Calculating Cost of Equity for an Indian Company

(Based on ‘Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2011 Edition by Aswath Damodaran’.)

In capital Asset Pricing Model (CAPM) the expected return on asset/investment is calculated as,

Expected Return = Riskfree Rate + Beta_Asset (Equity Risk Premium)

So, to arrive at the expected return on an investment one needs to know following three parameters,

1. Riskfree Rate: The return on any risk free investments such as T-Bills, Sovereign Bonds etc. The time horizon for investment should match with the maturity of riskfree investment considered to get Riskfree Rate. So, if investor is planning for 6 months of time horizon Interest rate of a T-Bill will do; and if he/she is planning for longer duration, comparable GOI bond should be considered. It is important that for bonds ‘Bid Yield’ is considered as Riskfree rate and not coupon rate.

Note: Rate of T-Bills can be found at Reserve Bank of India’s site (http://www.rbi.org.in), in the section ‘Current rates>market Trends>Govt. Securities Market’.

Yield on bonds can be found at The Fixed Income Money Market and Derivatives Association of India’s website as Par yield on current date for the bond in consideration.

Mature markets like U.S., Germany which are AAA rated are considered with zero default risk in Govt. Securities, while markets like India, China, Brazil etc. Are considered riskier than mature markets and hence Govt. Securities issued by these countries are considered to carry default risk. (There have been incidents in the past when even Governments have defaulted on Bond payments, like default by Russian Govt. in 1990-91.)

Hence to arrive at Riskfree rates for markets like India, Country Risk Premium (CRP) is subtracted from Bond’s (Current yield) Rate.

CRP is dependent on Sovereign Rating of a country and volatility in Benchmark Bond & Benchmark Equity index yields.

Risk Free Rate = Yield on Benchmark Bond/T-Bill – Country Risk Premium

2. Beta_{Asset
To learn how to calculate Beta of an asset/scrip see,}
 Estimating Regression Beta Using Excel Data Analysis Function

3. Equity Risk Premium (ERP)

Risk premium to be charged for an investment not only reflects the nature of risk associated with the security but also risk arising out of investments in markets which themselves carry certain default risk. Thus, ERP for a market is calculated by adding ‘Default Spread’ for a country (which depends on Sovereign Rating of a country) to Premium on Equity investment in Mature Markets like U.S..

Equity Risk Premium = Mature Market Premium + Default Spread

Data about CRP, Default Spread, ERP, Sovereign Ratings etc. can be found on Prof. Aswath Damodaran’s Home Page (Damodaran Online).

Example

To calculate, Expected Return for ‘Tata Power Ltd.’

Date	19 June 2011
Country	India
Moody's Rating	Ba1
Default Spread	2.40%
Country Risk Premium for India	3.60%
For US (Mature Market) risk premium	5.00%
Equity Risk Premium for India	8.60%
(Mature market Premium + Default Spread)
Risk Free Rate
10 year GOI Sovereign Bond yield as on June 17, 2011	8.28%
Risk Free Rate (Bond Yield - Country Risk Premium)	4.68%
Cost of Equity
Firm	Tata Power Ltd.
Beta of Tata Power	1.1881
Cost of Equity for Tata Power Ltd.	14.90%
(CAPM: Cost of Equity = Riskfree Rate + BetaAsset (Equity Risk Premium)

Working Excel can be downloaded from here.

Links:

1. Damodaran Online (http://pages.stern.nyu.edu/~adamodar/)

2. ‘Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2011 Edition by Aswath Damodaran’ (http://ssrn.com/abstract=1769064).

3. Important Excel functions for bond related calculations from RBI

(http://www.rbi.org.in/scripts/FAQView.aspx?Id=79#A4)

4. The Fixed Income Money Market and Derivatives Association of India

(http://www.fimmda.org)