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ALTERNATIVE WAYS TO ESTIMATE

COST OF CAPITAL

I think you should be more explicit here in

step two...

General Model where Rf denotes risk-free rate, MRP the world market risk premium, SR specific risk of the investment, and A some additional adjustment.

Four Different Models

two inputs (Rf and MRP) on the basis of worldwide markets are shared by all four models

two other inputs SR and A differ across the models

• The Lessard Approach

• The Godfrey-Espinosa Approach

• The Goldman Sachs Approach

• The SalomonSmithBarney Approach

Cost of Equity in Emerging Markets

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Cost of Equity in Emerging Markets

The Lessard Approach

measures specific risk (SR) as the product of a project beta (βp) and a country beta (βc):

where βp and βc capture the risk of industry and country, respectively.

cost of equity when investing in industry p and country c is:

βp (βc) is estimated as the beta of the industry (country) with respect to the world market, and no further adjustment ( A is assumed to be zero)

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SR

The Godfrey-Espinosa Approach Two adjustments with respect to CAPM:

1) Adjusting Rf by the yield spread of a country relative to the U.S. (YSc)

A = YSc

2) Measuring risk as 60% of the volatility of local market relative to world market (σc/σw)

SR = (0.60)·(σc/σW)

where σc and σw are the standard deviation of returns of stock market of country c and world, respectively.

cost of equity when investing in industry p and country c is:

this model ignores the specific nature of the project, but all that matters is the country in which the foreign company invests

Cost of Equity in Emerging Markets

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The Goldman Sachs Approach one adjustments with respect to Godfrey-Espinosa Approach :

replacing 0.60 by one minus the observed correlation between the stock market and bond market of the country c.

SR = (1–SB)·(σc/σW)

where SB is the correlation between stock and bond markets.

cost of equity when investing in country c is:

intuition of the model

SB = 0 no correlation, two sources of risk (stock and bond)

SB = 1 YSc captures all relevant risk

0<SB<1 the model incorporates both risk from bond and stock markets, but not double counting sources of risk

Cost of Equity in Emerging Markets

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The SalomonSmithBarney Approach account for the risk of investing in Specific Industry and/or Country

adjustments with respect to previous models :

1) Political risk (1: between 0 and 10)

2) Risk of accessing capital markets (2: between 0 and 10)

3) Financial importance of the project (3: between 0 and 10)

A = { (1+ 2+ 3) / 30}·YSc

intuition of the model

1 is a rough estimate of the likelihood of expropriation (e.g., oil industry)

2 is low for large firms and high for small undiversified firms

3 is low for large firms investing in relatively small projects and high for small firms investing in relatively large projects

Cost of Equity in Emerging Markets

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The SalomonSmithBarney Approach – continued intuition of the model

worst scenario A = YSc; the best case A = 0

For example, a large international firm investing a small proportion of its capital in an industry unlikely to be expropriated (A = 0)

A small undiversified company investing a large proportion of its capital in an industry likely to be expropriated would have to incorporate a full adjustment for political risk (A = YSc)

quantify SR (specific risk) with the project beta, then the cost of equity when investing in industry p and country c is:

this model, different from three previous ones, can allow discount rate to depend on not only specific project but also the company

Cost of Equity in Emerging Markets

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