Required rate of Return

The CAPM: Cost of Equity

• Cost of Equity = Risk free Rate + Equity Beta * (Equity Risk Premium)
• What are the inputs?
• In Practice
• Government security rates are used as risk free rates
• Historical risk premiums are used for the risk premium
• Betas are estimated by regressing stock returns against market returns
Risk free Rate
• What makes an investment risk free?
• No default risk
• No reinvestment risk
• Time horizon matters: Thus, the riskfree rates in valuation will
depend upon when the cash flow is expected to occur and will vary
across time.
 Is a Government bond actually risk
free?
• Not all government securities are riskfree: Some governments face default
risk and the rates on bonds issued by them will not be riskfree.
• The risk quotient of bonds issued by the Indian government needs to be
analyzed further, to assess if these are really risk free.
• India’s sovereign ratings issued by Moodys (Baa2) or S&P (BBB-) suggest
that treasury securities issued by the Indian gsovernment do carry an
element of default risk, and hence cannot be considered risk-less
• Therefore, theoretically, the default credit spread (rating-based default
spread) should be reduced from the yield on government bonds while
arriving at the risk-free rate
Calculating Risk free rate-India
• The Indian government had 10-year Rupee bonds outstanding, with a
yield to maturity of about 6.585% on January 10, 2020.
• In January 2020, the Indian government has a local currency
sovereign rating of Baa2. The 10-year CDS spread for India in early
2020 is 1.59% The riskfree rate in Indian Rupees in Jan is
6.585%-1.59%=4.995%
Equity Risk Premiums
• It is the difference between the returns expected on the market and the interest rate on treasury bond
• One of the important ERP parameter along with the risk-free rate is the market
• Selection of an index as a proxy for the equity market is important, the chosen index should be reflective of the market as a whole.
• This suggests using BSE 500 or CNX 500 but in India betas are generally measured against the BSE Sensex (or the NSE Nifty, which is
highly correlated with the Sensex) it is best to measure ERP using the Sensex or the Nifty.
• Also you can refer to following link which tries to prove that BSE sensex reflects the performance of Indian Capital Market
http://economictimes.indiatimes.com/markets/sp-bse-sensex-does-it-really-reflect-the-performance-of-the-indian-capital-
market/articleshow/35771095.cms
https://economictimes.indiatimes.com/markets/stocks/news/why-your-nifty-is-not-reflecting-state-of-the-economy-any-
more/articleshow/68229891.cms?from=mdr
https://economictimes.indiatimes.com/markets/stocks/news/india-needs-an-index-with-a-blend-of-m-cap-and-macros-saurabh-
mukherjea/articleshow/72186098.cms
https://blogs.cfainstitute.org/investor/2019/03/15/the-nifty-50-no-longer-reflects-the-indian-economy/
https://www.thehindubusinessline.com/opinion/is-the-sensex-obsession-justified/article29954951.ece
Sector representation of Nifty 50
What is the Risk Premium Supposed to
measure?
• It measures the extra return that would be demanded by investors for
shifting their money from a riskless investment to an average-risk
investment
• It should take two things in consideration
• Risk aversion of investors
• If high then investors demand higher risk premium. Can also depend on economic
prosperity and recent experiences in market
• Riskiness of the average-risk investment
• As risk increases, premium increases
Methods to determine ERP
Prof Aswath Damodaran in his paper ‘Equity Risk Premiums (ERP):
Determinants, Estimation and Implications – The 2012 Edition’
discusses three methods for determining the ERP:
• Survey method
• Historical premium method
• Implied premium method
Survey method
• The survey method determines the ERP based on a survey of various
market participants and academics.
• Prof Damodaran pointed out several issues with the survey method.
• Survey responses are based on various factors such as recent stock price
movements, who is surveyed (academics vs CFOs vs investment
professionals), how survey questions are framed, etc. Subjectivity of the
questionnaire and respondent proves to be a hurdle. And therefore there is
a lot of variation.
• No reasonability is provided, survey respondents could provide expected
returns that are lower than the risk free rate, hence extremely volatile
• Survey premiums tend to be short term, even the longest surveys do not go
beyond one year.
• A recent survey by Pablo Fernandez indicate ERP = 7.4% in India
Historical Premiums
Time period use
• Many use a shorter time frame of 5-10 years.
• The rationale is that the risk aversion of the average investor is likely to change over time and that using a
shorter and most recent time provides a more updated estimate.
• Suppose the annual standard deviation in market index is 20%, the standard error associated with the risk
premium estimated for different estimation periods can be

