applied corporate finance · source: applied corporate finance, aswath damodaran. why a hurdle...

Applied Corporate Finance

Unit 2

Calculating the Hurdle Rate

• Definition of Risk• Risk vs Return• Hurdle Rate

• Choosing a risk return model• CAPM

• Risk Free Rate• Equity Risk Premium• Beta

First Principles

The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should reflect the magnitude and the timing of the

cashflows as welll as all side effects.

The optimal mix of debt and equity

maximizes firm value

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend on whether they

prefer dividends or buybacks

Maximize the value of the business (firm)

Source: Applied Corporate Finance, Aswath Damodaran

Why a hurdle rate?

We work in a world of finite resources, so it is important for us to get basic returns from ourinvestment choices. This hurdle should be higher for riskier projects than for safer projects.

In simple words, if we can get a certain rate of return without taking any risk, then for anyrisk to be undertaken, we should be demanding an additional non-zero rate of return.

Hurdle Rate = Risk Free Rate + Risk Premium

The concept of Risk

In modern finance theory, Risk would mean both a danger and an opportunity. It would bea danger of losing money, while at the same time would provide an opportunity to makemore money.

Risk is therefore neither good nor bad. It is just a fact of life. The question that businesseshave to address is therefore not whether to avoid risk but how best to incorporate it intotheir decision making.

The concept of Risk

A decision that involves higher risk would entail demanding higher returns as well. In orderto maximize returns, the risk undertaken has to go up. It would not be incorrect to say thatRisk and Returns are two sides of the same coin in finance. They would go hand in hand.

The concept of Risk

The next question that faces us how we define risk?

Risk in traditional finance is unexpected outcome. Any deviation from expectation isconsidered risk. Thereby, variance and standard deviation become very good statisticalmeasures of risk. Higher risk would this mean higher variance around the expected return(mean)

The concept of Risk

Risk Reduction - Diversification

Assume you have the stock of Tata Steel in your portfolio. What happens if steel prices goup. And what happens if steel prices go down. Now imagine that you have the stock ofMaruti as well in your portfolio. Now what happen when steel prices move.

Addition of seemingly different stocks would have reduced the risk of the portfolio. Thisprocess is known as Diversification.

Risk Reduction - Diversification

Firm Specific Risk Industry Risk Market Risk

GMR Infrastructure Yes Yes Yes

All infrastructure stocks No Yes Yes

All stocks No No Yes

On economic grounds, diversifying and holding a larger portfolio eliminates firm-specific risk for two reasons-

a. Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio.

b. Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens.)

Risk Return Frameworks

A good risk return framework should outline what risks are rewarded and what not. Itshould incorporate a measure of risk that should apply to all assets, and not just one. Itshould come up with standardized risk measures, i.e., an investor presented with a riskmeasure for an individual asset should be able to draw conclusions about whether theasset is above-average or below-average risk.

Marginal Investor

The marginal investor is an investor who is assumed to be the next buyer or seller of thestock and is likely to influence the price of the stock. It is assumed under most Risk RewardModels that the marginal investor is well diversified.

Capital Asset Pricing Model

There are various risk return models which can be used to calculate the hurdle rate. The most common are

• Believes that the Risk is Risk added by any asset to the market portfolio

• There is no private information

• Market Risk = Risk added by any investment to the market portfolio

Capital Asset Pricing Model (CAPM)

• Market risk = Risk exposures of any asset to many market factors (Multiple Betas)

Arbitrage Pricing Model (APM)

• Market Risk = Risk exposures of any asset to many market factors (Multiple Betas)

Multi Factor Model


While some of the assumptions on CAPM are untenable, is still persists in financial markets and theory. The key reasons are

• Alternative models, while do well in terms of decoding the past, are unable to showcases similar benefits in the future

• Alternative models are more complicated and require more inputs

• Inherent simplicity of CAPM works in its favor

Why Capital Asset Pricing Model (CAPM) survives

• It also assumes that there are no transaction costs, and investors can lend and borrow unlimited amounts of money at risk free rate.

