Cost of Capital 2018

Cost of capital
Practical seminar for Deal Advisory

October 2018
Agenda
General definitions
Cost of Equity
Cost of Debt
Putting WACC together
© 2018 JSC “KPMG”, a company incorporated under the Laws of the Russian Federation, a member firm of the KPMG network of independent member firms affiliated with KPMG
International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. 1
General definitions
Standards of value (IVS)
Market Value
 is the estimated amount for which an asset should exchange between a willing
buyer and a willing seller in an arm’s length transaction;
 reflects the asset’s highest and best use;
 requires any advantages that would not be available to market participants
generally to be disregarded.
Fair Value
 is the estimated price for the transfer of an asset between identified
knowledgeable and willing parties that reflects the respective interests of those
parties;
 depends on the parties involved taking into account advantages or
disadvantages that each will gain from the transaction.
Investment Value
 an entity-specific basis of value.
Discount rate definition
Discount rate
 is a rate used to discount cash flows to determine the present value of future cash
flows;
 takes into account the time value of money and the risk or uncertainty of the
anticipated future cash flows.
Matching cash flows to the discount rate (1/2)
Real / Nominal
Currency
Pre-tax / After-tax
Do the cash flows include all risks?
Timing
Matching cash flows to the discount rate (2/2)
Free Cash Flow to Equity
Earnings Before Tax (EBT)
 cash flow to shareholders only; – Tax on EBT
+ Depreciation and amortisation
 discounted at Cost of Equity:
+/– Change in Net working capital
- CAPM; – Capital expenditures
+/– Change in Net debt
- Fama-French Model;
Free Cash Flow to Equity (FCFE)
- Arbitrage Pricing Theory.
Free Cash Flow to Firm

Earnings Before Interest and Tax
(EBIT)
 cash flow to all sources of
financing; – Tax on EBIT
+ Depreciation and amortisation
 discounted at Cost of Capital: +/– Change in Net working capital
- WACC. – Capital expenditures

Free Cash Flow to Firm (FCFF)
Weighted Average Cost of Capital (WACC) (1/3)
WACC:
 assumes fixed capital structure for the company;
 uses expected rates of returns from financing sources (e.g. debt and equity);
 is usually calculated on a after-tax basis;
 can be used as a benchmark to assess the attractiveness of an investment;
 represents the marginal cost of capital (i.e. for an extra $1 of financing).
Equity X Cost of Equity

Capital structure
WACC
Preferred Equity X Cost of Preferred Equity
Debt X Cost of Debt
 E   PS   D 
WACC = ke *   + k ps *   + k d * (1 − T ) *  
 E + PS + D   E + PS + D   E + PS + D 
ke - Rate of return on Equity; PS - Market value of Preferred Stock;

k ps - Rate of return on Preferred D - Market value of Debt;
Stocks; - Marginal corporate tax rate.
T
kd - Borrowing Rate;
E - Market value of Equity;
Cost of equity
Cost of equity
Approaches
Arbitrage Fama-
CAPM Pricing French
Theory Model
Cost of equity
Capital Asset Pricing Model (CAPM)
Classic CAPM formula Developed countries Emerging countries
E ( R ) = R f +β * ( E ( Rm ) − R f ) + [SP + SCRP ] + [CRP + FXRP ]
E (R ) – expected rate of return on asset SP – size premium;

during a specific time period;
SCRP – specific company risk premium;
Rf – risk free rate
CRP – country risk premium;
β – sensitivity of return on asset in
FXRP – currency risk premium.
relation to changes in return of
market portfolio
E ( Rm ) – expected return on a market

portfolio
Cost of equity
Cost of equity and its major determinants:
Risk-free rate
 Definition
 Duration
Risk free rate
 Nominal and real measure
 Rf Selection
Risk Free Rate
Definition
Risk Free Rate (Rf) = Return on a riskless asset (no variation in returns)
 Basic features of a risk free asset:

- No default risk;
- No reinvestment risk.
 The best proxy for Rf is a yield to maturity of zero coupon bonds of governments
that have never (or very rarely) defaulted:
- USA;
- UK;
- Germany;
- Japan.
Risk Free Rate
Government bond yield
Rf = the expected return on a long term zero coupon government bond
Maturity Zero coupon bond

 Maturity of bonds should match the  All principle due at maturity;
cash flows;
 No periodic payments for interest;
 Consider duration instead of
maturity if bonds are coupon  Bought at a price lower than its par
bearing. value.
Risk Free Rate
Duration
Macaulay Duration = a weighted average term to maturity of the cash flows
from a bond
n n
PVi
MacD = ∑ ti , V = ∑ PVi
i =1 V i =1
 is measured in years;
 used to compare bonds based on effective maturity;
 for zero coupon bonds: Duration = Maturity;
 higher duration = Higher interest rate risk / reward.
Risk Free Rate
Real and nominal measure
A Risk Free Rate (Rf) should match either real or nominal cash flows
 Approach 1: based on long-term inflation
Long-term
Real Rf 1 Nominal Rf 1 Inflation 1
 Approach 2: inflation-indexed treasury rate (such as US TIPs).
Risk Free Rate
Commonly used proxy for Rf
A commonly used proxy for Rf is US Treasury bond yields:
 Largest economy in the world;
 Historical default is very rare;
 Issues zero coupon bonds.
Rf = 2.98% yield to maturity on 20-yr US Treasury Bonds as at 30 June 2018
Rf = 2.91% yield to maturity on 10-yr US Treasury Bonds as at 30 June 2018
Risk Free Rate
Quiz
If you were to choose between 10-year and 20-year US

Treasury bond yields when calculating Rf, which one would
you suggest to use?
Risk Free Rate
Quiz: Answer
 There is no absolutely right answer, various Researchers/Practitioners Rf duration
researchers and experts use risk-free rates
with different duration. Duff&Phelps 20-y
 General KPMG practice is to use the 20-y US Damodaran 10-y
Treasury yield to maturity for the following
reasons: Bloomberg 10-y
− It matches long-term lifetime horizon of Ernst & Young 20-y
an equity investments; Societe Generale 10-y
− Less volatile; Credit Suisse (Global
20-y
− It matches the longest-term bond over Investment Returns Yearbook)
which the equity risk premium is
measured in the Duff&Phelps data series.
 The main rule is to be consistent in using risk-
free rate throughout the whole process of
estimation of the cost of capital (i.e. cash flows,
calculation of ERP, country risk premium,
currency risk premium, etc.).
Risk Free Rate
Quiz
What government bonds are appropriate to use for Rf

calculation other than US Treasuries?
Risk Free Rate
Rf selection
Government bond yields in local currency
10%
10y 20y 30y
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
Note: For 20-yr and 30-yr bonds the bond with the nearest maturity was used
Cost of equity
Equity Risk Premium
 Definition
 ERP approaches
− Historical approach
Equity Risk
Premium − Supply Side Model
− Survey approach
− Implied ERP
Cost of equity
Equity Risk Premium: Definition
 ERP measures the excess of the long-term stock market return over Rf
Capital Asset Pricing Model
CAPM basic formula:

