A Project Report

On

Computation of Hurdle rate for Idea Cellular and Bharti Airtel

BY
SHIVANI AGARWAL: 2013B3A3724H

Under the supervision of

Prof. Niranjan Swain

BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE PILANI (RAJASTHAN)

HYDERABAD CAMPUS
(NOVEMBER 2016)

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 Index

S. No. TOPICS Page

no.

1 Rationale for choosing Telecommunication sector for analysis: 3

2 Regression and Fundamental Betas 4-7

3 Risk premium 8-10

4 Weighted Average Cost of Capital (WACC) 11-18

5 Conclusion 18

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Rationale for choosing Telecommunication sector for analysis:

In today’s information age, the telecommunication industry has a vital role to play. India is currently the
world’s second-largest telecommunications market and has registered strong growth in the past decade and
half.

Globalisation has made telecommunication an integral part of the infrastructure of the Indian economy.
According to the TRAI, the total gross revenue of the Indian telecom services industry was Rs 1,524 billion
in FY09 up from Rs 1,291 billion in FY08 registering a growth of 18.03% over FY08 .Telecom has emerged
as a key infrastructure for economic and consumer growth because of its multiplier effect and the fact that it
is beneficial to trade in other industries.

The liberal and reformist policies of the Government of India have been instrumental along with strong
consumer demand in the rapid growth in the Indian telecom sector. The government has enabled easy market
access to telecom equipment and a fair and proactive regulatory framework that has ensured availability of
telecom services to consumer at affordable prices. Also, the government has taken certain policy initiatives,
which include the creation of the Universal Service Obligation Fund, for improving rural telephony. These
measures are expected to improve the rural tele-density and bridge the rural-urban gap in tele-density.

The Indian telecom industry has been an attractive avenue for foreign investors over the years. As per DIPP
figures, the cumulative FDI inflow during August 1991 to June 2009 period, in the telecommunication sector
amounted to US$ 113 bn.

The Indian telecom industry is characterised with intense competition, and continuous price wars. Currently,
there are around a dozen telecom service providers who operate in the wired and wireless segment. The Indian
telecom industry has immense growth potential as the tele density in the country is just 36 as compared with
60 in the US, 102 in the UK and 58 in Canada. In the next few years, the industry is poised to grow further, in
fact, it has already entered a consolidation phase as foreign players are struggling to acquire a pie in this
dynamic industry.

Hence, it makes sense to analyse the growth and return of the leaders in the telecommunication sector i.e. Idea
Cellular and Bharti Airtel in our assignments.

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Objective 1: To obtain a risk measure of our companies

Regression Beta

Monthly stock prices for a period of five years from January 2010 to July 2016 was taken for Idea Cellular
and Bharti Airtel in the telecom sector and returns were calculated. The data collected has been adjusted for
dividends.

𝑅𝑒𝑡𝑢𝑟𝑛𝑠 𝑖𝑛 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐸𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 − 𝑆𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 / 𝑆𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

To obtain beta, a measure of risk, we need to regress the company stock returns with market returns. Under
the assumptions of the Capital Asset Pricing Model, the market portfolio is the most diversified portfolio.
Hence we choose S&P BSE-500 Index, an index with 500 stocks, which represent nearly 93% of the total
market capitalization at Bombay Stock Exchange, and also covers all the major industries of the economy.

The following is the screenshot of regression of Idea and Airtel stock returns against BSE Index returns.

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The results from the regression are tabulated below:

S&P BSE 500 IDEA AIRTEL

Beta .126 ..254

R2 .0736 .218

Y intercept .005 .006

Standard error .0513 .0552

Idea cellular

 The regression beta, or the historical estimate for beta, during this period, for IDEA CELLULAR is
0.126 with respect to BSE Index. A low beta suggests low volatility w.r.t. the whole market.
 Standard error for the estimates is 0.0513 which is very low.
 The parameter R square gives us information about where the risk is coming from. We see that the
value of R square is 0.0736, which means that only 7.36% risk that IDEA CELLULAR has, comes
from BSE market, and the rest of the risk is company specific.

Airtel

 The regression beta, or the historical estimate for beta, during this period, for AIRTEL is 0.254 with
respect to BSE Index A low beta suggests low volatility w.r.t. the whole market.
 Standard errors for the estimates is 0.0552 which is very low.
 We see that the value of R square is 0.218, which means that only 21.8% risk that Airtel has, comes
from BSE market, and the rest of the risk is company specific.