Estimation Period Standard Error of Risk Premium

Estimate
5 years 20/5^1/2 = 8.94%
10 years 20/10^1/2 = 6.32%
25 years 25/25^1/2 = 4.00%
50 years 20/50^1/2 = 2.83%
Historical Premiums
Choice of risk –free security
• Arithmetic and geometric means
• Arithmetic- simple mean
• Geometric –looks at compounded returns
• Use of Geometric means are preferred
• Arithmetic mean overstate the risk premiums
• Takes compounding into consideration
Historical premium method- India
• The historical risk premium approach is widely used for determining
equity risk premiums. It is based on a geometric or arithmetic average
• The key question here is do we have a sufficiently long and stable
history to determine a reliable historical risk premium.
• the base year of the Nifty is 1995 and Sensex is 1979, Sensex index
was actually formulated in 1986
• It uses Pre liberalisation returns to predict future expected returns
• Lack of reliable estimate for risk-free rates prior to 1999
• Shorter period as risk aversion of investors keep changing
• Grant Thornton calculation show ERP =5.68%
Country Risk Premiums
• Equity Risk Premium = Base premium for mature equity market +
Country premium
• What should be the base premium for a mature equity market
• Mostly USA
• How to estimate the additional risk premium for individual countries?
• Three approaches
• Country bond default spread
• Equity volatility base approach
• Default spreads plus relative standard deviations
Based on country ratings

• Analyst use default spreads as measure of country risk premium and

add them both to cost of equity and debt
• e.g. Equity Risk Premium for the US in January 2020 is 5.20% and
India’s default risk based on rating is 1.69%.
• Therefore ERP =5.20%+ 1.69% = 6.79%
Equity volatility base approach
• This an approach use to calculate ERP for emerging markets
• According to this approach the ERP of a developed market, say the US
is adjusted for relative standard deviations (ratio of the standard
deviation of the subject country market portfolio to the standard
deviation of the US market portfolio).
• Equity risk premium country X = Risk premium US* Relative standard
deviation country X
• This method is based on the hypothesis that standard deviation being
a measure of risk, the higher the standard deviation of the index, the
riskier the index and therefore higher the risk premium.
Example
• Std deviation in Equities (weekly) India = 14.93%
• Std deviation in Equities (weekly) US = 12.69%
• Equity Risk Premium US = 5.20%
• Equity Risk Premium India = 5.20% x 14.93%/12.69% = 6.18%
Equity volatility base approach
Annualized daily standard deviation
Annualised daily standard Annualized daily standard
deviation-BSE Sensex deviation-S&P 500
10 year 25.80% 21.80%
5 year 29.50% 26.70%
2 year 18.50% 19.70%
1 year 19.90% 23.20%

