Question

India's sovereign bond rating was Baa3 in 2013, implying a default spread of 2%.The Indian government issue 10-year bonds at that time in rupees, with a yield of 6.25%. The US Equity Risk Premium was 5.5%. The standard deviation of Indian stock market was 18%, and the standard deviation of its government bond was 9%.

What is the Equity Risk Premium for India adjusted for relative riskiness of stock market relative to the bond market?

What is the cost of equity for a 100% Indian company with a beta of 1.08 to the Indian stock market.

Select one:

a. Adjusted ERP = 8.44%
New Cost of Equity = 15.06%

b. Adjusted ERP = 9.50%
New Cost of Equity = 14.51%

c. Adjusted ERP = 17.14%
New Cost of Equity = 22.06%

Answer 1

Given

Default spread for India = 2%

Indian bond rating = 6.25%

US Equity risk premium = 5.5%

Indian stock market SD = 18%

Indian bond market SD = 9%

Now,

We have default spread, and bond and stock standard deviation

First, we find country risk premium of India

India CRP = Default Spread * (SD of stocks / SD of bonds)

= 2 * (0.18/0.09)

= 4%

Now to find ERP of India we will add CRP of India to ERP of a developed country (US in our case)

India ERP = CRP of India + ERP of US

= 4 + 5.5

= 9.5%

Now, even though we got the answer which is option B

Still, we must calculate the cost of equity

First, we need to calculate the risk-free rate

Risk-free rate = Bond rate of India - Default Spread

= 6.25 - 2

= 4.25%

Now,

Cost of equity = Risk free rate + beta* ERP

= 4.25 + 1.08*9.5

= 14.51%

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