ESTIMATING HURDLE RATES II: RISK FREE RATE

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1 ESTIMATING HURDLE RATES II: RISK FREE RATE Nothing in life is guaranteed, right?

2 Set Up and Objective 1: What is corporate finance 2: The Objective: Utopia and Let Down 3: The Objective: Reality and Reaction The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate The Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The Dividend Decision If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your business Hurdle Rate 4. Define & Measure Risk 5. The Risk free Rate 6. Equity Risk Premiums 7. Country Risk Premiums 8. Regression Betas 9. Beta Fundamentals 10. Bottom-up Betas 11. The "Right" Beta 12. Debt: Measure & Cost 13. Financing Weights Investment Return 14. Earnings and Cash flows 15. Time Weighting Cash flows 16. Loose Ends Financing Mix 17. The Trade off 18. Cost of Capital Approach 19. Cost of Capital: Follow up 20. Cost of Capital: Wrap up 21. Alternative Approaches 22. Moving to the optimal Financing Type 23. The Right Financing Dividend Policy 24. Trends & Measures 25. The trade off 26. Assessment 27. Action & Follow up 28. The End Game Valuation 29. First steps 30. Cash flows 31. Growth 32. Terminal Value 33. To value per share 34. The value of control 35. Relative Valuation 36. Closing Thoughts

3 Inputs required to use the CAPM - The capital asset pricing model yields the following expected return: Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market PorRolio - Riskfree Rate) To use the model we need three inputs: a. The current risk- free rate b. The expected market risk premium (the premium expected for inveswng in risky assets (market porrolio) over the riskless asset) c. The beta of the asset being analyzed. 3

4 The Riskfree Rate and Time Horizon On a riskfree asset, the actual return is always equal to the expected return. For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two condiwons have to be met There has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free. There can be no uncertainty about reinvestment rates, which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed. TheoreWcally, this translates into using different riskfree rates for each cash flow - the 1 year zero coupon rate for the cash flow in year 1, the 2- year zero coupon rate for the cash flow in year 2... PracWcally speaking, if there is substanwal uncertainty about expected cash flows, the present value effect of using Wme varying riskfree rates is small enough that it may not be worth it. 4

5 The Bo_om Line on Riskfree Rates Using a long term government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximawon of the true value. For short term analysis, it is enwrely appropriate to use a short term government security rate as the riskfree rate. The riskfree rate that you use in an analysis should be in the same currency that your cashflows are eswmated in. In other words, if your cashflows are in U.S. dollars, your riskfree rate has to be in U.S. dollars as well. If your cash flows are in Euros, your riskfree rate should be a Euro riskfree rate. The convenwonal pracwce of eswmawng riskfree rates is to use the government bond rate, with the government being the one that is in control of issuing that currency. In November 2013, for instance, the rate on a ten- year US treasury bond (2.75%) is used as the risk free rate in US dollars. 5

6 What is the Euro riskfree rate? An exercise in November 2013 Rate on 10- year Euro Government Bonds: November % 8.30% 8.00% 7.00% 6.00% 5.90% 6.42% 5.00% 4.00% 3.30% 3.90% 3.95% 3.00% 2.00% 1.75% 2.10% 2.15% 2.35% 1.00% 0.00% Germany Austria France Belgium Ireland Italy Spain Portugal Slovenia Greece 6

7 When the government is default free: Risk free rates in November 2013! 7

8 What if there is no default- free enwty? Risk free rates in November 2013 If the government is perceived to have default risk, the government bond rate will have a default spread component in it and not be riskfree. There are three choices we have, when this is the case. Adjust the local currency government borrowing rate for default risk to get a riskless local currency rate. n In November 2013, the Indian government rupee bond rate was 8.82%. the local currency rawng from Moody s was Baa3 and the default spread for a Baa3 rated country bond was 2.25%. Riskfree rate in Rupees = 8.82% % = 6.57% n In November 2013, the Chinese Renmimbi government bond rate was 4.30% and the local currency rawng was Aa3, with a default spread of 0.8%. Riskfree rate in Chinese Renmimbi = 4.30% - 0.8% = 3.5% Do the analysis in an alternate currency, where gekng the riskfree rate is easier. With Vale in 2013, we could chose to do the analysis in US dollars (rather than eswmate a riskfree rate in R$). The riskfree rate is then the US treasury bond rate. Do your analysis in real terms, in which case the riskfree rate has to be a real riskfree rate. The inflawon- indexed treasury rate is a measure of a real riskfree rate. 8

9 EsWmaWng a sovereign default spread Estimating a default spread for a country or sovereign entity Market Based estimates Sovereign Bond spread 1. Find a bond issued by the country, denominated in US$ or Euros. 2. Compute the default spread by comparing to US treasury bond (if US $) or German Euro bond (if Euros). CDS Market 1. Find a 10-year CDS for the country (if one exists) 2. Net out US CDS 2. This is your default spread. Country Sovereign- Bond-Yield Currency Risk-free-rate Default- Spread CDS-Spread-(netof-US) Brazil 4.50% US$ 3.04% 1.46% 2.07% China NA NA NA NA 0.87% India NA NA NA NA 3.05% Poland 2.50% Euro 1.80% 0.70% 0.82% Rating/Risk score based estimates Step 1: Find a sovereign rating (local currency) for the country (on Moody's or S&P) Step 2: Look up the default spread for that rating in the lookup table below: Moody's rating Sovereign Bonds/CDS Aaa/AAA 0.00% Aa1/AA+ 0.40% Aa2/AA 0.50% Aa3/AA( 0.60% A1/A+ 0.70% A2/A 0.85% A3/A( 1.20% Baa1/BBB+ 1.60% Baa2/BBB 1.90% Baa3/BBB( 2.20% Ba1/BB+ 2.50% Ba2/BB 3.00% Ba3/BB( 3.60% B1/B+ 4.50% B2/B 5.50% B3/B( 6.50% Caa1/ CCC+ 7.50% Caa2/CCC 9.00% Caa3/ CCC % Country Moody's,Rating Default,Spread Brazil Baa2 1.90% China Aa3 0.60% India Baa3 2.20% Poland A2 0.85% 9

10 Risk free rates will vary across currencies: January % Risk free rate by Currency: January % 8.00% 6.00% 4.00% 2.00% 0.00% Japanese Yen Taiwanese $ Swiss Franc icelandic Krona Czech Koruna Phillipine Peso Bulgarian Lev Euro Danish Krone Hong Kong $ Lithuanian Litas Thai Baht Dutch Guilder CroaWan Kuna Swedish Krona Singapore $ Israeli Shekel BriWsh Pound Canadian dollar Malaysian Ringgit Hungarian Forint Norwegian Krone US $ Romanian Leu Polish Zloty Vietnamese Dong Pakistani Rupee Chinese Remimbi Australian Dollar Chilean Peso Colombian Peso Mexican Peso Peruvian Sul New Zealand $ ArgenWne Peso Russian Rouble Venezuelan Bolivar Indonesian Rupiah South African Rand Indian Rupee Turkish Lira Kenyan Shilling Nigerian Naira Brazilian Reais! 10

11 Task EsWmate the risk free rate in the currency of your choice Read Chapter 4 11