As per the table the relative standard deviations over a one or two-year period is less
than one, implying that ERP for India should be less than that for the US, which is
counter-intuitive.
Default Spread Plus Relative Standard
Deviations
• Country default spreads only measure the premium of default
• Equity risk premium should be greater than country default risk
spread
• To calculate the difference, volatility of the equity market in a country
relative to the volatility of the country bond is used to estimate the
spread i.e.
• Country risk premium = Country default spread x (Std. Deviation Equity/
Std. Deviation Country Bond)
• This country risk premium will increase if the country ratings drop or
volatility in equity market increases
Example
• Std deviation in Equities (weekly) India = 14.93%
• Std deviation in Bonds India= 2.93%
• Std deviation in CDS India = 16.59%
• Country default spread= 1.59%
• Country Risk Premium India = 1.59% x 14.93%/2.93% = 8.10%
• Equity Risk Premium India = 5.20% +8.10% =13.30%
• Country Risk Premium India = 1.59% x 14.93%/16.59% = 1.43%
• Equity Risk Premium India = 5.20% +1.43% =6.63%
Difference between both the approaches?
• Both have different bases
• In the first the base is standard deviation in the U.S market, assuming
investor has a choice across equity markets
• In second the assumption is that the investors are more likely to
choose between Indian government bond or equity
Implied ERP approach
• The implied premium approach is based on the fundamental premise that the
expected return on the market portfolio is built into the current market
valuations.
• The simplest way to compute the implied premium is by applying the Gordon
Growth Dividend Discount model.
• According to the approach, once the dividend yield and expected growth rate are
determined ERP can be estimated.
• In India, the historical dividend yields have been very low, around 1%. Thus the
classic Gordon Growth model will result in a very low estimate of expected
returns, and therefore, the ERP.
• Therefore, dividendable cash flows as opposed to dividends can be used. In other
words, free cash flow yield is a more appropriate measure compared to dividend
yield.
Implied premium approach- Inputs
• FCFE yield
• can be computed based on the aggregate of the FCFE for all 30
Sensex/50 Nifty companies for the financial year (the latest data
available) divided by the Sensex/ Nifty market capitalization as on
date of calculation.
• A six-month average market capitalization would be ideal, but it
becomes difficult to account for changes in the index composition.
Implied premium approach- Inputs
Growth rate
• Bloomberg gives consensus Sensex earnings growth estimates for
next two years
• in. reuters.com provides long term (5 yrs) growth projections made by
analyst for most of the companies.
• You can also take projected growth rate in EPS for all sensex stocks
from websites like icicidirect.com, moneycontrol.com and calculate its
average to approximate growth rate
Implied premium approach- Inputs
Stable growth rate
• Prof. Damodaran uses riskfree rate to approximate the stable growth
rate.
• Some people also use, long-term GDP projections
Which equity risk premium to use?
• If you assume, premiums revert back to historic norms and your time
yields the same
• Historical risk premium
• Market is correct in the aggregate and that your valuation should be
market neutral
• Current implied equity risk premium
• Market makes mistakes even in the aggregate but is correct over time
• Average implied equity risk premium over time.
Which equity risk premium to use?
• Average can also be used
Beta
Three approaches
• Historical data on market prices for individual assets
• Estimation based on fundamentals
• Using accounting data
Historical market Beta
What should be the
• length of estimation period
• Return interval
• Choice of market index
• Have relevance for APM also
Example
• The regression of Cipla against Sensex returns is
• RCipla = 0.05% +.55 R Sensex
[0.24%] [0.17]
R sqr = 34%

• Standard error =.20 means beta can be in the range of 0.38 to 0.72
• And from 0.21 and 0.89 with 95% confidence
• Shows we should consider estimates of betas from regression with caution
• Beta extracted from service providers should also be used with caution
Fundamental Betas
Depends on three variables
• Type of business
• Degree of operating leverage
• High operating leverage high beta
• Small firms high beta
• Degree of financial leverage
• High leverage high beta
Asset Beta
• ßl = ßu (1 + (1-t) (D/E))
• Fundamentally beta depends on two things
• Riskiness of business and amount of financial leverage risk
Bottom-Up Betas
• Identify business or businesses a firm is in
• Estimate average unlevered beta of other publicly traded firms that
are in each of these businesses
• Unlevered beta needs to be corrected for cash = unlevered beta
(1-Cash/Firm Value)
• Take a weighted average of the unlevered betas of the business the
firm operates in
• Calculate the current debt/equity ratio and estimate levered beta
Why bottom-up beta?
• Can be used for firms with no price history e.g. IPOs, private
businesses, division of companies
• Standard error will be a function of number of comparable firms
i.e. Average beta / square root of number of firms
• Can be adjusted for recent and forthcoming changes in firm’s
business and financial leverage
Accounting Beta
• Regressing change in earnings with the change in earnings of the
market
• Pitfalls
• Accounting figures are smoothed out
• Can be manipulated
• Timing- quarterly, yearly
 Example
• You have been asked to estimate the beta of a high-technology firm
which has three divisions with the following characteristics
Division Beta Market Value
Personal
1.60 $100 million
Computers
Software 2.00 $150 million
Computer
1.20 $250 million
Mainframes
A. What is the beta of the equity of the firm?
B. What would happen to the beta of equity if the firm divested
itself of its software business?
C. If you were asked to value the software business for the
divestiture, which beta would you use in your valuation?
Example
• The following are the betas of the equity of four forestry/paper product companies, and their
debt/equity ratios.
Company Beta Debt/Equity Ratio

