Business Valuatin

Rajiv Bhutani
IIM Sambalpur
2018
 Advanced Estimation Issues in
WACC

Measuring Cost of Debt

Measuring Cost of Equity

Measuring Risk Free Rate

Measuring Market Risk Premium

Measuring Market Risk Premium for Other Sovereigns

Correct Weights

Measuring Beta
 Debt and Its Cost

What should be included in Debt calculation

Long Term Debt

Short Term Debt

Operating Leases



Cost of debt should be computed using current
yields
 Cost of Equity

Approach 1: CAPM Model

Approach 2: Dividend Discount(Growth) Model
 Ke = Div1/S0 + g

How to determine g?
 Approach 2a: g = Internal Growth

g = ROE*(1-Payout Ratio)

RoE comes from Income Statement and B/S

Payout ratio = DPS/EPS
 Approach 2b: g = Historical Growth of Dividends
 Dn = D0(1+g)n
 Risk Free Rate

Risk free means
 There is no default risk, but some countries default, so we need to have “Country Risk Premium (CRP)”
 There is no reinvestment risk, so T-Bond risk become problematic since it pays periodic coupons and those coupons
will be reinvested at a different rate in future. A solution is default free zero coupon bonds like STRIPS in US
 Does above means we should use different STRIPS to discount different year’s coupons. Theoretically YES,
practically no one does it as the PV effect of using different discount rates is not very significant, for most rate
environments

Use the longest risk free rate that you can get for a country

The caveat is it might be difficult to estimate Country Risk Premium (CRP) and Equity Risk Premium
(ERP)

Q1: A company incorporated in US, has largest investor in Singapore, and has largest operations in
Europe. What risk free rate to choose?

A1: Since most of the Cash flows are coming from Europe, they should be discounted with a Euro
discount rate.

So, the correct answer to Q1 would be that we can use risk free rate of Euro, if Cash flows are in Euro.
Equally, we can transform the Cash flows to Japanese yen and use a JPY interest rate.
 Risk Free Rate

In periods of high inflation, it is best to use real cost of capital, which means real risk free rate should
be used

In US real risk of rates is available, as inflation indexed Treasuries trade and are liquid

Risk free rate when there is no government bond or government bond has default risk
 Approach 1: Largest & safest firms in the market and take average of what they pay on their long term
borrowings in local ccy. Reduce this rate by little to get risk free rate for local currency


 Approach 2: If long term forward contracts trade on currency, use interest rate parity and T-Bond rate to get
local ccy risk free rate
 Fforeign/USD = Sforeign/USD((1+rforeign)/(1+rUSD))^10 ; compute rforeign


 Approach 3: Subtract default spread for the country to get riskless local ccy rate
 Riskless BR rate = Brazil govt bond rate – Default spread = 12%-2% = 10%
 (Brazilian government rating is BBB which corresponds to 2% default spread)
 Riskless INR rate = India 10yr G-Sec rate – Defaut spread = 7.82% - 1.95% = 5.87%
 Indian government rating is Baa2 (Moodys)
 Risk Free Rate – Measuring
Sovereign Default Spread
●
Approach 1: Find sovereign USD denominated
bonds, subtract US T-Bond with same maturity
– Default Sprd = Sovereign G-Bond (USD) – US Tbond
●
Approach 2: Find CDS value of sovereign
– Default Sprd = Sovereign CDS sprd – US CDS sprd
●
Approach 3: Sovereign rating based sprd:
Countries that do not have bonds or CDS spread,
use average sprd for other countries with same
sovereign rating
Local Ccy Bond Rates – Jan 2017
Currency Govt Bond Rate 12/31/16 Currency Govt Bond Rate 12/31/16

Australian $ 2.76% Malyasian Ringgit 4.24%

Brazilian Reai 11.37% Mexican Pesi 7.63%
Britsh Piund 1.35% Nigerian Naira 15.97%
Bulgarian Lev 2.04% Nirwegian Krine 1.61%
Canadian $ 1.70% NZ $ 3.25%
Chilean Pesi 4.12% Pakistani Rupee 8.03%
Chinese Yuan 3.25% Peruvian Sil 6.43%
Cilimbian Pesi 6.76% Phillipine Pesi 4.75%
Criatan Kuna 3.13% Pilish Zlity 3.67%
Czech Kiruna 0.49% Rimanian Leu 3.44%
Danish Krine 0.42% Russian Ruble 8.38%
Euri 0.29% Singapire $ 2.45%
HK $ 1.69% Siuth African Rand 8.80%
Hungarian Firint 3.41% Swedish Krina 0.62%
Iceland Krina 5.06% Swiss Franc -0.19%
Indian Rupee 6.40% Taiwanese $ 1.17%
Indinesian Rupiah 7.60% Thai Baht 2.70%
Israeli Shekel 2.06% Turkish Lira 11.00%
Japanese Yen 0.06% US $ 2.45%
Kenyan Shilling 14.02% Venezuelan Bilivar 20.43%
Kirean Win 2.08% Vietnamese Ding 6.10%