Expected Return
E ( R ) = R f +β * ( E ( Rm ) − R f )
ERP
Rf Rf
Beta
Cost of equity
Equity Risk Premium: Approaches
Forward-looking
Historical approach
approach
Arithmetic Survey
Geometric Implied ERP
Supply Side Model
Cost of equity
Equity Risk Premium: Historical Approach
Arithmetic Geometric
corresponds to additive (not represents the compound
compounded) nature of CAPM average return
equates the expected future value when applied for expected future
with the present value value, results in the median of the
distribution
more appropriate for discounting more appropriate for reporting
FCF past performance
Cost of equity
Equity Risk Premium: Implied ERP
As an alternative to historical data, we can use a basic discounted cash flow model
and current stock index levels to estimate the future risk premium implied by current
stock prices.
𝐷𝐷𝐷𝐷𝐷𝐷 (𝑡𝑡 + 1) 𝐷𝐷𝐷𝐷𝐷𝐷 (𝑡𝑡 + 1)

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = 𝑅𝑅 = 𝑔𝑔 +
𝑅𝑅 − 𝑔𝑔 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
 Dividends can be generalized to include stock buybacks.

 The model can also be extended to include a high growth period.
5
𝐷𝐷𝐷𝐷𝐷𝐷 𝐷𝐷𝐷𝐷𝐷𝐷𝐷 ∗ (1 + 𝑔𝑔)
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = � +
(1 + 𝑅𝑅)𝑡𝑡 𝑅𝑅 − 𝑔𝑔 ∗ (1 + 𝑅𝑅)5
𝑡𝑡=1
Cost of equity
Equity Risk Premium: Implied ERP
Example
Consider the following information for the U.S. Market:
 S&P 500 index level = 2 674

 10-year T-Bond rate = 2.6%
 Dividend payments in 2017 = 1.91% of index value
 Expected dividend growth rate = 5% (based on average GDP growth)
𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡 + 1 = 2 674 ∗ 2.6% ∗ 1,05 = 73
73
𝑅𝑅 = 5% + = 7,7%
2 674
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐸𝐸𝐸𝐸𝐸𝐸 = 7,7% − 2,6% = 5,1%
Cost of equity
Equity Risk Premium: Estimates of approaches
A reasonable long‐term estimate of the average U.S. ERP is from 3.2% to 6.2%
Cost of equity
Equity Risk Premium: Choosing the approach
Predictive Power
Predictive Power of different estimates: 1960 - 2016
Correlation with implied Correlation with actual risk Current implied

Predictor premium next year premium next 10 years
premium has the best
Current implied premium 0.761 0.537
predictive power
Average ERP: Last 5 years 0.716 0.745
Historical Premium -0.490 -0.456
Source: Damodaran research
Beliefs about markets
Current implied
Historical and the ERP
average implied
Survey ERP ERP
No faith in market Market seems over-or

Efficient market
efficiency undervalued
Cost of equity
Equity Risk Premium: KPMG Analysis
ERP research
ERP approach Experts Period ERP

Survey
CFOs survey Campbell & Harvey 2015 4.51%
Global Fund Managers survey Merrill Lynch January 2014 4.60%
Historical premium
Arithmentic average, US Ibbotson and Chen 1926 - 2016 6.94%
Arithmentic average, US Damodaran 1928 - 2017 6.38%
Arithmentic average, US Credit Suisse 1900-2016 6.40%
Arithmentic average, World Credit Suisse 1900-2016 4.40%
Geometric average, US Damodaran 1928 - 2015 4.62%
Geometric average, US Credit Suisse 1900-2016 4.30%
Geometric average, World Credit Suisse 1900-2016 3.20%
Implied
Implied ERP Damodaran January 2018 5.08%
Average Implied ERP Damodaran 1960-2017 4.16%
Supply side
Supply-side arithmetic average Ibbotson and Chen 1926-2016 5.97%
Supply-side geometric average Ibbotson and Chen 1926-2016 3.99%
Supply-side arithmetic average Grabowski 1926-2011 6.60%
Minimum 3.20%
Average 5.08%
Median 4.61%
Maximum 6.94%
Cost of equity
Quiz
If an Appraiser / Client / Investor suggests to use ERP of 6%,

what is your response?
If 7%?
4%?
3%?
Cost of equity
Cost of equity and its major determinants: Beta
 Definition
 Interpretation
Beta  Key parameters
 Comparable companies analysis
Cost of equity
Beta: BP p.l.c.
BP p.l.c. beta
25% Beta
20%
y = 0.5476x + 0.0009
15%
BP p.l.c. Returns (%)
10%
5%
0%
-5%
-10%
-15%
-8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
S&P500 Returns
Note: 5-yr monthly Beta from June 2013 to June 2018
Cost of equity
Beta: Definition
 Beta assumes that the equity is a part of a diversified portfolio
 Beta is the slope of the regression of returns on equity of a company to the
returns on a diversified market portfolio (such as the S&P 500)
Cov (rs , rm )
βs =
Var (rm )
βs – the beta of the security
Cov (rs , r f ) – the expected covariance between the return on security s and the market return
Var (rm ) – the expected variance of the return of the overall stock market
Cov (rs , r f ) =
2
∑ (rs ,t − rs , A )(rm,t − rm, A ) ∑ (rm,t − rm, A )