• It arrives at the expected return from the asset using the following formula

Expected Return ( R ) = Risk Free Rate (RF) + Beta * (Equity Risk Premium)

This gives the risk free rate in the economy This gives the excess return one gets

by investing in equity markets – over the risk free rate

Gives a measure of the systematic risk the asset will add to the portfolio. Beta will signify how much asset returns will vary when compared to the market return


Questions

• How do we define risk in traditional corporate finance?• Explain how diversification will take away the risk from investments, with an example.


Unit 2

Limitations of CAPM

There are a variety of limitations which come up with CAPM. They are

• The model makes unrealistic assumptions

• There could be problems with the chosen market index

• If the model is completely correct, there should be a linear relationship between returns and betas, and the only

variable that should explain returns is betas. However, in reality, betas are not able to explain stock performance.

Other variables (size, price/book value) seem to explain differences in returns better. For example, a high beta stock

should result in better performance over a period, but in reality, that may not be the case.

Expected Return ( R ) = Risk Free Rate (RF) + Beta * (Equity Risk Premium)

Now, while using CAPM, we need 3 major inputs,

• The Current Risk-free Rate

• The Expected Market Risk Premium, the premium expected for investing in risky assets, i.e. the market portfolio, over the riskless asset.

• The Beta of the asset being analyzed.


• Can some asset really be risk free? What do we infer by Risk Free? On a riskfree asset, the actual return should always be equal to the expected return. The variance of returns should thus be zero.

• Now while we consider that the government debt is risk free, in theory, the government can default. Also, there is one more condition. The traditional yield to maturity calculations (the return expected on a bond) assume that the intermediate payments get reinvested at the same rate. However, in real life, when you get payments (such as coupon payments on a bond), they may not get reinvested at the same rate because interest rates in the markets may have changed.

• What that means is that to be completely risk free, by definition the asset should not have any default risk or reinvestment risk.

Risk Free Rate

• Default Risk Free Security - Generally, even the best and largest private companies are liable to default, and hence are not considered Risk Free in the complete sense. Only Governments are considered to be risk free in the context of default risk, but this is also only in context of the local currency (simply because the government can resort to printing money to pay of local currency debt. This however may not work in case of a foreign currency debt)

• Reinvestment Risk Free Security - As for reinvestment risk, generally the rate used is for a zero coupon bond issued by the government, which does not have any risk regarding reinvestment of the interest payments (since there are no interest payments)

Risk Free Rate

We are thus looking at the yield to maturity on a zero coupon government bond to be used as a risk free security. But we have still not answered the question of tenure. We will simplify the discussion here. While we should be matching the tenure of the cash flow being discounted to arrive at the return, we can practically assume that we are evaluating companies, which are infinite in tenure (the going concern principle). Thus, we use a long term government bond yield. The most commonly traded and available long term government bond is for 10 years. Hence we use the risk free security as 10 year Zero Coupon Government Bond Yield.

Risk Free Rate

One more important caveat that we have to remember is that the riskfree rate that we use in the analysis should be in the same currency that the cashflows are in. For example, Infosys is listed in India and US. If you are valuing the stock of Infosys with its cash flows in INR, then the risk free rate to be used is Indian Government 10 year Zero Coupon Bond Yield, while it the cash flows are projected in USD, then the risk free rate to be used is the US Government 10 year Zero Coupon Bond Yield.

Risk Free Rate

10 Year Government Bond Yields

1.4

2.9

-0.2 -0.1

0.80.2

12.2

1.2

7.4

8.4

1.0

2.0

1.2

5.9

-2

0

2

4

6

8

10

12

14

UnitedStates

China Japan Germany UnitedKingdom

France Brazil Italy India Russia Canada Australia Spain Mexico

10 year government bond yield

Is there anything as completely risk free?

However, what if even the government is not considered risk free. After all, governments do default from time to time. We have recently heard the cases of Greece and Argentina. In fact, while we may want to use 7.5% as the approximate risk free rate for India, the reality is that India’s rating by any of the global rating agencies is not AAA. Which means that there is a finite risk that Indian government may also default. Now how do we assess this risk.

Is there anything as completely risk free?

