Project Work: Calculation of WACC and Beta

Group – 1
Section: F

Submitted to Prof Rajesh Kumar Sinha

In the course FM-1

Submitted By: Group 1

Aditya Shaurya (BD22066)

Anupam Sharma (BD22073)

Divyanshi Agrawal (BD22077)

Mridhula Ravi (BD22089)

Market Portfolio Selection for calculation of Market Returns (Rm)

The market portfolio is a tricky notion, and the assets that may possibly be considered as a component
of the market are greatly constrained by the absence of data. Therefore, for the purposes of our
mathematical computations in the CAPM Model, we must choose a proxy that most closely reflects the
market. We must make sure that the proxy is selected after careful thought and study because the
expected rate of return is a key factor in determining the cost of equity.

For the purpose of this project, we have decided to use the index BSE 500 as the proxy for the market.
Indices like BSE 30, BSE 100, Nifty 50, mainly comprising of large cap funds might have a large-cap bias in
calculation of the market risks, and the subsequent expected returns and might not be able to present
an accurate picture of the market as a whole, as they represent only a fragment of the market. On the
other hand BSE 500 contains 100 large cap companies, 150 mid-cap companies and 250 small cap
companies, representing a much broader segment of the market. The selection of BSE 500 might help
reduce the large cap bias that comes with the other indices.

The large companies at the BSE 30 performed remarkably well during the pandemic, even when India's
economy collapsed. If an index is chosen as a market proxy but does not correlate with local
macroeconomic fundamentals, the very objective of doing so is defeated.

Even though there are issues with choosing the BSE 500 as a proxy, given the limitations and lack of
alternatives, it would be the greatest depiction of the market since it has a wider range than the other
indexes indicated. In this regard, we predicted that the BSE 500, which has a clear large cap bias
compared to the other indices, would more closely connect to the macroeconomic changes in the
nation.

Method of calculation of Risk-Free Rate (Rf):

Assuming that governments do not fail, at least on local currency borrowings, we typically use the 10-
year government bond rate as the country's risk-free interest rate. As a result, these bonds are viewed
as being exceptionally safe. Although this method is thought to be risk-free, the majority of countries' 10
year government bonds do not meet the Aaa (default risk-free) benchmark on the Moody's rating,
therefore it has inherent weaknesses. As an illustration, even something as straightforward as the
government engaging in quantitative easing to avoid defaulting on its bond obligations might potentially
result in increased inflation and lower the real rate of return.

Moody's has determined that there is a default risk associated with government bonds as well (even if it
may not be immediately apparent to the layperson), so we have chosen to take it into account when
determining the risk-free interest rate. This is crucial because if the risk-free rate is assumed to be true,
both the cost of debt and the cost of equity could be calculated incorrectly, resulting in a double
mistake.

Therfore, to balance this out we need to subtract the country's default spread from the government
bond rate to arrive at a more accurate estimation of the risk-free rate.
Equity Risk Premium (Rm – Rf):

Equity Risk Premium is the difference between returns on equity/individual stock and the risk-free rate
of return. It is the excess return the stock pays to the investor over and above the risk-free rate. It is the
expected extra compensation on the part of investors when they invest in relatively riskier assets like
the stock market in place of risk-free securities. The equity risk premium is an important factor in the
calculation of the cost of equity of a firm. Based on our methods of calculations of Rf and Rm explained
above, the equity risk premium for the Indian market is:

Rm= 11.53 %

Rf= 7.37%

Equity Risk Premium (Rm – Rf) = 4.16 %

Stock Selection:
We have taken stocks from varied industries encompassing FMCG, Aviation, Cement, Automotive etc.
The selection of stocks from multiple sectors has helped us in garnering vast knowledge on how various
financial parameters change with respect to the industry in which the companies are operating.

COMPANY INDUSTRY
ITC FMCG
Adani Power Energy
Tata Motors Automotive
Indigo Aviation
Apollo Hospitals Pharma

The stock prices of the companies were taken for the past 5 years. We compiled the monthly stock price
movement of all the above-mentioned stocks. All the stock prices along with that of the BSE 500 were
recorded from till Jan 2023.

Methodology:

1. Determining Beta:

In this project, following the compilation of the stock prices we did linear regression analysis of each
stock to find out the levered beta. We took the value of BSE 500 as the base line for our analysis for
the same period. The regression yielded the beta and r-square values for each stock which were put
to use for later calculations. The slope of the regression corresponds to the beta of the stock and
measures the riskiness of the stock. The R squared (R2) of the regression provides an estimate of the
proportion of the risk (variance) of a firm that can be attributed to market risk.
 Where,

Covariance is the measure of a stock’s return relative to that of the market and Variance is the
measure of how the market moves relative to its mean. It can be interpreted as, higher the beta,
more is the stock correlated to the market. Lower the beta, more the independent the stock is from
the market.

2. WACC Calculation:

For calculating WACC, we had to take into consideration the weighted average of debt and equity.
The factors with which the weight of equity and debt to be multiplied viz. Ke and Kd were found out
using the following equations.

