While Weeramantry has been researching Microsoft, his colleague Delacour has been investigating the required return on Larsen & Toubro Ltd. shares (BSE: 500510, NSE:

LT).36 Larsen & Toubro Ltd. is the largest India-based engineering and construction company. Calling up the beta function for LT on her Bloomberg terminal on 31 July 2013, Delacour sees the screen shown in Exhibit 3.

Delacour notes that Bloomberg has chosen the Sensex as the equity index for estimating beta. Delacour changes the Bloomberg default for time period/frequency to the specification shown in the exhibit for consistency with her other estimation work; in doing so, she notes approvingly that the beta estimate is approximately the same at both horizons.
Raw beta, 1.537, is the slope of the regression line running through the scatterplot of 60 points denoting the return on LT (y-axis) for different returns on the Sensex (x-axis); a bar graph of the distribution of returns in local currency terms is superimposed over the x-axis.
Noting from R2 that beta explains more than 73 percent of variation in LT returns—an exceptionally good fit—Delacour also decides to use the CAPM to estimate LT stock’s required return.37 Delacour has decided to use her own adjusted historical estimate of 4.0 percent for the Indian equity risk premium and the 10-year Indian government bond yield of 8.7 percent as the risk-free rate.38 Delacour notes that an 8.7 percent yield is shown on the Bloomberg cost of capital screen for LT (as the “bond rate”)
and that the same screen shows an estimate of the Indian equity risk premium (“country premium”) of 3.3 percent—close to her own estimate of 4.0 percent.

Based only on the information given, address the following:

i. Demonstrate the calculation of adjusted beta using the Blume method.

ii. Estimate the required return on LT using the CAPM with an adjusted beta.

iii. Explain one fact from the Bloomberg screen as evidence that beta has been estimated with accuracy.

Transcribed Image Text:

EXHIBIT 3 A Bloomberg Screen for Beta Larsen & Toubro Ltd. GRAB Number of points may be insufficient for an accurate beta. Relative Index SENSEX Index LT IN Equity Data Last Price Linear Beta Range 07/31/2008 Non-Parametric 07/31/2013 Period Honthly Historical Beta Local CUR Lag Y LARSEN & TOUBRO LTD X=S&P BSE SENSEX INDEX Item Value Raw BETA 1.537 Adjusted BETA 1.358 ALPHA(Intercept) -0.404 R^2(Correlation 2) 0.736 R(Correlation) 0.858 Std Dev of Error 6.997 Std Error of ALPHA 0.908 Std Error of BETA 0.121 t-Test 12.730 Significance 0.000 Last T-Value -1.267 Last P-Value Number of Points 0.105 60 ggggattyy Last Observation Australia 61 2 9222 6600 Brazil 5511 3048 4500 Europe 44 20 7330 7500 Germany 49 69 9204 1210 Hong Kong 052 2977 6000 Japan 81 3 3201 8900 Singapore 65 6212 1000 U.S. 1 212 318 2000 Copyright 2013 Bloomberg Finance L.P. SN 236442 H259-5551-0 05-Aug-13 15:47-12 EDT GMT-4:00