1 n 1 n
Var (rm ) =
n − 1 t =1 n − 1 t =1
rs ,t – the return on security s in period t
rm ,t – the market return in period t
rs , A – the arithmetic mean return for security s
rm , A – the arithmetic mean of the market return
n – the number of periods
Cost of equity
Beta: Interpretation
ß = 1 Similar risk to the market portfolio
ß > 1 Higher risk than the market portfolio
ß < 1 Lower risk than the market portfolio
ß < 0 Negative correlation with the market portfolio
Beta relevered
Industry Beta unlevered
@ 20% income tax
Metal Mining 0.60 0.69
Gold Mining 0.50 0.60
Semiconductors 1.02 1.12
Motor vehicles dealers 0.91 1.82
Building construction 0.82 1.19
Food and Kindred products 0.64 0.76
Electric services 0.33 0.53
Sources: Duff&Phelps Valuation Handbook, Industry Cost of Capital, 2017
Cost of equity
Commercial service beta
Commercial services providing beta data:
 Morningstar (Ibbotson)
Beta for BP p.l.c.
 Bloomberg
 Damodaran
 Standard & Poor’s
 Yahoo Finance
 Value Line
 Bank of America
 Merrill Lynch
Source: Bloomberg
Cost of equity
Beta Parameters
Cost of capital
Beta: Key Parameters
What is important to consider?
Market proxy?
Time interval?
Cost of equity
Beta Parameters: Time Interval
Time interval
Adds noise to the regression equation

 Daily resulting in poor statistics
 Weekly Good for 2 to 3 years
 Monthly Good for 5 years
 Quarterly
Too few data
points
 Annually
Cost of equity
Beta Parameters: Historical time period
Historical time period
 Many data points (>60) needed for better statistical precision of the regression
 Companies are changing over time so their systematic risk can change over time too. The
older data (i.e. capital structure, operations, corporate structure) may not be indicative of
future risk
 Generally accepted to use 2 to 5 years
 An industry-specific event may lead to preference for a shorter period of time
(i.e. deregulation, taxation, breakthrough technology)
5 years
5 years
5 years
-7 year -6 year -5 year -4 year -3 year -2 year -1 year Valuation

date
Note: (*) Historical time period includes 84 monthly data points
Cost of equity
Beta Parameters: Market proxy
S&P 500 Index is in general a good proxy. Why?
 Larger Indices tend to include:
− lower cap stocks;
 DJIA
(30 companies)
− less liquid;
− accounted for separately as “size premium”  DAX
(30 companies)

 Includes a well-diversified portfolio of industries
Russell 2000 &
Can we use a local index? Wilshire 5000
 Yes, if: (lots of small caps)
− you are consistent using local data for ERP and Rf;
− the index is sufficiently diversified for industries;
− the index contains primary large cap companies;
− the index has a sufficiently large number of companies
 Common local indices used: FTSE 100, Nikkei 225
Cost of equity
Beta Comparable: company analysis (1/10)
STEP 1 Understand the business of the subject company
STEP 2 Select comparable companies
STEP 3 Download the raw data for the beta calculation
STEP 4 Perform a regression to calculate the levered betas
STEP 5 Perform t-tests and R-square tests to screen statistically unreliable betas
STEP 6 Unlevered beta calculation
STEP 7 Optional: Make a Blume adjustment to beta
STEP 8 Relever beta with the target capital structure
Cost of equity
Step 4: Perform a regression to calculate the levered betas
Share prices and return
BP p.l.c. S&P 500

Date Day Close Price % Change Day Close Price % Change
29-Jun-18 578.3 0.35% 2718.37 0.48%
31-May-18 576.3 7.12% 2705.27 2.16%
30-Apr-18 538.0 12.26% 2648.05 0.27%
30-Mar-18 479.3 0.86% 2640.87 -2.69%
… … … … …
28-Jun-13 455.3 -3.84% 1606.28 -1.50%
Cost of equity
Step 4: Perform a regression to calculate the levered betas (continued)
5-yr average levered beta *

Company 30.06.2016 30.06.2017 30.06.2018
BP p.l.c. 1.41 1.02 0.96
Chevron Corporation 1.16 1.22 1.13
ConocoPhillips 1.33 1.14 1.17
Note: (*) Beta is calculated over a 5-yr period for each date
Cost of equity
Step 5. Perform t-tests on calculated betas
 T-tests are a simple measure of the statistical significance of the estimated Beta-
coefficient
 The t-tests investigates the hypothesis that beta is zero (i.e. there is no correlation
between stock and market return)
 The crucial t-statistic at a 95% confidence level is approximately 2.0
T-test result
Company 30.09.2015 30.09.2016 30.09.2017

BP p.l.c 6.99 3.99 3.62
Chevron Corporation 7.72 6.32 5.32
ConocoPhillips 5.26 3.71 3.54
Cost of equity
Step 5. Perform a R-squared test
R-squared distribution for entire population

 The R-squared is a statistic that
450
measures the quality of the
Number of compaies
Most beta regression line

regressions
have a R-  A maximum possible R-squared
300
squared < 0.3 of 1.0 means that the
independent variable explains
100% of the variation in the
150 dependent variable
R-squared result
0 Company R-square
0.01 0.07 0.13 0.19 0.25 0.31 0.37 0.43 0.49 0.55 0.61 0.67
BP p.l.c 0.29
Range of R-squared values
Chevron Corporation 0.41
ConocoPhillips 0.23
Cost of equity
Step 6. Unlevered beta calculation
 a Levered beta (equity beta) includes the risk of a company’s financial structure
 an Unlevered beta (asset beta) excludes the risk of a company’s financial structure
Levered Beta Unlevered Beta Relevered Beta
Capital structure: All companies Capital structure:

Comparable normalized to 100% Industry / Target /
company specific equity Company specific
Cost of equity
Step 6. Unlevered beta calculation using the Hamada formula
β Li
βUi =
1 + i (1 − ti )
D
Ei
βUi – the unlevered beta for the company i
β Li – the levered beta for the company i
Di – the total debt for the company i
Ei – the total equity capitalization for the company i
ti – the marginal tax rate for the company i
Cost of equity
Step 6. Unlevered beta calculation
 Requirement: Debt /MVIC* < 75%
Parameters
Tax rate Debt / MVIC*

Company
30.09.2015 30.09.2016 30.09.2017 30.09.2015 30.09.2016 30.09.2017
BP p.l.c. 19% 24% 45% 33% 35% 28%
Chevron Corporation 40% 12% 14% 18% 18% 14%
ConocoPhillips 40% 40% 28% 35% 30% 15%
Unlevered beta calculation
Levered beta** Unlevered beta**

Company
30.09.2015 30.09.2016 30.09.2017 30.09.2015 30.09.2016 30.09.2017
BP p.l.c. 1.41 1.02 0.96 1.00 0.72 0.79
Chevron Corporation 1.16 1.22 1.13 1.02 1.03 1.00
ConocoPhillips 1.33 1.14 1.17 1.01 0.91 1.03
Note: (*) MVIC – Market Value of Invested Capital
(**) Beta is calculated over a 5-yr period for each date
Cost of equity
Step 7. Optional: Make a Blume adjustment to beta
 Blume found that betas tend to revert toward their mean value over time (i.e.,
towards the market beta of 1)
β1 = 1 / 3 * β m + 2 / 3 * β 0
β1 – prospective beta
β 0 – historical beta
β m – market beta = 1
Cost of equity
Step 8. Relever beta with the target capital structure using the Hamada formula
Levered beta calculation
Adjusted unlevered beta* 3-yr Debt / Levered