India’s rating by Moody’s is Baa3, equivalent to BBB-. This means that we are rated Lower Medium Grade and the risk rating states that An obligor has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

Country SpreadsRating Default spread in basis points

Aaa 0

Aa1 44

Aa2 55

Aa3 67

A1 78

A2 94

A3 133

Baa1 177

Baa2 211

Baa3 244

Ba1 277

Ba2 333

Ba3 399

B1 499

B2 610

B3 721

Caa1 831

Caa2 998

Caa3 1108

Ca 1330

India

This shows that India’s spread is 2.44%, and based on this, we can now calculate the risk free rate for India. This is assuming if India had a AAA rating. Thus, we subtract the 2.44% spread from the 10 year bond yield, to get the risk free rate for India.

Therefore – Risk Free Rate (India) = 7.4% - 2.44% = approximately 5%.

Global Ratings

Questions

• What are the key features needed for a security to be considered as risk free?• If a country’s rating is A3 as per the table earlier, what would be the risk free rate considering its 10

year Zero Coupon bond yield is at 6.1%?


Unit 2

The Equity Risk Premium is the amount of extra return over and above the risk free rate that you would expect for investing in equities. As a general principle, it should be greater than zero (since you would never accept a return lesser than the risk free rate) and it should increase with the risk aversion of the investors in the markets.

Equity Risk Premium

One point we need to remember is that risk premiums could be dynamic in nature, and this also gets proven by the fact that if the market has just fallen 20%, and we ask someone for the extra return they want for investing in the equity markets, this number would surely be higher than the number if the markets were stable.

Equity Risk Premiums can change

There are 3 broad methods of calculating the equity risk premiums.

• We can survey investors about what their expected return from the equity markets is

• We can calculate historical excess return generated by stock markets over and above the risk free rate, and assume that investors would continue to expect the same premium over the future as well

• We can assume the current market levels to be correct, and back calculate the Implied return based on the current Cash Flows we expect from the market as a whole.

Equity Risk Premiums calculations

Question for you

If the risk free rate in India is 5%, how much return would you be happy with while investing in equity markets.

a) An extra 0-3%

b) An extra 3-5%

c) An extra 5-7%

d) An extra 7-10%

e) More than 10%

Note that you will always ask for a positive number in addition to the risk free rate.

The Survey Method

The Survey Method

While survey method is one of the simplest methods to be used, there are serious limitations of this method. The basic approach about trying to find ERP using a survey of various investors, fund managers, academicians, businessmen etc – to arrive at the equity risk premium. This however is fraught with volatility, as judgments are subjective, and the value depends a lot on who we ask and how we ask and also when we ask.

What we just saw on the previous slide was an example of the survey method.

The Survey Method

The Historical Returns Method

This involves choosing a market index and a risk free rate, and then finding the difference in returns over a period of time. However, both the steps have issues. Which index to choose, and what time period to choose. The time period chosen has massive impact on even long term equity risk premiums, especially if we happen to include an year as bad as 2008. For example, ERP for the US stocks from 1928 – 2008 is 3.88%, but if we look at 1997-2008 as the period, this actually is negative : -7.95%. Even in the 80 year period, if we end at 2007 instead of 2008, then the ERP comes at 4.79%, much higher than the 3.88% estimated if we include 2008. Thus the choice of the year becomes a very important factor.


Solving the problem of what year to choose?

We can make two adjustments to this. Firstly, to gauge risk premiums better, we should be looking at a peak to peak in the equity markets. For example, the stock market peaked in India in 1992, and again in 2008. In 2008 the peak levels were at 21000 on the BSE Sensex. However, it fell to as low as 9000 in 2009. Now if you calculate the return from 1992, and end at 2008 instead of 2009, there is a wide difference in the returns achieved. Thus, it is prudent to end at the similar point in business cycle as the starting point. Since 1992 was a peak, we should end the cycle at 2008, which was also a peak. This would likely give better results. Thus, in the above calculation of US, we get 4.8% as the correct number.


Mature vs Emerging Markets

The second adjustment is to understand that markets like India do not have too much of history. Thus, they may sometimes give incorrect data. Thus it may make sense to take a mature market like the US, calculate equity risk premium for them, and then add the risk specific to Indian Equities.

