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BPP Practice and revision Kit has a problem called as Burcolene (12/07, amended) on page 38. There are two companies in this problem, which are Burcolene and PetroFrancais, which have separate default risk premium specific to each company. The problem also introduces a different global equity risk premium. In calculating cost of equity based on CAPM, the risk premium used to calculating is the global equity risk premium, but not default risk premium specific to each company for both companies. I want to ask, what is the different between global equity risk premium and default risk premium specific to each company?. Can we use default risk premium specific to each company to calculate cost of equity based on CAPM ? As the risk premium is applied for the whole market or the whole industry, why there is a default risk premium specific to each company for both companies?
Thank you!The equity risk premium depends on the risk of the shares, and the return on equity is always calculated by using the beta of the shares, the risk free rate, and the global equity risk premium.
The default risk premium does not relate to equity at all. It relates to the debt borrowing, and is added to the risk free rate in order to get the return on debt. It is different for each companies debt because of different risks of default.
(This question was set by the previous examiner, and it is the only time things have been worded in this way. I don’t think the current examiner would word things like this 🙂 )
part(a)
why using w.a.c.c to arrive at the valuation of company instead of ke=10.4%
please advise?
(you have mentioned that it is explained in your videos, but i am unable to trace the answer for this part)The lectures are a complete course and are supposed to be watched in order (just as would be the case if you were attending a face-to-face course).
We always discount at the WACC to get the value of the business (and the question even leads you in to this by asking you to calculate the WACC as part of the requirement).
We only discount at the cost of equity (and then we discount only the free cash flows to equity) if we are just valuing the equity in the business, rather than valuing the whole entity.
This is all explained (with examples) in the lectures.
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