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MPBIM / DISSERTATION / FINANCE / 2005-2007

Ex Ante Cost of Equity Estimates of Nifty Stocks:

The choice between Global and Domestic CAPM

By

ANSHUL JINDAL
05XQCM6012

This dissertation report under the guidance of Prof Nagesh S. Malavalli,

MPBIM submitted in the partial fulfillment of the requirement for MBA
degree of Bangalore University

M P BIRLA INSTITUTE OF MANAGEMENT

(Associate Bharatiya Vidya Bhavan)
Bangalore-560001
MAY 2007
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DECLARATION

I hereby declare that this dissertation titled “EX ANTE COST OF EQUITY
ESTIMATES OF NIFTY STOCKS: THE CHOICE BETWEEN GLOBAL AND
DOMESTIC CAPM” is a record of independent work carried out by me, towards the
partial fulfillment of requirements for the M.B.A. degree course of Bangalore University
at M.P. Birla Institute of Management. This has not been submitted in part or full towards
the award of any other degree or diploma.

PLACE: Bangalore Anshul Jindal

DATE:

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PRINCIPAL’S CERTIFICATE
This is to certify that this research report titled “EX ANTE COST OF EQUITY
ESTIMATES OF NIFTY STOCKS: THE CHOICE BETWEEN GLOBAL AND
DOMESTIC CAPM” has been prepared by Mr. Anshul Jindal bearing the registration no.
05XQCM6012 under the guidance and supervision of Dr. N. S. Malavalli, M.P. Birla
Institute of Management.

PLACE: Bangalore Dr. N. S. Malavalli

DATE: (Principal)

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GUIDE’S CERTIFICATE

This is to certify that this research report entitled “EX ANTE COST OF EQUITY
ESTIMATES OF NIFTY STOCKS: THE CHOICE BETWEEN GLOBAL AND
DOMESTIC CAPM”, done by Mr. Anshul Jindal bearing the registration no.
05XQCM6012 is a bonafied work done carried under my guidance and supervision
during the academic year 2005-2007 in the partial fulfillment of the requirement for the
award of MBA degree by Bangalore University. To the best of my knowledge this report
has not formed the basis for the award of any other degree.

PLACE: Bangalore Dr. N. S. Malavalli

DATE: (Professor)

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ACKNOWLEDGEMENT

The research work which I had done gave me enormous amount of knowledge and the
understanding of various financial issues related to the firm’s cost of equity. This
research project work is made successful by the combining efforts of a no. of officials
and bears the imprint of many people. This project can not be said completed unless and
until, I fulfill my duty of thanking those persons to whom I deeply indebted. I wish to
express my deep gratitude towards them to their whole hearted support and existence.

Firstly I would like to thank Dr. N. S. Malavalli, principal, M P Birla Institute of

Management, Bangalore, who has given his valuable support and guidance in carrying
out this project work.

I am also extremely thankful to Dr. T. V. N. Rao, Professor, M P Birla Institute of

Management, Bangalore, who has guided me to do this project by giving valuable
suggestion and advice.

Further, I am grateful to Professor Santhanam, Professor, M P Birla Institute of

Management, Bangalore, who gave his suggestions to improve the accuracy and the
dependability of the data.

They all guided me during the period and helped me in each and every step to prepare
this report.

My overriding debt continues to be to my parents and my friends to help me in preparing

my report.

DATE: Anshul Jindal

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CONTENTS
PAGE
CHAPTERS PARTICULARS NO.

Research Abstract 6

1 Introduction and Theoretical Background 8

2 Review of Literature 19

3 Research Methodology
3.1 Statement of the Problem 25
3.2 Objectives of the study 26
3.3 Methodology and data 27
3.4 Limitations of research 30

4 Data Analysis
4.1 Risk premium differences for DCAPM and GCAPM 32
4.2 Cross section regression on systematic risk 34

5 Conclusion 36

6 Bibliography and references

6.1 Bibliography 39
6.2 References 40

7 Annexure 41

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RESEARCH ABSTRACT

Cost of Equity estimation is an important area of research in financial markets and lot of
effort has been extended towards finding out new and advanced models for calculating
cost of equity and checking the relevance of models in the practical world.

In this direction, this paper attempts to estimate the ex ante cost of equity for a sample of
S&P CNX Nifty stocks over the period 2004-2006.

This research studied the choice between global and domestic CAPM by examining
which of the two models provides the better fit with a sample of ex ante expected equity
return estimates for large Indian firms. In contrast to many prior studies that use realized
returns, we estimate implied expected returns based on the theory’s call for a forward
looking measure. This study period covers 2004 to 2006.

The ex ante estimates show a better overall fit with the domestic version of the single
factor CAPM than with the global version, but the difference is small. The finding has no
trend in time. The findings suggest that for estimating the cost of equity, the choice
between domestic and global CAPM may not be a material issue.

The study’s practical implications are based on the widespread use of the CAPM in cost
of capital estimation by the investors, where the traditional use of the S&P 500 index as
the “market portfolio” continues to be the standard.

The paper is organized as follows. Section 1 provides the introduction and theoretical
background which is followed by reviews related literature. This review includes the
domestic and global versions of the CAPM and why the two models are theoretically
likely to result in different expected rates of return for a given asset. Section 2 discusses
the methodology and data for the empirical analysis. Section 3 reports the results of the

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empirical comparison of the ex ante expected return estimates with the estimates of the
two CAPM versions and with corresponding measures of risk. Section 4 provides
summary and conclusion.

