Problems and Questions

1. Assume that you are valuing an Indonesian firm in US dollars. What would you use as the riskless rate?

2. Explain why a 6-month treasury bill rate is not an appropriate riskless rate in discounting a five-year cash flow.

3. You have been asked to estimate a riskless rate in Indonesian Rupiah. The Indonesian government has rupiah denominated bonds outstanding with an interest rate of 17%. S&P has a rating of BB on these bonds, and the typical spread for a BB rated country is 5% over a riskless rate. Estimate the rupiah riskless rate.

4. You are valuing an Indian company in rupees. The current exchange rate is Rs 45 per dollar and you have been able to obtain a ten-year forward rate of Rs 70 per dollar. If the U.S. treasury bond rate is 5%, estimate the riskless rate in Indian rupees.

5. You are attempting to do a valuation of a Chilean company in real terms. While you have been unable to get a real riskless rate in Latin America, you know that inflationindex treasury bonds in the United States are yielding 3%. Could you use this as a real riskless rate? Why or why not? What are the alternatives?

6. Assume you have estimated the historical risk premium, based upon 50 years of data, to be 6%. If the annual standard deviation in stock prices is 30%, estimate the standard error in the risk premium estimate.

7. When you use a historical risk premium as your expected future risk premiums, what are the assumptions that you are making about investors and markets? Under what conditions would a historical risk premium give you too high a number (to use as an expected premium)?

8. You are trying to estimate a country equity risk premium for Poland. You find that S&P has assigned an A rating to Poland and that Poland has issued Euro-denominated bonds that yield 7.6% in the market currently. (Germany, an AAA rated country, has Euro-denominated bonds outstanding that yield 5.1%).

a. Estimate the country risk premium, using the default spread on the country bond as the proxy.

b. If you were told that the standard deviation in the Polish equity market was 25% and that the standard deviation in the Polish Euro bond was 15%, estimate the country risk premium.

9. The standard deviation in the Mexican Equity Index is 48% and the standard deviation in the S&P 500 is 20%. You use an equity risk premium of 5.5% for the United States.

a. Estimate the country equity risk premium for Mexico using the equity standard deviations.

b. Now assume that you are told that Mexico is rated BBB by Standard and Poor's and that it has dollar denominated bonds outstanding that trade at a spread of about 3% above the treasury bond rate. If the standard deviation in these bonds is 24%, estimate the country risk premium for Mexico.

10. The S&P 500 is at 1400. The expected dividends and cash flows, next year, on the stocks in the index is expected to be 5% of the index. If the expected growth rate in dividends and cash flows over the long term is expected to be 6% and the riskless rate is 5.5%, estimate the implied equity risk premium.

11. The Bovespa (Brazilian equity index) is at 15000. The dividends on the index last year were 5% of the index value, and analysts expect them to grow 15% a year in real terms for the next 5 years. After the fifth year, the growth is expected to drop to 5% in real terms in perpetuity. If the real riskless rate is 6%, estimate the implied equity risk premium in this market.

12. As stock prices go up, implied equity risk premiums will go down. Is this statement always true?

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