Lecture Notes: Risk-Free Rates, Betas, and Cost of Capital

Introduction

• Group organization and selection of companies for project.
• Discussion on the importance of picking a company soon.

Risk-Free Rate

• Currency Choice: The first step in valuation is picking a currency.
• Risk-Free Rate Dependent on Currency:
  • Less work if the government is default-free (e.g., US, Switzerland).
  • More work for countries like Indonesia, India, Brazil, requiring cleanup.

Equity Risk Premium

• Calculation:
  • Based on where the company does business.
  • Use equity risk premiums of each part of the world and take a weighted average.

Beta - Measure of Relative Risk

• Traditional Beta Estimation:
  • Run a regression of actual returns on stock vs. a market index.
  • Issues with regression betas: statistical number, backward-looking, unsuitable for private companies.
• Problems with Regression Betas:
  • Significant standard errors lead to a wide range of beta estimates.
  • Betas are backward-looking, reflecting past business conditions.
  • Private companies and divisions cannot have regression betas.
• Bottom-Up Beta:
  • Based on businesses the company is involved in.
  • More precise than regression betas.
  • Adjust for fixed costs and financial leverage.
  • Utilizes the law of large numbers for precision.

Examples and Applications

• Valuing Companies:
  • Apple: Broken down into smartphones, computer services, and hardware.
  • Amazon: Segmented into retail, AWS (cloud), and Amazon Prime.
  • Vale: Focus on iron ore with exposure to global demand, especially China.
  • Embraer: A Brazilian aerospace company evaluated with global comparables.

Cost of Debt

• Calculation:
  • Rate at which money can be borrowed long-term today.
  • Includes default spread.
• Default Spread:
  • Can be determined using synthetic ratings if no bond rating exists.
  • Use interest coverage ratio for synthetic ratings.
• Country Risk:
  • Default spreads are adjusted based on the country’s risk.

Ratings and Synthetic Ratings

• Importance of Ratings:
  • Often derived using interest coverage ratio.
  • Provides a benchmark for default spread.
• Adjustment for Country Risk:
  • Even if a company has a low default risk, country risk factors into cost of debt.

Financial Leverage and Cost of Capital

• Impact of Borrowing:
  • Borrowing increases equity risk.
  • Importance of calculating the market value of debt.
• Cost of Capital:
  • Weighted average of cost of equity and cost of debt.
  • Debt-to-equity ratios impact the overall cost of capital.

Conclusion

• Summary:
  • Risk-free rate, equity risk premium, and beta each have distinct roles in valuation.
  • Importance of understanding financial leverage and market conditions.
• Next Steps:
  • Mop up cost of debt discussions and move on to cash flows in the next class.

These notes cover key concepts and techniques in business valuation, including the calculation and application of risk-free rates, equity risk premiums, betas, and the cost of debt. Understanding how to properly assess and incorporate these components is crucial for accurate financial analysis and valuation.