Lesson 6 of 14
CAPM can be used to estimate the cost of equity capital for an emerging market.
Note however, if the country is not very well integrated into the global capital market system, then CAPM may be an unsuitable technique, so be mindful of this qualifier when reading the item set.
Start by creating a risk free rate estimate for the foreign country:
RFforeign = RFUS + (Inflationforeign – InflationUS)
Next estimate a market risk premium to add on to the foreign risk free rate.
When using CAPM, then the beta for a company or industry should be calculated against a global market index and the market risk premium should reflect a global risk premium and not the local market risk premium.
rce = RFforeign + β * (Market Risk Premium global)
The cost of debt is equal to the foreign risk free rate calculated above plus an additional premium for the systemic portion of credit risk.
The cost of debt will not include a country risk premium; more to come on this below.
rdebt = RFUS + (Inflationforeign – InflationUS) + Credit Spreadsystemic
One the analyst has his/her cost of equity and cost of debt for the emerging market company or industry a standard WACC calculation can be made.
Do not forget to apply the company’s appropriate tax rate shield to the cost of debt when calculating WACC.
WACC = ((1-tax rate)* rdebt * Weight debt) + (rce * Weight ce)
The weights represent the percent of debt or equity as part of the total capital structure.
An emerging market country will have its own unique risks, such as political instability.
In order to account for these, the analyst can add a country risk premium to the discount rate used in valuation.
Once WACC is calculated, then a country risk can be applied.
Sometimes the sovereign debt spread between the emerging country’s sovereign interest rate and a developed country’s sovereign interest rate can be used to create a country risk premium, but this is only when the cash flows of the company correlate with the payments on government bonds.
Country risk premiums can be calculated in other ways and no consensus exists. The analyst must carefully understand the assumptions used to derive the country risk premium used in a valuation.