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CHAPTER 1
INTRODUCTION AND
THEORETICAL BACKGROUND

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INTRODUCTION AND THEORETICAL BACKGROUND

The estimation of a firm’s cost of equity capital remains one of the most critical and
challenging issues faced by financial managers, analysts, and academicians. Although
theory provides several broad approaches, recent survey evidence reports that among
large firms and investors, the capital asset pricing model (CAPM) is by far the most
widely used model.

Among the variety of decisions to be made in implementing the CAPM is the choice
between a domestic or global index for the market portfolio. Although theory suggests
that using a domestic market index is appropriate only for an asset traded in a closed,
national market, empirical research has thus far failed to establish whether a global or
domestic pricing model performs better with Indian stocks.

Capital (money) used to fund a business should earn returns for the capital owner who
risked their saved money. For an investment to be worthwhile the estimated return on
capital must be greater than the cost of capital. Otherwise stated, the risk-adjusted return
on capital (incorporating not just the projected returns, but the probabilities of those
projections) must be higher than the cost of capital.

COST OF CAPITAL:
The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt.
Firms finance their operations by three mechanisms: issuing stock (equity), issuing debt
(borrowing from a bank is equivalent for this purpose) (those two are external financing),
and reinvesting prior earnings (internal financing).

The cost of debt is relatively simple to calculate, as it is composed of the interest paid
(interest rate), including the cost of risk (the risk of default on the debt). In practice, the
interest paid by the company will include the risk-free rate plus a risk component, which
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itself incorporates a probable rate of default (and amount of recovery given default). For
companies with similar risk or credit ratings, the interest rate is largely exogenous.

Cost of equity is more challenging to calculate as equity does not pay a set return to its
investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-
weighted projected return required by investors, where the return is largely unknown. The
cost of equity is therefore inferred by comparing the investment to other investments with
similar risk profiles to determine the "market" cost of equity.

The cost of equity is also known as the discount rate, the rate at which projected earnings
will be discounted to give a present value.

Cost of debt
The cost of debt is computed by taking the rate on a non-defaulting bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This
default premium will rise as the amount of debt increases (since the risk rises as the
amount of debt rises). Since in most cases debt expenses is a deductible expense, the cost
of debt is computed as an after tax cost to make it comparable with the cost of equity
(earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax
rate. This is used for large corporations only.

Cost of equity
In finance, the cost of equity is the minimum rate of return a firm must offer shareholders
to compensate for waiting for their returns, and for bearing some risk.

The cost of equity capital for a particular company is the rate of return on investment
that is required by the company's ordinary shareholders. The return consists both of
dividend and capital gains, e.g. increases in the share price. The returns are expected
future returns, not historical returns, and so the returns on equity can be expressed as the

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anticipated dividends on the shares every year in perpetuity. The cost of equity is then the
cost of capital which will equate the current market price of the share with the discounted
value of all future dividends in perpetuity.

The cost of equity reflects the opportunity cost of investment for individual shareholders.
It will vary from company to company because of the differences in the business risk and
financial or gearing risk of different companies.
The cost of equity is calculated by the following formula:

Ke=D1/Po + g

Po=D1/ (Ke-g)

Where D1=Do (1+g)

The formula above calculates the cost of equity based on a firm's current rate of return. If
one assumes a perfect market, industry-specific costs of equity reflect the riskiness of
particular industries. A high cost of equity would then indicate a higher-risk industry that
should command a higher return to compensate for the higher risk.

The various models which are used for calculating the cost of equity are as follows:

Capital asset pricing model:

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically
appropriate required rate of return (and thus the price if expected cash flows can be
estimated) of an asset, if that asset is to be added to an already well-diversified portfolio,
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given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's
sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a
number often referred to as beta (β) in the financial industry, as well as the expected
return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan
Mossin independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory. Sharpe received the Nobel Memorial Prize in
Economics (jointly with Harry Markowitz and Merton Miller) for this contribution to the
field of financial economics.

The formula:

The CAPM is a model for pricing an individual security (asset) or a portfolio. For
individual security perspective, we made use of the security market line (SML) and its
relation to expected return and systematic risk (beta) to show how the market must price
individual securities in relation to their security risk class. The SML enables us to
calculate the reward-to-risk ratio for any security in relation to that of the overall market.
Therefore, when the expected rate of return for any security is deflated by its beta
coefficient, the reward-to-risk ratio for any individual security in the market is equal to
the market reward-to-risk ratio, thus:

Individual security’s = Market’s securities (portfolio)

Reward-to-risk ratio Reward-to-risk ratio

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The market reward-to-risk ratio is effectively the market risk premium and by rearranging
the above equation and solving for E (Ri), we obtain the Capital Asset Pricing Model

Where:

• is the expected return on the capital asset

• is the risk-free rate of interest

• (the beta coefficient) the sensitivity of the asset returns to market returns,

• is the expected return of the market

• is sometimes known as the market premium or risk premium (the

difference between the expected market rate of return and the risk-free rate of return).

Asset pricing:

Once the expected return, E(Ri), is calculated using CAPM, the future cash flows of the
asset can be discounted to their present value using this rate (E(Ri)), to establish the
correct price for the asset.

In theory, therefore, an asset is correctly priced when its observed price is the same as its
value calculated using the CAPM derived discount rate. If the observed price is higher
than the valuation, then the asset is overvalued (and undervalued when the observed price
is below the CAPM valuation).

Alternatively, one can "solve for the discount rate" for the observed price given a
particular valuation model and compare that discount rate with the CAPM rate. If the
discount rate in the model is lower than the CAPM rate then the asset is overvalued (and
undervalued for a too high discount rate).