Company Median
average MVIC** beta
30.09.2015 30.09.2016 30.09.2017
BP p.l.c. 1.00 0.82 0.86 0.89
Chevron Corporation 1.01 1.02 1.00 1.01 0.99 26.0% 1.13
ConocoPhillips 1.00 0.94 1.02 0.99
(**) MVIC – Market Value of Invested Capital
Cost of equity
Size Risk Premium
 Definition
 Size or liquidity effect
Size Risk
Premium  Morningstar/Ibbotson data
 Perils of Usage
Cost of equity
Size Risk Premium: Definition
 Market capitalization is usually the basis for measuring the size premium
− Assets or revenue could also be measures, but Center for Research in
Security Prices (CRSP) didn’t track this
 The size effect was initially reported by Banz (1981) and Reinganum (1981)
 Size effect research indicates:
− Smaller companies tend to exhibit higher returns than the levels predicted
by CAPM
− The size effect is volatile over time
− Studies have confirmed the existence of SRP in the US as well as many
other countries
Cost of equity
Size Risk Premium: Size or liquidity effect
Question: Is a company’s size responsible for the effect or is size just a proxy for
one or more other factors?
 A series of studies argue that the reason for excess returns is a proxy for other
ignored risks such as liquidity and poor information
 Research indicates that less liquid companies (measured by bid-ask spread,
market depth, trading volume, price impact per dollar traded) tend to exhibit
higher returns than those predicted by CAPM
 Pratt and Abbott (October 2011) found that:
− Size matters but…
− The liquidity effect may be bigger
Cost of equity
Size Risk Premium: Morningstar/Ibbotson (1/2)
Size risk premium Mean return by Deciles Mean return for Large
(Deciles 1-10) Cap (S&P 500)
Cost of equity
Size Risk Premium: Morningstar/Ibbotson (2/2)
Size risk premium calculated according to Ibbotson study
Arithmetic mean Actual return in CAPM return in

Decile Beta return excess of Rf excess of Rf Size premium
1- Largest 0.92 11.05% 6.04% 6.38% -0.35%
2 1.04 12.82% 7.81% 7.19% 0.61%
3 1.11 13.57% 8.55% 7.66% 0.89%
4 1.13 13.80% 8.78% 7.80% 0.98%
5 1.17 14.62% 9.60% 8.09% 1.51%
6 1.17 14.81% 9.79% 8.14% 1.66%
7 1.25 15.41% 10.39% 8.67% 1.72%
8 1.30 16.14% 11.12% 9.04% 2.08%
9 1.34 16.97% 11.96% 9.28% 2.68%
10-Smallest 1.39 20.27% 15.25% 9.66% 5.59%
Mid-Cap 3-5 1.12 13.82% 8.80% 7.79% 1.02%
Low-Cap 6-8 1.22 15.26% 10.24% 8.49% 1.75%
Micro-Cap 9-10 1.35 18.04% 13.02% 9.35% 3.67%
Cost of equity
Size Risk Premium: Perils of usage
Small cap companies tend to become large cap over time
No adj. for size should be made in the specific company risk

premium or in the discount for lack of marketability
Be careful with Decile 10b
Inclusion of a small size premium should reduce the lack of marketability

discount somewhat if liquidity is not included as a risk premium
Cost of equity
Country Risk Premium
 Definition
 Approaches
− Bond Yields
Country Risk
Premium − Default spread and relative standard deviation (DSRSD)
− Academic Research
− Relative Standard Deviation
 CRP across the World
Cost of equity
Country Risk Premium: Definition
 Country Risk – the form of risk associated with investing in an international
company rather than the domestic market
 Country Risk Premium – the premium that is required by an investor for
bearing country risk
Cost ofcapital
Cost of equity
Country Risk Premium: Approaches
Country Risk Premium: Approaches
Approaches of Country Risk Premium:
Relative Standard
Deviation
Cost of equity
Country Risk Premium: Bond Yields (1/4)
Bond Yields:
 Spread between local country Eurobond and foreign currency government
bonds yield
Country Risk Government Eurobond US Treasury

Premium Yield of any Country Bond Yield
With the same

duration
Cost of equity
Example
Yield to maturity of 14-yr Russian Government Eurobonds: 5.21%

Yield to maturity of 14-yr US Treasury bond: 3.01%
Country Risk Premium for Russia as of 30 June 2018
5.21% - 3.01% = 2.20%
Cost of equity
Example
Yield to maturity of 10-yr Azerbaijan Government Eurobonds: 5.55%

Yield to maturity of 10-yr US Treasury bond: 3.01%
Country Risk Premium for Azerbaijan as of 30 June 2018
5.3% - 2.9% = 2.4%
Cost of equity
Pros
Cons
 Simple approach  Works only for countries with USD or EUR

denominated bonds
 Data accessibility
Cost of equity
Country Risk Premium: Default Spread and
Relative Standard Deviation (1/3)
Default Spread and Relative Standard Deviation
 Default spread and relative standard deviation can be considered to be a country risk
premium
Standard Standard
Country risk Default
deviation deviation
premium spread
in stocks in bonds
Accounts for
Default risk only
Cost of equity
Default spread Default spread (for smaller and riskier firms)
If interest If interest
Rating is
coverage ratio ≤ to Rating is Spread is coverage ratio ≤ to Spread is
greater than greater than
8.5 100000 Aaa/AAA 0.54% 12.5 100000 Aaa/AAA 0.54%
6.5 8.499999 Aa2/AA 0.72% 9.5 12.5 Aa2/AA 0.72%
5.5 6.499999 A1/A+ 0.90% 7.5 9.499999 A1/A+ 0.90%
4.25 5.499999 A2/A 0.99% 6 7.499999 A2/A 0.99%
3 4.249999 A3/A- 1.13% 4.5 5.999999 A3/A- 1.13%
2.5 2.999999 Baa2/BBB 1.27% 4 4.499999 Baa2/BBB 1.27%
2.25 2.49999 Ba1/BB+ 1.98% 3.5 4 Ba1/BB+ 1.98%
2 2.25 Ba2/BB 2.38% 3 3.499999 Ba2/BB 2.38%
1.75 1.999999 B1/B+ 2.98% 2.5 2.999999 B1/B+ 2.98%
1.5 1.749999 B2/B 3.57% 2 2.499999 B2/B 3.57%
1.25 1.499999 B3/B- 4.37% 1.5 1.999999 B3/B- 4.37%
0.8 1.249999 Caa/CCC 8.64% 1.25 1.499999 Caa/CCC 8.64%
0.65 0.799999 Ca2/CC 10.63% 0.8 1.249999 Ca2/CC 10.63%
0.2 0.649999 C2/C 13.95% 0.5 0.799999 C2/C 13.95%
-100000 0.199999 D2/D 18.60% -100000 0.499999 D2/D 18.60%
Source: Damodaran data, January 2018
Cost of equity
Pros
Cons
 Availability of input data  It is not applicable in emerging markets

