Finance: Estimating Cost of Debt and Risk Premiums

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Questions and Answers

What is a limitation of using the yield to maturity on a straight bond outstanding from a firm to estimate the cost of debt?

It only considers new bonds issued.

Few firms have long-term straight bonds that are liquid and widely traded. (correct)

Most firms do not issue bonds.

It is highly accurate for all firms.

Which statement accurately describes estimating a firm’s rating using multiple bond ratings?

Different bonds from the same firm can have different ratings, requiring a median rating for estimation. (correct)

The rating should be ignored if there are multiple issued ratings.

You should take the highest rating available.

All bonds from one firm will have the same rating regardless of market conditions.

What method can be used to estimate a synthetic rating for a firm?

By averaging bond yields from competitors.

By analyzing historical stock prices.

By calculating the interest coverage ratio. (correct)

By assessing the total asset value of the firm.

How is the interest coverage ratio calculated?

EBIT / Interest Expenses Signup and view all the answers

What should be done if a firm has no ratings or multiple ratings?

Estimate a synthetic rating based on financial characteristics. Signup and view all the answers

What is the Brazil Country Risk Premium calculated using the given data?

4.92% Signup and view all the answers

Which approach assumes that every company in a country is equally exposed to country risk?

Approach 1 Signup and view all the answers

What is the Total Equity Risk Premium (ERP) for Brazil calculated in January 2024?

9.52% Signup and view all the answers

In Approach 2, what term represents the additional country risk premium added to the mature market equity risk premium?

CRP Signup and view all the answers

Which company accounted for 3% of its revenues from Brazil and the remainder from mature markets in 2004?

Embraer Signup and view all the answers

According to the content, which option refers to the risk-free rate in estimating expected return?

Riskfree Rate Signup and view all the answers

What is the standard deviation in the Bovespa (Equity) reported for Brazil?

30% Signup and view all the answers

Which component is NOT part of the equation for Approach 3 in estimating E(Return)?

Market Capitalization Signup and view all the answers

What does a higher financial leverage indicate about a company's equity beta?

It will generally be higher. Signup and view all the answers

How can the cost of equity be estimated according to the debt-based measures?

Using observable costs of debt along with a scaling factor. Signup and view all the answers

What is suggested by a high operating leverage in a firm?

The firm has a greater proportion of fixed costs. Signup and view all the answers

Which type of product or service typically leads to a higher beta?

Discretionary consumer goods. Signup and view all the answers

Which of the following statements regarding cyclical companies is true?

They tend to have higher betas than non-cyclical firms. Signup and view all the answers

What role does the scaling factor play in estimating the cost of equity?

It adjusts the observable costs of debt. Signup and view all the answers

In the context of risk assessment, qualitative models take into account which of the following factors?

The quality of management among other factors. Signup and view all the answers

What implication does increased infrastructure need have on a firm's beta?

It indicates a higher equity beta. Signup and view all the answers

What is the expected return on stocks calculated from the given input data?

11.18% Signup and view all the answers

What is the implied equity risk premium for India based on the expected return and growth rates?

4.42% Signup and view all the answers

Which of the following is true about the current implied equity risk premium based on the correlation data?

It correlates positively with actual returns in the next 5 years. Signup and view all the answers

What is the standard procedure for estimating betas according to the regression formula provided?

Rj = a + b Rm Signup and view all the answers

What does the historical risk premium indicate about market valuation?

It provides a long-term average for comparison. Signup and view all the answers

What is the expected growth rate beyond year 5 assumed in the computation?

6.76% Signup and view all the answers

How does the average implied premium over the last 5 years compare with the current implied premium?

It is significantly lower. Signup and view all the answers

What is the significance of the default spread based premium in the context of risk measures?

It indicates the risk associated with defaulting on a bond. Signup and view all the answers

What is the Gross Debt/Equity (D/E) ratio for Embraer?

18.95% Signup and view all the answers

How is the Net Debt Ratio for Embraer calculated?

(Debt - Cash) / Market value of Equity Signup and view all the answers

What levered beta is associated with the net debt approach for Embraer?

0.93 Signup and view all the answers

What does the cost of equity formula include?