Fundamental Beta
Regression beta is the standard approach for obtaining a risk measure for a firm. But it is backward looking
as it depends on past data. Also, it does not takes into accounts the fundamentals of a company like its Debt
to equity ratio, change in the business mix etc. , which makes it just a statistical number.

Thus, we calculate a bottom-up beta which is estimated by starting with the businesses that a firm is in,
estimating the fundamental risk or beta of each of these businesses and taking a weighted average of these
risks.

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In order to calculate to calculate the bottom-up beta we followed these steps:

Step 1: We divide the company’s revenues into different businesses. Each business is a specific industry. Here
we have divided Bharti Airtel into 3 industries namely- Telecom (Wireless), Telecom. Services and Telecom.
Equipment.

Step 2: Then we calculate the betas of all the companies in each industry as defined above and calculate their
respective average betas.

Limitation: All of these industries have many firms, and in order to calculate the betas for each firm we lack
availability of data, also it would have been a tedious and time taking task to calculate betas; so we used
Aswath Damodaran’s data bank which gives the betas for specific industries.

Step 3: We take the median D/E ratio of the each industry.

Limitation: The balance sheets of all the firms were not available(or were lacking important data), so we took
Aswath Damodaran’s data bank which gives a median or industry D/E ratio and also gives the industry level
of cash in the firm.

Step 4: We unlever the average betas calculated in Step-2. We also correct the unlevered beta for cash and
cash equivalents.

Step 5: We dug into the annual report of Bharti Airtel and found out all the businesses they do and their
respective percentage of revenue generation. Then again from Aswath Damodaran’s data set we dug out the
industry average-EV/sales ratio.

Step 6: We multiply the Revenues and EV/sales to get an estimated value. This gives us the weights for each
industry. We then take the weighted average of the pure play beta (which is unlevered beta corrected for cash).
But this gives us the unlevered beta for operating business.

Step 7: In order to calculate unlevered beta for firm, we include the weight of cash-and-cash-equivalents
(which has β=0).

Step 8: We then compute the D/E ratio of the firm. We took a tax rate of 36.1%. From these we get the levered
beta for firm which is our required bottom-up beta.

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Bottom up beta calculations for Airtel and Idea respectively are shown below:

Airtel

Idea

The betas for Idea and Airtel are 1.108 and 0.967 reapectively, which will be used for further calculations.

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Objective 2: To calculate Risk premium for our companies
The risk premium is the premium that investors demand for investing in an average risk investment, relative
to the risk-free rate such as government treasury bonds.

As a general proposition, this premium should be greater than zero, increase with the risk aversion of the
investors in that market increase with the riskiness of the “average” risk investment.

While estimating Risk Premium in practice, we could have surveyed investors on their desired risk-reward
and then used the average premium as ERP. The use of this method is limited as usually the expectations of
people are unreasonable and surveys often reflect the investor’s hopes rather than expectations. Or another
method is to use historical data i.e. by observing stock market and government bond performance over a
defined period of time, for example from 1950 to the present but this quantity is backward looking in the sense
that it assumes that investor’s risk aversion has remained constant across time.

Due to the above limitations we have chosen to employ Implied Equity Risk Premium(IERP) which is a
forward looking approach to calculate ERP. As an alternative to historical data, we can use a basic discounted
cash flow model and current stock index levels to estimate the future risk premium implied by current stock
prices.

To estimate the implied expected return on stocks we have discounted future cash flows at this rate and equated
it with the nifty 50 index price.

The following formulae has been used to calculate IERP:

CF CF(1 + g) CF(1 + g)2 CF(1 + g)3 CF(1 + g)4 CF(1 + g)5 1
S= + + + + + ∗
1+r (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 r−g (1 + r)5

*(r-g) factor is used in the 6th term to imply that the cash flows cannot grow indefinitely and therefore it is
reasonable to assume that it eventually pans out to the economy’s growth rate after about 5 years.

Where,
S = stock index price of Nifty- 50 on 28/04/15.
CF = Cash flow estimated by using dividends issued by the companies in year 2015-16(Dividends declared
on 28/04/2015).
g = GDP growth rate of the year 2015-16 assuming growth rate of company’s earnings is equal to growth
rate of Indian economy.
r = implied expected return on stocks which is to be calculated.

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Now,

IERP = r − Rf

Where, Rf is the risk-free rate of return which is usually calculated using Indian government bonds, since
they have a negligible chance of default. Here, we have used 10 year T bond rate.

