Investors required rate of return

Investors required return of return can be associated with the price for taking a given risk, i.e. the minimum return investors require to accept that the future cash flow will deviate from what was initially expected (Brealey et al., 2008). When estimating the investors required rate of return, 𝑟_h, the Capital Assets Pricing Model (CAPM) is used (Petersen et al., 2017) with the formula shown below:

𝑟_h= 𝑟_l+ 𝛽_h∗ (𝑟_A− 𝑟_l)

Risk-free rate

The risk-free rate corresponds in theory to the rate investors achieve when investing risk-free.

There are different views and calculations of the risk-free rate among investors and financial analysts. According to a report conducted by PWC (2019), the majority use a 10 years government bond while others use a 3% normalized risk-free rate. When applying government bonds, it is beneficial to use a longer majority, since short-term bond rates tend to miscalculate the alternative cost of investing in long-term projects (Koller et al, 2015). Since both NewCo and RemainCo will be listed at OSE and have their main operations in Norway, the Norwegian government bond is

applied. As mentioned in PESTLE, the global capital markets experiences historically low federal rates, which might explain the relatively low current 10-year Norwegian government bond of 1,49%

compared to 1,88% in 2018 (Norwegian Bank, n.d). Based on this, the applied risk-free rate is built upon an average of the normalized rate and the government bond, resulting in a risk-free rate of 2,3%.

Market Risk premium

The market risk premium (MRP) is the excess return an investor can require from holding a risky portfolio instead of a risk-free asset, i.e. the difference between the return on the market portfolio, 𝑟_A, and risk free rate, 𝑟_l. Deciding on a suitable MRP is among the most discussed issues in corporate finance and there are no models for calculating a precise estimate (Petersen et al., 2017). Institutions, such as PWC conduct a yearly survey concerning the MRP in the Norwegian market and claims the MRP in Norway has been historically stable, remaining unchanged at 5%

(PWC, 2019). Another commonly used source is Aswath Damodaran, a highly acknowledged finance professor, which estimates the equity risk premium (ERP) in Norway to be 5,2% in 2020 (Damodaran, 2020). However, this ERP varies greatly between countries, and is above 8% in Brazil while the USA has the same ERP as Norway of 5,2%. Since Yara is headquartered in Norway, the Norwegian ERP of 5,2% is applied, which is close to the MRP determined by PWC of 5%. Both estimations are based on an ex-ante approach (Petersen & Plenborg, 2012).

Beta

Beta is the correlation between the stock return of a company and the return on the market portfolio. It is the systematic risk, i.e. the undiversified risk, a company faces (Petersen et al., 2017). In practice, there are several methods for calculating beta, and the section below will discuss and assess the most common approaches.

A straightforward method is through a regression-analysis of the stock return. This is calculated by using the daily percentage change of Yara’s share price against the market return from the last five years. As Yara is listed on OSE, the OSEBX Index is used. This resulted in an adjusted beta of 0,97, indicating that the stock is slightly less volatile than the market with a beta of 1. Since NewCo and RemainCo are not yet separate listed companies with no stock prices, the regression cannot be directly used for determining the betas. An alternative source can be Damodaran (2020a), which offers betas for different sectors. Among these sectors, the most associated for RemainCo and NewCo can respectively be farming/agriculture with a beta of 0,89 and chemical (specialty) with a beta of 1,14. Further, based on Bloomberg, offering betas for companies, the betas of Yara, RemainCo, NewCo is calculated based on their peer groups, as shown in the figures below.

However, excluding the outliers of the two Russian companies, Phosagro and Acron, the peer beta of RemainCo is 0,98, which is equal to Yara’s beta found on Bloomberg.

As the above approaches are based on historical numbers, a supplemented qualitative method through a “common sense” analysis provides a more powerful tool to estimate the systematic risk (Petersen & Plenborg, 2012). However, it is worth mentioning that the analysis is based on subjective assessments with no consensus of categorizing the respective risk levels. The table in Appendix 31 presents the different values of beta based on the level of both operational- and financial risk. While operational risk expresses the uncertainties regarding the day-to-day business, financial risk is expressed as the danger that share- and bondholders might lose their money.

Operational risk RemainCo:

Initially, the fertilizer industry can be considered with low operational risk, as the necessary goods may not be as harmed during economic downturns due to strong demand for fertilizers to efficiently feed the increasing world population. Being the largest fertilizer distributor in the world with benefits from the scale, geographical diversity and strong brand name, supports the low operational risk. In addition, the increased vertical integration provides the company with more control over the market and value chain. However, as the earnings in the industry are heavily influenced by the highest cost component, natural gas price, in addition to volatile fertilizer prices, increases the operational risk. Therefore, the risk is categorized as neutral.