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Asset-specific required return:

The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at
which future cash flows produced by the asset should be discounted given that asset's
relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below
one indicate lower than average. Thus a more risky stock will have a higher beta and will
be discounted at a higher rate; less sensitive stocks will have lower betas and be
discounted at a lower rate. The CAPM is consistent with intuition - investors (should)
require a higher return for holding a more risky asset.

Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the
market as a whole, by definition, has a beta of one. Stock market indices are frequently
used as local proxies for the market - and in that case (by definition) have a beta of one.
An investor in a large, diversified portfolio (such as a mutual fund) therefore expects
performance in line with the market.

The market portfolio:

An investor might choose to invest a proportion of his or her wealth in a portfolio of risky
assets with the remainder in cash - earning interest at the risk free rate (or indeed may
borrow money to fund his or her purchase of risky assets in which case there is negative
cash weighting). Here, the ratio of risky assets to risk free asset does not determine
overall return - this relationship is clearly linear. It is thus possible to achieve a particular
return in one of two ways:

1. By investing all of one's wealth in a risky portfolio,

2. Or by investing a proportion in a risky portfolio and the remainder in cash (either
borrowed or invested).

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For a given level of return, however, only one of these portfolios will be optimal (in the
sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any
other asset, option 2 will generally have the lower variance and hence be the more
efficient of the two.

This relationship also holds for portfolios along the efficient frontier: a higher return
portfolio plus cash is more efficient than a lower return portfolio alone for that lower
level of return. For a given risk free rate, there is only one optimal portfolio which can be
combined with cash to achieve the lowest level of risk for any possible return. This is the
market portfolio.

Assumptions of CAPM:

• All investors have rational expectations.

• There are no arbitrage opportunities.
• Returns are distributed normally.
• Fixed quantity of assets.
• Perfectly efficient capital markets.
• Investors are solely concerned with level and uncertainty of future wealth
• Separation of financial and production sectors.
• Thus, production plans are fixed.
• Risk-free rates exist with limitless borrowing capacity and universal access.
• The Risk-free borrowing and lending rates are equal.
• No inflation and no change in the level of interest rate exists.
• Perfect information, hence all investors have the same expectations about security
returns for any given time period.

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Shortcomings of CAPM:

The model assumes that asset returns are (jointly) normally distributed random variables.
It is however frequently observed that returns in equity and other markets are not
normally distributed. As a result, large swings (3 to 6 standard deviations from the mean)
occur in the market more frequently than the normal distribution assumption would
expect.
The model assumes that the variance of returns is an adequate measurement of risk. This
might be justified under the assumption of normally distributed returns, but for general
return distributions other risk measures (like coherent risk measures) will likely reflect
the investors' preferences more adequately.

The model does not appear to adequately explain the variation in stock returns. Empirical
studies show that low beta stocks may offer higher returns than the model would predict.
Some data to this effect was presented as early as a 1969 conference in Buffalo, New
York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is
itself rational (which saves the efficient markets hypothesis but makes CAPM wrong), or
it is irrational (which saves CAPM, but makes EMH wrong – indeed, this possibility
makes volatility arbitrage a strategy for reliably beating the market).

The model assumes those given a certain expected return investors will prefer lower risk
(lower variance) to higher risk and conversely given a certain level of risk will prefer
higher returns to lower ones. It does not allow for investors who will accept lower returns
for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock
traders will pay for risk as well.

The model assumes that all investors have access to the same information and agree
about the risk and expected return of all assets. (Homogeneous expectations assumption)

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The model assumes that there are no taxes or transaction costs, although this assumption
may be relaxed with more complicated versions of the model.

The market portfolio consists of all assets in all markets, where each asset is weighted by
its market capitalization. This assumes no preference between markets and assets for
individual investors, and that investors choose assets solely as a function of their risk-
return profile. It also assumes that all assets are infinitely divisible as to the amount
which may be held or transacted.

Arbitrage pricing theory:

Arbitrage pricing theory (APT), in Finance, is a general theory of asset pricing, that has
become influential in the pricing of shares.

APT holds that the expected return of a financial asset can be modeled as a linear
function of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor specific beta coefficient.
The model derived rate of return will then be used to price the asset correctly - the asset
price should equal the expected end of period price discounted at the rate implied by
model. If the price diverges, arbitrage should bring it back into line.

The theory was initiated by the economist Stephen Ross in 1976.

The APT model:

If APT holds, then a risky asset can be described as satisfying the following relation:

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Where,
• E(rj) is the risky asset's expected return,
• RPk is the risk premium of the factor,
• rf is the risk-free rate,
• Fk is the macroeconomic factor,
• bjk is the sensitivity of the asset to factor k, also called factor loading,
• and εj is the risky asset's idiosyncratic random shock with mean zero.

Relationship with the capital asset pricing model:

The APT along with the capital asset pricing model (CAPM) is one of two influential
theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in
its assumptions. It allows for an explanatory (as opposed to statistical) model of asset
returns. It assumes that each investor will hold a unique portfolio with its own particular
array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM
can be considered a "special case" of the APT in that the securities market line represents
a single-factor model of the asset price, where Beta is exposure to changes in value of the
Market.

Additionally, the APT can be seen as a "supply side" model, since its beta coefficients
reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks
would cause structural changes in the asset's expected return, or in the case of stocks, in
the firm's profitability.

On the other side, the capital asset pricing model is considered a "demand side" model.
Its results, although similar to those in the APT, arise from a maximization problem of
each investor's utility function, and from the resulting market equilibrium (investors are
considered to be the "consumers" of the assets).

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CHAPTER 2
REVIEW OF LITERATURE

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REVIEW OF LITERATURE

Review of literature .means examining and analyzing the various literatures available in
any field either for references purposes or for further research.

