Question

You have the following information for a Croatian company

	Revenue (Croatian Kuna)	CDS spread	Standard Dev of gov't bond	Standard Deviation of Stock Market
EU (excluding Croatia)	120	0.5%	4%	8%
South-easter Europe	180	3%	9%	14%
Croatia	250	2%	7%	12%

German Euro bond rate = 0.50%. Croatian Gov't Bond, in local currency Kuna has a rate of 4%. Kuna's credit rating is 2%, the same as implied by the CDS spread.

Estimate the cost of equity for this company if a mature market such as US or Germany has an ERP of 5% and its beta=1.56

a.

14.95%

b.

17.45%

c.

11.05%

d.

18.25%

Please show work. Answer 11.05 is incorrect. Thanks

Answer 1

First we will estimate Country risk premium for each country using their respective CDS, Standard Dev of Bond market and Standard Deb of Stock market.

Country risk premium = Credit Default Spread * (Standard Dev of Stock market / Standard Dev of Bond market)

Croatia

CDS = 2% | StdDev of Bond market = 7% | StdDev of Stock market = 12%

Country risk premium of Croatia = 2% * (12% / 7%) = 3.43%

South-easter Europe

CDS = 3% | StdDev of Bond market = 9% | StdDev of Stock market = 14%

Country risk premium of SE Europe = 3% * (14% / 9%) = 4.67%

EU (excl Croatia)

CDS = 0.5% | StdDev of Bond market = 4% | StdDev of Stock market = 8%

Country risk premium of EU (excl Croatia) = 0.5% * (8% / 4%) = 1%

We will estimate Weights of each country in Company's total revenue.

Total revenue = Sum of all countries revenues = 120 + 180 + 250 = 550

Weight of Croatia = Croatia Revenue / Total Revenue = 250 / 550 = 45.45%

Weight of SE Europe = 180 / 550 = 32.73%

Weight of EU(excl Croatia) = 120 / 550 = 21.82%

Using the weights and Country risk premium, we can find Total country risk premium for the company.

Total Country Risk Premium = Weighted sum of all countries Country Risk Premium (CRP)

Total Country Risk Premium = Weight of Croatia * CRP of Croatia + Weight of SE Europe * CRP of SE Europe + Weight of EU (excl Croatia) * CRP of EU (excl Croatia)

Total Country Risk Premium = 45.45% * 3.43% + 32.73% * 4.67% + 21.82% * 1%

Total Country Risk Premium = 1.56% + 1.52% + 0.22%

Total Country Risk Premium = 3.30%

Mature Country's ERP = 5%

Company's Total Country risk premium should be provided as a return in excess of Mature country's ERP.

Therefore, Company's ERP = Mature Country's ERP + Total Country risk premium

Company's ERP = 5% + 3.30% = 8.30%

Beta of the company = 1.56

Cost of Equity formula = Risk-free rate + Beta * Equity Risk Premium (ERP)

Croatian Govt Bond in local currency = 4% | Default Spread = 2%

Since it is not default-free as it includes Default Spread, therefore, we need to remove the Default Spread from Govt bond yield to find the actual Risk-free rate offered by the govenment.

Croatian Govt bond's risk-free rate = 4% - 2% = 2%

We will use Croatian Govt bond's actual risk-free rate as the risk-free rate for our Cost of Equity calculation.

Cost of Equity of the company = 2% + 1.56 * 8.30%

Cost of Equity of the company = 2% + 12.95%

Cost of Equity of the company = 14.95%

Hence, Company's Cost of Equity is 14.95%, which is Option (a) among the given choices.