Calculation Of Risk Premium

Calculation of cost of equity, Ke Cost of equity is the return desired by equity holders from the firm. Investor is assumed to diversify their holding and hence the return corresponds to only the non-diversifiable risk. For a company like AES with business across geographies the problems become manifold. Identified issues 1. 2. 3. 4.

How to account for country specific risk Calculation of market risk premium Identification of the risk relation between business and systematic risk Matching of the time horizon of the project with the discount rate

Country specific risk Approach 1: Spread between the 10 year US Treasury Note and dollar denominated bond issues by a Country. Approach 2: For a country that does not issue dollar denominated bond we can see its rating from rating agencies and then use the spread from another country having the same rating Approach 3: US 10 year T note + Credit default spread of the country Market risk Approach 1: Historical average of market risk premium Approach 2: Equity risk premium of US market + Country specific risk obtained from one of the approaches above Dependence of business and systematic risk Approach 1: Regress the market and business returns Approach 2: Regress the operating revenue with the GDP Approach 3: Look into the various macro factors that affect your business and develop a model that reflect this relation Time horizon The time horizon of the projects has to be matched with the corresponding discount rate. Here we are using long term rates for calculation of Wacc. Our Conclusion: 1. We are using the sovereign spread given in table to account for country specific risk. We believe that the dollar denominated bond spread will capture this risk across different countries 2. Market risk is obtained by adding US equity premium to sovereign spread as many of these markets doesn’t have a well functioning equity market

3. The