Discount Rate and WACC

Discount rate estimation

• Principal input for discounted Cashflow method
• Appropriate discount rate is applied depending on the type of cash flow and riskiness of the cash
flows
 Equity cash flow is discounted at cost of equity
 Firm cash flow is discounted at cost of capital

• Three components are important

• Cost of Equity
• Cost of Debt
• Cost of Preference shares
Cost of Equity
 Characteristics of Equity

 Higher risk, higher return

 Different models for estimation

 CAPM
 Multi Factor
 Regression
Cost of Equity - CAPM
Cost of Equity = Rf + βi * (E(Rm) – Rf)

Rf Risk free rate

βi Equity Beta
E(Rm) Expected market return
Cost of Equity - CAPM

The risk free rate in the economy is seen at 7%. The

industrial stock is trading at a beta of 0.75. The
broader market is expected to return 16%. Calculate
the cost of Equity

7% + 0.75*(16%-7%) = 13.75%
CAPM – Risk free rate

• Risk-free interest rate - return of an investment with no risk of

financial loss. Investors expectation of risk-free investment
over a given period of time.
• Risk-free rates - when the cash flow is expected to occur and
will vary across time.
• Long-term, default-free rate - riskfree rate.
• Yield on the 10 year government bond - proxy for the risk free
rate
• In emerging markets, there are two problems:
• Government may not be risk-free (Latin America)
• Lack of long term government rate (China)
CAPM – Risk free rate

Risk-free rate for a given local currency includes the default spread

For the Euro zone, the currency is same namely Euro

However the yields on the 10 yr bonds are (on 14 Sept 2022)

Greece 4.240%
Portugal 2.770%
Finland 2.284%
Germany 1.704%
Italy 3.982%
The differences are primarily due to default risk
CAPM – Beta

•Beta measures the risk added on to a diversified portfolio,

rather than total risk.
•Beta measures the relative risk.

Estimation of Beta is a fairly straight process

“The beta for an asset can be estimated by regressing the

returns on any asset against returns on an index representing the
market portfolio, over a reasonable time period.”
CAPM – Beta

Y variable - the returns on the asset

X variable - the returns on the market
index

Slope of the line gives value for beta

CAPM – Beta
However, there are a number of measurement issues that can
distort the beta estimate.

•Choice of market index

Apply a ‘market portfolio’ test
 Indices with more securities should provide better
estimates
 Indices that are market-weighted should yield better
estimates

BSE 500 is better market index in BSE Sensex

CAPM – Beta

•Choice of time period

 Longer time frame gives more data points for regression.
 However the firm characteristics may have undergone a
change

•Choice of return interval

 Daily estimates have bias due to non-trading days.
 Weekly and Monthly estimates can give sufficient data points
only if it has long trading history.
CAPM – Beta

Post-Regression Beta Adjustments

Studies indicate that over time, the beta for a firm tends to move
towards 1.
Firms that survive in the market tend to
i. increase in size over time,
ii. Be more diversified and
iii. have more assets in place, producing cash flows.

Adjusted Beta = Regression Beta (0.67) + 1.00 (0.33)

CAPM – Beta
Equity Beta is impacted by Debt Equity Ratio
βL = βU * (1+ (1-t) * D/E))

βL = Levered or Equity Beta

βU = Unlevered Beta (Asset Beta)
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
Pure Play Beta
• Beta using regression works for listed firm
• Pure play method of Beta estimation
• Unlisted firms
• Use comparable listed firms
• Adjust for debt
• Focus on business risk
CAPM – Risk Premium
• Risk premium measures what investors, on average , demand
as extra return for investing in a portfolio relative to a risk
free asset

• Beta, on the other hand, measures the risk added on to a

portfolio by the equity asset being analyzed
CAPM – Risk Premium
Historical Premium approach

• The actual returns earned on stocks over a long time period is

estimated, and compared to the actual returns earned on a
default-free (usually government security).
• The difference, on an annual basis, between the two returns is
computed and represents the historical risk premium

Risk premium shows divergence due to

• Time Period Used

• Choice of Risk-free Security
• Arithmetic and Geometric Averages
CAPM – Risk Premium
Risk Premium for India

• Go back as far as you can.

• Premium should be the one over T-Bonds
• Use the geometric risk premium. It is closer to how investors
think about risk premiums over long periods
CAPM – Risk Premium
Risk Premium based on sovereign rating

• Use the default spread implied in the sovereign rating

• Use the equity risk premium for mature market (US)

• India risk premium

= default spread implied by India sovereign rating +
equity risk premium for US
CAPM – Risk Premium
Modified Historical Premium approach

Used for economies where both mature equity and bond markets
exist

• Measure country risk

Use the country debt rating issued by rating agencies
Derive the country default spread

• Estimate country risk premium

Country equity risk premium
= Country default spread *( σequity-country / σcountry bond)
CAPM – Risk Premium
Relative Equity Market Premium approach

• Country risk premium relative to the US market

• Based on volatility of the market relative to US market

• Estimate country risk premium

Total Country equity risk premium
= Risk PremiumUS *( σequity-Country / σEquity -US)
CAPM – Risk Premium

Equity risk premium for US is seen at 5.75%. US equity index is expected at

22%
BSE standard deviation is 47.6% while the standard deviation of India G-sec is
seen at 27%.
Moody’s rating for India is Baa3, implying a default spread of 2.2%.