Source: Aswath Damodaran

Appriach 1: Default spread frim Givernment
Binds

The Brazil Default Spread

Brazil 2018 Bond: 4.86%
US 2018 T.Bond: 1.22%
Spread: 3.64%

Source: Aswath Damodaran

 Appriach 2: CDS Spreads – January 2017
CDS Spread adj Ciuntry CDS Spread adj Ciuntry CDS Spread adj
Ciuntry CDS Spread CDS Spread CDS Spread
fir US fir US fir US
Abu Dhabi 0.97% 0.59% Hungary 1.67% 1.29% Peru 1.73% 1.35%
Argentna 5.14% 4.76% Iceland 1.10% 0.72% Philippines 1.61% 1.23%
Australia 0.49% 0.11% India 1.76% 1.38% Piland 1.17% 0.79%
Austria 0.52% 0.14% Indinesia 2.25% 1.87% Pirtugal 3.42% 3.04%
Bahrain 3.17% 2.79% Ireland 1.02% 0.64% Qatar 1.17% 0.79%
Belgium 0.60% 0.22% Israel 1.12% 0.74% Rimania 1.51% 1.13%
Brazil 3.59% 3.21% Italy 2.22% 1.84% Russia 2.46% 2.08%
Bulgaria 1.87% 1.49% Japan 0.62% 0.24% Saudi Arabia 1.45% 1.07%
Chile 1.29% 0.91% Kazakhstan 2.13% 1.75% Slivakia 0.85% 0.47%
China 1.65% 1.27% Kirea 0.67% 0.29% Slivenia 1.52% 1.14%
Cilimbia 2.42% 2.04% Latvia 1.02% 0.64% Siuth Africa 2.87% 2.49%
Cista Rica 3.40% 3.02% Lebanin 5.57% 5.19% Spain 1.25% 0.87%
Criata 2.60% 2.22% Lithuania 0.94% 0.56% Sweden 0.40% 0.02%
Cyprus 2.67% 2.29% Malaysia 1.94% 1.56% Switzerland 0.50% 0.12%
Czech Republic 0.74% 0.36% Mexici 2.20% 1.82% Thailand 1.28% 0.90%
Denmark 0.41% 0.03% Miricci 2.11% 1.73% Tunisia 5.00% 4.62%
Egypt 4.76% 4.38% Netherlands 0.51% 0.13% Turkey 3.44% 3.06%
Estinia 0.81% 0.43% New Zealand 0.50% 0.12% Ukraine 7.64% 7.26%
Finland 0.45% 0.07% Nigeria 5.76% 5.38% United Kingdim 0.61% 0.23%
France 0.70% 0.32% Nirway 0.34% 0.00% United States 0.38% 0.00%
Germany 0.44% 0.06% Pakistan 4.18% 3.80% Venezuela 30.82% 30.44%
Hing King 0.58% 0.20% Panama 1.94% 1.56% Vietnam 2.61% 2.23%

Source: Aswath Damodaran

Appriach 3: Typical Default Spreads: January
2017
S&P Sivereign Ratng Miidy's Sivereign Ratng Default Spread
AAA Aaa 0.00%
AA+ Aa1 0.46%
AA Aa2 0.57%
AA- Aa3 0.70%
A+ A1 0.81%
A A2 0.98%
A- A3 1.39%
BBB+ Baa1 1.84%
BBB Baa2 2.20%
BBB- Baa3 2.54%
BB+ Ba1 2.89%
BB Ba2 3.47%
BB Ba3 4.16%
B+ B1 5.20%
B B2 6.36%
B- B3 7.51%
CCC+ Caa1 8.66%
CCC Caa2 10.40%
CCC- Caa3 11.55%
CC+ Ca1 13.86%
CC Ca2 15.25%
CC- Ca3 16.50%
C+ C1 18.00%
C C2 20.00%
C- C3 25.00%