Weyerhauser 1.15 33.91%

Champion
1.18 54.14%
International

Intenational Paper 1.05 45.50%

Kimberly-Clark 0.91 11.29%

(All the firms face a corporate tax rate of 40%)

A. Estimate the unlevered beta of each firm. What do the unlevered betas tell you about these
firms?
B. Assume now that Kimberly Clark is planning to increase its debt/equity ratio to 30%. What
will its new beta be?
C. If you were valuing an initial public offering in the paper products area, what beta would you
use in the valuation? (Assume that the firm going public plans to have a debt/equity ratio of
40%.)
Example
• The following is a description of the cost structure and betas of five firms in the food production
industry:
Fixed Variable
Company Beta D/(D+E)
Costs Costs
CPC
62% 38% 1.23 18.83%
International
Ralston Purina 47% 53% 0.81 38.32%
Quaker Oats 45% 55% 0.75 13.28%
Chiquita 50% 50% 0.88 75.35%
Kellogg's 40% 60% 0.76 5.57%

(Assume that all firms have a tax rate of 40%.)

A. Based upon just the operating leverage, which firms would you expect to have the highest and lowest betas
(assuming that they are in the same business)?
B. Chiquita's beta is believed to be misleading because its financial leverage has increased dramatically since the
period when the beta was estimated. If the average D/(D+E) ratio during the period of the regression (to estimate the
betas) was only 30%, what would your new estimate of Chiquita's beta be?
 Example
• You are attempting to estimate the beta of a private firm that has no comparable firms. You decide to
estimate an "accounting" beta using past earnings. You have six years of accounting data on the
private firm, and the comparable information on earnings changes for the average S&P 500 company
during the same period.
Earnings
Net Income of Change-
Year
Private Company Average Firm
in S&P

2014 $10.00 million + 7%

2015 $15.00 million +10%

2016 $18.00 million + 5%

2017 $18.50 million - 10%

2018 $19.00 million - 8%

2019 $22.00 million + 6%

A. Estimate the accounting beta for the private company.

B. What are the limitations of an "accounting" beta?
 Example
• The following are the betas of three companies involved in a merger battle. The target firm is
Paramount Communications, and the competing bidders are QVC and Viacom:
Market Value
mpany Beta Debt
of Equity

Paramount 1.05 $6,500 million $817 million

QVC 1.70 $2,000 million $100 million

$2,500
Viacom 1.15 $7,500 million
million

(Assume that all firms have a tax rate of 35%.)