where there is a relatively low standard
deviation
Cost of equity
Country Risk Premium: CRP across the World
Austria 0.46% Armenia 5.19%
Belgium 0.70% Azerbaijan 3.46%
Cyprus 4.15% Belarus 8.64%
Denmark 0.00% Bulgaria 2.19%
Finland 0.46% Croatia 3.46%
France 0.57% Czech Republic 0.81%
Germany 0.00% Estonia 0.81%
Greece 10.38% Georgia 3.46%
Iceland 1.38% Hungary 2.54%
Ireland 0.98% Kazakhstan 2.54%
Isle of Man 0.57% Latvia 1.38%
Canada 0.00%
Italy 2.19% Lithuania 1.38%
United States 0.00%
Liechtenstein 0.00% Macedonia 4.15%
Luxembourg 0.00% Moldova 7.50%
Malta 1.38% Montenegro 5.19%
Netherlands 0.00% Poland 0.98%
Bangladesh 4.15%
Norway 0.00% Romania 2.54%
Russia Cambodia 6.34%
Portugal 2.88% 2.88%
Spain Serbia 4.15% China 0.81%
2.19%
Argentina Sweden Slovakia 0.98% Fiji 4.15%
6.34% 0.00%
Bolivia Switzerland Slovenia 1.84% Hong Kong 0.57%
4.15% 0.00%
Brazil Turkey Slovenia 10.38% India 2.19%
3.46% 2.88%
Chile United Kingdom 0.57% Ukraine 14.21% Indonesia 2.54%
0.70%
Colombia Japan 0.81%
2.19%
Costa Rica Bahrain 5.19% Korea 0.57%
3.46%
Ecuador 7.50% Israel 0.81%
El Salvador 8.64% Jordan 5.19%
Honduras 5.19% Kuwait 0.57%
Mexico 1.38% Lebanon 7.50% Australia 0.00%
Nicaragua 6.34% Oman 2.19% New Zealand 0.00%
Panama 2.19% Qatar 0.70%
Paraguay 2.88% Saudi Arabia 0.81%
Peru 1.38% United Arab
Emirates 0.57%
Source: Damodaran, January 2018
Cost of equity
Country Risk Premium: Relative Standard
Deviation
Relative Standard Deviation
 Volatilities in the market can be used to calculate a country risk premium
without default spread
Country risk Equity Risk Relative Equity Risk

premium Premium Volatility Premium
Cost of equity
Quiz
If a country does not have government bonds and a credit

rating assigned by international agency. What alternative
ways of calculating country risk premium do you know?
Cost of equity
Country Risk Premium: OECD ratings
OECD ratings
 Calculation of CRP is based on matching the CRP for countries with the
same country risk level as that of the analysed country (risk group #)
provided by OECD with the CRP for these countries according to
Damodaran data
 To estimate the CRP for a country the following factors for the countries
within the same risk group should be considered and compared with those
for the analysed country:
 GDP per capita
 Government Effectiveness Index
 Rule of Law Index
 Control of Corruption Index
Source for the above factors: World Bank data
Cost of equity
Country Risk Premium: OECD Country risk premium calculation
Example Country Region Dam odaran ratings OECD rating CRP
Turm enistan Central Asia NA 6 NA
Albania Eastern Europe & Russia B1 6 6.4%
Angola Africa B1 6 6.4%
Argentina Central and South America B3 6 9.2%
Armenia Eastern Europe & Russia B1 6 6.4%
Cambodia Asia B2 6 7.8%
Cameroon Africa B2 6 7.8%
Cape Verde Africa B2 6 7.8%
Congo (Republic of) Africa B3 6 9.2%
Côte d'Ivoire Africa Ba3 6 5.1%
Ecuador Central and South America B3 6 9.2%
Egypt Africa B3 6 9.2%
Fiji Asia B1 6 6.4%
Georgia Eastern Europe & Russia Ba3 6 5.1%
Ghana Africa B3 6 9.2%
Kazakhstan Eastern Europe & Russia Baa3 6 3.1%
Kenya Africa B1 6 6.4%
Mongolia Asia Caa1 6 10.7%
Nigeria Africa B1 6 6.4%
Papua New Guinea Asia B2 6 7.8%
Rw anda Africa B2 6 7.8%
Senegal Africa B1 6 6.4%
Serbia Eastern Europe & Russia B1 6 6.4%
Sri Lanka Asia B1 6 6.4%
Suriname Central and South America B1 6 6.4%
Uganda Africa B2 6 7.8%
Zambia Africa B3 6 9.2%
Min 3.1%
1st quartile 6.4%
Median 7.1%
Average 7.3%
3rd quartile 8.9%
Max 10.7%
Range selected for the Com pany
Min 7.3%
Max 8.9%
Cost of equity
Currency Risk Premium
 Definition
Currency Risk  Approaches
Premium − Bond Yields
− Inflation Difference
− Exchange Rate Difference
Cost of equity
Currency Risk Premium: Definition
 Currency Risk – the form of risk that arises from the change in price of one
currency against another
 Currency Risk Premium – the premium that is required by an investor for
bearing currency risk
Cost ofcapital
Cost of equity
Currency Risk Premium: Approaches
Currency Risk Premium: Approaches
Approaches of Currency Risk Premium:
Inflation Difference
Cost of equity
Currency Risk Premium: Bond Yields (1/3)
 Currency Risk Premium: Exchange Rate Difference (1/3)
Yield to maturity Yield to maturity

