Capital Asset Pricing Model (CAPM)

  1. To obtain the cost of equity capital, it is obvious to refer to Capital Asset Pricing Model (CAPM) for guidance. I searched for Sydney airport on Yahoo Finance for stock information, the beta coefficient of Sydney airport (SYD) is estimated to be 0.78. The property of beta is to measure the volatility or systematic risk of the risky asset compared to the overall equity market. Therefore, the beta of 0.78 implies that the Sydney airport share is less volatile than the whole market. If the market goes up by 10%, SYD is likely to go up by 7.8%. Or if the market decreases by 10%, SYD is likely to decrease by 7.8%.

 

 

  1. The ASX Ordinaries Index can be regarded as a benchmark for Australia stock market. It consists of share prices of 500 largest public companies. The market capitalization of these 500 companies is over 95% of the value of all shares on the ASX.

 

  1. The average monthly return for ordinaries index over 5-year period is 0.397%. After downloading the historical monthly data for ASX ordinaries index, I decided to use close price series to compute the returns. For the column of monthly return, I applied the formula of (P(t)-P(t-1))/P(t-1) and obtained the results for each month except the first one, which is understandable. Then I took an average of all the returns and got the average return of 0.397%.

 

  1. The term sheet for this treasury bond shows that it is due on April 21st, 2033. As of Sep. 30th, 2020, the remaining maturity of this bond is 12 years and approximate 7 months. The average monthly return for this treasury bond over 5-year period is 0.331%. Similar to the computation for ASX monthly return, I did for the treasury bond. However, there is a missing monthly observation, which is August 1st, 2016. Therefore, I used daily data of 131.47 on July 13th, 2016, which is also the nearest value before August 1st, 2016, to replace this missing value. Since there is no daily data in the whole August, I would deduce that the missing value of August, 2016 monthly data is probably because there is no transaction for this GSBG33.AX in this month. The risk-free rate refers to the yield that investors can earn with no risk to lose. The return of exchanged-treaded treasury bonds (eTBs) can be used as risk-free rate because treasury bonds are long-term, government-backed bonds, which are considered nearly free of default risk. Even though there is no guarantee that Australian government will never default, eTBs are still viewed as the closest investment to be risk-free.

 
 

  1. The annual market risk premium is estimated to be 0.792%. Based on the results obtained previously, the monthly market return is 0.397%, and the monthly risk-free rate is 0.331%. The monthly market risk premium is the difference between 0.397% and 0.331%, which is 0.066%. The annualized market risk premium is 0.066% x 12 = 0.792%.

 

  1. The cost of equity capital is 4.590%. According to CAPM, the cost of equity capital is given by risk-free rate + beta * market risk premium. At this point, all the inputs are ready. If using the average risk-free rate computed above, the annual risk-free rate is 0.331% x 12 = 3.972%. The cost of equity capital is equal to 3.972% + 0.78 x 0.792% = 4.590%.

 

  1. Using the current government bond yield for the risk-free rate is a good suggestion. Theoretically, the historical risk-free rate is used to calculate the market risk premium because we can only get historical market return. For the cost of equity capital in the future, the current risk-free rate should be used instead of the historical one. The government bond that I should use is 5-year Australia Bond. Because my CFO asked me to estimate the cost of capital for a project of Sydney airport, which has a 5-year forcast horizon. The time horizon should match to each other, which means that the time period of the risk-free rate used in valuation of the project should be in line with the time period of cash flow occurrence. That is why I chose to use the 5-year government bond.

 

  1. After reading the article of Do You Know Your Cost of Capital, I believe that there are three improvements for my estimation of the cost of equity capital. Firstly, for Sydney airport, it is necessary for us to pay attention to which risk-free rate other companies in the same industry use. With very similar business, the benchmark of risk-free rate should be identical. Secondly, the beta, which measures how the share price of SYD would react to the overall market, should be larger than 0.78. Theoretically, we would expect that the business of international airports would not be very sensitive to the economy, because traveling has become one of the usual events, and an increasing number of international flights has existed. However, it has been proved that international airports are seriously affected by the pandemic because people can not easily fly to an international country. The revenue has been largely decreased since the pandemic. This shock for SYD is larger than that for the overall market. Last but not least, considering the current economic and business conditions, especially during and after the pandemic, the market risk premium would be lower, because the market return is expected to be lower. Investors probably are reluctant to invest in business like SYD and thus the cost of capital overall would expect to be large for SYD.

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