Further research can be done by identifying the areas which have not been studied and in
turn undertaking research to add value to the existing literature.

For the purpose of literature review various sources of information have been used.
Sources include books, journals as well as some literature papers.

Recent survey evidence (Bruner, Eases, Harris, and Higgins, 1998) and Graham and
Harvey, 2001) reports that the capital asset pricing model (CAPM) is widely used by
large US firms and investors. The CAPM also continues to have the wide popularity in
academic textbooks and applied articles (e.g. Kaplan and Peterson, 1998 and Ruback,
2002).

These applications use the traditional domestic CAPM, Ki = Rf + Bid [Kmd – Rf]; where
Ki is the equilibrium expected rate of return for asset i; Rf is the risk free rate; Bid is the
beta of asset i against the domestic market portfolio returns; Kmd is the equilibrium
required rate of return on the domestic market portfolio; and Kmd- Rf is the risk premium
on the domestic market portfolio.

A. Global CAPM and domestic CAPM:

Stehle (1997) and Stulz (1995a, 1995b, 1999) argue that using a domestic market index
is only appropriate for an asset traded in a closed, national financial market. Although
equilibrium international asset pricing models are multifactor in general, if the purchasing
power parity (PPP) condition holds, then the single factor CAPM equation can be adapted

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to a international context for asset in the global market portfolio, as discussed in Stulz
(1995c). We emphasize the difference between the domestic and global CAPMs by
equation (1).

Ki = Rf + BiG [KmG - Rf] (1)

Where, Ki is the equilibrium expected rate of return for asset I in a specific pricing
currency, Rf is the nominal rate of return on an asset that is risk free and denominated in
the pricing Currency, BiG is the beta of asset i’s returns against the unhedged global
market index returns, with returns computed in pricing currency, KmG is the equilibrium
required rate of return in the pricing currency on the unhedged global market portfolio,
and KmG - Rf is the risk premium on the unhedged global market portfolio.

Karolyi and Stulz (2003) point out that only in special case in which BiG equals Bid BdG
does the global CAPM result in the same expected return as the domestic CAPM, i.e.,
when an asset’s global beta is equal to its domestic beta times the global beta of the
domestic market portfolio. Generally, this condition does not hold. Instead, when BiG is
greater than Bid BdG, the domestic CAPM is likely to underestimate the asset’s expected
return relative to the global CAPM, because there is more global systematic risk in the
asset’s returns than is accounted for by the domestic market index. Similarly, when BiG
less than Bid BdG, the domestic CAPM is is likely to overestimate the asset’s expected
return relative to the global CAPM, because the asset has less global systematic risk in its
returns than is accounted for by the domestic market index.

Stehle (1977) reports empirical support for the global CAPM over the domestic version
in realized returns for the US stocks from 1956 to 1975. Harvey’s (1991) study provides
further empirical support of the global pricing of US equities. Black (1993) asserts that
the issue of whether a global or domestic index should be used in CAPM applications is
not yet settled. However, given the significant globalization of the world financial
markets, Stulz (1995a, 1995b, 1999) advocates the use of global version. In contrast to
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Stehle’s (1977) findings, Griffin (2002) reports that for the period between 1981 and
1995, a three – factor (Fama- French) domestic model had lower pricing errors for firms
than did an analogous Three factor world version. His results indicate that a domestic
pricing model is a better fit with realized return data than a global pricing model.
Campbell’s (1996) empirical analysis of a multifactor domestic pricing model finds that
the single facto domestic CAPM is a good approximate model for stock and bond prices,
since the additional factors (returns to human capital and changes in expected market
return) are highly correlated with the market index returns. Ng (2003) reaches a similar
conclusion in the context of the global CAPM, with the additional factors of FX risk and
shifts in both expected market returns and expected FX changes. Therefore, we only
examine the two Single- factor CAPMs. Griffin (2002) does not report results on
domestic compared to world Single- Factor (Market index) models. Griffin reported that
the domestic version of the single factor model had lower pricing errors than did the
world model.

A domestic index could be the preferred benchmark for investors with a significant
‘home bias’, as in the Cooper and Kaplanis (2000) model of partially integrated world
markets. However, we do not know whether the popularity of the domestic CAPM
among firms is for this reason.

Finally, Robert S. Harris, Dev R Mishra (2003) advocates that Single factor domestic
CAPM has a better fit than the global CAPM but at the end they gave a lead in their
article that after extending our study to smaller companies, we might shed more light on
DCAPM and GCAPM.

B. Ex Ante Expected Return Estimates:

Empirical tests comparing global to domestic pricing models usually rely on realized
returns. However, Elton (1999) points out that ex ante estimates of expected returns are
more desirable. We obtain ex ante expected return estimates through discounted cash

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flow (DCF) models, as in a number of prior studies, including Claus and Thomas
(2001), Fama and French (2002), and others discussed below.

In contrast to research that uses realized returns, almost all of the studies using ex ante
expected return estimates find an empirical relation between expected return and beta
risk, despite differences in approaches and time periods. Harris and Marston (1992) and
Harris (1993) report a significant relation between ex ante expected return estimates and
(domestic0 betas for a sample of US stocks in the 1982-1987 periods. At the same time
they confirm the findings of previous empirical studies of no significant relation between
realized returns and betas.

The results of Gebhardt, Lee, and Swaminathan (2001) provide the only exception that
we know of to a positive empirical relation between ex ante expected return and beta risk
estimates. Their study, which uses IBES forecasts and a clean surplus residual income
valuation model, reports no significant association between their ex ante expected returns
estimates and domestic betas for a sample of US stocks from the period 1979-1995.

