Financial Modeling and Business

Plan
Note on Project’s Discount Rates
Pedro Leite Inácio Feb/2017
 Project’s Discount Rates
• Projects are analyzed under two main assumptions:
– Assuming they are all equity financed, therefore the
discount rate should reflect the situation of an
unlevered company (i.e., with no debt)
– Then, assuming at first there is no inflation, therefore
that rate should be expressed in real terms
• And, finally, assuming there will be inflation after all,
which leads to the consideration of nominal rates,
rather than real ones

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 Traditional Approach
• In countries where the stock market is not that much
developed and in times where it was almost
inexistent, projects were still analyzed with discount
rates that were supposed to reflect the project’s risk.
• There was a rule of thumb according to which the
required return for a project was a function of its
perceived risk, as shown in the following table

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Project’s Risk vs. Required Return

Project’s Risk Real Required Rate of

Return
Low 5%
Medium 10%
High 15%
Innovative Project >= 20%

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 CAPM = Capital Asset Pricing Model
• In a Modern Approach, discount rates are determined by
Sharpe’s CAPM – Capital Asset Pricing Model:
Required Rate of Return (or RE) = Risk Free Rate (or RF) +
Beta Factor (or ß) *Market Risk Premium (or = RM – RF)
where:
– RM is the Expected Market Return
– RF = Risk Free rate, usually the interest rate (or YTM= Yield to
Maturity) offered by a Government (or Treasury) Bond, i.e., the return
of sovereign debt
– ß = the sensitivity of an investment to market risk (usually measured
by the return of a stock market index ), therefore it is a measure of
market risk exposure
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 Reconciling both Approaches
• Let us assume the following:
– Risk-Free Rate (RF) =5%
– Market Risk Premium (RM-RF) = 5%
– Therefore, the implied Betas considered in the returns shown on the previous
table are the following:
– Low Risk = 5% => ß = (5% - RF)/(RM-RF) = 0
– Medium Risk = 10% => ß = (10% - 5%)/5% = 1
– High Risk = 15% => ß = (15%-5%)/5% = 2
– Innovative Project (minimum) = 20% => ß = (20%-5%)/5% = 3

• So, these were the assumptions behind the traditional approach

regarding Beta (i.e., the exposure of a project to market risk)

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 Reconciling both Approaches
• Notice that we had said Real Required Rates of
Return, so expected inflation was excluded from
them. Therefore, the 5% risk-free rate presented was
a real rate, from which we had previously taken out
the expected inflation rate.
• These assumptions were mainly applied to projects
implemented in developed countries, namely the US,
which is considered as the country with the most
developed stock market.

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 Expected market returns for other
countries: Damodaran’s Approach
• Professor Damodaran, in (www.damodaran.com), a site we
recommend you use for assessing financial data, suggests that to
find out the expected market return for a given country we
should do the following
• RM of the Country = Risk Free Rate of the Country + (Market Risk
Premium of the US + Equity Additional Country Risk Premium)
• Market Risk Premium of the US = 5.69% (based on SP500)
• Current Adjustment Factor for Additional Equity Country Risk
Premium = 23% (based on emerging markets average)
• Current US Risk Free Rate = 2.41% (10-year T-Bond) or 3.02%
(30-y T-Bond)
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 Portuguese Example
• Moody’s rating = Ba1
• Rating Default Spread = 2.89%
• Sovereign Interest Rate Difference vs. US = 3.04%
(since this spread is above the theoretical value, we
are going to consider this one!)
• US T Bond rate = 2.41% (10 years)
• Portuguese estimated Risk-free rate = 2.41% + 3.04%
= 5.45% (if we had considered the theoretical spread
of 2.89%, this rate would be just = 5.30%)
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 Portuguese Example - continued
• But the Current 10-y Portuguese Government Bond YTM =
2.89% (i.e., exactly equal to the theoretical spread)
• And the Current German 10-y YTM = 0.30%
• It could be argued that as our currency is the Euro, our
reference should be Germany and not the US
• So, if we measure the country risk premium implied in the
difference between those two European rates, we get
• Country Risk Premium (CRP) = Portuguese 10-y YTM –
German 10-y YTM = 2.89% - 0.30% = 2.59%
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 Portuguese Example - continued
• So, we have 3 possible estimates for our CRP= 2.59%, or 2.89%,
or even 3.04%, as current interest rates are unusually low, we
may be tempted to opt for 3.04% instead of 2.59%. When doing
so, we are saying that our 10y YTM should be as high as = 0.30%
+ 3.04% = 3.34% and not just 2.89%

• The next step is to consider that equity market risk premium

must be aggravated considering an additional 23% of the
country’s sovereign risk premium, that should amount to: as low
as 2.59%*23% = 0.60%, or an intermediate value of 2.89%*23%
= 0.66%, or finally an upper limit of 3.04% * 23% = 0.70%

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 Portuguese Example - continued
• So, if we base our calculations on the actual
Portuguese risk-free rate, we get: RM Portugal =
2.89% + (5.69%= US Equity Risk Premium +
Additional Country Risk premium = 0.66%) = 2.89% +
6.35% = 9.24%
• If we consider the normative value for the RF of
3.34%, we should then arrive at: RM Portugal =
3.34% + (5.69% + 0.70%) = 3.34% + 6.39% = 9.73%

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 Portuguese Example - continued
• Finally, we must adjust those nominal discount rates to real
ones
• For that purpose, let us assume that Portuguese expected
inflation is about 1%
• Therefore, we may subtract inflation form those nominal
rates in order to have a quick answer to our problem: Real
Portuguese RM = 9.24% - 1% = 8.24% or 9.73% - 1% = 8.73%
• Or when applying the exact formula = Real Rate =
[(1+nominal rate)/(1+expected inflation rate)] – 1 =
(1.0924)/(1.01) – 1 = 8.16% or (1.0973)/(1.01) – 1 = 8.64%