Currency risk
premium government bond in local government Eurobond in
currency U.S. dollars
The same duration
Cost of equity
Example
Yield to maturity of 10-yr Russian government bond
in Russian rubbles (RUB): 7.71%
Yield to maturity of 10-yr Russian government Eurobonds
in USD: 5.02%
Currency Risk Premium for Russia as at 30 June 2018,
7.71% ‒ 5.02% = 2.69%
Cost of equity
Pros
Cons
 Simple approach  Works only for countries with foreign

currency bonds
 Data accessibility
 Government bonds have to be actively
traded
Cost of equity
Currency Risk Premium: Exchange Rate
Difference (1/4)
 Exchange Rate Difference:
Forecast exchange rates can be used to derive a currency risk premium
Currency Expected Current Current Rf Rf

risk exchange exchange exchange in foreign of foreign
premium rate rate rate currency country
From forward See the earlier

FX market discussion for Rf
determination
Cost of equity
Difference (2/4)
Example
Spot exchange rate – 62.76 RUB/USD

2-yr forward exchange rate – 67.05 RUB/USD
Yield to maturity 2-yr US Treasury bond – 2.53%
Yield to maturity 2-yr Russia Eurobond – 3.56%
Currency risk premium for Russia as at 30 June 2018:

67.05 − 62.76
62.76
Correct calculation:
– 3.56% – 2.53% = 6.84% – 1.03% = 5.81%


67.05
( − 1)– 3.56% – 2.53% = 3.37% – 1.03% = 2.34%
62.76
Cost of equity
Difference (4/4)
Pros
Cons
 Data accessibility  Currency risk premium can be highly

volatile
 Good for short-term cash flows
(< 2 years)  Difficult to forecast exchange rate
 Long-term forward rates tend to be not
actively traded
Cost of equity
Currency Risk Premium: Inflation Difference (1/4)
 Inflation Difference:
Inflation rate can be used to derive a currency risk premium
Currency risk Long-term Inflation Long-term Inflation

premium in Country in USA
Potential sources:
Global Insight / EIU /
Ministry of Economy
 Key Assumption:
Assumes that purchasing power parity (PPP) holds
Cost of equity
Example
Long-term inflation for Russia: 2.9%

Long-term inflation for the USA: 1.9%
Currency Risk premium for Russia as at 30 June 2018,
2.9% − 1.9% = 1.0%
Cost of equity
Example
Long-term inflation for Azerbaijan: 3.0%

Long-term inflation for the USA: 1.9%
Currency Risk premium for Azerbaijan as at 30 June 2018,
3.0% − 1.9% = 1.1%
Cost of equity
Pros
Cons
 Good when there is no actively traded  Purchasing power parity (PPP) doesn’t
local government bond market hold in the short-run
 Simple approach  Assumes that real exchange rates are
constant
Cost of equity
Currency Risk Premium: Different methods
application
Inflation Difference = 1.0%
Bond Yield Method = 2.69%
Exchange Rate Difference = 2.34%
OFZ cap = 2.50%
Cost of equity
Specific Company Risk Premium
 Definition
 Example for Oil & Gas industry
Specific  Approaches
Company Risk
− Implied SCRP
Premium
− Expert opinion
− Total beta
− Factor model
Cost of equity
Specific Company Risk Premium: Definition
 Modern portfolio theory holds that there are two fundamental sources of
investment risk:
− systematic
− unsystematic
 Systematic risk is measured by the standard deviation of the return on the
market portfolio. This return is affected by macroeconomics, market systems,
and market events
 Unsystematic or company-specific risk is the risk that is inherent in the
investment itself
 The Specific Company Risk Premium accounts for bearing unsystematic risks
not included explicitly in the cash flows
Cost of equity
Quiz
What could be specific risks associated with companies

operating in the Oil & Gas industry?
Cost of equity
Specific Company Risk Premium: Possible risks
in Oil & Gas industry
Examples of specific risks associated with companies operating in the Oil & Gas industry:
 Uncertainty in forecasting:
− the volume of recoverable oil reserves;
− a production profile;
− capital expenditures;
− conditional-variable and fixed operating costs; or
− administrative costs;
 A potential change in the length of the period required to complete the pre-assessment
phase of technical feasibility of a project;
 A potential change in the length of the period required for obtaining necessary
documentation;
 A potential change in the expected period of oil extraction;
 Difficulty in obtaining funding for a project to develop oil/gas fields;
 The risk of license termination due to a breach of gov’t requirements;
 The risk of loss of rights to resources in a disputed area of jurisdiction (example of Russia
and Ukraine in the Black Sea)
Cost of capital
Specific Company Risk Premium: Approaches
Approaches to Specific Company Risk Premium:
Expert
Implied SCRP Total Beta
opinion
Factor Model
Cost of equity
Specific Company Risk Premium: Implied SCRP
(1/5)
Adjust “no event” cash flows for one or more particular specific
Step 1 company events assuming 100% probability (i.e., OPEC shuts
down oil production for a year). Record the business value
Return to the “no event” cash flows and calculate the implied
Step 2 WACC that gives you the recorded business value under the
“event” scenario
Calculate the difference of the implied WACC and the “no
Step 3 event” WACC, and multiply by the assumed probability weight
for the scenario occurrence
Adjust the figure from Step 3 by the debt / equity ratio to arrive
Step 4
at the SCRP appropriate to add in the cost of equity
Step 5 Sum up the probability-weighted SCRPs from each scenario
Cost of equity
(2/5)
Business Forecast
Scenarios
70% 30%
Adjusted for
Base Scenario Company Specific
Risk Scenario
Let’s consider required WACC adjustment to have single DCF model
Cost of equity
(3/5)
I. II.
Adjusted for Company

Base Scenario
Specific Risk Scenario
• Base Cash Flows • Adjusted for Risk Cash Flows

• Base WACC = 15% • Base WACC = 15%
• Industry E/(D+E) = 0.85 • Industry E/(D+E) = 0.85
• EV = RUB 100 mln. • EV = RUB 80 mln.
Which is correct? None. Both of them just PROBABLE
Cost of equity
(4/5)
What WACC measure gives you EV = RUB 80 mln. based on the unadjusted
cash flows?
• Base Cash Flows

Goal
• Implied WACC = ??? Implied WACC = 18%
Seek
• EV = RUB 80 mln.
SCRP:
Implied Base Industry

SCRP Probability
WACC WACC E/(D+E)
18% 15% 30% 0.85 1.06%
Cost of equity
(5/5)
Pros
Cons
 Explicit account for each issue  Challenge in estimation of probability
 Easy to calculate  Estimations depend on subjective opinions
 There may be unaccounted for cross-effects
Cost of Debt
Cost of debt
Cost of debt estimation: Content
 Definition
 Approaches
 Debt to Equity structure
Cost of debt
Cost of debt estimation: Definition
 Cost of debt is the marginal interest rate the company would receive if it were to
take on additional debt on the valuation date
Marginal debt is assumed