Calculations:

Idea:

r= x = 0.0789 and hence, IERP= 0.88

Airtel:

r= x = .0957 and hence, IERP= 2.56

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Thus, the implied equity risk premium for Idea and Airtel are 0.88 and 2.56 respectively, which will be used
for further calculations.

Limitations:
1. Cash flows are to be computed by using Dividends and Buybacks both but due to the unavailability of
data for buyback shares, only dividend data has been used.
2. Indian economy’s growth rate and dividends’ growth rate are assumed to be the same.

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Objective 3: To calculate Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all
its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.

Step 1: Finding Cost of Equity

Cost of Equity is found by two methods by inserting riskless rate, Implied ERP and Betas (Fundamental &
Regression) into CAPM model which gave two values of cost of equity. Riskless rate was 7.02%

Step 2: Market Value of Equity

Market Value was calculated by multiplying number of outstanding shares by average share price of
company stock

Step 3: Market value of Debt

Book value of debt was converted to market value of debt by using formula in excel sheet.

Step 4: Cost of Debt

This was found by adding riskless rate to default spread of company bond. Now, there were two methods to
estimate the Default spread.

a) Using Moody’s credit rating

b) Using Synthetic Rating

Moody’s Rating for Airtel was Baa3 and for Idea was BBB- and accordingly default spread was found out
referring to Aswath Damodaran’s databank.

For Synthetic rating, Market Capitalization of 9 companies was found and accordingly their Interest
Coverage Ratio was calculated. Based on this calculation a scale was prepared to accommodate credit
ratings as per Aswath Damodaran’s databank. Default Spread was calculated using these ratings and added
to riskless rate to find out Cost of Debt.

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SYNTHETIC RATING

Company Market Type EBIT from Interest Lease Interest Rating Default
Cap Operations Expense Rental Coverage Spread
Ratio

Reliance 11,523.98 Large 2,107.00 2,033.00 0 1.036 CCC 9%

Communication

Bharti Airtel 125,538.35 Large 36,703.50 8,701.80 0 4.218 A- 1.75%

Idea Cellular 28,538.17 Large 11,824.26 1,797.96 0 6.576 AA 1.00%

Tata 16,116.75 Large 1,170.85 20.45 0 57.254 AAA 0.75%

Communication

ADC India 130.55 Small 3.42 0.02 0 171.000 AAA 0.75%

MTNL 1,247.40 Small -736.84 1,296.71 0 -0.568 C- 18%

AGC Networks 228.59 Small -15.87 24.1 0 -0.659 C- 18%

ITI Limited 1,300.80 Small -172.36 157.15 0 -1.097 D 20.00%

Tata Teleservices 1,102.58 Small 790.04 755.04 0 1.046 CCC 9%

**Limitation: Lease rental is assumed to be zero.

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INTEREST COVERAGE RATIO

From To Bond Rating Spread

-10000 -1 D 20.00%

-0.9 -0.1 C- 18%

0.1 0.5 C 16%

0.5 1 CC 12%

1 1.5 CCC 9%

1.5 2 B- 7.50%

2 2.5 B 6.50%

2.5 3 BB 4.25%

3.5 4 BBB 2.25%

4 5 A- 1.75%

5 6 A 1.25%

6 7 AA 1.00%

7 10000 AAA 0.75%

Step 5: Calculating Weighted Average Cost of Capital

WACC is given by

𝑀𝑉𝑒𝑞𝑢𝑖𝑡𝑦 𝑀𝑉𝑑𝑒𝑏𝑡
Cost of Capital =Cost of Equity 𝑀𝑉𝑒𝑞𝑢𝑡𝑖𝑦+𝑀𝑉𝑑𝑒𝑏𝑡 + Cost of Debt 𝑀𝑉𝑒𝑞𝑢𝑡𝑖𝑦+𝑀𝑉𝑑𝑒𝑏𝑡

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The following tables shows the values for calculation of WACC using Moody’s rating and synthetic rating
respectively, for both the companies.

