the client, not a recommendation.