Marginal interest rate will vary according to the type of debt
to come from the mix of
capital used (e.g. borrowing additional funds through
debt instruments currently
unsecured or subordinated debt requires higher interest
in the debt capital
rates due to increased risk exposure)
structure
Debt covenants of the Existing senior debt agreement may prohibit the company
existing company’s debt from using additional debt with the same seniority as the
may influence interest existing debt; therefore additional funds in the form of
rate on marginal debt subordinated loan would be issued at higher cost of debt
Cost of debt
Cost of debt estimation: Role in WACC
calculation
Weighted Cost of Weighted Cost of Weighted Cost of
WACC
Common Equity Preferred Equity Debt
 E   PS   D 
WACC = ke *   + k ps *   + k d * (1 − T ) *  
 E + PS + D   E + PS + D   E + PS + D 
WACC – Weighted Average Cost of Capital

ke – Rate of return on Equity
k ps – Rate of return on Preferred Stocks
kd – Borrowing Rate
E – Market value of Equity
PS – Market value of Preferred Stock
D – Market value of Debt
T – Marginal corporate tax rate
Cost of debt
Cost of debt estimation: Approaches
Company’s market-traded bond yield
Company’s effective rate on outstanding debt
Credit rating model
Industry cost of debt
Expert opinion by the Appraiser / Spread to ke
Bank offers for lending to the company
Central Bank rates (the last resort)
Cost of debt
Cost of debt estimation: Market-traded bond
yield (1/2)
Company’s bond yield:
■ Looking up the yield to maturity on a company’s bond trading in the market on the
valuation date
Example
5.0-yr yield to maturity of LUKOIL

Eurobond (USD) for June 2018: 4.34%
Currency risk premium as at 30 June 2018: 2.69%
LUKOIL cost of debt in USD: 4.34%
Cost of debt in RUB = Cost of debt in USD + Currency risk premium
LUKOIL cost of debt in RUB as at 30 June 2018:

4.34% + 2.69%= 7.03%
Cost of debt
Cost of debt estimation: Market-traded bond
yield (2/2)
Pros
Cons
 Market-indicated interest rate  Very few companies have long term

bonds with sufficient deep and liquid
 Third party data market
 Easily observable from Bloomberg or  May require adjustments for maturity
CBonds and currency risk premium
 The company may not have issued
long-term bonds
Cost of debt
Cost of debt estimation: Effective rate on
outstanding debt (1/3)
A company’s effective rate on outstanding debt:
■ Calculate the weighted average interest rates for the company’s debt portfolio
Example
In April 2017 Company X obtained from a third party a long term loan in
USD with maturity in 2020 with effective interest rate based on 3m LIBOR +
margin 3.6% (plus additional commission)
Currency risk premium as at 30 September 2017: 3.4%
Cost of debt
Example Cost of debt analysis as at 30 Septem ber 2017
Base
Issue date Apr-17
Maturity date Nov-20
Bank PAO Sberbank
Borrow er Company
Currency USD
Securitisation Yes
Margin 3.60%
3M LIBOR 1.30%
Commissions 0.17%
Effective interest rate 5.07%
Issue date adjustm ent 0.19%
Eurobonds 2020 @ Apr 2017 2.70% Base
Eurobonds 2020 @ Sep 2017 2.89% Target
Calculation
Calculation USD 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027
Base @ Sep 17 USD 5.26%
Eurobonds @ Sep 17 1.74% 2.44% 2.89% 3.21% 3.46% 3.66% 3.83% 3.98% 4.11% 4.23%
Spread 2018/relevant year (1.2%) (0.5%) - 0.3% 0.6% 0.8% 0.9% 1.1% 1.2% 1.3%
Market rate @ Sep 17 USD EUR 4.1% 4.8% 5.3% 5.6% 5.8% 6.0% 6.2% 6.3% 6.5% 6.6%
Calculation RUB
Currency risk premium USD / RUB 5.9% 5.2% 4.7% 4.4% 4.1% 3.9% 3.7% 3.6% 3.5% 3.4%
Market rate @ Dec 16 RUB 10.0% 10.0% 10.0% 9.9% 9.9% 9.9% 9.9% 9.9% 10.0% 10.0%
Cost of debt
A company’s effective interest rate is:
■ An interest rate that is based on the actual interest rates on the company’s
existing loans, which includes all additional expenses according to the loan
agreement (e.g. bank’s commission, insurance payments, etc.)
Cost of debt
Pros
Cons
 Easy method  Not market-based. Rates in original bonds

likely to be different from market yields
 Based on third party data
 The older the debt, the less the rates infer
 Easily observable “marginal” rates
 Loans must be arm’s length
 Loan conditions may be very specific

(pledge, guarantee, covenants etc.)
Cost of debt
Cost of debt estimation: Bank offers for lending
to the Company
Bank offers:
■ Based on offers by one or more banks near the valuation date for long-term
lending
Pros
Cons
 Closest to a marginal rate without  May be too conservative (Represents

actually borrowing a high-end rate since it is an offer that
may not have been accepted)
 May be the only option for start-ups
and unique companies  The offer may be too far from the
valuation date to be relevant
 Terms may not reflect long-term
lending in the relevant currency or the
correct entity (holding vs. subsidiary)
Cost of debt
Cost of debt estimation: Optimal structure of
D/E (1/3)
■ The optimal capital structure for a company is one which offers a balance
between the ideal debt-to-equity range and minimizes the firm's cost of capital
Value of firm under Miller-Modigliani

