IFT Notes for Level I CFA^{®} Program

## R33 Cost of Capital

# Part 3

## 4. Topics in Cost of Capital Estimation

A firm’s beta is used to estimate its required return on equity. Beta is a measure of risk; riskier firms will have higher betas, whereas less risker firms will have lower betas. Beta is estimated by regressing a stock’s returns with overall market returns.

At times, we need to estimate the beta for a project or a company that is not publicly traded. In this case we use the pure-play method.

**Pure-Play Method**

This method has three steps:

__Step 1__**:** Shortlist comparable publicly traded companies.

__Step 2__**:** Derive unlevered beta or comparable asset beta for the project using comparable company’s D/E and tax rates:

__Step3__**:** Get the equity levered beta for the project using project specific D/E and tax rate:

**Example**

AA Corp. is a large conglomerate and wants to determine the equity beta of its food division. This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable publicly traded food company has an equity beta of 1.2 and a D/E ratio of 0.5. What is the equity beta of AA’s food division?

**Solution:**

Using the pure play method, we can calculate the equity beta of AA’s food division as:

- Unlevered beta of publicly traded food company = 1.2 *= 0.923
- Levered equity beta of AA’s food division = 0.923 [1 + 0.6 x 0.7] = 1.31

Inference: Since AA’s food division has more debt than the publicly traded company, it is riskier and has a higher beta value.

**4.2. Country Risk**

The general assumption so far has been that an investor is investing in a developed country. But what happens when an investor invests in emerging economies? Here the CAPM is modified to adjust for additional risk in a developing market by adding country risk premium (CRP) to market risk premium.

The country risk premium is computed as:

Country ERP = Sovereign yield spread *

where:

Annualized standard deviation of equity index

= Annualized standard deviation of the sovereign bond market in terms of the developed market currency

For example, assume you are a U.S. based investor investing in Indian securities. The risk-free rate is 3% and the beta for a stock is 1.5. The market risk premium is 6% and CRP for India is 3%. The cost of equity is 3 + 1.5[6+3] = 16.5%.

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