India Power Sector Cost of Equity

India attracted USD43 billion in Foreign Direct Investment (FDI) for the period April 2016 to March 2017, according to government statistics (Read more here).     The power sector in India received USD1.15 billion FDI inflows for the same period, accounting for 3% of total FDI inflows in India.

Strong power consumption demand in India and favourable government policy such as allowing 100% FDI under the automatic route in the power segment and renewable energy has attracted global power companies to invest in India (Read more here).  For example, Malaysia’s largest power utility company, Tenaga National Berhad (TNB), acquired 30% of GMR Energy Limited (GEL) power asset for USD300 million in 2016 (Read more here).

For investors who are interested to include India power sector into their portfolio, one of the key questions is the cost of equity, k_e.  The most common methods of estimating the k_e is the capital asset pricing model (CAPM).  The CAPM states that the k_e, is the sum of risk-free rate, R_f, and a premium for bearing market risk, β(R_m – R_f):

                                                            k_e            = R_f + β(R_m – R_f)

where

β             = return sensitivity of stock/ portfolio to changes in the market return

R_m          = expected return on the market

Assuming an investor would like to hold a portfolio of equally weighted top ten largest power generation companies in India (Read more here), the β of the portfolio could be estimated by taking the average β of these ten stocks.  The duration and frequency of the data selection will affect the value of β.  Generally, three years duration of monthly data are common choice.  Using the information from Infinancials (Read more here), the estimated portfolio β is 0.98.

The R_f and R_m information could be obtained freely from financial data providers such as Market Risk Premia (Read more here).  As at April 2017, the R_f and R_m are 6.96% and 8.90% respectively according to Market Risk Premia.

The estimated cost of equity using the above information is 8.86%.  Keep in mind that this number is calculated from local Indian investors perspective, and the investors are able to diversify their portfolio risk.  Foreign investors should add other additional risks premium such as country risk premium, or liquidity risk if investing in non-listed companies.

For more information about India power sector, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my