Kd= (Rf+Company risk premium+Country risk premium) *(1- t)

Ke= Rf+ beta*( Return on markets- Rf)

Where,

• Rf indicates the risk-free rate, which was basically the 10 year government bond rate adjusted to
the default spread.

• Beta represents the risk factor associated with each of the stocks

• Return on markets is the CAGR of the BSE 500 since its inception

• It indicates the corporate tax rate of 25.17%

Weight of equity and debt ie, We and Wd are calculated as their respective proportions in the sum
of equity and debt

WACC= Kd*Wd+Ke*We

Introduction of Companies and Industries:

ITC:

The FMCG sector in India mainly comprises of sales from household and personal care items. The urban
areas account for 55% of the revenue and for the rural areas, spending on FMCG products accounts for
50% of the total spending. The sector is growing at a rate of about 20-25% per annum since 2017 and is
expected to increase at a CAGR of about 15% till 2025.

ITC is an Indian conglomerate with a diversified presence across various industries like FMCG, hotels,
infotech, paperboards and agribusiness. It is one of India's foremost private sector companies with a
Gross Sales Value of ₹ 74,979 crores and Net Profit of ₹ 13,032 crores. The products of ITC are such that
the overall beta of the company is less than one. Almost all the ITC’s FMCG products have inelastic
demand which drives down the value of Beta. This is because of the good brand name ITC has along with
the relatively low prices ITC products have. Besides ITC deals with non-discretionary products, thus
lowering the overall level of Beta of the company.

Adani Powers:

The power sector is subject to high government regulations and is highly affected by economic
downturns. The regulations also impose restrictions on the rate at which energy can be sold. The power
sector is also plagued by high inefficiency at the discom level.

Adani Power Limited is an Indian power business subsidiary of Indian conglomerate Adani Group with
head office in Ahmedabad, Gujarat. It is a private thermal power producer, with capacity of 12,450 MW.
They have received a percentile score of 65 for Adani Power in Corporate Sustainability Assessment by
DJSI-S&P Global and a leading position in India and number 30th in world in ESG benchmarking for 2019
making them a leading player in the market.

Tata Motors:

Indian automobile market was the 5th largest2 in 2020 after being the 7th largest in 2019. Not only is
the 2- wheeler market in India huge and growing exponentially, but Indian automobile sector is also one
of the biggest exporters. India might end up being the leader of both two-wheeler and four-wheeler
market by the end of this year.

Tata Motors Limited is an Indian multinational automotive manufacturing company. The company
manufactures passenger cars, trucks, vans, coaches, buses, luxury cars, sports cars, and construction
equipment. It recently became the second largest-selling automobile company in India.

Indigo:

Over the past three years, the civil aviation sector in India has become one of the sectors with the
nation's quickest growth. The air traffic movement, which was 613,566 in the first quarter of FY 2022–23
compared to 300,405 in the same period last year, an increase of 104.24%, shows that the Indian
aviation industry has largely recovered from the COVID-19 pandemic shock. Within the next ten years,
India, which is currently the world's seventh-largest civil aviation industry, is anticipated to overtake the
United States as the third-largest civil aviation market.

InterGlobe Aviation Ltd, also known as IndiGo, is a low-cost airline based in India. It is India's largest
airline in terms of both passenger numbers and fleet size. It is also the largest individual Asian low-cost
carrier in terms of jet fleet size and passengers transported, as well as Asia's sixth largest carrier, with
over 6.4 crore passengers carried in fiscal year 2018–19. As of 2019, the airline flew 1,500 passengers
each day to 95 destinations, 71 domestic and 24 international. Its principal hub is Delhi's IGI Airport.
 Apollo Hospitals:

The Indian pharmaceutical sector has developed over time into a robust industry, rising at a CAGR of
9.43% over the past nine years, and is currently ranked third in pharmaceutical output by volume. Some
of the key sectors of the Indian pharmaceutical business include generic drugs, over-the-counter
medicines, bulk meds, vaccines, contract research & manufacturing, biosimilars, and biologics.

The Apollo hospitals have an ecosystem of services like pharmacies, hospitals and diagnostic clinics. The
company is also situated abroad and operates in Colombo. The company also had 1% stake in Medics
International Life Sciences, which now has become a subsidiary of Apollo. As of March 2021, the book
value of shares was INR 361.72 per share and dividend per share was INR 636.51. The company earns
over INR 10000 Cr from its pharmacy business per annum.

Results (Interpretations) of matrices calculated: CAGR

CAGR is a good indicator of the long-term performance of the company and the returns to stock
investors can expect from the company. We have calculated the 1 year, 3 year and the 5-year CAGRs of
the companies and mentioned the 1-year (short term) and 5-year (long term) values below. Thus, the
returns are:

From the above workings, we can see that Adani Power seems to be the most lucrative business to
invest into, both from their long term as well as their short-term returns, while investments in Tata
Motors seems to be shrinking, and the company as a whole seems to be me facing losses instead of
profits over the last five years, which has been expediated in the last year.