Thus the Equity Risk Premium for an emerging market becomes

ERP = Base premium for mature market + Country Risk Premium



Now we have the base premium for the mature market, which is US. How do we calculate the country risk premium for India. We already have the bond yield spread for India, which is 2.44%. However, note that this is the risk for debt markets in India. It is expected that equity markets will be riskier, and hence have a bigger risk premium. To arrive at this, we use an approximation. We use the debt premium, and scale it up by a factor, which is the relative risk of the stock market against the debt market. This is given by dividing the standard deviation of the stock market by the standard deviation of the debt market


Country Risk Premium = Country Default Spread *sEquity

s Country Bond

æ

è ç

ö

ø ÷


Now while we can calculate the Standard Deviation for Equities and Bonds, historically this ratio comes around 1.5 for emerging markets. Thus,

Country Risk Premium for India = 2.44% X 1.5

= 3.6%

Now we can calculate the Equity Risk Premium.

ERP = Base premium for mature market + Country Risk Premium

= 4.8% + 3.6%

= 8.4%


This method assumes that the current market valuation is correct, and tries to discount the cash flows expected from the market in order to arrive at an expected discount rate. This is in a way treating the equity cash flows the same as debt cash flows. Recall that to value at debt security, we would discount the cash flows by its Yield to Maturity. We are doing the same here.

The Implied Equity Risk Premium

Let us assume that the Sensex Earnings Per Share (EPS) expected in the next financial year is Rs 1700. Look at the following table. Assuming a declining growth in cash flows (EPS) from 15% to 5% over the next 6 years, we can project the cash flows. We can now try and find out what discount rate matches with the current market price (Sensex Value). The Sensex is around 27,500 as we write this. Calculations would yield an equity return of nearly 3%. This would result in a risk premium of nearly 8% (12% minus Risk Free Rate of 5%), similar to what we had calculated earlier.



Year 2017 2018 2019 2020 2021 2022 Terminal Year

Sensex EPS 1,700 1,955 2,209 2,452 2,673 2,860 37,537

Growth Assumed 15.0% 13.0% 11.0% 9.0% 7.0% 5.0%

years to Cash Flow 1 2 3 4 5 6 6

Present Value of Cash Flows 1,504 1,531 1,531 1,504 1,451 1,374 18,030

Return Expected 13.00%

Total PV 26,925



Sensex EPS 1,700 1,955 2,209 2,452 2,673 2,860 37,537

Growth Assumed 15.0% 13.0% 11.0% 9.0% 7.0% 5.0%




Total PV 26,925

Equity Risk Premium = Return Expected – Risk Free Rate= 13% - 5% = 8%



Sensex EPS 1,700 1,955 2,209 2,452 2,673 2,860 37,537

Growth Assumed 15.0% 13.0% 11.0% 9.0% 7.0% 5.0%




Total PV 26,925

The benefit of using this method is that this is dynamic, and would change the risk premium when markets run up or fall down. The drawback is that it assumes that markets are correctly priced at all points of time.

Even after arriving at an equity risk premium for a country, there are some adjustments which may be required

• Studies show that small companies, or smaller market capitalization stocks tend to outperform larger companies in the longer run. Thus the equity risk premium for these stocks must be higher, which then requires adding up a small stock equity risk premium here. This can be calculated by long term outperformance of smaller companies in the market

Equity Risk Premium – some final adjustments

Even after arriving at an equity risk premium for a country, there are some adjustments which may be required

• Some companies are highly dependent on global earnings. Example - Infosys. The equity risk premium for Infosys should be lower than that of an average Indian firm. While there are arguments that the beta should capture this – it may not always happen. Betas generally are not good guides of country risk – and in the case of Infosys, the country risk of US is more pertinent than that of India. Hence the equity risk premium has to be scaled down a bit. A good rule of thumb is to use revenue weighted Equity Risk Premium. For example, if a company derives 50% of its revenue from the US and 50% from India, then the equity risk premium should be

= 50% * ERP -US + 50% * ERP – India

= 50% * 4.8% + 50% * 8%

= 6.4%

Equity Risk Premium – some final adjustments

Name the various methods using which you can calculate equity risk premium.

Explain the method of historical equity risk premium calculation for countries with less trading price history.

Questions


Unit 2

Beta is the parameter which is unique to each security, and perhaps one of the most important concepts in finance.