Source: Aswath Damodaran

 Risk Free Rate – Brazil Case
●
The Brazilian government bond rate in nominal reais on January 1, 2017 was 11.37%.
To get to a riskfree rate in nominal reais, we can use one of three approaches.
●
Approach 1: Government Bond spread
●
The 2018 Brazil bond, denominated in US dollars, has a spread of 3.64% over the US
treasury bond rate.
●
Riskfree rate in $R = 11.37% - 3.64% = 7.73%
●
Approach 2: The CDS Spread
●
The CDS spread for Brazil, adjusted for the US CDS spread was 3.21%.
●
Riskfree rate in $R = 11.37% - 3.21% = 8.16%
●
Approach 3: The Rating based spread
●
Brazil has a Ba2 local currency rating from Moody’s. The default spread for that rating
is 3.47%
●
Riskfree rate in $R = 11.37% - 3.47% = 7.90%
Risk Free Rates Across Countries
Risk free Rates - January 2017
25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
n a a v c i e $ e a t d t g u el $ n e $ n i $ $ ty $ it $ i a e i il h le i d ar ai ra g ra
Ye un un Le an ur n e e n rin n ah n Le k K i n n ua es S re i n gg Z es in e es S ia b es n iv e Li lin ai
se Kir n K ian s Fr E Kri nes Rup Kri Fi Piu ai B e Di ian She H n W Kri dia e Y e P U pi h Zl alia Rin N n P Kr Rup n P ian Rup Ru n P n Ra Bil n R ish hil n N
ne h ta ar is sh a ni sh n h h s n li a ga is tr n ia k S a
ni Taiw ista edi aria rits T ame ma rae ea an n es in in Pil Aus sia
a d n ia v n a a
ile lan dia mb eru sian ssia exic fric elan azil Tur yan eri
apa zec ria ulg Sw a g s Kir egi Ca hin illip S a C h e n P e u A r n ig
J C C B D k w n B n i I w C Ph y Ic I il i M th ezu B
-5.00% Pa S Hu i et R ir al C d in R u n Ke N
V N M In Si Ve

Risk free Rate Default Spread based in ratng

Source: Aswath Damodaran

 Market Risk Premium

Risk Premium (RP) means the extra return demanded by investors for shifting
their money from a riskless investment to an average-risk investment. So, it
should depend on:
 Risk aversion of investors: Recent experiences play a big role E.G. after a big drop,
people become very risk averse
 Riskiness of average-risk investment: This can change over time

Market Risk Premium (MRP)/Equity Risk Premium (ERP) should be
determined by the weighted average of the wealth that each investor brings to
market

3 Ways to Estimate MRP
 Survey Investors
 Historical MRP
 Implied MRP
 Market Risk Premium

Survey:
 Maynot be reasonable. Responders may give MRP < r f
 Survey premiums are extremely volatile
 Available only for short term, longest goes till 1 year

Historical:
 Time period used;
 Choice of risk free security
 Arithmetic or Geometric Average
AM GM
Stocks - TBill Stocks - TBond Stocks - TBill Stocks - TBond
1928-2015 7.92% 6.18% 6.05% 4.54%
1966-2015 6.05% 3.89% 4.69% 2.90%
2006-2015 7.87% 3.88% 6.11% 2.53%
 Market Risk Premium

Implied:
 This is same as applying Dividend Discount(Growth) Model
 Ke = Div1/S0 + g
 Assume S&P500 = 900, div yield on index = 3%, expected growth rate in earnings and div long term = 6%, then r =
(3%*900*(1.06))/900 + 0.06 = 9.18%
 So, if current rf = 6%, MRP = 9.18% - 6% = 3.18%