Results of matrices calculated: WACC

The yearly WACC of the companies is as below. WACC indicates the average rate that a company
expects to pay to finance its assets. Taking ITC whose WACC is 9.87% as an example, this means that
the company must pay it’s investors an average of $0.097 in return for every $1 in extra funding.

Results (Interpretations) of matrices calculated: Beta

Beta of a company is linked to three factors, namely – the nature of a business, it’s operating leverage
and it’s financial leverage (debt to equity ratio). The Beta and the corresponding debt to equity ratio of
the companies is as below:
Businesses that are asset intensive and need higher amounts of capital expenditure will tend to have a
higher than market beta, as can be seen in the case of Adani Power which has a Beta higher than 1. A
higher beta indicates that the price of the stock is more volatile than the price of the market. This could
also be a factor of the company being relatively new compared to the other established organisations.
All the other companies have a Beta lower than 1, with ITC having the lowest. FMCG companies tend to
have a lower Beta because of the low value of the goods and continuous round the year consumption
which is not affected by changes in the market.

The low Beta values also correspond to the Debt to Equity ratio of the companies. ITC is almost debt
free, meaning that their obligations to their investors is extremely low and the equity share of the
investors and the returns to stock will be high.

On the other hand, Interglobe Aviation (Indigo) has a negative shareholder equity meaning that they
have an incredibly high amount of liabilities and are a high-risk company, and that investors are losing
money rather than gaining any interest from their investment. This is an indicator of how capital
resource intensive the airline industry is, and the very low payoffs investors have from investing in this
seemingly loss-making industry.

Adani Power and Tata Motors have moderate to high levels of debt, indicating that they have high debt
implications and high financial leverage. This means that they are profitable, however, a significant part
of their earnings must be used to fund their debts. This also increases the unsystematic risk the
companies is vulnerable to.

The last factor that contributes to Beta is the operating leverage, which indicates the fixed costs of a
compnany. Companies with higher fixed costs tend to have higer Betas, as can be seen with Adani
Power which is a very infrastructure heavy industry. The other companies except ITC – TATA Motors,
Apollo Hospitals and Interglobe Aviation will also have a high operating leverage, as they are capital
intensive and infrastructurally heavy industries such as manufacturing and pharmaceuticals.

Company wise Beta, r Square, Std.Error and 2 standard deviation values

Interpretations of matrices calculated: Standard Error

The standard error tells us the absolute distance each data point on the regression line. Smaller values
indicate a more robust regression model, as it tells us the proximity of the points to the fitted line.

Higher values indicate there is a lot of deviation in the data. It can be observed that as we reduce our
frequency of calculation (i.e., shift from daily to monthly calculations), value of standard error increases.
This is because the data points move away from the trend line as the overall mean values are apart for
monthly data points.

Comparatively, ITC has the least standard error, followed by Interglobe Aviation, Apollo Hospitals and
TATA Motors. Adani Power has the highest standard error. This can be interpreted as the FMCG sector is
least affected by cyclicity and seasonality through the year whereas and shows a similar trend
throughout, whereas players in energy industry see greater variations owing to cyclicity and thus the
demand for their goods and services.

Interpretations of matrices calculated: R Square

R2's value indicates how much of the movement in stock return is caused by the market. In other
words, it is the proportion of stock return variance that may be accounted for by market volatility. The
fraction of data variation explained by the market increases with R2 value. Lower values suggest that it
is hardly associated and varies less with market movement. The remaining portion results from variables
unique to the company, such as strategic marketing, etc.

From the companies that we evaluated, it can be seen that Apollo Hospitals and Adani Power has least
R2 value. This shows that the Energy and pharmaceutical companies hardly depend on the market
behavior and their internal factors contribute largely to their change in market value. Tata Motors is
largely varied by the market, which can indicate that people’s investments and borrowings could be a
significant factor contributing to this variation.

Recommendations for reduction of company’s beta:

Beta of a stock or a company is a function of multiple factors such as the nature of the business and its
cost structure, its operating leverage, and its financial leverage. We know that leverage is positively
correlated to systematic risk.

High Beta of can be attributed to the factors like capital intensive as well as the high financial leverage
which contributes to higher fixed costs. While controlling fixed costs in a manufacturing domain is
difficult, the company can focus on increasing operational efficiencies which will in turn help to generate
higher profit margins for the same cost levels. This will help improve their Beta. Furthermore, debt
reduction in interest expenses would also help control their Beta to moderate levels.

The companies with already lower than market Beta should maintain the existing debt structure and the
stagnated macroenvironmental growth factors to sustain the existing Beta levels.

Conclusion:
It is clear from the research of the aforementioned five firms that buying shares in a company requires
careful consideration of a number of different aspects. The quality of investing decisions would suffer if
one only considered a single factor, such as returns or dividends. As a result, in order to make wise
investment selections, a thorough analysis taking into account a wide range of criteria is required.

References

• https://www.investopedia.com/terms/b/beta.asp

• https://www.moneycontrol.com/financials/

• https://www.screener.in/

• https://people.stern.nyu.edu/adamodar/podcasts/valspr15/valsession6.pdf