with corporate taxes and debt
Maximum firm
Company Value
Present value of
value financial distress costs
Actual value of firm
Value of firm with no debt
Present value of tax
shield on debt
Debt, %
Cost of debt
D/E (2/3)
Debt to equity ratio options:
Market or industry ratio based on an average
Current ratio for the company
Target based on an optimization strategy
Note: All indicators should be based on fair values rather than book values
Cost of debt
D/E (3/3)
Example Which capital structure has the lowest cost of capital?
Calculation of cost of capital
Leverage scenarios
No Debt 50% Debt 80% Debt
Assets (mln USD) 3,000 3,000 3,000
Debt (mln USD) - 1,500 2,400
Equity (mln USD) 3,000 1,500 600
Proportion of debt 0% 50% 80%
Proportion of equity 100% 50% 20%
Cost of equity 15% 18% 24%
Pre-tax cost of debt 0% 12% 16%
After-tax cost of debt 0% 7.8% 10.4%
WACC 15.0% 12.9% 13.1%
Putting together
WACC
Putting together WACC
WACC puzzling: WACC formula
Weighted Cost of Weighted Cost of Weighted Cost of
WACC
Common Equity Preferred Equity Debt
 E   PS   D 
WACC = ke *   + k ps *   + k d * (1 − T ) *  
 E + PS + D   E + PS + D   E + PS + D 
WACC – Weighted Average Cost of Capital
ke – Rate of return on Equity
k ps – Rate of return on Preferred Stocks
kd – Borrowing Rate
E – Market value of Equity
PS – Market value of Preferred Stock
D – Market value of Debt
T – Marginal corporate tax rate
WACC puzzling: Pros vs. Cons
Pros
Cons
 Most widely used approach  Depends on the method of cost of

equity and cost of debt calculation
 Easy to understand and explain
 Has some limitations:
 Cost of hybrid securities (e.g.
convertibles)?
 Other effects of financing (e.g.
costs of distress)?
 Non-constant debt ratios?
 Personal taxes?
WACC puzzling: NK Rosneft example of WACC
calculation
Example: WACC calculation for NK Rosneft
Terms of discount rate: 30 June 2018
Post-tax, USD, Nominal
Discount Rate Component Damodaran Duff&Phelps Comparable Source
data Data company data
Risk-free rate 2.98% 2.98% 2.98% 20-yr US Treasury bond
Equity risk premium 5.08% 5.97% 5.00% Damodaran / Duff&Phelps / Research
Beta (unlevered) 1.23 0.87 1.07 Damodaran / Duff&Phelps / Comparable cos.
Beta (market/relevered) 1.38 0.95 1.33 Damodaran / Duff&Phelps / Comparable cos.
Share of Equity in Inv. Capital 86.74% 89.30% 76.67% Damodaran / Duff&Phelps / Comparable cos.
Share of Debt in Inv. Capital 13.26% 10.70% 23.33% Damodaran / Duff&Phelps / Comparable cos.
Small size risk premium - - - Large cap
Country risk premium Difference b/w 20-yr US Treasury bond and
2.44% 2.44% 2.44%
implied 20-yr Russia Eurobond
Currency risk premium - - - n/a
Specific risk premium - - - n/a
Cost of Equity 12.43% 11.11% 14.62% n/a
Cost of Debt (pre-tax) 8.11% 8.11% 8.11% CB commercial loan (longest year avg)
Income tax 20.00% 20.00% 20.00% n/a
Cost of Debt (post-tax) 6.49% 6.49% 6.49% n/a
Cost of Capital 11.37% 10.39% 13.53% n/a
WACC puzzling: WACC drivers for different
valuation purposes
WACC drivers that can Financial Investment Project Business Valuation for non-financial
be treated differently / reporting in reporting purposes (i.e., tax, regulatory)
Valuation purpose accordance with
IFRS/US GAAP
Type of value Value in use, fair Investment Fair market value / Investment value
value value Market value
Capital structure Current (VIU), Project specific Optimal / Market Target (fixed /
(Debt / Equity) Market (FV) (fixed / changing) (industry average) changing)
Cost of debt Marginal market Project Marginal market rate Company specific
rate specific
Timing related to risk-free rate, Long-term (going Project period Long-term (going Long-term (going
country risk, and currency risk concern) or until concern) or until concern) or until
termination of termination of termination of
operations operations operations
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Cost of capital

Practical seminar for Deal Advisory

Do the cash flows include all risks?

Free Cash Flow to Firm

- WACC. – Capital expenditures

Equity X Cost of Equity

Debt X Cost of Debt

ke - Rate of return on Equity; PS - Market value of Preferred Stock;

E (R ) – expected rate of return on asset SP – size premium;

E ( Rm ) – expected return on a market

 Basic features of a risk free asset:

Maturity Zero coupon bond

 Approach 2: inflation-indexed treasury rate (such as US TIPs).

Rf = 2.98% yield to maturity on 20-yr US Treasury Bonds as at 30 June 2018

Rf = 2.91% yield to maturity on 10-yr US Treasury Bonds as at 30 June 2018

If you were to choose between 10-year and 20-year US

What government bonds are appropriate to use for Rf

Capital Asset Pricing Model

CAPM basic formula:

Geometric Implied ERP

Supply Side Model

𝐷𝐷𝐷𝐷𝐷𝐷 (𝑡𝑡 + 1) 𝐷𝐷𝐷𝐷𝐷𝐷 (𝑡𝑡 + 1)

 Dividends can be generalized to include stock buybacks.

 S&P 500 index level = 2 674

𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡 + 1 = 2 674 ∗ 2.6% ∗ 1,05 = 73

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐸𝐸𝐸𝐸𝐸𝐸 = 7,7% − 2,6% = 5,1%

Correlation with implied Correlation with actual risk Current implied

Beliefs about markets

No faith in market Market seems over-or

ERP approach Experts Period ERP

If an Appraiser / Client / Investor suggests to use ERP of 6%,

Note: 5-yr monthly Beta from June 2013 to June 2018

∑ (rs ,t − rs , A )(rm,t − rm, A ) ∑ (rm,t − rm, A )

Sources: Duff&Phelps Valuation Handbook, Industry Cost of Capital, 2017

What is important to consider?

Adds noise to the regression equation

 Weekly Good for 2 to 3 years

 Monthly Good for 5 years

-7 year -6 year -5 year -4 year -3 year -2 year -1 year Valuation

Note: (*) Historical time period includes 84 monthly data points

STEP 2 Select comparable companies

STEP 3 Download the raw data for the beta calculation

STEP 4 Perform a regression to calculate the levered betas

STEP 6 Unlevered beta calculation

STEP 7 Optional: Make a Blume adjustment to beta

STEP 8 Relever beta with the target capital structure

Share prices and return

BP p.l.c. S&P 500

5-yr average levered beta *

Company 30.09.2015 30.09.2016 30.09.2017

R-squared distribution for entire population

Most beta regression line

Levered Beta Unlevered Beta Relevered Beta

Capital structure: All companies Capital structure:

Tax rate Debt / MVIC*

Unlevered beta calculation

Levered beta** Unlevered beta**

Levered beta calculation

Adjusted unlevered beta* 3-yr Debt / Levered

Arithmetic mean Actual return in CAPM return in

Levered beta Unlevered beta