There is some controversy about IBES forecasts. La Porta (1996) asserts that analysts’
growth forecasts tend to be too extreme, but Lee, Myers, and Swaminathan (1999) find
that IBES forecasts improve their intrinsic value estimates over forecasts based on a time
series model.

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CHAPTER 3
RESEARCH METHODOLOGY

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3.1 STATEMENT OF PROBLEM

The estimation of a firm’s cost of equity capital remains one of the most critical and
challenging issues faced by financial managers, analysts, and academicians. Although
theory provides several broad approaches, recent survey evidence reports that among
large firms and investors, the capital asset pricing model (CAPM) is by far the most
widely used model.

In this research project the question we ask is -

“Whether the domestic or the global version of the single – factor CAPM provides the
better fit with the dispersion of the ex ante expected return estimates for a sample of Nifty
stocks”.

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3.2 OBJECTIVES

¾ To test which model provides the better fit with the sample of ex ante expected
equity return estimates for Nifty stocks

¾ To analyze the risk premium differences for DCAPM and GCAPM.

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3.3 METHODOLOGY AND DATA

A. Ex Ante Expected return Estimation:

For each year from 2004 through 2006, we calculate an ex ante expected return estimate
for S&P CNX Nifty stock for which data is available. The firm is eliminated if the
standard deviation around the mean forecast exceeds 20%, or if there are not sufficient
historical returns for the prior 36 months to perform the beta estimations. The dividend
and other firm specific information is obtained by the various sources like Capitaline and
Prowees databases.
The ex ante expected rates of returns are estimated by using the constant dividend growth
model.
Ki = D1i /P0i + Gi
Where Ki is the ex ante expected rate of return (cost of Equity) estimate for the company
I, D1i is the dividend per share expected to be received at time 1, P0i is the current price
per share, and Gi the expected growth rate in dividends per share, which are calculated by
taking the EBIT growth rate for the 10 years.

This study is a joint ‘test’ of the underlying model and the empirical constructs used.
Therefore this cannot be concluded whether rejection is due to failure of the model or of
the empirical proxies.

Finally, using the widespread use of the CAPM, the conflicting empirical results on the
impact of using a domestic or global index warrants additional study using a variety of
approaches. Furthermore, additional empirical results on the constant growth model,
given its longstanding history and continued use, could be useful.

B. Global CAPM compared to Domestic CAPM:

To use either the global or the domestic CAPM to estimate a firm’s cost of equity, a time
varying approach is applied to estimate betas and market risk premia. The equity betas

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are estimated for a particular year with yearly excess returns (the stock return minus 91
days Treasury bill (T – bill) return) for three years prior to the year for which the cost of
equity is estimated. The equity betas for all companies are estimated by using an ordinary
least squares (OLS) of the excess returns on excess market index returns. The monthly
stock returns are obtained from January 2001 through December 2006 from
CAPITALINE database. T Bill returns are obtained from the website of Reserve Bank of
India. S&P CNX 500 index is used as the domestic Indian market index. The Dow Jones
Wilshire Global Total Market Index is used as global portfolio or index. The data for the
global index is obtained from the website of Dow Jones: www.djindexes.com/global.

The question in this research report is which of the two CA versions, if we assume that
version is the “correct” model, has less variation in its fit with the ex ante expected return
estimates for the individual firms. To implement this investigation, we ‘back out’ the
estimated market risk premia (domestic and global) for each month from the ex ante
expected returns of the individual stocks. To do so, for a given month, we first turn each
stocks ex ante expected return estimate into an ex ante risk premium estimate by
subtracting the yield on the 91 days T-bond. Then we aggregate the stocks ex ante risk
premia estimates with value weighting, producing an ex ante portfolio risk premium
estimate. For the domestic CAPM, we value-weight the firms domestic beta estimates
into a portfolio domestic beta estimate for the month. Since the portfolio risk premium
should be equal to the portfolio beta times the market risk premium, the domestic market
risk premium estimate for the month is found implicitly by dividing the portfolio risk
premium estimate by the portfolio domestic beta estimate. To ensure a fair comparison
between the domestic CAPM (DCAPM) and the global CAPM (GCAPM), we use an
analogous procedure (each year) to estimate the implicit global market risk premium
from the ex ante portfolio risk premium estimate and the portfolio’s global beta estimate.
In other words, we estimate the domestic market risk premium by assuming that the
domestic CAPM is valid for the average stock, and estimate the global market risk
premium by assuming that the global CAPM is valid for the average stock By design, this

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approach implies that the average difference between the model estimates and the ex ante
estimates is zero for both CAPM versions.

We then investigate how much variation exists for individual firms between the ex ante
risk premium estimates and the corresponding estimates of each of the two CAPM
versions. For each year from January 2004 until December 2006, we analyze each stock
as follows. We begin by using the stock’s domestic beta and the domestic market risk
premium estimates to find the firm’s risk premium estimate under the DCAPM, We also
estimate the stock’s risk premium under the GCAPM with the stock’s global beta and the
global market risk premium estimates. We then compare the ex ante risk premium
estimate for the stock with the risk premium estimates of both CAPM versions.

We use three metrics to assess which of the two CAPM versions has the better overall fit
with the ex ante estimates. First, we examine the average of the absolute differences
between the model estimates and the ex ante estimates. We decide that the model with the
lower overall average of absolute differences across all observations for the individual
firms is the better-fitting model for this metric. Second, we determine the percentage of
the ex ante estimates for which the DCAPM provides a closer fit than the GCAPM. In the
third metric, we compare the results of cross-sectional OLS of ex ante risk premium
estimates for the individual stocks against both the estimated domestic betas and the
estimated global betas. Whichever regression has the higher r-squared indicates the
better-fitting CAPM version with this approach. We also examine the regression results
for relative consistency with the theory: an intercept of zero and a positive slope.

