Chapter 7 BV

INVESTMENT PROJECT EVALUATION
1. Assume that you are valuing an Indonesian firm in U.S. dollars. What would you use as the
riskless rate?
As we know, we should definitely use the U.S. Treasury Bond rate as the risk-free rate because it does
not really matter where the company is, but in which currency the firm receives its cash flows.
However, nowadays we live in a world characterized by the existence of multinational companies that
can be valued using different currencies because their cash flows are received in different currencies,
and this could bring the company valuations to be different according to which currency we use to
determine it!
2. Explain why a six-month Treasury bill rate is not an appropriate riskless rate in discounting a
five-year cash flow.
A six-month T-Bill is not an appropriate riskless rate because, first of all, it does not have the 2 basic
conditions that every risk-free rate should meet; specifically we are speaking about the 2nd one, which
assumes that there can be no reinvestment risk, but, in fact, in our case, the reinvestment risk exists
because we don’t know what the T-Bill rate will be in 6 months!
However, sometimes, if we are interested in a short-term valuation, we could use it, but this lead us to
the second reason for which our answer to this question is no, and it is that we are discounting a 5-year
cash flow which is not exactly a short-term analysis!
If we were to use the 6 months t bill it would be riskless just for its duration (6 months) not for the
whole 5 years needed; it is definitely the wrong choice to use this rate in discounting a 5-year cash flow!
The best way would be to use a 5-year treasury zero coupon rate.
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.
In order to estimate the risk-free rate in Indonesian Rupiah, given the data in the text, we can use a very
simple formula:
Risk-free rate = Government bond rate – Default spread
So, the risk-free rate, in this case, should be estimated to be (17% - 5%) = 12%.
But why don’t we just use the interest rate of 17% given by the Indonesian government? Well, it is
because investors don’t feel sure about the Indonesian government, they just don’t think it is default risk
as a risk-free rate should be.
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 10-year forward rate of Rs 70 per dollar. If the U.S. Treasury
bond rate is 5%, estimate the riskless rate in Indian rupees.
In order to find out the 10-year risk-free rate in Indian rupees, we will have to use the following formula:
Forward rate= Spot rate * (1+ RFRrupees)T / (1+ RFRU.S. dollars)T
Now, we know that:

 Forward rate= 70
 Spot rate= 45
 T=10
 RFRU.S. dollar= 5%
So, the RFRrupees is 9.74%.
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 inflation-indexed 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?
Well, we actually cannot say that this 3% can be considered as the real riskless rate, but we can say that
it can be a part of it.
In this kind of cases (where we are unable to get a real risk-free rate) we can use the ‘build-up approach’,
which consists in adding up expected inflation in Chilean currency and expected real rate.
The 1st element (expected inflation) can be estimated from the current inflation rate which will lead us,
of course, to the expected inflation in the future.
For the real rate, the 2nd component, we can use the rate of the inflation-indexed U.S. Treasury bond
with the rationale that real rates should be the same globally.
So, basically, if we had the expected inflation rate in Chile, we could simply sum it up with the 3%
inflation-indexed U.S. Treasury bonds rate, and we would have derived the real riskless rate that we
need to evaluate the Chilean company.
7. When you use a historical risk premium as your expected future risk premium, 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)?
When we use a historical risk premium as expected future risk premium, we are assuming that:
 The average risk investment has remained constant;
 There is no selection bias;
 The risk preferences of investors have not changed during the time in our analysis.
Basically, we would have a too high historical risk premium to be used as an expected premium, in 3
different cases:
 If the average risk investment has become less risky over time;
 If investors have become less risk averse, so they are actually demanding a smaller premium
than before for the same level of risk;
 If there is a ‘survivor-market’.
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, a 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.
a. The country risk premium, in this case, will be 7.6% - 5.1% = 2.5%
b. The country risk premium is 2.5% * (25% / 15%) = 4.17%

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INVESTMENT PROJECT EVALUATION

Risk-free rate = Government bond rate – Default spread

Now, we know that:

So, the RFRrupees is 9.74%.

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