Risk-free Rate, Beta, and Risk Premium Signup and view all the answers

Why is the cost of equity using net debt levered beta lower for Embraer?

The net debt ratio reduces perceived risk. Signup and view all the answers

What does the cost of debt reflect?

The rate you can borrow at currently. Signup and view all the answers

What type of beta is preferred for estimating the cost of equity?

Bottom-up beta based on other firms in the business Signup and view all the answers

What can affect the country's risk premium in calculating the cost of equity?

The country's default spread Signup and view all the answers

What does the standard error of a bottom-up beta estimate depend on?

Average Std Error across betas Signup and view all the answers

What does the levered beta formula incorporate in its calculation?

Unlevered beta, tax rate, and debt-equity ratio Signup and view all the answers

Can a bottom-up beta be estimated without historical stock prices?

Yes, for initial public offerings and private businesses Signup and view all the answers

What was Vale's unlevered beta according to the provided data?

0.86 Signup and view all the answers

What happens to the levered beta if the debt-equity (D/E) ratio increases?

It increases Signup and view all the answers

What is the primary use of bottom-up betas in financial analysis?

To assess risk for investment analysis Signup and view all the answers

What can bottom-up betas be adjusted for?

Changes in firm’s business mix and financial leverage Signup and view all the answers

Which of the following is NOT a correct assumption when estimating an unlevered beta for a Brazilian aerospace company?

The unlevered beta from U.S. and European companies is directly usable Signup and view all the answers

Study Notes

Discount Rates

Used in valuation to estimate cash flows over long time periods.

Risk-Free Rate

The return on a risk-free investment has no variance around the expected return.
A risk-free investment has no default risk and no reinvestment risk.
Crucial to estimate because risk-free rates vary across time, currencies, and even governments.
Time horizon matters; rates vary based on the expected cash flow time period.
Currencies matter; rates differ for different currencies.
Not all government securities are risk-free; some governments face default risk.
The best risk-free rate to use in valuing a US company should be determined among several factors such as three-month Treasury bill rate, ten-year Treasury bond rate, thirty-year Treasury bond rate, TIPS (inflation-indexed treasury) rate, the highest or lowest of those rates, or other (specify).

Sovereign Default Spread

Method 1 (Government Bonds): Emerging government bonds - US treasury bond rate.
Method 2 (CDS Spreads): The traded CDS value for the emerging government.
Method 3 (Rating Based Spreads): Calculated as the average spread for other countries with the same sovereign ratings.

Approach 1: Default Spread from Government Bonds

A table with detailed figures for different countries

Approach 2: CDS Spreads

A table with detailed figures for different countries

Approach 3: Typical Default Spreads

Table showing default spread based on S&P and Moody's ratings, with associated figures

Getting to a Risk-Free Rate in Brazilian Reais

Three approaches presented to determine the risk-free rate in Brazilian Reais (BRL) using data from January 1, 2024, including government bond spread, CDS spread, and rating-based spread.

Test 4: a Real Risk-Free Rate

Real risk-free rates are derived from Treasury indexed securities.
The 10-year indexed treasury bond yield in January 2024 was 1.80%.

Why Do Risk-Free Rates Vary Across Currencies/Time

Risk-free rates in different currencies/time periods differ depending on local sovereign currency ratings and default spreads. A chart depicts different risk-free rates for several currencies.

US Treasuries across Time

A graph of US Treasury rates from February 14, 2020, to August 14, 2020

Risk-Free Rate: Don't Have or Don't Trust the Government Bond Rate

Scaling the risk-free rate of a base currency (US dollar, Euro) by the differential inflation between the base currency and the other currency

The Equity Risk Premium

The difference in return that stocks have earned over risk-free securities historically.
Historical estimates used tend to be less accurate due to a variety of factors, including how far back one goes in history or whether arithmetic or geometric averages are used.
Important to be aware of biases like survivorship bias when creating a historical estimate.

The Country Default Spread

It is the country's equity risk premium, which can be calculated in one of three ways:
Default spread on a dollar denominated bond issued by the country.
Sovereign CDS spread for the country.
Default spread based on the local currency ratings for the country, along with maturity-date matching.