Calculate the equity risk premium for India

Method 1

Country equity risk premium= 2.2% *(47.6%/27%) = 3.88%

Method 2
Total Equity risk premium = 5.75 %*(47.6%/22%) = 12.44%
Country equity risk premium = 12.44% – 5.75% = 6.69%
Cost of Equity-DDM Approach

• When the firm’s dividends are expected to grow at a constant rate, g, forever
and this rate is less than the firm’s cost of equity capital, the above valuation
expression can be reduced to the following:

Consequently, the cost of equity can be found by solving for ke in Equation

Example

• Duke Energy Corporation (DUK), which is involved in a number of

businesses, including natural gas transmission and electric power
production. In 2013, the company paid a dividend of $3.12 per share,
and on February 26, 2014, the firm’s stock closed trading at a price of
$70.91. The analysts’ expected rate of growth in earnings for 2014
through 2019 is 3.92% per annum constantly.
Three-Stage Growth Model

• This model provides for different dividend growth rates for years 1
through 5, 6 through 10, and 11 and beyond. The corresponding three-
stage growth model can be written as
Cost of Debt
• Rate of Borrowing
• Default risk
• Rate prevalent in the market
• Methods for estimating
• YTM of long term bond issued by firm
• Use firm rating and default spread corresponding to the
rating over the G-sec yield
• Customised rating scheme where firm is not rated
• Country default risk also needs to be incorporated
Cost of Debt – Firm rating
Moody's Rating-based Moody's Rating-based
rating Default Spread rating Default Spread
Aaa 0.00% Ba1 2.50%
Aa1 0.40% Ba2 3.00%
Aa2 0.50% Ba3 3.60%
Aa3 0.60% B1 4.50%
A1 0.70% B2 5.50%
A2 0.85% B3 6.50%
A3 1.20% Caa1 7.50%
Baa1 1.60% Caa2 9.00%
Baa2 1.90% Caa3 10.00%
Baa3 2.20%

Source: Damodaran
Cost of Debt – Customised rating
• The rating for a firm can be estimated using the financial
characteristics of the firm.
• Interest Coverage Ratio = EBIT / Interest Expenses
• Using this ratio, a corresponding rating from the rating scale
can be estimated
Cost of Debt – Customised rating
If Coverage Estimated Default
Ratio is Bond Rating Spread
> 8.50 AAA 0.75%
6.50 - 8.50 AA 1.00%
5.50 - 6.50 A+ 1.50%
4.25 - 5.50 A 1.80%
3.00 - 4.25 A– 2.00%
2.50 - 3.00 BBB 2.25%
2.00 - 2.50 BB 3.50%
1.75 - 2.00 B+ 4.75%
1.50 - 1.75 B 6.50%
1.25 - 1.50 B– 8.00%
0.80 - 1.25 CCC 10.00%
0.65 - 0.80 CC 11.50%
0.20 - 0.65 C 12.70%
< 0.20 D 15.00%
Cost of Preference Share
• Preference shares have fixed dividend
• Cost of Pref Share = Pref Dividend / Pref Share Price
• ABC Corp issues a preference share that pays an annual
dividend of Rs45, with a market value of Rs510. Compute the
cost of preference share
Cost of Capital
• Sources of capital
• Debt
• Equity
• Preference
• Single number that gives the overall cost for the capital
employed
• Weighted average cost of capital (WACC)
• WACC = We*Ke + (1-t)*Wd*Kd + Wp*Kp
Example:
Caliber’s Burgers and Fries is a rapidly expanding chain of fast-food
restaurants, and the firm’s management wants to estimate the cost of
equity for the firm. As a first approximation, the firm plans to use the beta
for McDonalds Corporation (MCD), which equals .56, as a proxy for its
beta. In addition, Caliber’s financial analyst looked up the current yield on
ten-year US Treasury bonds and found that it was 4.2%. The final piece of
information needed to estimate the cost of equity using the capital asset
pricing model is the market risk premium, which is estimated to be 5%.
Both the firms are under 25% tax bracket.
a. Estimate the cost of equity for Caliber’s using the CAPM and McDonalds
Corporation’s beta.
b. McDonalds Corporation has an enterprise value of about $80 billion and
a debt of $15 billion. If Caliber’s has no debt financing, what is your
estimate of Caliber’s beta coefficient?