 Illustration: Jan 1, 2006, S&P500 = 1248.29, Div yield on index = 3.34%, 10yr T-Bond = 4.39%
 Consensus estimate of growth in earnings = 8% for next 5 yrs
 g of 8% is unsustainable, so apply a 2 stage model, wherein 2 nd stage g = T-Bond rate = 4.39%, after 5 year period. Yr
1 CF = 3.34%*1248.29*1.08 = 45.03
 Solve for 1248.29 = 45.03/(1+r) + 48.63/(1+r)^2 +...+ 61.26/(1+r)^5 + 61.26*1.0439/(r-0.0439)/(1+r)^6
 Gives r = 8.47%
 Implied ERP = 8.47% - 4.39% = 4.08%
 Note 1: This approach gives more volatile ERP values
 Note 2: Historical ERP is generally > Implied ERP
 Note 3: Implied ERP increased historically with increase in inflation. This sounds realistic
 MRP other markets (1900-2015)
Ciuntry Geimetric ERP Arithmetc ERP Standard Errir
Australia 5.00% 6.60% 1.70%
Austria 2.60% 21.50% 14.30%
Belgium 2.40% 4.50% 2.00%
Canada 3.30% 4.90% 1.70%
Denmark 2.30% 3.80% 1.70%
Finland 5.20% 8.80% 2.80%
France 3.00% 5.40% 2.10%
Germany 5.10% 9.10% 2.70%
Ireland 2.80% 4.80% 1.80%
Italy 3.10% 6.50% 2.70%
Japan 5.10% 9.10% 3.00%
Netherlands 3.30% 5.60% 2.10%
New Zealand 4.00% 5.50% 1.70%
Nirway 2.30% 5.20% 2.60%
Siuth Africa 5.40% 7.20% 1.80%
Spain 1.80% 3.80% 1.90%
Sweden 3.10% 5.40% 2.00%
Switzerland 2.10% 3.60% 1.60%
U.K. 3.60% 5.00% 1.60%
U.S. 4.30% 6.40% 1.90%
Euripe 3.20% 4.50% 1.50%
Wirld-ex U.S. 2.80% 3.90% 1.40%
Wirld 3.20% 4.40% 1.40%
Source: Aswath Damodaran
 Market Risk Premium for Other
Sovereigns
 Approach 1: MRPX country = MRPUS + X-Country Default Risk

3 ways to measure Default Spread. Use default spread for a country. Estimate:
 Default spread on a dollar denominated bond issued by a country. Jan 2017 it was
3.64% for a $denom Brazil bond
 Sovereign CDS spread for a country. In Jan 2017, 10yr CDS Brazil over US was 3.21%
 Based on local ccy rating. Brazil Sovereign rating is Ba2, and default spread for a Ba2
is 3.47% in Jan 2017

Add default spread to mature MRP. So, Brazil MRP = US MRP + default
spread for Brazil

So, MRP Brazil = 4.54% + 3.64% = 8.18% OR

MRP Brazil = 4.54% + 3.21% = 7.75% OR

MRP Brazil = 4.54% + 3.47% = 8.01%
 Market Risk Premium for Other
Sovereigns

Approach 2: Relative Standard Deviation

Rationale behind this method is that differences in MRP/ERP between two
markets should reflect the differences in riskiness of equities between 2
markets, rather than default risk of a country
 MRPX country = MRPUS * STDEVX/STDEVUS
 Assume, MRPUS = 4.54%, Annualized standard deviation of S&P500 = 20%,
Annualized standard deviation of BOVESPA = 36%, then
 MRPBrazil = 4.54% * 36%/20% = 8.17%
 Country Risk Premium (CRP)Brazil = 8.17% - 4.54% = 3.53%

It is a very nice approach till the time you realize that markets can have very
different liquidity and market structure. So, for markets with low liquidity and low
trading, chances are this method will understate MRP
 Market Risk Premium for Other
Sovereigns

Approach 3: Default spread + Relative STDEV

This is a hybrid approach
 CRPX country = Default Spread *STDEVX Equity/STDEVX Bond

Lets take Brazil Default spread = 3.64%

STDEV Brazilian $ denom Bond = 27%
 So, CRPBrazil = 3.64% * 36%/27% = 4.85%
 MRPBrazil = MRPUS + CRPBrazil = 4.54% + 4.85% = 9.39%

Why ERP would be related to country bond spread?

Both approach 2 and 3 use STDEV of an equity market to estimate CRP. App 3
uses country bond as base, App2 uses STDEV in US equity market as base. App 3
assumes investors are more likely to choose between Brazilian bonds and
Brazilian Equity. App 2 assumes choice is across equity markets
 Estimating Beta – Historical Beta

Historical Beta
 Length of estimation period: Longer period more data but firm characteristic
might have changed
 Return interval: Be careful using daily or Intra-day data since betas can be
shifted downwards due to non-trading
 Market Index: So many choices, 20 broad indices in US alone. Sometimes,
people use index which is appropriate for the person for whom analysis is
being done. WRONG
 Index should be determined by the holdings of the marginal investor in the
stock