The Country Total ERP: A Volatility-Based Approach

An approach using the standard deviation of two equity markets (emerging market and a base market, usually the US). The total equity risk premium for an emerging is based on the volatility of the market in question relative to the US market.

A Melded Approach to Estimating the Additional Country Risk Premium

Calculate country equity risk premium using the product of default spread on country bond, volatility, and equity/volatility in country bond

Template for Estimating the ERP

A table describing steps for estimating ERP for different sovereign ratings, default spreads, and other factors

ERP Estimates: January 2024

A chart of country ratings, associated CRP, and ERP values for several countries

From Country Equity Risk Premiums to Corporate Equity Risk Premiums

Three approaches that firms can take when calculating corporate equity risk premiums, with varying levels of exposure to country risk

Estimating Country Risk Premium Exposure

Two main approaches, accounting for varying levels of exposure to country risk

Operation Based CRP: Single Versus Multiple Emerging Markets

Example of how revenue is used to calculate relative exposure to country risk (lambda values), demonstrating both single and multiple emerging markets

Extending to a Multinational: Regional Breakdown

Example case of Coca-Cola in 2012 showing regional detail in revenue allocation and risk.

Two Problems with These Approaches

Focusing solely on revenues when assessing country risks.
Exposure not adjusted or based on beta while measuring exposure to country risk

A Production-Based ERP: Royal Dutch Shell

Example of a production-based computation of ERP using detailed revenue figures for different countries

Estimate a Lambda for Country Risk

Explains the factors that affect country-exposure risk (e.g. risk management, government interests) by highlighting the importance of risk management and government interests

A Revenue-Based Lambda

Illustrates calculation of the parameter "λ" (lambda), which measures the relative exposure of a firm to country risk

A Price/Return Based Lambda

Explains how regression analysis can be used to calculate the parameter "λ" (lambda) and presents two regression charts relating the return of Embraer to returns on C Bonds

Estimating a US Dollar Cost of Equity for Embraer - September 2004

Provides five alternative estimated methods for cost of equity to consider for a company (Embraer) in September 2004, including a consideration of CRP within each method

Valuing Emerging Market Companies with Significant Exposure in Developed Markets

The prevalent method of valuation in investment banking.

Implied Equity Premiums

Calculating the implied equity risk premium for given valuations

Equity Risk Premium: January 2020

Detailed calculations for implied equity risk premium in January 2020

And in 2020...Covid Effects

Graph showcasing equity risk premium for the S&P 500 between December 2019 and December 2020 to illustrate the impact of the COVID-19 pandemic

An Updated Estimate: ERP in 2024

Detailed calculation for implied equity risk premium with emphasis on expected earnings/cash flow growth in January 2024.

Implied Premiums in the U.S.: 1960-2023

Graph presenting implied equity risk premium values from 1960 to 2023 in the US.

Implied Premium Versus Risk-Free Rate

Shows a graph of the implied equity risk premium versus the risk-free rate over time from 1960 to 2023

Equity Risk Premiums and Bond Default Spreads

Graph providing a timeline of equity risk premiums and bond default spreads from 1960 through the present

Equity Risk Premiums and Cap Rates (Real Estate)

Graph depicting the relationship between equity risk premiums and real estate risk premiums across different years spanning from 1980 through the present.

Why Implied Premiums Matter

The importance of evaluating results when using historical data as a basis for implied risk.

Which Equity Risk Premium Should You Use

Comparison of different predictors and their correlations with actual market returns

An ERP for the Sensex

Calculation of the equity risk premium (ERP) for the Sensex index (India) using historical data.

The Evolution of Emerging Market Risk

Chart tracking PBV, PBVY, ROE, US T-Bond, growth rate, cost of equity and differential. Demonstrates the trend in Emerging Market Risk across multiple years (2004 to 2023).

Relative Risk Measures

The calculation and analysis of relative risk as a means to understand various relative risk metrics

The CAPM Beta: The Most Used (And Misused) Risk Measure

An explanation of the calculation and potential issues with a standard calculation of CAPM beta, including its high standard error, reflecting a firm's outdated business mix, and reflecting average financial leverage vs. current leverage

Unreliable, When It Looks Bad..