Beta is the measure of the risk of the asset with respect to the market – in other words, it is the risk an asset will add to the market portfolio. It is obtained by standardizing covariance between the asset and the market by dividing it with the market variance. Covariance of the market with itself is the variance of the market.

It is the amount of times an asset’s return will be that of the market returns.

Beta

Covariance (Asset and market)

Variance of the market

=

Note that we are saying that if the beta for a stock is 1.2, then historically it has moved 1.2 times the underlying market. If the market goes up 10%, the stock is likely to go up 12%, and if the market goes down 10%, the stock is likely to go down 12%. Thus there exists a linear relationship that best describes who historically the stock has moved against the market. Therefore, it must be possible to find beta using linear regression.

Beta

There are two ways to find beta

• Historical calculation – here the stock returns are regressed against the market returns, and the slope of the regression line will represent the beta of the company. The three decisions to be made here are length of estimation period, return interval and the choice of the market index. We can use Excel functions such as Slope and Linest to do the same.

Beta Calculation

• Historical calculation – Let’s try and calculate beta for any company. For this, we need historical stock prices, which we can get on either www.nseindia.com or Yahoo Finance.

• Let’s try this for Reliance Industries

• We will also need to choose an index. We can use the BSE Sensex for that.

• We will also need to choose a return frequency – lets say daily or weekly.

Beta Calculation

http://www.nseindia.com/

There are two ways to find beta

• Fundamental calculation - Beta logically should be driven by business decisions. Leverage plays an important role here. The major determinants of beta will be the type of business the company is in, and its degree of operating and financial leverage. Since we are looking at similar firms, the operating leverage will be similar for firms. Hence, beta should be getting determined by the financial leverage, or how much loan a firm has. The beta can be estimated using the betas of the other firms in the same segment, or average market beta. Here we need to define 2 more terms, levered and unlevered beta. Levered beta takes into consideration the debt of the firm – the beta reported for a stock is usually the levered beta. Unlevered beta is the beta assuming that the firm has no debt.

Beta Calculation

Fundamental calculation - The formula for levering and unlevering beta is given below

Under fundamental calculation, let us say for a firm that has no price history, we use the following steps.– Find comparable firms – in size and business

– Estimate betas of these firms against common index

– Find the unlevered beta for the firms – by using the Debt/Equity ratio and Tax Rate for the firms.

– Find the average unlevered beta of the sector by average those of the firms

– Use the firm’s current Debt/Equity ratio and Tax rate on this unlevered beta of the sector to find the levered beta of the firm.

Beta Calculation

Fundamental calculation – Assume that we want to find the fundamental beta of any firm. Let us assume we want to calculate that for Vodafone.

• We use the betas of Idea Cellular and Bharti Airtel for this. These are 0.76 and 0.68 respectively (over the last 1 year against Nifty).

• Debt Equity Ratio for Bharti Airtel – 0.32, for Idea Cellular – 0.42

• Assume tax Rates to be 30%

• Assume Debt Equity of Vodafone to be 0.25

Beta Calculation

Betas for Nifty 50 stocksSr. No Security Name Industry Beta Sr. No Security Name Industry Beta

