Country Risk and the Cost of Equity

5 Pages Posted: 21 Oct 2008

See all articles by Wei Li

Wei Li

University of Virginia - Darden School of Business; Centre for Economic Policy Research (CEPR)

Abstract

An exercise in case format that demonstrates how to compute the cost of equity for an investment project in an emerging market using both the Lessard and the Godrey and Espinosa methods. ADDITIONAL MATERIALS: Spreadsheets, recommended articles on methodology.

Excerpt

UVA-F-1392

COUNTRY RISK AND THE COST OF EQUITY

In October 2001, Aero-Products, Inc., a U.S.-based recreational aircraft manufacturer, was looking for an overseas site to build a greenfield engine plant using internal funds. Based on its own research, the company had eliminated all but two sites: an industrial park inSt. Petersburg, Russia, and an industrial zone just outside Buenos Aires, Argentina. Cash-flow projections showed that both sites had internal rates of return (IRRs) well over 25%. Eliza Euling, the CFO and a recent MBA graduate from a top U.S. business school, understood the drawbacks of comparing IRRs and wanted to compare the NPVs obtained by discounting the cash flows using the opportunity cost of equity. Conceptually, she thought that the cost of equity should incorporate both the time value of money and the risk premium commensurate with the risk of investing in each of the two countries. “The discount rate has got to be higher in Argentina or Russia than here,” said Eliza's father, John Euling, who was the CEO and founder of the company. The company, owned and operated by the Euling family, had used little debt. For investment projects located in the United States, John Euling had traditionally used a beta of 1.1 to estimate the cost of equity.

The job of estimating the cost of capital for this overseas expansion naturally fell on Eliza. She remembered the Donald Lessard article that she had studied in school. She found the article in the attic and reread it, taking notes on what data she would need and what steps she should take to estimate the cost of equity. She called one of her B-school classmates working in an investment bank in New York, who promptly e-mailed her the needed data in an Excel spreadsheet.

According to Lessard, Eliza wrote in her notes, the cost of equity for an investment project in an emerging market was the sum of

1. the risk-free discount rate, Rf

. . .

Keywords: cost equity, emerging market, Lessard Godrey Espinosa, country analysis, valuation

Suggested Citation

Li, Wei, Country Risk and the Cost of Equity. Darden Case No. UVA-F-1392. Available at SSRN: https://ssrn.com/abstract=1279325

Wei Li (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
804-243-7691 (Phone)
804-243-7681 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/li.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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