Fundamental Beta aka Bottoms up Beta

Accounting Beta
 Estimating Beta – Fundamental
Beta

Fundamental Beta: Beta is determined by 1) type of business 2)
firm’s operating leverage 3) firm’s financial leverage

Operating leverage = Fixed Cost/Total Cost

A firm with higher operating leverage will have higher variability in
operating income, thus higher beta. This partially explains why small
firms should have higher betas than the larger firms in the same
business

Financial leverage: Higher leverage increases variance in EPS. If
BetaDebt = 0 (i.e. all market risk being borne by stockholders), then
BetaL = BetaU [1 + (1-t)D/E]
 If BetaD <>0, then BetaL = BetaU [1 + (1-t)D/E] - BetaD (1-t)D/E
 Estimating Beta – Fundamental
Beta

Unlevered beta of a firm is determined by the types of the business in which it
operates and its operating leverage

Also called “Asset Beta” since its value is determined by the assets of the firm

Levered beta/Equity beta is determined by both the business and the financial
leverage

So, it should be the case that firms with high business risk would try to have
small leverage and firms in stable businesses would be more willing to have
higher leverage

So, high beta could be due to high operating leverage or high financial
leverage or sometimes both

Note: To estimate fundamental beta, we do need historical data on a company
 Estimating Beta – Bottoms up Beta

Bottoms up Beta: Note: Betas for two assets is a weighted average of individual betas, with weights
based on market value. Steps

1) Identify the businesses of the firm. Accounting statements typically will provide breakdown of
revenues, earnings etc. by business

2) Estimate average unlevered betas of other publicly traded firms
 Identify Comparable Firms
 Estimate Beta of comparable firms
 Unlever first or last: Either unlever first then take average or otherwise
 Average beta could be simple average or weighted average
 Adjust for cash: Investments in cash and marketable securities have close to 0 beta. To get unlevered beta net of
cash:
 BetaU Net of cash = BetaU/(1-Cash/Firm Value)

3) Take weight average of unlevered betas of different businesses that firm operates in, weights being
revenue (since division wise market value is seldom available). This weighted average beta is called
Bottoms up unlevered beta

4) Estimate the levered beta for the firm using unlevered betas and target debt/equity ratios
Estimating Beta – Bottoms up Beta

Advantages of Bottoms up beta:
 Betas can be estimated for private firms
 Standard error in average betas are smaller
 SigmaAverage Beta = (Average sigma)Beta/SQRT(# firms)
 So, if each beta has standard error of 0.27, for 9 firms,
standard error would be 0.27/SQRT(9) = 0.09
 Bottoms up beta can reflect upcoming changes in the
business, since we can change mix of comparables and
weights of different businesses while computing Betas
 Estimating Beta – Accounting Beta

Estimate MRP using accounting earnings rather than market returns

So, regress changes in earnings for a firm or a business division
against change in earnings for the market like S&P500

Problems with this approach:
 Accounting earnings are smoothed, so accounting betas would underestimate
risk for risky firms and betas would be biased up for safer firms. i.e. betas will
be closer to 1 for all firms with this approach
 Accounting earnings can be influenced by non operating factors like changes in
depreciation/inventory methods, allocation of corporate expenses at the
divisional level etc.
 Data is available only yearly or quarterly

Now, estimate cost of equity using CAPM
 Adjustments in CAPM

Small Firms: Fama French (FF) show that CAPM underestimates returns of small firms.
 Small firm premium is added to get ke

1926-2004: average small premium = 3-3.5%

Small firm premium has been very volatile and had disappeared in 1980s

Small firm premium generally arises from smallest stocks

Using constant small firm premium removes analyst’s incentive to look closely at financial and operating
leverage

Private Firms: Marginal investor is not diversified generally. He cares about the total risk rather than
systematic risk. So, for private business, cost of equity using CAPM would understate the risk. 3 solutions:
 1) Assume business would do an IPO shortly
 2) Add a premium to ke. Remember, VC needs higher returns from smaller companies
 3) Adjust beta to reflect total risk rather than systematic risk. Total beta is given by
 Total Beta = Market Beta/SQRT(R^2)
 For a private firm with bottoms up beta = 0.82 and an average bottom up R^2 of 0.16,
 Total beta = 0.82/SQRT(0.16) = 2.05
 This shows that private firms have much higher cost of capital. So, they either sell or many diversify on their own
 Adjustments in CAPM

Companies with Country Risk Exposure: Companies which are incorporated in Emerging
markets or have substantial operations in these markets, we must adjust cost of equity for
additional country risk
 Approach 1: ke = rf + CRP + Beta*MRPUS