NewCo:

High expected market growth in the industrial nitrogen markets and an increased number of countries introducing strict environmental regulations, benefits NewCo and supports a low

operational risk. This is also emphasized by the company being geographically diverse on various regulated markets. However, the operation risk increases as the earnings are influenced by multiple market factors such as prices of natural gas, ammonia and urea, in addition to other risk factors affecting the customer markets. The attractiveness of the industrial nitrogen market creates threats of new and alternative products possibly substituting NewCo’s. Uncertainties regarding

Peers Beta Adjusted (Bloomberg)

Intrepid 1,16

Incitec Pivot 1,16

K+S AG 1,08

Avg. Peer beta 1,13

Beta NewCo

Beta Beta Adjusted (Bloomberg)

Nutrien 1,16

Coromandel International 0,79

Fatima Fertilizer 0,69

Phosagro PJSC 0,51

Fauji Fertilizer 1,27

Chambal fertilizers 0,97

Avg. Peer beta 0,90

Beta RemainCo

customer agreements may also arise after the carve-out. All these risk factors considered, the operational risk is categorized as neutral to high.

Financial risk

As mentioned, there is limited information regarding the distribution of financial liabilities.

Therefore, the financial risk of RemainCo and NewCo can arguably be reflected by Yara’s financial risk. Yara has experienced historically low ROE, ROIC and profitability-margins compared with its peers, supporting a high financial risk. However, these ratios and margins have increased

significantly in 2019. Further, Yara’s long-term liquidity risk is also considered healthy relative to peers as the company has the highest equity- and interest coverage ratio, which strengthening its leverage situation during economic downturns. In addition, as shown in Appendix 34, Yara has achieved its NIBL/EBITDA ratio target of 1,5-2 each year, except for the peak in 2018, and has the lowest level among its peers. A significant Norwegian state-ownership in both companies may also provide security during economic downturns. Therefore, the financial risk of both companies can be categorized as neutral.

Based on the common sense table and the discussion above, each company has been assigned a beta range, as seen in Appendix 33. RemainCo falls in the range with a beta between 0,85 and 1,15 due to neutral operational- and financial risk. This is in line with the historical and current BBB rating of Yara reflecting neutral risk levels (S&P Global, 2019). Based on this interval, the peer- and industry beta, and the risk found in the regression of Yara reflecting ReimanCo’s risk, a beta of 1 is delegated to RemainCo. Furthermore, due to neutral to high operational risk and neutral financial risk, NewCo has been assigned a broader interval of 0,85-1,40. This interval, in addition to the peer- and industry beta, supports a higher beta of 1,1.

There might be other additional risk premiums (ARP) that should be added, when calculating the investors required rate of return, 𝑟_h= 𝑟_l+ 𝛽_h∗ (𝑟_A− 𝑟_l+ 𝐴𝑅𝑃). Some of these ARPs will be

discussed below.

Additional risk premiums

The most frequently used additional risk premium (ARP) is the country risk premium (KPMG, 2018). However, this will not be added as Damodaran (2020) considers the country risk premium of Norway to be 0%. Although “small-scale companies” often receive a premium (PWC, 2019), this will neither be applied as RemainCo is predicted to remain one of the top ten largest companies at OSE while NewCo will be within the 30 largest companies (Hovland, 2019). Furthermore, the use of risk premium for companies with low presentation regarding environment and sustainability is

currently increasing (PWC, 2019). PESTLE discovered that both the companies operate in markets that negatively impacts the climate. However, VRIO analysis presented various initiatives,

engagement and focus on environment and sustainability which exempts both the companies from this risk premium.

Economic uncertainty risk premium

As a consequence of the current disruptive business models of global companies which are constantly in change, a significant degree of uncertainty can be expected when forecasting. A study conducted by KPMG (2018) presents that companies exposed to a future of uncertainty, consider a variety of additional risk factors when determining WACC. Risk premium for planning uncertainties increases (KPMG, 2018), as investors require a higher rate of return in unpredictable periods (PWC, n.d.). As previously discussed in PESTLE, the market situation is currently facing uncertainties regarding global political instabilities, abnormally low treasure- and federal rates, as well as a historical long bull stock market which may shift in the nearest future due to cyclical markets. These uncertainties are considered to affect both RemainCo and NewCo, and hence an ARP of 0,5% may arguably be added to investors required rate of return, 𝑟_h. This provides a higher 𝑟_h for both companies as calculated below:

RemainCo: 𝑟_h = 2,3% + 1 ∗ 5,2% + 0,5% = 8,0%

NewCo: 𝑟_h = 2,3% ∗ 1,1 ∗ 5,2% + 0,5% = 8,6%