wk 2 - DCF Valuation_discount rates_2011 s2

wk 2 - DCF Valuation_discount rates_2011 s2 - FINS3641...

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Prepared by Henry Yip 1 FINS3641 SECURITY ANALYSIS AND VALUATION PART 2 - DISCOUNTED CASH FLOW VALUATION MODELS Week 2: Estimating Discount Rates Topics: Estimating the cost of equity The choice of risk free asset and risk free rate Estimating equity risk premium Esitmating beta Estimating the cost of debt Estimating the cost of capital Learning Outcomes: Learn the techniques to compute discount rates for the DCF models Resources: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctrypre m.html - adjusted default spreads, total and country risk premiums Reading: Damodaran Chapters 7-8

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FINS3641 SAV Week 2: Estimating Discount Rates 2 A. The Cost of Equity: E(r i ) = r f + b i [E(r M ) – r f ] 1. Estimating the Risk Free Rate of Return – the base / bare minimum rate of return i. What are the requirements for (attributes of) an asset to be risk free? a. No default risk b. No reinvestment/refinancing risk ii. What are the implications of these requirements as to the choice of risk free assets? a. In theory, we need reference to debts issued by stable and well-run governments with prudent reserves and means to withstand external shocks. zero coupon debts with durations that match the lifespan of the cash flows used in the valuation exercises. b. In practice, the time horizon is generally infinite and long term debts come with coupon interest. We typically regard long (rather than short) term U.S. Treasury bonds as proxies for the risk free asset and use its yield to discount nominal cash flows that are denominated in the same currency as the cash flows of the bonds .
Week 2: Estimating Discount Rates 3 1. Estimating the Risk Free Rate of Return – the base / bare minimum rate of return iii. How do we determine the risk free rate for firm valuation in countries that are not default risk free and with governments that do not borrow long term? a. May use the long-term debts raised by the local blue-chip firms look up the interest rate on long-term local currency denominated debts issued by the largest and safest firms in the country take away the default spread (that corresponds to a marginal lower credit rating, i.e., AA. See footnote 3, p. 157 and Table 7.5, p. 166) to arrive at the risk free rate and apply this rate to local currency cash flows. b. May use interest rate parity theory if there are long term dollar-denominated forward contracts on the (local) currency: ܨ݋ݎݓܽݎ݀ ݎܽݐ݁ ி஼,\$ ൌܵ݌݋ݐݎܽݐ݁ ி஼,\$ 1൅ ݅݊ݐ݁ݎ݁ݏݐ ݎܽݐ݁ ி஼ ሺ1൅݅݊ݐ݁ݎ݁ݏݐݎܽݐ݁ \$ If the current spot rate is 38.1 Thai baht per USD, the 10-year forward rate is 61.36, and the current 10-year US Treasury bond is 4.29%, then 10-year Thai risk free rate is: 9.38% (see footnote 4, p. 158 if only short term forward rate is available.) c. If the government have raised long-term local currency debts, may deduct the default spread from the yield on these debts. For example, suppose that the

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wk 2 - DCF Valuation_discount rates_2011 s2 - FINS3641...

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