Disadvantage is that it assumes all companies are exposed to the country risk to exactly
same extent
 Approach 2: ke = rf + Beta*(CRP + MRPUS)

This scales CRP to beta. If beta measures exposure to all other risks, so measures exposure
to country risk as well, sounds reasonable. However, if CRP is different from other
macroeconomic exosure, this approach misfires

Approach 3: Estimate country risk as a separate risk factor and estimate risk exposure to
that component separately from beta

If a company’s exposure to country risk is lambda, then
 ke = rf + Beta*MRPUS + lambda*CRP
 Adjustments in CAPM

Approach #3 accounts for significant differences between companies as far as their
exposure to country risk is concerned. Exporter in an emerging market would be much
lesser exposed to country risk than domestic companies

This also allows us to consider risk exposure in multiple countries. Also it allows us to
include country risk in companies of developed markets

Question is how to estimate lambda? Again 3 approaches exist:

App1: Base it on proportion of a firm’s revenue in a particular market, scaled to average
firm’s revenue in that market
 So, if X derives 35% revenue from Brazil, and average co gets 70% from Brazil, lambdaX =
0.5

App2: Where are the manufacturing facilities of X, what risk management produces does X
uses, incorporate this information in lambda

App3: Estimate lambda like beta by regressing X return against a country bond return (or
some other market instrument which is primarily impacted by the country risk)
 Example – Bottoms up Beta

Disney reports break-up of its revenue across 4
major components in its annual report viz.
Studio Entertainment, Media Networks, Park
Resorts and Consumer Products. Information
for these divisions and their comparable pure
play businesses is as below.
Business #Comp Av Media Unlevered Cash/Fir Unlevered Beta
arable levered n D/E Beta m Value corrected for
Firms Beta (%) (%) cash
Media 24 1.22 20.45 0.75
Resorts 9 1.58 120.76 2.77
Studio 11 1.16 27.96 14.08
Consumer 77 1.06 9.18 12.08
 Example – Bottoms up Beta

Now, to compute unlevered beta for Disney, we
need to value weight these betas with respect
to revenues or firm value. Assume, marginal tax
rate = 37.3%, MV (Equity) = 55,101 and M
(Debt) = 14,668, compute equity beta for
Disney from above asset beta for Disney.
Revenue (mm) EV/Sales Estimated Value Firm Value (%) Unlevered Beta

Business
Media 10,941 3.41 37,278.62 49.25 From above
Resorts 6,412 2.37 15,208.37 20.09 From above
Studio 7,364 2.63 19,390.14 25.62 From above
Consumer 2,344 1.63 3,814.38 5.04 From above
DISNEY 27,061 Not needed 75,691.51 100.0 COMPUTE
 Applying CRP to Companies –
Estimating Lambda
●
Method 1: Base it on proportion of a firm’s revenue in a
particular market, scaled to the average firm’s revenue in that
market. A Co gets 35% revenue from Brazil, average co. Gets
70%, so Lambda = 0.5
●
Method 2: Incorporate into lambda location of manufacturing
facilities and other measures like risk management products that
co uses (like F&O for hedging). Companies sensitive to national
interest like defense, space, electronics etc. Would also be
exposed to country risk
●
Method 3: Regress co’s returns against country bond (or some
other market instrument which is primarily impacted by country
risk)
 Example
●
Embraer is a Brazilian aerospace company, competing against Boeing and Airbus. 97% Revenues
come from outside Brazil, 3% from Brazil. Compute Ke
● Using Boeing and Airbus, we estimate BetaU = 0.95
●
Embraer D/E = 18.95%
●
Marginal Tax = 34%
● BetaL = BetaU *(1+ (1-Tax) * D/E) = 1.07
●
Estimate Dollar cost of equity.
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● CRP = 3.47%, rf = 2.45%, ERP($) = 4.54%, BetaL = 1.07

● Equal Exposure Approach Ke = 2.45% + 3.47% + 1.07 * 4.54% = 1.78%
● Beta Scaled Approach Ke = 2.45% + 1.07 * (3.47% + 4.54%) = 11.02%
● Lambda Approach Ke = 2.45% + 1.07 * 4.54% + 0.27 * 3.47% = 8.24%
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Lambda estimation = 3%/70% = 0.04
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Lambda estimation – Regress Embraer stock against Brazilian govt $ bond gives 0.27