1 ACC Ltd. CEMENT AND CEMENT PRODUCTS 0.72 26 I T C Ltd. CIGARETTES 0.66

2 Adani Ports and Special Economic Zone Ltd. SHIPPING 1.36 27 ICICI Bank Ltd. BANKS 1.58

3 Ambuja Cements Ltd. CEMENT AND CEMENT PRODUCTS 0.93 28 Idea Cellular Ltd. TELECOMMUNICATION - SERVICES 0.68

4 Asian Paints Ltd. PAINTS 0.80 29 IndusInd Bank Ltd. BANKS 0.98

5 Aurobindo Pharma Ltd. PHARMACEUTICALS 1.14 30 Infosys Ltd. COMPUTERS - SOFTWARE 0.84

6 Axis Bank Ltd. BANKS 1.39 31 Kotak Mahindra Bank Ltd. BANKS 1.04

7 Bajaj Auto Ltd. AUTOMOBILES - 2 AND 3 WHEELERS 0.91 32 Larsen & Toubro Ltd. ENGINEERING 1.33

8 Bank of Baroda BANKS 1.57 33 Lupin Ltd. PHARMACEUTICALS 0.69

9 Bharat Heavy Electricals Ltd. ELECTRICAL EQUIPMENT 1.33 34 Mahindra & Mahindra Ltd. AUTOMOBILES - 4 WHEELERS 0.96

10 Bharat Petroleum Corporation Ltd. REFINERIES 0.79 35 Maruti Suzuki India Ltd. AUTOMOBILES - 4 WHEELERS 0.94

11 Bharti Airtel Ltd. TELECOMMUNICATION - SERVICES 0.76 36 NTPC Ltd. POWER 0.90

12 Bharti Infratel Ltd. TELECOMMUNICATION - EQUIPMENT 0.57 37 Oil & Natural Gas Corporation Ltd. OIL EXPLORATION/PRODUCTION 1.21

13 Bosch Ltd. AUTO ANCILLARIES 0.91 38 Power Grid Corporation of India Ltd. POWER 0.65

14 Cipla Ltd. PHARMACEUTICALS 0.78 39 Reliance Industries Ltd. REFINERIES 1.07

15 Coal India Ltd. MINING 0.83 40 State Bank of India BANKS 1.56

16 Dr. Reddy's Laboratories Ltd. PHARMACEUTICALS 0.73 41 Sun Pharmaceutical Industries Ltd. PHARMACEUTICALS 0.80

17 Eicher Motors Ltd. AUTOMOBILES - 4 WHEELERS 0.91 42 Tata Consultancy Services Ltd. COMPUTERS - SOFTWARE 0.68

18 GAIL (India) Ltd. GAS 1.17 43 Tata Motors Ltd DVR AUTOMOBILES - 4 WHEELERS 1.57

19 Grasim Industries Ltd. CEMENT AND CEMENT PRODUCTS 0.66 44 Tata Motors Ltd. AUTOMOBILES - 4 WHEELERS 1.64

20 HCL Technologies Ltd. COMPUTERS - SOFTWARE 0.75 45 Tata Power Co. Ltd. POWER 1.01

21 HDFC Bank Ltd. BANKS 0.78 46 Tata Steel Ltd. STEEL AND STEEL PRODUCTS 1.73

22 Hero MotoCorp Ltd. AUTOMOBILES - 2 AND 3 WHEELERS 0.88 47 Tech Mahindra Ltd. COMPUTERS - SOFTWARE 0.79

23 Hindalco Industries Ltd. ALUMINIUM 1.84 48 UltraTech Cement Ltd. CEMENT AND CEMENT PRODUCTS 0.90

24 Hindustan Unilever Ltd. DIVERSIFIED 0.54 49 Wipro Ltd. COMPUTERS - SOFTWARE 0.61

25 Housing Development Finance Corporation Ltd. FINANCE - HOUSING 1.11 50 Yes Bank Ltd. BANKS 1.48

26 I T C Ltd. CIGARETTES 0.66 51 Zee Entertainment Enterprises Ltd. MEDIA & ENTERTAINMENT 1.14

Betas for Nifty 50 stocks

Observations• Safe businesses like Pharma, FMCG have lower betas.

Example – Sun Pharma – 0.8, Lupin – 0.69, Hindustan Unilever – 0.54, ITC – 0.66• Cyclical and volatile businesses, affected by global price moves, like metals have high betas.

Example – Hindalco – 1.84, Tata Steel – 1.73, ONGC – 1.21• Firms in sectors with high capital intensity, and higher debt, also tend to have higher betas

Example - L&T – 1.33, BHEL – 1.33, Adani Ports – 1.33• Banks tend to have higher betas

Betas for Nifty 50 stocks

We can generalize the above findings into two learnings

• Businesses with a lot of debt would be considered to be riskier by the financial markets and investors. In other words, businesses with a lot of financial leverage would be considered to be risky.

• Businesses with huge fixed costs, known to have higher operating leverage, will be considered to be more risky. The reason is that with higher fixed costs, a small change in revenues brings about a large change in profitability. For example, if a business has a revenue of Rs 100, and only fixed costs of Rs 90, then a 10% jump in revenues (revenues going up to 110) would bring about a 100% jump in profitability (Profits jumping from Rs 10 to Rs 20). Similarly, a 10% dip in revenues could wipe out the entire profits. Hence, the beta for such businesses would be higher.

