Monte Carlo Simulation Use Case in Valuation

Assumtions in DCF Model:

  1. Risk Free Rate of 91 days Tbill taken as 6%
  2. Market Risk Premium 6%
  3. Beta calculated from regression model = 1.2
  4. Tax Rate = 30%
  5. Terminal Growth Rate of Industry = 6%

Problem with the Assumptions:

Risk free free

  1. Subject to change by monteory policy.
  2. We are not sure about the direction of change but we are certain basis previous montetoy policies that maximum rate change is 25bps.
  3. Better Assumtpion: If current risk free rate of 91 days T Bill is 7% then new rate will be in range 6.75% to 7.25%

Market Risk Premium

  1. Indian Markets are volatile and every industry has different risk premiums
  2. Statisca US Market Risk Premium publication shows that lower range of 5.3% and higher range of 5,7% prevails in the US
  3. Using Coefficient of Variation of we can derive India Market risk premium using USA Market risk premium
  4. Better Assumption: Inida Market Risk Premium = USA Market Risk Premium * Coeff of Variation

Beta:

  1. Which granularity of data – Daily/Weekly/Monthly stock data with the Index. Every day prices will change which will impact the regression beta
  2. Better Assumtption: We can take 95% confidence range from regression results rather than using a point estimate for the beta

Tax Rate:

  1. Companies Tax structure is complex and we cannot assume a flat rate of 30%
  2. Better Assumption: Tax Rate lower limit 26% and higher limit 30%

Terminal Growth Rate

  1. We can use industry growth rate as guide for terminal growth rate but company specific growth will be different depending on the buisness life cycle
  2. Better Assumption: Mean Growth Rate 7% with standard deviation of 1%

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