25-09-2012, 11:23 AM
Estimation of cost of equity for private airport operators in India
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Objective
This study is performed in order to estimate the cost of equity for Airport operators in India. Aviation sector in India has been transformed from an over regulated and under managed sector to a more open, liberal and investment friendly sector since 2004. Forecasts by AAI have projected a sustainable growth rate of 16% for international and 20% for domestic aviation sector. With the rise in the number of airlines, growing passenger segment and route expansion, the need for Indian airports to have their infrastructure in place has become key.
The Government has acknowledged the infrastructure deficiency and has wisely sought private sectorparticipation to facilitate infrastructure improvements (modernization of Delhi and Mumbai airports, commissioning of green field projects at Hyderabad and Bengaluru, modernization of 35 non metro airports). The estimated investments at Delhi airportare in the order of Rs. 7,531 crores; while that atMumbai airport is estimated to be in the region ofRs. 11,553crores. Greenfield airport projects havealso been proposed at Goa, Navi Mumbai, Pune,Greater Noida and Kannur. The objective is to developfacilities conforming to international standards and tryto encourage the domestic operators to shift base,so as to decongest the major airports.
With the entering of private sector operators like GMR and GVK groups, it has become increasingly important to estimate the cost of equity for private operators in airport sector. Given the plans of Airport Authority of India, to either modernize or built airports in various locations across India, requires huge investments by both government and private players. Operations of private players in this sector are a relatively new business area in India and given the huge sunk costs involved, the risk is higher. The right estimation of cost of equity is an essential parameter in order to estimate the project viability and also to attract the new investors. Given the huge amounts of funds required, it is more important to finance required funds through open market participation. All these things increase the importance of cost of equity estimation more appropriately.In this study estimation of cost of equity is performed using CAPM and the required parameters are derived based on the publically available data. However firms that are already in airport sector can significantly improve the input data, as they have access to the firsthand information. More importance is given to the market associated risk parameters, as the study is meant for estimation of cost for raising funds from open market. Hence usage of CAPM is justified as it better estimates the market associated risk parameters compared to other models.
Build-Up Method:
The build-up method is similar to the risk premium approach. It is usually appliedto closely held companies where betas are not readily obtainable. One popularrepresentation is:
Required return = RF + equity risk premium + size premium + specific-companypremium
The size premium would be scaled up or down based on the size of the company.Smaller companies would have a larger premium. As before, computing the required return would be a matter of simply adding up thevalues in the formula. Some representations use an estimated beta to scale the size of thecompany-specific equity risk premium but typically not for the other factors.The formula could have a factor for the level of controlling versus minority interests anda factor for marketability of the equity; however, these latter two factors are usually used to adjust the value of the company directly rather than through therequired return.
The CAPM offers the basic conceptual framework for understanding the determinants of the cost of equity. It is also parsimonious in its data requirements, involving few explanatory variables and parameters, each with a clear economic interpretation. In addition, the CAPM has been widely adopted by regulators, including SEBI and AERA. Taking these factors into account it is appropriate to choose CAPM for estimation of the cost of equity for private airport operators.
Estimation of required parameters
As discussed, CAPM method has been used for determination of Rate of Return on Equity. Factors considered in CAPM model are Risk Free Rate, Equity Risk Premium and Beta. Calculation of these factors is discussed below,
A) Beta:
Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
In order to estimate the beta for private airport operators in India, appropriate sample of private listed airport operators is required. Since we did not have listed private operators in India, a sample of 22 airport operators was taken based on data availability.
The beta values are taken from Reuters.com and they are calculated based on trailing 5-year prices, on a monthly basis. The beta value in a future period has been found to be on average closer to the mean value, the beta of an average-systematic-risk security, than to the value of the raw beta. Because valuation is forward looking, it is logical to adjust the raw beta so it more accurately predicts a future beta. The most commonly used adjustment was introduced by Blume. Hence theseraw beta values are adjusted for mean reversion also called beta drift as per Blume’s method. Beta drift refers to the observed tendency of an estimated beta to revert to industry's mean value over time. To account for beta drift, Blume suggested the below mentioned conversion formula.
Estimating Equity Risk Premium:
The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. However in emerging markets, where historical data tends to be limited and noisy, it is not appropriate to use this approach. Instead equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium
Conclusion
The estimated cost of equity for Delhi International Airport and Mumbai International Airport are 18.18% and 21.23% respectively. However these estimates are more sensitive to beta estimate and the future changes in debt to equity ratio. There is great possibility for infrastructure firms to increase their financial leverage in future and that may increase the required return on equity significantly. The beta value estimated based on airport operators in emerging markets may still need upward revision, given the recent policy paralysis in India and also the poor economic outlook for future.
The estimation is done based on Capital Asset Pricing Model (CAPM), that has significant limitations when it comes to the scope of risk parameters considered. CAPM is a market based approach and it does not account for firm specific risk. The possible natural monopoly in airports operating industry and recently introduced user development charges can effectively reduce the firm specific risk to greater extent.