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3.4 LIMITATIONS OF THE RESEARCH

1. Sample is restricted to S&P CNX Nifty index.

2. Data considered for six years only.
3. The models are tested on the basis of 3 years forecasted expected returns values
only.

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CHAPTER 4
DATA ANALYSIS

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4.1 RISK PREMIUM DIFFERENCES FOR DCAPM AND GCAPM

Table I summarizes the average absolute differences between the ex ante risk premium
estimates and the DCAPM and GCAPM estimates, and the percentage of instances in
which the ex ante estimates are closure to DCAPM estimate than to the GCAPM
estimate. For all the observations in the sample, over all years from 2004 through 2006,
the DCAPM’s estimated expected return differs in absolute terms from the corresponding
ex ante estimate by an average of 0.093. The GCAPM’s estimated expected return differs
in absolute terms from the corresponding ex ante estimate by an average of 0.176.

For every year, the average absolute difference between the DCAPM estimates and the ex
ante estimates is less than or equal to the average absolute difference between the
GCAPM estimates and the ex ante estimates. Based on the average absolute difference
criterion, it is found that the DCAPM has the better overall fit with the ex ante risk
premium estimates.

Table 1.Summary of Risk Premium Differences for DCAPM and GCAPM

%DCAPM
Year Ex Ante BiD RPD Ex- D BiG RPG Ex- G Closure

2004 0.310 0.956 0.109 0.201 0.832 0.108 0.202 0.433

2005 0.308 0.923 0.295 0.014 0.628 0.103 0.205 0.733

2006 0.287 0.917 0.222 0.065 1.076 0.166 0.122 0.900

The column s show, respectively the value weighted averages of the estimated ex ante
risk premia (Ex Ante), average domestic beta estimates (BiD), the average domestic
market risk premium estimates (RPD), the average absolute differences between the ex
ante estimates and those of the DCAPM (Ex- D), the average global beta estimates (BiG),
the average global market risk premium estimates (RPG), the average absolute differences

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between the ex ante estimates and those of the GCAPM (Ex- D), and the percentage of
cases in which the ex ante estimates is closure to the DCAPM estimate than to GCAPM
estimate (% DCAPM Closure).

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4.2 CROSS – SECTION REGRESSIONS ON SYSTEMATIC RISK

Table 2 reports the results of the cross – section regression of the firms’ ex ante risk
premium estimate on the beta estimates. Overall, the cross – section regressions provide
further evidence that consistently throughout the time period 2004 -2006, the ex ante
estimates have the better fit with those of DCAPM than with the GCAPM. Table 2 shows
that the R- squares of all the regressions are higher when we use the domestic beta as the
independent variable than with the global beta. More over, the DCAPM regression results
are consistently better aligned with the theory. The regression intercepts are closer to zero
for DCAPM than for the GCAPM, and their T-statistics on the slope coefficients are
more significant for the DCAPM than for the GCAPM. These observations apply to the
entire period, to all three years covered in the study.

The findings of significant, positive slope coefficients in each of the 3 years’ cross –
section regressions appear to strongly confirm the basic asset pricing theory prediction
that expected returns are positively related to beta risk. However, the positive regression
intercepts suggest the possible omission of risk factor(s) or systematic optimism in the
growth forecasts. Further exploration of this issue is beyond the scope of this study.

Table 2.Cross – Section Regressions

Versus Domestic Beta Versus Global Beta

Year Intercept Slope R - Sq Intercept Slope R - Sq

2004 0.201 0.114 0.053 0.383 0.088 0.038

2005 0.406 0.106 0.065 0.417 0.174 0.054

2006 0.355 0.074 0.088 0.428 0.131 0.061

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The table presents the results of cross – section regression of ex ante risk premium
estimates and systematic risk estimates for individual firms. This research used ordinary
least squares, with ex ante risk premium estimates as the dependent variable and firm
beta against indicated market portfolio as independent variable.

INTERPRETATION:
Together, Tables 1 and 2 lead us to conclude that using all three metrics (average
absolute differences, percentage of cases with the better fit, and cross- section regression
results), the domestic CAPM fits the dispersion of ex ante risk premium estimates better
than does the global CAPM. This finding is consistent with the Cooper and Kaplanis
(2000) model of partially segmented global capital markets and home bias.

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CHAPTER 5
CONCLUSION

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CONCLUSION

We compared ex ante expected return estimates, which are implicit in share prices,
growth rates, and the dividend growth model, with expected return estimates from the
global CAPM and the domestic CAPM. We use the Dow Jones Wilshire World global
index as the market benchmark for computing betas for the Global CAPM, and S&P
CNX 500 Index for computing betas for the domestic CAPM. Our sample comprises
S&P CNX NIFTY companies over the period 2004 – 2006.

We find that the domestic CAPM has a better fit with the dispersion of ex ante expected
return estimates, overall and for all samples the previous researches also emphasis on this
fact and in this study we also found that the DCAPM has the less risk premium
differences than compared to GCAPM for all the three years. And only in the case of
year 2004 the %DCAPM Closure value is less than 0.5 which shows that the DCAPM is
very much desirable while calculating the cost of capital.

When we did the cross section regression of the firms’ ex ante risk premium estimate on
the beta estimates, we found that the ex ante estimates have the better fit with those of
DCAPM than with the GCAPM with high R square values in the case of DCAPM
compared to the GCAPM. Regression intercepts are also closure to zero in the case of
DCAPM. This type of results are also found in the previous research works done by
several researchers in this area and most of them strongly emphasizing on the use of
DCAPM for calculating the firms cost of equity instead of GCAPM.

