“CAPM Assignment Help- Cost Of Capital- Clarify your Basics”

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 Hope my last post on myth behind numbers helps you in developing insight to look beyond numbers while making a decision about company or projects because numbers are often illusory in nature, one can easily twist and manipulate it as per one’s advantage. Hence, be careful while taking decision just on the basis of numbers.

Let’s start today’s post from the point where I left my fourth post. I think after getting through my previous posts you can easily calculate the FCFF or FCFE, if the balance sheet of the company is given. But the real problems lie in calculating or making assumptions about the factors that I had mentioned in my fourth post. These factors are quite important for calculating the enterprise value. Today, I am going to explain to calculate one’s such factor that is how to calculate Cost of Capital. Please keep in mind that it is the same cost of capital/WACC that is used to discount all the future cash flows to find enterprise values. Since, it involves many sub factors; it will take minimum 5 to 6 post to cover the whole concepts. Now, before getting into the details please look at the factors essentials to consider before calculating Cost of capital or WACC. These factors are as follows:

Factors	Consideration
Models used	If you are using FCFF for your calculation then use cost of capital for discounting else use cost of equity for FCFE. Any mismatching will lead to erroneous results
Currency used	The currency used for estimating cash flows and discount rate should be same.
Inflation	If you consider inflation in your cash flow i.e. calculating Nominal cash flow then discount rate should be nominal and vice versa.

. The formula to calculate WACC is given by

WACC = (E/V) * Ke + D/V * ( Kd) * (1-Tc)

Where:
Ke = cost of equity
Kd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

From, the formula it is clear that while calculating firm’s cost of capital each category of capital is proportionately weighted. Generally, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

The first thing that we will have to consider in order to calculate Cost of Capital is Cost of Equity. The most common method used to calculate Ke is CAPM Model. It basically describes the relationship between risk and expected return and that is used in the pricing of risky securities.The formula is given by

Ke = Rf + Beta* ( Rm-Rf)

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (Rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-Rf). Please remember that there are many complexities while calculating Ke, which I will discuss in my next post.

Hope this post helps you in understanding the basics of Cost of capital. Be ready to enter the world of risk free rate in my next post.

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“CAPM Assignment Help- Risk Free Rate – Logic Behind Basic Assumptions”

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Hope my last post on cost of capital helps you in understanding its fundamentals and various factors affecting it. As discussed in the last post, the cost of Equity is given as

Ke = Rf + Beta* ( Rm-Rf)

Where

Rf = Risk free rate

Rm= Expected return from the market

Here, Risk Free rate is rate at which there lies no variance around the expected return rate. It means that on a risk free asset, the actual return is equal to the expected return. For any investment to become risk free it must satisfy two conditions which are as follows:-

1)      No Default risks

2)      No Reinvestment risks

The first condition states that it shouldn’t carry unwanted risks i.e. Business risks, financial risks or any other risks whereas second one states that there should not be any risk associated with the reinvestment of the money in the same assets.

Besides these the other two things that one must keep in his mind while taking assumptions for risk free rate is that time horizon matters , which means it is always better to take risk free rate of that assets for the current period rather than from any historical data. It also states that it is always better to take risk free rate for that asset whose time period of maturity matches with the time period of your valuation. Suppose you want to do valuation for a company by taking cash flow for 10 periods, then it is better to take 10 years Treasury bond rate as Rf rather than 6 months treasury bill rate because reinvestment risk is attached with 6 months treasury bill. Secondly, not all government securities are risk free.so, before using any Government securities rate as risk free rate kindly check the risk associated with it. For example, most of the analysts in the world uses U.S. Treasury bond as risk free rate but after 2008 crisis Moody has downgraded U.S. bond ratings from Aaa grade. So, we can’t take it as risk free rate rather we must subtract its credit spread associated with its bond ratings to get Rf.