Airtel-Moody:

EQUITY DEBT

No. of Shares 3,997,400,000.00 Total Debt 95,498.30

Average Market Price 340.5626582 Maturity 4

Market Value Equity (in Crores) 136136.517 Interest 8,701.80

Weight of Equity 0.592805246 Riskless Rate 7.02%

Riskless Rate 7.02 Default Spread Moody 2.75%

Fundamental Beta 0.96757 Tax Rate 0.361

IERP 2.56 Pre-tax Cost of Debt 9.77%

Cost of Equity (Fundamental) 9.4969792 Post-tax Cost of Debt 6.24%

Regression Beta 0.254 Market Value of Debt 93511.4455

Cost of Equity (Regression) 7.67024 Total Capital Market Value 229647.962

Weight of Debt 0.40719475

Cost of Debt 6.24

Cost of Capital (Fundamental) 8.17075436

Cost of Capital (Regression) 7.08785378

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Idea-Moody:

EQUITY DEBT

No. of Shares 3,600,509,000.00 Total Debt 37,803.89

Average Market Price 114.156962 Maturity 4

Market Value Equity (in Crores) 41102.31692 Interest 1,797.96

Weight of Equity 0.559856208 Riskless Rate 7.02%

Riskless Rate 7.02 Default Spread Moody 2.25%

Regression Beta 0.126 Tax Rate 0.361

IERP 0.88 Pre-tax Cost of Debt 9.27%

Cost of Equity(Regression) 7.13088 Post-tax Cost of Debt 5.92%

Cost of Equity (Fundmental) 7.906778 Market Value of Debt 32313.53

Total Capital Market Value 73415.846

Weight of Debt 0.440144

Cost of Debt 5.92

Cost of Capital (Regression) 6.597919

Cost of capital(Fundamental) 7.03231

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Airtel-Synthetic:

EQUITY DEBT

No. of Shares 3997400000 Total Debt 95,498.30

Average Market Price 340.562658 Maturity 4

Market Value Equity (in Crores) 136136.517 Interest 8,701.80

Weight of Equity 0.58499512 Riskless Rate 7.02%

Riskless Rate 7.02 Default Spread Moody 1.75%

Fundamental Beta 0.96757 Tax Rate 0.361

IERP 2.56 Pre-tax Cost of Debt 8.77%

Cost of Equity(Regression) 7.67024 Post-tax Cost of Debt 5.60%

Cost of Equity(Fundamental) 9.4969792 Market Value of Debt 96577.42

Total Capital Market Value 232713.9

Weight of Debt 0.415005

Cost of Debt 5.6

Cost of Capital(Regression) 6.81108

Cost of capital(Fundamental) 7.879714

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Idea-Synthetic:

EQUITY DEBT

No. of Shares 3600509000 Total Debt 37,803.89

Average Market Price 114.156962 Maturity 4

Market Value Equity (in Crores) 41102.3169 Interest 1,797.96

Weight of Equity 0.54929826 Riskless Rate 7.02%

Cost of Equity (Regression) 7.13088 Default Spread Moody 1.00%

Cost of Equity (Fundamental) 7.90677874 Tax Rate 0.361

Pre-tax Cost of Debt 8.02%

Post-tax Cost of Debt 5.12%

Market Value of Debt 33724.64

Total Capital Market Value 74826.96

Weight of Debt 0.450702

Cost of Capital(Regression) 6.224573

Cost of capital(Fundamental) 6.650773

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The final values of WAAC and hence the hurdle rate are as follows:

Cost of Capital (Fundamental)

Airtel 8.170754

Idea 7.032

Conclusion:

 For both Airtel and Idea Cellular, we prefer to choose Cost of capital as calculated using
fundamental Beta as it is higher and could be justified as we are following a conservative approach
by taking higher risk and simultaneously keeping in mind the business risk of Airtel that is arising
due to operating revenues coming from different sectors. Similar case is with Idea.
 Also if we compare the cost of debt as calculated by Moody’s Rating or through Synthetic rating.
The Moody’s rating yields a higher cost of debt as it incorporates more risk by including a huge
number of companies while assessing the credit ratings. But in our synthetic scale, the ratings are
done among the 9 companies present in a sector which makes the sample space small and thus
reducing the cost of debt (low risk).
 Regression Beta for Airtel (0.254) and Idea (0.126) may seem very low as the frequency for which
the data is considered is monthly which reduces the riskiness of stock and beta calculations are
dependent on time interval also.
 Comparing the Cost of Capital of Airtel Vs Idea Cellular, we can see that Bharti Airtel has higher
cost of capital than Idea cellular which means that investors who are going to invest in a mixed
portfolio of Debt and Equity for Airtel will be expecting more return as it has got more market
capitalization and debt as compared to idea which increases the investment risk.

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