Class #12, Thursday, February 21, 2002

Topic: Valuation Model II, Downside Risk Approach

Darden technical note: COST OF CAPITAL:  THE DOWNSIDE RISK APPROACH, UVA-F-Draft

Darden case file: downside-risk.doc.xls

Reading: THE COST OF EQUITY IN EMERGING MARKETS: A DOWNSIDE RISK APPROACH.

(The paper compared the downside risk approach with other approaches.  It applies this method to estimate the cost of equity for an average project in each emerging economy.  The method is of course applicable to the estimation of the cost of equity for a particular project, a firm,  or an industry.) 

The readings for this class is a bit technical.  To help you understand the downside risk approach to valuation, Lourdes Alers and I have prepared a technical note to explain the logic of this approach and the steps you need to take to calculate the cost of capital. 

My recommendation for preparation for this class is the following.  First,  read the first reading.  Second, read the Darden technical note to understand the steps you will need to take to estimate the cost of equity.  And finally, work on the data exercise, first individually and then discuss it with your study team. 

Assignments:

A. Study Questions:

1. What are the assumptions behind the downside-risk approach?  Does this approach require that the local capital market be integrated with the global market? 
2. Does this approach take into account the benefits of diversification?  Why should diversifiable risks matter to investors?  To financial managers (the decision-makers)?
3. What data are needed for calculating the cost of equity?
4. Would this approach be appropriate for developed economies?

B. Data Exercise.  (Graded.  Due in the beginning of the class.  You may email me your solution before the class or give me a hard copy in the beginning of the class).

Data File: data-ex2.xls

This file contains the MSCI world total return index, the total return indices for three emerging market companies, YPF, a large Argentine oil company, Tsingtao, a large beer brewery in China, and SHA Diesel Engine in China.  (In the next class, we will look at Repsol's acquisition of YPF.  The data on Tsingtao will be useful in our last class.)

1. Calculate the monthly log returns on each of the four indices included in data-ex2.xls.
2. Calculate the semi-deviation of the log returns on each of the four indices.
3. Assume that the risk free rate for U.S. dollar investment is 5%, and the global equity risk premium is 6%.  Calculate the cost of equity for YPF, Tsingtao, and SHA Diesel Engine using the downside risk approach.