Questions

• What kind of businesses will enjoy lower betas?

• Assuming the debt-equity of L&T to be 0.5, calculate the unlevered beta of the firm, using tax rate as 30% and levered beta as 1.33


Unit 2

Hurdle Rate

Now that we have the relevant components, we can look at calculating the hurdle rate – the Cost of equity. Now we have all the three components of calculating cost of equity. We could just plug in the numbers and calculate the cost of equity for any company.

Cost of EquitySr. No Security Name Industry Beta Sr. No Security Name Industry Beta

1 ACC Ltd. CEMENT AND CEMENT PRODUCTS 0.72 26 I T C Ltd. CIGARETTES 0.66

2 Adani Ports and Special Economic Zone Ltd. SHIPPING 1.36 27 ICICI Bank Ltd. BANKS 1.58

3 Ambuja Cements Ltd. CEMENT AND CEMENT PRODUCTS 0.93 28 Idea Cellular Ltd. TELECOMMUNICATION - SERVICES 0.68

4 Asian Paints Ltd. PAINTS 0.80 29 IndusInd Bank Ltd. BANKS 0.98

5 Aurobindo Pharma Ltd. PHARMACEUTICALS 1.14 30 Infosys Ltd. COMPUTERS - SOFTWARE 0.84

6 Axis Bank Ltd. BANKS 1.39 31 Kotak Mahindra Bank Ltd. BANKS 1.04

7 Bajaj Auto Ltd. AUTOMOBILES - 2 AND 3 WHEELERS 0.91 32 Larsen & Toubro Ltd. ENGINEERING 1.33

8 Bank of Baroda BANKS 1.57 33 Lupin Ltd. PHARMACEUTICALS 0.69

9 Bharat Heavy Electricals Ltd. ELECTRICAL EQUIPMENT 1.33 34 Mahindra & Mahindra Ltd. AUTOMOBILES - 4 WHEELERS 0.96

10 Bharat Petroleum Corporation Ltd. REFINERIES 0.79 35 Maruti Suzuki India Ltd. AUTOMOBILES - 4 WHEELERS 0.94

11 Bharti Airtel Ltd. TELECOMMUNICATION - SERVICES 0.76 36 NTPC Ltd. POWER 0.90

12 Bharti Infratel Ltd. TELECOMMUNICATION - EQUIPMENT 0.57 37 Oil & Natural Gas Corporation Ltd. OIL EXPLORATION/PRODUCTION 1.21

