Question

You are pondering over the valuation of your firm which is operating in a new do- main offering veganmeat, which ismeat productsmade out of vegetables. The main challenge is to arrive at the estimate of a fair expected return on your eq- uity capital. Your firm is an all equity firm with diffused ownership (many num- ber of shareholders). You understand that only the systematic component of the risk ofthe cashflows of a firm are compensated bythe market.Hence youchoose toevaluate thesensitivityofsimilarfirmsinother countries.You got the follow- ing estimate of betasfrom your research, 1.8, 1.9, 1.5, 2.2, 1.85, and 1.4. If the equity market in India is giving an average return of 14% and the nominal yields forthe 10 yeartreasury securities are at 6.5%, what isthe expected return that you should consider in the valuation of your firm?

Answer 1

As per CAPM or Capital Assets Pricing Model,

Expected return in equity = Risk free rate+Beta * [Expected market return - Risk free rate]

As the firm is Fully equity firm, hence the return as per the CAPM should be taken in the valuation of the Firm.

Average Beta = [1.8+1.9+1.5+2.2+1.85+1.4] / 6 = 1.775

Expected market return = 14%

Risk free rate = return on treasury security = 6.5%

hence

Expected return = 6.5%+1.775*[14%-6.5%] = 19.8125%