A. If QVC acquires Paramount, using a mix of debt and equity comparable to its current debt/equity ratio, what
would the beta of the combined firm be?
B. If QVC acquires Paramount, using only debt, what would the beta of the comparable firm be?
C. If Viacom acquires Paramount, using a mix of debt and equity comparable to its current debt/equity ratio,
what would the beta of the combined firm be?
D. If Viacom acquires Paramount, using only equity, what would the beta of the comparable firm be?
Ke for Private and Closely Held Businesses
• From owner perspective rather marginal investors
• Three solutions
• Assume that the business will be sold in near term. In such case, its
reasonable to use market beta and ke
• Add a premium to ke to reflect the higher risk created by the owners’
inability to diversify
• Adjust beta to reflect total risk rather than market risk
Example
• Kristin Kandy is a small privately owned candy manufacturing
business. To estimate its beta, data of publicly traded food processing
companies with market cap of less than $ 250 million is collected. The
average beta across these firms was .98. The average debt to equity
ratio of these firms was 43% (30% debt, 70 % equity). Marginal tax
rate is 40%. Average R square across all the food processing company
regressions was 11.12%. Calculate both levered and total levered beta
assuming Kristin Kandy will fund its operations using the same mix of
debt and equity as public traded firms in sector. What would be its
cost of equity (using levered and total beta) if rf is 4.5% and risk
premium is 4%.
• Which of these ke will you use in valuing Kristin Kandy?
What should be counted as debt?
• All interest bearing securities
• In case of multiple borrowing, combine all debt-short and long-term,
bank debt and bonds and attach long term cost.
• Why long term cost when effective cost be lowered by using short-
term cost?
• It is the hurdle rate for long term and the firm which uses short term
debt to finance long term needs to return to the market to roll over
the debt.
Cost of debt
• If nothing has changed since last issue then current coupon rate can be
taken as Kd.
• If conditions have changed, analyst must estimate kd based on current
market interest rate and default risk
• Analyst use YTM on option free bond if conditions have changed
• Weighted average YTM is used if firm has many outstanding bonds of
different maturity
• If debt is not traded frequently then YTM can be determined by looking at
YTM of bonds of similar rated firms
• For firms whose debt is unrated then analyst compare debt coverage
ratios, debt/equity ratios and operating margin ratios with similar
companies and use YTM of similar companies as Kd of unrated company
Tax Rate
Cost of preferred stock
• Kpr>Kd
• Kpr = dpr/PR
• E.g. if a firm pays Rs 2 preference dividend on its preferred stock,
current value of preferred stock is Rs 50. Calculate cost of preferred
stock
Required Returns: Cost of Capital

Weighted Average Cost of Capital (WACC):1,2

WACC = ke x E + kd (1-t) x D + kpr x __PR__

(E+D+PR) (E+D+PR) (E+D+PR)

Where E = the market value of equity

D = the market value of debt
PR = the market value of preferred stock
ke = cost of equity
kpr= cost of preferred stock
kd = the interest rate on debt
t = the firm’s marginal tax rate

1To estimate WACC, use firm’s target debt-to-total capital ratio (TC).
2(D/E)/(1+D/E) = [(D/E)/(E+D)/E] = [(D/E)(E/(E+D)] = D/(E+D) = D/TC; E/TC = 1 – D/TC.
Weights in WACC
• Weights represent the target capital structure
• i.e. the capital structure that the firm hopes to achieve and sustain in
future
• If in any of the firm’s statement e.g MD&A, target capital structure is
mentioned then that should be used for calculation
Appropriate Discount Rate
• What if the discount rates are too high?
• What if low?
• What if the acquirer is merging with high risk business?
• What is both acquirer and target have same risk?
• What if acquirer is more risky?
Example
• Merck & Company has 1.13 billion shares traded at a market value of $32
per share, and $1.918 billion in book value of outstanding debt (with an
estimated market value of $2 billion). The equity has a book value of $5.5
billion, and the stock has a beta of 1.10. The firm paid interest expenses of
$160 million in the most recent financial year, is rated AAA and paid 35% of
its income as taxes. The ten-year government bond rate is 6.25%, risk
premium is 5.5% and AAA bonds trade at a spread of twenty basis points
(0.2%) over the treasury bond rate.
• A. What are the market value and book value weights on debt and equity?
• B. What is the cost of equity?
• C. What is the after-tax cost of debt?
• D. What is the cost of capital?