A chart visualising different aspects of beta

Or When It Looks Good..

Graph and table showcasing historical beta calculation. Focuses on Nokia's beta calculated using period 8/14/98 to 8/4/00 and S&P 500 index data, presenting adj, unadjusted values and other related statistics

One Slice of History..

Visual chart (graph) highlighting the dramatic price fluctuations of GME (GameStop) stock.

And Subject to Game Playing...

Historical beta calculation for Bombardier Inc, and an analysis of data points from 2010, 2004, 1989, and 1994 related to the stock market.

Measuring Relative Risk: You Don't Like Betas or Modern Portfolio Theory? No Problem..

Providing various approaches to measure risk that are based on the price of the asset rather than relying on the CAPM model or beta.

Don't Like the Price-Based Approach..

Presents alternative approaches to measure risk and explains their potential limitations when they are not perfectly correlated to price

Determinants of Betas & Relative Risk

Factors that influence betas (operating leverage and financial leverage) and their impact

IN a Perfect World... We Would Estimate the Beta of a Firm By Doing the Following

Steps on estimating the beta of a firm, including business beta, operating leverage, and financial leverage.

Adjusting for Operating Leverage..

Adjustment techniques to compute unlevered betas for firms with operating leverage

Adjusting for Financial Leverage..

Methods for adjusting betas for financial leverage, including the conventional and debt-adjusted approaches.

Bottom-Up Betas

A method for estimating betas focused on understanding the firm's components and weighting them

Why Bottom-Up Betas

Explaining why bottom-up betas are less noisy and how they can be updated to reflect the current business mix and financial leverage

Estimating Bottom Up Betas & Costs of Equity; Vale

Data, calculation, and cost of equity estimations by business sector ( metals, mining, iron, ore, fertilizers, logistics, etc)

Embraer's Bottom-Up Beta

Calculation and assessment of Embraer's beta using a bottom-up approach.

Gross Debt Versus Net Debt Approaches

The advantages and disadvantages between computing the cost of debt using a gross or net debt approach.

The Cost of Equity: A Recap

Review of factors and processes which together can be used to estimate the cost of equity for a firm accurately, including the approach using historical premium and use of implicit premiums.

Cost of Debt

Methods for estimating the cost of debt for a firm

Estimating Synthetic Ratings

Methods of estimating ratings given financial characteristics of a firm via an Interest Coverage Ratio

Interest Coverage Ratios, Ratings and Default Spreads: 2004

Information table converting interest coverage ratios into rated bond rating default spread values for the year 2004

Cost of Debt Computations

Calculating the cost of debt using the interest coverage ratio, synthetic rating given a set of data and considerations of country default risk and company default spread

Synthetic Ratings: Some Caveats

Explanation of possible limitations of using synthetic ratings.

Default Spreads: Change is a Constant

Graph illustrating the changing default spreads of corporate bonds over time in a given year

Subsidized Debt: What Should We Do?

Explanation about what to do next in cases of subsidized debt, considering the Brazilian government's role. Discussion focuses on whether to use subsidized cost of debt or fair cost for capital projects

Weights for the Cost of Capital Computation

Discussion of using market value weights over book-value weights based on the accuracy of market values compared to book value weights, when computing the cost of capital

Estimating Cost of Capital: Embraer in 2004

Detailed calculation of the cost of capital for Embraer in 2004.

If You Had to Do It... Converting a Dollar Cost of Capital to a Nominal Real Cost of Capital

Shows two approaches for converting dollar cost of capital into nominal real cost of capital.

Dealing with Hybrids and Preferred Stock

Handling of hybrids and preferred stocks

Decomposing a Convertible Bond

The valuation of a convertible bond is broken down into its components: the debt and equity portions.

Recapping the Cost of Capital

A summary of the factors and steps of estimating the cost and capital, which should be used for computing the cost of borrowing and cost of equity

Studying That Suits You

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Description

This quiz covers key concepts related to estimating the cost of debt, interest coverage ratios, and country risk premiums. It includes questions on synthetic ratings, firm ratings, and evaluations of financial metrics. Enhance your understanding of corporate finance and risk assessment techniques.