- Estimating Risk free rate and Equity Risk Premium
a. Choose a currency to do your analysis in and estimate a risk free rate in that
currency. If there is a Aaa rated entity issuing long term bonds in the currency,
you can use the interest rate on those bonds as your risk free rate. If not, you will
have to subtract out the default spread for the entity from the interest rate on the
entity’s bonds to get to a risk free rate.
b. Based on the geographical risk exposure of your company, estimate an equity risk
premium for the company. You should be able to find at least a revenue
breakdown by region, in your company’s financial reports, and sometimes asset
and income breakdowns. You can find equity risk premiums for individual
countries, as well as regions, on http://www.damodaran.com (under updated data). - Estimating relative risk
4.105
105
a. Run a regression of returns on your firm’s stock against returns on a market
index. Use the regression to evaluate your company’s performance on a risk
adjusted basis during the period of the regression and its riskiness, relative to the
market, and break down the risk into firm specific and market components. To
run the regression, you will need to get data on past returns for your stock and for
a market index.
b. Based on your company’s business mix, estimate a “bottom up” beta for your
company’s operating businesses. You should be able to find the breakdown by
business in your company’s financial filings, though the details are richer in some
than others. To get the beta for each business, you will need to find other publicly
traded companies that operate primarily in that business, average their betas and
correct for financial leverage and cash holdings.
c. If your company is a privately owned business and the owner is not diversified,
adjust the unlevered beta that you have computed for the owner’s absence of
diversification. (If the owner is completely undiversified, you will use a total beta.
If partially diversified, you will use a beta between the unlevered market beta and
the total beta).
d. Estimate the market value of debt outstanding in the company (see below),
compute a market debt to equity ratio for the entire company, and use that ratio to
compute a levered beta for the company. If you can allocate the debt across the
different businesses, compute the debt to equity ratio and levered beta for each
business. (If not, use the company’s debt to equity ratio for all of the businesses).
If you are working with a privately owned, make a judgment on whether you want
to use industry-average debt to equity or owner-specified target debt to equity
ratio in computing the levered beta.
e. Use the levered betas, in conjunction with the risk free rate and equity risk
premium, to compute costs of equity for each business and for the overall
company. - Estimating Default Risk and Cost of Debt
a. If your company is rated, find the bond rating and estimate a default spread based
on the rating. Add the default spread to the risk free rate to estimate a pre-tax cost
4.106
106
of debt. If the company’s divisions can borrow money on their own, estimate the
cost of debt at the divisional level.
b. Estimate a synthetic rating for your company, based upon financial ratios. If the
company has an actual rating, compare the synthetic rating to the actual rating and
explain the reasons for differences. If your company does not have an actual
rating, use the synthetic rating to estimate a default spread for the company’s debt
and a pre-tax cost of debt based on that spread.
c. Estimate the marginal tax rate for your company, based on the country of
incorporation and use that tax rate to compute an after-tax cost of debt for the
company and its divisions (if they have their own costs of debt) - Estimating Cost of Capital
a. Compute the market value of all of the company’s equity, if it is publicly
traded.
b. Compute the market value of the company’s interest-bearing debt, using the
interest expenses and weighted maturity of the debt, if need be. Compute the
present value of lease and other contractual commitments that your company has
contractually obligated itself to pay. Add the two values to estimate the market
value of debt (which you will need to use for the levered beta computation in the
earlier section)
c. Compute a debt to capital ratio, using the market values, and a cost of capital
based on this ratio for both the company and its individual business units. If you
are working with a privately owned business, stay consistent with the debt ratio
choice you made in the levered beta computation (industry average or ownerspecified) to compute the cost of capital.
Sample Solution