One can calculate risk free rates in three ways

Ø  Risk free rates when valuation is done in local currency:-When we want to do valuation for a company in local currency then the best way to calculate the risk free rate is to subtract the Credit spread from the local government bond rate. Now, the question arises, why we subtract the credit spread? And the answer to this question is that as discussed above not all Government securities are risk free rather they have some inherent risks which is calculated by Credit Rating agencies and is given in the form of Credit spread. Hence, once we subtract that credit spread we will get the Rf. The credit spread arises because of various economic, social, political, legal etc. risks associated with a country. Hence, as an investor I will invest in those bonds when I will be getting the premium and that premium is calculated in the form of credit spread by the rating agencies.

Ø  Risk Free rate in Real term:-When you are doing valuation in real term then take the government inflation indexed bond as risk free rate or if such rate is not available then take the normalized value of the growth rate of country as risk-free rate.

Ø  Stable currency denominated bond can be used as risk free rate but it must be issued by the country whose currency you think is stable. For ex- Dollar ( Though Moody has downgraded the rating of U.S. bond but still people all over the world uses it), Euros.

One thing that we must keep in mind that the risk free rate varies across currencies, therefore we use stable currency denominated bond as risk free rate. The reason behind difference in the risk free rate for different currencies is that every currency is associated with the economy of its host country and hence any downslides in the economy affect its stability. Hence, risk free rate varies across the currency depending upon the stability of its host country. (Please note that there are many other issues attached with the stability of the currency)

Hope this blog helps you in understanding the way one will take risk free rate. Be ready to explore the world of Risk premium in my next post.

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CAPM Assignment Help- Understanding Risk Premium- An important step to calculate Cost of Equity”

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It has been long time since I came out with a blog. Today, I am going to concentrate on Risk premium. The CAPM model which is basically used to quantify the market risk in the form of market return consists of two things which is given by

Ke = Risk free rate + Risk premium

= Rf  + ( Rm – Rf )

The second value basically speaks about the premium that an investor expects from his investment for taking extra risk to invest in the stock of a particular company. The most simple step to calculate risk premium is to subtract ( Rf) from expected market return ( Rm ). But the problem with this approach is that we use historical data to calculate the average value of Rm. Hence, the value changes significantly with change in sample size and the method use to find average. Secondly, the standard error also increases with increase in the standard deviation of the return as standard error is given by

S.D/ Sqrt(n)

Where n= Sample size

For example, If we calculate Rm from past 20 years data of BSE with an assumption that standard deviation is 20 %, then the value of standard error will be around 4.4 %, which is significantly large. Hence we must explore some other methods to calculate Risk premium.

Equity risk premium can also be calculated by using country risk premium. Generally, Country equity risk premium shows the value that an investor expects to get because of the extra risks that he takes compare to stable equity market. For ex, the U.S.A market is considered extremely stable. Hence, CERP for U.S.A is must be kept minimum or zero.

Country risk premium can be calculated in one of the two ways

1)      By treating the value of CERP equal to the value of default spread i.e. the extra return that an investor expects from the risk associated with country bond as compare to stable market bond as per the rating given by rating agencies But the problem with this approach is that the risk taken by equity’s investors is more than bond’s investors. Hence, CERP should be more than default spread.

2)      In order to overcome above problem we can adjust the above calculated CERP by multiplying it with ratio of standard deviation of country’s equity market and the country’s bond market.

Adjusted CERP = Default spread * ( S.D of equity market/ S.D of Bond market)

We generally use second method to calculate CERP. Hence, here onwards we use CERP in place of adjusted CERP in all the discussions. Once we calculated the CERP,  the  risk premium associated with one’s equity can be calculated in one of the following two ways:-

1)      If we assume that the risk taken by company in other country is similar to home’s country, then  Risk premium is given by

Risk premium = Beta*(CERP+ US premium)

2)      If we assume that the risk is different in different countries then,

Risk premium = Beta*(US premium) + lambda *(CERP)

Here, lambda shows the ratio of revenue earned by company in domestic market to the average revenue earned by similar’s business firm in the same market. In the above example we used US premium while calculating risk premium because we assume that the US is the most stable country and there is negligible or no risk associated with US market.

Hence, once the risk premium is calculated, add it to risk free rates to get cost of equity (Ke). Hoping, this article will help you in understanding the concept behind calculation of (Ke) by using different approaches. Kindly follow my blogs to explore the world of financial modeling and valuations.

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