Cost of Capital in Emerging Markets
10 Pages Posted: 3 Nov 2012
Date Written: June 30, 2006
The computation of the cost of capital for a company located in a developed country when investing in a mature industrialized area is based on the well-established Capital Asset Pricing Model (CAPM) financial method integrating both equity and debt. However, as clearly shown by Harvey (1995), CAPM models provide systematically biased estimations for cost of capital in emerging markets, with usually a result that is too low compared to the risks associated. Therefore, the standard definitions and formula simply do not work, and indeed are not used, for companies located in industrialized countries and investing in emerging markets. The major challenges in designing a method close to the CAPM for emerging markets are related to two inter-related sets of issues: the specific nature of risks in emerging countries, and the specific nature of the potential economic or financial shocks registered by such countries, compared to what is usual in more mature countries.
Our approach to measuring the cost of capital in emerging markets is founded on two core principles. Firstly, the WACC to be applied to an investment in an emerging market is the cost of capital of the company on its « reference market » (home country of the company, or the US as it is commonly accepted that the US Government bond yield is the ultimate risk-free interest rate), to which a « risk premium » expressed in basis points has to be added. Such a premium should reflect the probability of seeing the country of investment registering a significant macro-shock (economic or financial) able to affect the net present value of the invested funds. Secondly, the risk premium has to be estimated from a thorough quantitative analysis of the probability of occurrence of such shocks, and should not be directly linked to the observed price signals derived from the emerging markets themselves. Our measures are based on a comprehensive, sophisticated and robust country risk measurement tool (an internal tool called RiskMonitor).
Note: Downloadable document is in French.
Keywords: Cost of capital, wacc, country risk, emerging markets
JEL Classification: D24, D81, O12, O19
Suggested Citation: Suggested Citation