Phase II: Risk and Return (14 marks)

Objective Estimate the risk parameters for your company and use these parameters to

estimate costs of equity and capital for the firm.

Key Steps

1. Looking at the stock price history of your company, evaluate both its riskiness and its performance as an investment, relative to the market and after adjusting for risk.

2. Develop a measure of equity risk in the company and compute a cost of equity for it. If the company is in multiple businesses and regions, estimate the cost of equity for each.

3. Develop or find a measure of default risk in the company and compute a cost of debt for it.

4. Based on the mix of debt and equity used by the company, estimate an overall cost of capital for the company. If it is in individual businesses and regions, estimate the cost of capital for each.

Framework for Analysis

1. Estimating Risk free rate and Equity Risk Premium (4 marks)

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 entitys 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 companys 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).

2. Estimating relative risk (5 marks)

a. Run a regression of returns on your firms stock against returns on a market index, preferably using monthly data and 5 years of observations. Use the regression to evaluate your companys 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.

• What is the intercept of the regression? What does it tell you about the performance of this company's stock during the period of the regression?
• What is the slope of the regression?
  • What does it tell you about the risk of the stock?
  • How precise is this estimate of risk? (Provide a range for the estimate.)
• What portion of this firm's risk can be attributed to market factors? What portion to firm-specific factors? Why is this important?
• How much of the risk for this firm is due to business factors? How much of it is due to financial leverage?

b. Based on your companys business mix, estimate a bottom up beta for your companys operating businesses. You should be able to find the breakdown by business in your companys 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.

• Break down your firm by business components, and estimate a business beta for each component
• Attach reasonable weights to each component and estimate an unlevered beta for the business.
• Using the current leverage of the company, estimate a levered beta for each component.

c. 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 companys debt to equity ratio for all of the businesses).

d. 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.

3. Estimating Default Risk and Cost of Debt (2 marks)

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 of debt.

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 companys 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)

4. Estimating Cost of Capital (3 marks)

a. Compute the market value of all of the companys equity.

b. Compute the market value of the companys 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.

Proper referencing in text and bibliography (1 mark)

Overall neatness of the report (1 mark)

Executive Summary (1 mark)

Oral presentation for Phase I and II (2 marks)