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 Proposed Exercise - Spain
• Additional Data for Spain:
– Moody’s Rating = Baa2
– Rating Default Spread = 2.20%
– Spanish 10 Y Bond YTM = 1.91%
– Spanish Expected Inflation Rate = 1%

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Proposed Exercise – Spain-Solution
• Comparing the Spanish YTM with Germany´s, we get
a Country Risk premium of:
• Sovereign CRP = 1.91% - 0.30% = 1.61%
• Additional Equity Country Risk premium =
1.61%*23% = 0.37%
• RM Spain = 1.91% + (5.69% + 0.37%) = 1.91% +
6.06% = 7.97%
• RM Spain in real terms = (1.0797)/(1.01) – 1 = 6.90%
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Proposed Exercise – Spain-Solution
• Alternatively, using the theoretical Credit Default
Spread of 2.20%
• And, continuing to use the 0.30% German rate as the
Reference, Spanish Theoretical RF = 0.30% + 2.20% =
2.50%
• Additional Equity Country Risk premium =
2.20%*23% = 0.51%
• RM Spain = 1.91% + (5.69% + 0.51%) = 8.11%
• RM Spain in real terms = (1.0811)/(1.01) – 1 = 7.04%
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 Industry Factors
• After having presented the procedure to find out the
expected market return for a given country, we must now
address the issue of dealing with risk for a specific industry
or sector
• In CAPM [RE= RF + ßE (RM – RF)], the Beta used is usually
the Beta of the equity, calculated with a market share price
series that is regressed against a series of the market index
for where the share is listed
• So, it is a levered beta, i.e., it includes the effect of the
existence of debt in the capital structure of the company,
that is the financial risk premium due to leverage
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Deleveraging Beta: from Levered Beta
to Unlevered
• We usually assume the following expression, which involves
admitting that the Beta of debt is zero (therefore, its
interest rate should be close to RF = risk free rate)
• BE or BL = BU * [1 – D/E*(1-t)]
• Beta Equity or Levered = BE or BL
• Beta Unlevered = BU
• D =Debt at market value
• E = Equity at market value
• t = Income Tax rate

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 Deleveraging Beta: An Example
• BE = 1,4 (for the shares of the company)
• D/E = 1
• t = 25%
• BU = ?
• 1,4 = BU * [ 1 + 1 (1-0.25)] = BU * 1.75
• BU = 1.4/1.75 = 0.8
• If RF= 4% and RM-RF = 6%, then RU = ?
• RU = 4% + 0.8*6% = 4% + 4.8% = 8.8%, while
• RE = 4% + 1.4*6% = 4% + 8.4% = 12.4%
• Therefore, we should discount the cash flows of the project at 8.8%
(instead of 12.4%) since the project is all equity financed, unlike the
company

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 Deleveraging Beta: An Example
• In the previous example we assumed that the
interest rate of the loan (RD) was close to RF (4%),
and therefore the Beta of Debt was zero
• Let us now assume that quite on the contrary RD =
5.5%; therefore, the Beta of Debt (BD) must be:
• Beta of Debt (BD) must be = (RD-RF)/(RM-RF) =
(5.5%-4%)/6% = 1.5%/6% = 0.25, definitively not zero
(0)!

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 Deleveraging Beta: An Example
• When the Beta of Debt is different from Zero, we then use the
following expression:
• BE or BL = BU + (BU – BD) * D/E * (1-t)
• Assuming the same data of our previous example except for
BD
• 1.4 = BU + (BU – 0.25) * 1 * 0.75 = 1.4 = BU*1.75 – 0.1875 =>
1.75 BU = 1.5875 => BU = 1.5875/1.75 = 0.9071 close to 0.91
• Therefore, the Project Cash Flows should be discounted at =
RU = 4% + 0.91*6% = 4% + 5.46% = 9.46% (instead of 12.4% or
even 8.8%, as Unlevered beta is now 0.91, and not just 0.8!)

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 Deleveraging Beta: Using
Damodaran’s Data
• Professor Damodaran database presents by industry
and by market (US, Europe, Japan, Emerging
Markets, Just China, just India, and Global) betas:
– (Levered or Equity) Betas
– Unlevered Betas
– Unlevered Betas Adjusted for Cash (assuming that the Beta
of cash is also Zero), which is the best way to estimate a
project’s discount rate.

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 Industry Betas (Europe)
Industries Beta Unlevered Unlevered
Beta Beta Adjusted
for Cash
Apparel .95 .80 .84
Food Processing .76 .65 .67
Hotel .80 .54 .59
Retail Distributors .96 .61 .64
Telecom Services .99 .54 .57

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 Final Example: A Hotel in Portugal
• Let us assume we want to analyze a project for a
hotel in Portugal with the following data:
• Portuguese Risk-Free rate = 2.89%
• Portuguese Market Risk Premium = 6.35%
• Industry Unlevered Beta Adjusted for cash = 0.59
• Expected Inflation = 1%
• Nominal RU = 2.89% + 0.59*6.35% = 2.89% +
3.75% = 6.64%
• Real RU = (1.0664/1.01) – 1 = 5.58%
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 Final Example: A Retail Distributor in
Spain
• Let us now assume we want to analyze a project for a
retail distributor in Spain, with the following data:
• Spanish Risk-Free rate = 2.50%
• Spanish Market Risk Premium = 6.06%
• Industry Unlevered Beta Adjusted for cash = 0.64
• Expected Inflation = 1%
• Nominal RU = 2.50% + 0.64*6.06% = 2.50% + 3.88% =
6.38%
• Real RU = (1.0638/1.01) – 1 = 5.33%
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