Reading 45: Cost of Capital LOSj习题精选 cell

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LOS j: Explain the country equity risk premium in the estimation of the cost of equity for a company located in a developing market.

In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A) use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B) add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

C) add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

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In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

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Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis: 

• Indian 10-year government bond yield = 7.20%
• 10-year U.S. Treasury bond yield = 4.60% 
• Annualized standard deviation of the Bombay Sensex stock index = 40%.
• Annualized standard deviation of Indian dollar denominated 10-year government bond = 24%
• Annualized standard deviation of the S& 500 Index = 18%. 

The estimated country risk premium for India based on Marian’s research is closest to:

A) 2.6%.

B) 5.8%.

C) 4.3%.

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

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Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services company based in the U.S. Stolzenbach’s management team is considering opening new stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach’s investment in Mexico. Winfield has researched bond yields in Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All Share Index stock index and the S& 500 index was 38% and 20% respectively. The annualized standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was 26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the cost of equity that Winfield should use in his analysis?

 

Country Risk Premium for Mexico

Cost of Equity for Project

A) 5.89% 17.36%

B) 4.53% 17.36%

C) 4.53% 19.06%

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.077 – 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%

Cost of equity = R_F + β[E(R_MKT) – R_F + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36%