In this research we observe no trend in this fit over time. While the domestic model
provides a better fit of our data, the relatively small empirical difference between the
models suggests that for estimating the cost of equity, the choice between the domestic
and global CAPM may not be a material issues for many large firms.

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CHAPTER 6
BIBLIOGRAPHY

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6.1 BIBLIOGRAPHY

BOOKS
1. Basic Econometrics: By Damodar N. Gujrati
2. Investments: By Bodie, Kane, Marcus, Mohanty
3. Financial Management: By I M Pandey

WEBSITES
1. www.nseindia.com
2. www.yahoofinance.com

ECONOMETRICS SOFTWARE PACKAGES

1. Eviews
2. SPSS

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6.2 REFERENCES

¾ Robert S. Harris; Felicia C. Marston; Dev R. Mishra; Thomas J. O’Brien, “Ex

Ante Cost of Equity Estimates of S&P 500 firms: The choice between global and
domestic CAPM”, Financial Management, Vol. 32, No. 3. (Autumn, 2003), pp.
51-66.

¾ Black, F., 1993, “Estimating Expected Return,” Financial Analysts Journal 49,
September – October, 36-38.

¾ Campbell, J.Y., 1996, “Understanding Risk and Return,” Journal of Political

Economy 104, 298- 344.

¾ Griffin, J.M., 2002, “Are the Fama French Factors Global or Country Specific?”
Review of Financial Studies 15, 783-803.

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ANNEXURE
S&P CNX NIFTY STOCK BETAS FOR 2004 TO 2006

Company Year Domestic Beta Global Beta

ABB 2004 1.241 0.579
2005 0.863 0.253
2006 0.836 0.896
ACC 2004 1.195 0.894
2005 0.723 0.489
2006 0.689 0.534
BAJAJ 2004 0.317 0.726
2005 0.836 0.752
2006 0.708 0.608
BHEL 2004 1.043 0.928
2005 0.904 0.403
2006 0.795 0.929
BPCL 2004 0.722 0.867
2005 1.225 0.896
2006 1.042 1.741
CIPLA 2004 0.651 0.546
2005 0.737 0.573
2006 0.857 0.802
DABUR 2004 0.455 0.73
2005 0.874 0.714
2006 0.886 0.886
Dr. REDDY 2004 0.734 0.337
2005 0.793 0.596
2006 0.724 1.026
GLAXO 2004 1.497 0.593
2005 0.444 0.497
2006 0.44 1.073
GRASIM 2004 0.817 0.846
2005 0.825 0.397
2006 0.962 1.062
AMBUJA 2004 0.624 0.79
2005 0.72 0.399
2006 0.608 0.576
HDFC 2004 1.185 0.464
2005 0.787 0.666
2006 0.867 1.209
HERO HONDA 2004 1.128 0.739
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2005 0.865 1.149
2006 0.682 1.332
HINDLEVER 2004 0.996 0.239
2005 0.883 0.652
2006 0.889 1.453
ICICI BANK 2004 1.661 0.543
2005 0.93 0.282
2006 0.919 1.018
INFOSYS 2004 1.2498 1.278
2005 0.6014 0.539
2006 0.6648 0.284
IPCL 2004 1.2183 1.465
2005 1.1931 0.736
2006 1.0419 0.528
ITC 2004 0.3208 0.531
2005 0.6539 0.438
2006 0.673 0.933
LT 2004 1.0534 1.129
2005 0.7627 0.902
2006 0.7468 1.458
NATIONALUM 2004 0.7168 0.45
2005 1.2422 0.312
2006 1.3818 1.726
ONGC 2004 0.647 0.764
2005 0.9263 0.435
2006 1.0485 1.333
RANBAXY 2004 0.4493 0.047
2005 0.5517 0.243
2006 0.687 1.073
RELIANCE 2004 0.7292 0.914
2005 0.739 0.522
2006 0.8257 1.166
SAIL 2004 1.4955 1.068
2005 1.8489 0.48
2006 1.8547 1.384
SBI 2004 0.8168 0.774
2005 1.047 0.563
2006 1.0734 1.384
SUNPHARMA 2004 0.6335 0.735
2005 0.5456 0.663
2006 0.5065 0.809
TATA POWER 2004 1.1766 1.344
2005 1.4406 0.869
2006 1.4226 1.39
TATA STEEL 2004 1.224 1.043
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2005 1.2529 0.503
2006 1.3906 1.286
VSNL 2004 1.0129 1.694
2005 1.1836 1.522
2006 1.1944 2.075
ZEEL 2004 1.6689 1.902
2005 1.2869 1.382
2006 1.0907 0.317

