Investment Analysis as the Chief

Investment Analysis

As the Chief Investment Officer you are concerned that the values applied to estimate the discount rate have not been updated for several years. As AusGrocers is not a publicly listed company you need to find a proxy company that reflects the profile of your firm. You need to identify a suitable proxy and collect the required data to empirically estimate a proxy beta that can be applied to AusGrocers taking care to adjust for changes in leverage. You then use the beta to estimate an appropriate discount rate for AusGrocers. You will also need to collect data to estimate the risk free rate and the expected equity risk premium. You write a report to the board outlining your analysis of the choice of Machine using the proxy discount rate. In your report you must fully discuss and justify the data you acquired, the time period and data interval used and the estimation procedure you applied.

Determining a proxy company for AusGrocers is limited by the lack of suitable organizations within that industry that share similar financial characteristics. Coles Group would potentially represent one of the closest competitors in terms of its position in the industry however there exist many limitations in this selection. For instance, in November of 2007 Coles Group was purchased by Wesfarmers and now represents a larger conglomeration of public operations. Since Wesfarmers has substantially more leverage than AusGrocers it is reasonable to suspect that it requires a larger discount rate than smaller competitors. However, the financial data for Wesfarmers is readily available and thus serves as accessible comparison. The financial data used in the calculations are derived from the following summary (Reuters, 2010):

Source: Reuters Financial

The next step in acquiring data is to determine the risk free rate. Data was acquired from the Reserve Bank of Australia in their statistical section downloads (The Reserve Bank of Australia, 2010). The best data set that was available that would most accurately represent the risk free rate was the 180 day bank accepted bill (BAB) rate. Sixty months of data was used in determining the risk free rate resulting in a risk free rate of 5.68%.

Bank accepted bills

required rate of return must also be estimated to determine the discount rate that the company should use in its equity calculations. Since the Routers data gives us the industry average of eight point ninety one percent, this can be used as a baseline. Since the organization aspires to outperform the industry average then it is reasonable to set the expected return at ten percent. Hence, having the expected return the discount rate can be calculated:

10% = 5.68% + .93(Rd -- 5.68%)

Rd = 10.33%

Therefore, as CIO to AusGrocers it is recommended that the discount rate be updated to 10.33% to be utilized in any financial calculations in the future. This rate has been compiled using data from the Reserve Bank of Australia and financial information Wesfarmers over a five-year period. Furthermore, the rate of expected return has been estimated as slightly outperforming the industry average. Also, it is necessary to restate two important limitations that affect this manner of calculating the discount rate. First, the Wesfarmers group has more leverage and a larger portfolio than AusGrocers and hence the beta assumption used for this analysis may not correctly represent the organization. Secondly, the risk free rate was calculated by using bank accepted bill rate as opposed to a ten-year government bond. Therefore the risk free rate is most likely slightly higher than would be if a ten-year treasury bond was used to determine the risk free rate.

Part 4:

You are having second thoughts about your choice of a proxy company and are concerned that a wrong choice may impact on the investment decision. To alleviate your fears (and those of the board) you run a sensitivity analysis to see how changes in the beta estimate affect your investment choice. You include this analysis in your report to the board and discuss the implications of you analysis.

Since the calculations used in the previous section were based off of a historical figure of beta that represents more of a conglomeration than just a grocer it is necessary to consider what would happen if the beta was incorrect. Since both organizations are at least remotely similar in their scope of operations a deviation of twenty percent error in should be sufficient to determine the sensitivity of the beta to such a miscalculation. Therefore an analysis can be conducted using betas of .74 (.93 * 80%) and also .84 (.93 * 90%). Since the beta is remarkably close to 1, it is unreasonable to suspect that the beta value was underestimated and hence the analysis should consider an overestimation by both ten and twenty percent.

Holding the variables used in the previous calculation constant (cet. par.) and changing the beta to .74 would result in a discount rate of roughly eleven and a half percent (11.52%). This would result in the discount rate being a full percentage point higher than previously estimated. If the beta value was only off by ten percent, then the discount rate would be roughly half a percentage point (10.82%). Since the Wesfarmers holdings are reasonably more diversified than the AusGrocer's holdings, it's reasonable to suspect that the AusGrocer beta would not be as high as Wesfarmers but, at the same time, it is doubtful that the beta would be a full twenty percent lower. Therefore it is recommended to the board that a beta of .81 be used (.93 * 85%) for future calculations.