In this class, we  introduce the real option based approach for estimating the cost of equity. 

 

 


Assignment Sheet
Emerging Markets Finance
 

Class #11, Thursday, November 17, 2005

Topic: Real Option Based Approach to Estimating the Cost of Capital

Technical Note: Valuation in Emerging Markets--A Summary

This summary note documents the approaches we have learned in this course on valuation in emerging markets. For this assignment, please read from Section 6 to the end. The following excel file contains a calculator to simplify the calculation of the real option based opportunity cost of equity (ROBOCE). It includes an electronic version of the example in the technical note.

File: ROBOCC-Caculator.xls (attached in the email)

The technical note explains in more detail 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 my technical note listed above and answer the study questions listed below. This note is literally fresh off the press. It summarizes in less technical terms my research results in this area.

Second, follow the excel example closely.

And finally, work on the last graded data exercise (10% of grade) individually.

The purpose of this is data exercise is to familiarize with the technical and methodological issues with estimating the real options based opportunity cost of capital.    

Assignments:

A. Study Questions:

  1. Why does the option to delay an investment raises the opportunity cost of investment today? 
  2. Why is this opportunity cost more important in emerging markets? Is it relevant to making capital budgeting decisions in the developed economies?
  3. How does this new approach to estimating the cost of capital related to the ones introduced in this course? How does it relates to CAPM based cost of equity?

B. Data Exercise.  (Graded.  Due before the class.)

Data File: Data-ex3.xls (attached in the email; it was named ex3, but it is the second and the last for the current course.)

This file contains the US$ price index of SHA Diesel Engine Class B Share, capital market assumptions/conditions, and systematic risk measures of US comparables.

  1. Calculate the monthly log returns on SHA stock prices using price index data in Data-ex3.xls.
  2. Calculate the annual volatility of SHA stock price movement.
  3. Estimate the terminal growth rate of SHA.
  4. Assume that the risk free rate for U.S. dollar investment is 5%, and the global equity risk premium is 6%. Calculate the ROBOCE for SHA.