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S&P CNX 5OO AND DOW JONES WILSHIRE GLOBAL MARKET

INDEX DATA FROM 2001 TO 2006

YEAR S&P 500 INDEX DJW global index

200612 3190.63 3772.78
200611 3212.33 3665.87
200610 3044.23 3558.01
200609 2879.70 3440.57
200608 2689.50 3390.41
200607 2479.00 3282.05
200606 2409.00 3265.50
200605 2831.38 3444.25
200604 2949.13 3434.54
200603 2787.80 3322.00
200602 2609.48 3274.19
200601 2521.30 3219.04
200512 2383.93 3125.61
200511 2214.55 3016.07
200510 2174.55 2948.61
200509 2218.38 2998.41
200508 2080.85 2942.79
200507 1970.05 2863.13
200506 1869.83 2819.15
200505 1762.48 2747.77
200504 1751.83 2746.20
200503 1810.15 2812.75
200502 1798.43 2800.13
200501 1742.55 2747.47
200412 1723.65 2751.51
200411 1578.43 2633.63
200410 1508.28 2521.41
200409 1429.20 2477.75
200408 1346.88 2399.69
200407 1285.68 2443.98
200406 1238.95 2476.08
200405 1317.38 2404.65
200404 1532.23 2491.00
200403 1453.43 2476.29
200402 1474.65 2487.37
200401 1542.75 2449.09
200312 1426.75 2337.55
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200311 1249.55 2233.49
200310 1189.30 2183.04
200309 1089.78 2124.24
200308 1020.00 2021.05
200307 913.05 1999.87
200306 853.25 1983.35
200305 755.30 1862.55
200304 716.13 1738.42
200303 734.40 1650.84
200302 754.28 1676.97
200301 763.08 1754.89
200212 756.90 1773.71
200211 717.20 1768.99
200210 692.88 1637.14
200209 717.75 1709.21
200208 719.93 1784.85
200207 746.68 1821.24
200206 772.58 1995.36
200205 762.45 2101.16
200204 782.95 2113.54
200203 788.60 2121.42
200202 766.53 2015.94
200201 718.23 2089.97
200112 712.35 2098.02
200111 674.33 2047.56
200110 599.13 1963.01
200109 615.30 1938.30
200108 695.75 2180.99
200107 706.35 2216.36
200106 743.83 2302.31
200105 775.75 2372.48
200104 712.60 2225.37
200103 850.60 2235.55
200102 966.73 2458.19
200101 950.95 2509.05

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CALCULATED COST OF EQUITIES

COMPANY YEAR Ke D Ke G Ke
ABB 2004 22.386 11.944 9.622
2005 22.263 27.991 7.731
2006 21.886 20.887 14.935
ACC 2004 40.006 11.781 11.134
2005 40.358 24.570 9.362
2006 40.033 18.505 11.671
BAJAJ 2004 22.292 8.660 10.328
2005 22.201 27.332 11.180
2006 21.801 18.813 12.338
BHEL 2004 25.019 11.241 11.298
2005 25.036 28.994 8.768
2006 24.878 20.223 15.233
BPCL 2004 9.041 10.100 11.005
2005 8.363 36.839 12.176
2006 6.104 24.225 22.555
CIPLA 2004 46.381 9.847 9.463
2005 35.268 24.912 9.943
2006 35.076 21.227 14.088
DABUR 2004 20.512 9.150 10.347
2005 22.150 28.260 10.918
2006 16.302 21.697 14.845
Dr. REDDY 2004 62.458 10.142 8.460
2005 63.055 26.281 10.102
2006 62.702 19.072 16.108
GLAXO 2004 42.637 12.854 9.689
2005 42.700 17.751 9.418
2006 41.182 14.471 16.531
GRASIM 2004 11.859 10.437 10.904
2005 11.869 27.063 8.726
2006 11.992 22.929 16.432
AMBUJA 2004 57.470 9.751 10.635
2005 40.497 24.496 8.740
2006 40.324 17.193 12.050
HDFC 2004 18.474 11.745 9.070
2005 18.650 26.134 10.586
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2006 18.002 21.389 17.758
HERO HONDA 2004 46.356 11.543 10.390
2005 45.651 28.040 13.925
2006 44.378 18.392 18.867
HINDLEVER 2004 17.237 11.074 7.989
2005 18.245 28.480 10.489
2006 17.941 21.746 19.958
ICICI BANK 2004 82.666 13.437 9.449
2005 82.160 29.629 7.931
2006 81.701 22.232 16.035
INFOSYS 2004 63.937 11.976 12.978
2005 66.780 21.598 9.708
2006 63.077 18.113 9.417
IPCL 2004 10.645 11.864 13.876
2005 12.021 36.059 11.070
2006 11.612 24.223 11.617
ITC 2004 47.178 8.673 9.391
2005 55.016 22.881 9.010
2006 20.756 18.246 15.269
LT 2004 17.596 11.278 12.263
2005 17.508 25.540 12.217
2006 14.020 19.442 20.003
NATIONALUM 2004 23.965 10.081 9.003
2005 23.975 37.259 8.139
2006 23.772 29.730 22.419
ONGC 2004 27.380 9.833 10.510
2005 30.669 29.539 8.989
2006 28.605 24.330 18.876
RANBAXY 2004 16.307 9.130 7.068
2005 16.236 20.383 7.662
2006 15.342 18.473 16.531
RELIANCE 2004 21.736 10.125 11.230
2005 21.892 24.961 9.591
2006 21.793 20.720 17.370
SAIL 2004 47.484 12.849 11.970
2005 53.107 52.088 9.300
2006 51.201 37.392 19.336
SBI 2004 13.681 10.437 10.558
2005 14.173 32.489 9.874
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2006 13.628 24.733 19.336
SUNPHARMA 2004 31.131 9.785 10.371
2005 29.762 20.234 10.565
2006 29.801 15.549 14.151
TATA POWER 2004 13.317 11.716 13.295
2005 13.528 42.109 11.989
2006 13.358 30.391 19.390
TATA STEEL 2004 33.257 11.884 11.850
2005 33.421 37.521 9.459
2006 33.311 29.873 18.452
VSNL 2004 14.534 11.134 14.975
2005 14.579 35.827 16.503
2006 13.055 26.694 25.566
ZEEL 2004 24.142 13.465 15.974
2005 23.967 38.352 15.536
2006 24.159 25.014 9.714

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M P BIRLA INSTITUTE OF MANAGEMENT, BANGALORE