13 Bosch Ltd. AUTO ANCILLARIES 0.91 38 Power Grid Corporation of India Ltd. POWER 0.65

14 Cipla Ltd. PHARMACEUTICALS 0.78 39 Reliance Industries Ltd. REFINERIES 1.07

15 Coal India Ltd. MINING 0.83 40 State Bank of India BANKS 1.56

16 Dr. Reddy's Laboratories Ltd. PHARMACEUTICALS 0.73 41 Sun Pharmaceutical Industries Ltd. PHARMACEUTICALS 0.80

17 Eicher Motors Ltd. AUTOMOBILES - 4 WHEELERS 0.91 42 Tata Consultancy Services Ltd. COMPUTERS - SOFTWARE 0.68

18 GAIL (India) Ltd. GAS 1.17 43 Tata Motors Ltd DVR AUTOMOBILES - 4 WHEELERS 1.57

19 Grasim Industries Ltd. CEMENT AND CEMENT PRODUCTS 0.66 44 Tata Motors Ltd. AUTOMOBILES - 4 WHEELERS 1.64

20 HCL Technologies Ltd. COMPUTERS - SOFTWARE 0.75 45 Tata Power Co. Ltd. POWER 1.01

21 HDFC Bank Ltd. BANKS 0.78 46 Tata Steel Ltd. STEEL AND STEEL PRODUCTS 1.73

22 Hero MotoCorp Ltd. AUTOMOBILES - 2 AND 3 WHEELERS 0.88 47 Tech Mahindra Ltd. COMPUTERS - SOFTWARE 0.79

23 Hindalco Industries Ltd. ALUMINIUM 1.84 48 UltraTech Cement Ltd. CEMENT AND CEMENT PRODUCTS 0.90

24 Hindustan Unilever Ltd. DIVERSIFIED 0.54 49 Wipro Ltd. COMPUTERS - SOFTWARE 0.61

25 Housing Development Finance Corporation Ltd. FINANCE - HOUSING 1.11 50 Yes Bank Ltd. BANKS 1.48

26 I T C Ltd. CIGARETTES 0.66 51 Zee Entertainment Enterprises Ltd. MEDIA & ENTERTAINMENT 1.14

Calculate the Cost of Equity for SBI, Infosys, Tata Steel, NTPC and HUL from the above table.

Cost of Capital

Now suppose we are estimating what is the cost of funds for the entire firm. So far, we have only looked at what would be the cost for only the equityholders, that is, what returns the equity holders would be happy with. Now we have to estimate the cost of debt as well, since for the firm that is also a source of capital.

Cost of Debt

There are various methods of calculating the cost of debt for firms• Firms may have specified this in the annual report – notes to accounts section.• If the company’s bonds are trading in the market, the yield to maturity can give us an idea of the cost

of debt• If the company’s bonds are not trading, we could look at the credit rating and compare the yield on

similar rated bonds in the markets• If none of the above are available, we could calculate the cost of debt by dividing the interest cost by

the total loans outstanding.

Cost of Debt

Finally, some companies have international debt. Remember that cost of debt also has to be in the same currency as the cash flows. So if a company has USD debt at 4%, this needs to get converted to INR rates. How can we do it? We can use the interest rate parity equation from economics.

1 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 (𝐼𝑛𝑑𝑖𝑎)

1 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 (𝑈𝑆)=

1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 (𝐼𝑛𝑑𝑖𝑎)

1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 (𝑈𝑆)

Therefore, if cost of debt in USD is 4%, and inflation in India is 6% while that in the US is 2%, the Cost of Debt in India would be given by

1 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 (𝐼𝑛𝑑𝑖𝑎)

1 + 4%=

1 + 6%

1 + 2%

This will give Cost of Debt (India) as 8.1%

Cost of Capital

Now we calculate the cost of funds based on the weight of funds raised by the company. This is known as weighted average cost of capital (WACC). The broad formula for WACC is given by

Where

E = Equity Value of the firm D = Debt of the firm V = E + D

Rd = Cost of Debt Re = Cost of Equity Tc = Tax Rate

WACC – What weights to use?

A common debate is what weights should be used for Equity and Debt – Book Values or Market Values. The values used should be market values. The reasons why market value is better are listed below

• Market Value reflects today’s business environment. If the company raises equity today, it is more likely to be closer to the market value than the book value

• Contrary to popular belief, using book values is not conservative. As book value of equity is far lower than market value, and book value of debt is closer to market value of debt, using book values will increase the Debt component in the WACC equation. Since Cost of Equity is higher than Cost of Debt, this will result in a lower WACC, which will become a more aggressive estimate of value rather than conservative

• It is assumed that market value is more volatile, hence more prone to error. However, the market value starts discounting the business scenario, whereas book value is inelastic to such changes.

WACC calculation

Calculate WACC for Tata Steel with data given in the table earlier. Assume Market value of Equity as Rs 30,000 crore, Debt as Rs 70,000 Crore. Cost of Debt is 10% and Tax rates are 30%. What should be the WACC?

Choosing a hurdle rate

We now finally reach a point where we have to choose a hurdle rate. The simple logic that follows is• If we are evaluating the value of equity of a firm, we use cost of equity as the hurdle rate• If we are evaluating the value of the total stakeholders of a firm, we use cost of capital as the hurdle rate

Questions

• Explain whether we should use market weights of equity and debt or book values of equity and debt while calculating WACC

• Calculate WACC for Spicejet with data given below.Beta = 1.45Risk Free Rate = 5%Equity Risk Premium = 8%Pre tax Cost of Debt = 10%Tax Rate = 30%Debt = 2000 croreEquity = 4000 crore

applied corporate finance · source: applied corporate finance, aswath damodaran. why a hurdle...

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