You have a company incorporated in Malaysia
Operating a factory in China
Customers are from Southeast Asia, mainly Indonesia
Cash flows are denominated in USD
The company is listed in Hong Kong
How do you find this company's Cost of Equity?
Which risk free rate do you use? Why?
Which index to benchmark the regression of the firm? Why?
My answer was "China", because when we look at the discount rate we are trying to get discount the cash flows that best captures the operating risk of the firm and i felt that the factory would be the main risk.
20 Y government bonds in China
Index: trick question (we can just use the US index as the benchmark and adjust it for the country specific risk)
Hope to open up a discussion.
This is actually a very good interview question... I may use it myself going forward.
Answer: Risk free rate: US risk free rate Rationale: this is not representative of risk but is rather just for the purpose of adjusting USD cash flows back to present value (before company, industry, or country discounting component) Benchmark: Probably Indonesia, but you could do a weighted average of other countries too.
Rationale: Think about a US business which sells in the US but manufactures in Vietnam - you would not use the Vietnam benchmark, because that is not representative of the risk you are taking. In fact it may even be inverse to the risk because if Vietnam improves a whole bunch, your cost of labor may go up. The relevant benchmark is normally based on where you are selling because your performance as a firm is dependent on how the customer country is doing.
Other consideration: if this is a listed company, you could actually run multivariable regressions against various benchmarks to see what components make up the risk of the firm. It could be multiple things as opposed to just one variable.
Thanks for sharing Texan, happy to give you ideas to drill incoming candidates!
However, using the US risk free rate does not factor in the country risk of the cash flow like you mentioned, which country would you adjust the US risk free rate for?
Formula for equity risk is:
Risk free rate + Beta(benchmark risk premium)
Or for multivariate:
Risk free rate + Weighted Beta1 * (benchmark risk premium1) + Weighted Beta2 * (benchmark risk premium2) + Weighted Beta3 * (benchmark risk premium3) Etc.
Since risk free rate is independent of any risk premium, no adjustment is needed. It's always just the risk free rate of the currency in which the cash flows are denominated.
On INSEAD they teach you to use risk free rate of US (reflecting US inflation) due to USD business plan and forward FX rates for the relevant currencies. General benchmarks for country risk are deemed irrelevant and should be reflected by business plan scenarios. Beta in that case only shows industry risk, not country.
Betas are determined against local index for each peer.
US Risk free rate, Hong Kong beta and ERP and Malaysia country risk premium.
That is a tough question though.
Where you are listed doesn't matter to the risk of a company... If it were listed in the US or on a London exchange, it would have the same risk.
Same thing with incorporation. It could be incorporated anywhere, but that's not relevant to the risk of the cash flows of the company.
Nope, incorrect. I suggest you read Damodaran's paper on country risk.
this is a tough one...
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