Question

You are comparing the regression output across two publicly-traded companies. Both regressions were run using monthly data for 5 years and against the S&P500 with the returns on each company’s stock as the independent variable.

	Nero Cannery	Rand Foods
Intercept	0.15%	0.45%
R-squared	20%	35%
Slope	1.20	1.10

1.If the implied equity risk premium with a constant dividend growth rate and based on a broad U.S. stock market index is equal to 8% and the risk-free rate is 2%, what is the required return of an investor in Nero Cannery? Rand Foods?

2. You just found out that even though Rand Foods is incorporated in the U.S. it gets 100% of its revenues from Mexico. Is it appropriate to use an implied equity risk premium based on a U.S. stock market index for calculating an investor’s required return in Rand? Why or why not? If the Mexican government bond rating is A3 (not default-free), how will you approach the estimation of the ERP, i.e. what method will you use and what information do you need?

3. Is the regression above an “excess returns” regression or a “raw returns” regression? Explain.

(4) Interpret the R² and intercept for Rand Foods.

Answer 1

Slope shall be the beta:

According to CAPM:
return = rf+(Beta*MRP)
MRP = 8-2=6
Rf=2
Return nero cannery = 2+(1.2*6)=9.2%
Return Rand foods= 2+(1.1*6)=8.6%


2) The revenues from mexico have a higher risk than US. These risk may be due to political reason, currency exchange etc. Hence it is better to add up a premium to equity premium of USA for more accurate results. Equity risk premium shall add up country risk premium over and above required return in USA. We can also use bond returns + Equity risk premium + Liquidity premium + Currency premium+ Country risk premium to arrive at proper investor required return

3)It is a raw returns regression as total returns have been taken

4)R suared for nero indicates that S&P can only explain 20% of returns of nero foods and the rest come from other factors

R suared for Rand indicates that S&P can only explain 35% of returns of Rand foods and the rest come from other factors. S&P explains more returns of Rand as compared to Nero