Motivation Two important points Javier Estrada This issue is on - - PDF document

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Emerging Markets (III):

Cost of Capital

Javier Estrada ADFIN – Winter/2014

• 1. Motivation
• Two important issues
• The CAPM in EMs
• 2. Models
• Lessard
• Godfrey‐Espinosa
• Goldman Sachs
• SalomonSmithBarney

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation

• Two important points
• This issue is on very shaky ground
• Many methodologies exist

 None is currently widely accepted  We will consider four models

• Because there is no widely‐accepted approach,

discount rates (DRs) typically are …

• arbitrarily estimated
• more often than not overestimated

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The CAPM in EMs

• Theoretical problems
• The ‘arbitrage’ assumption within/across EMs

(EMs are ‘less efficient’ than DMs)

• Practical problems
• ‘Low’ correlation between mean returns and betas
• Rho (MR‐Beta, 1988‐2013) = 0.48
• Rho (MR‐SD, 1988‐2013) = 0.61
• Rho (MR‐SSD, 1988‐2013) = 0.56
• ‘Low’ estimates of the required return on equity
• RR (Colombia) = 6.8%
• RR (Malaysia) = 7.2%
• RR (Egypt) = 7.5%
• RR (EMs) = 8.8%

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

To Keep in Mind Throughout

• Direct and indirect investments in EMs should be

broadly diversified

• Q: How correlated are the political (and other) risks

in the countries in which your company invests?

• Avoid an arbitrary estimation of DRs
• Q: Can you defend/justify the DR you use?
• Q: Aren’t you too conservative in the DR you use

(hence bypassing valuable opportunities)?

• Q: Have you considered what your DR implies in

terms of cash flows scenarios?

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• For all models keep in mind the following
• Evaluations are typically made in strong currency
• CFs are first estimated in local currency and then

converted to strong currency

• Discount rates should be estimated in the same strong

currency

• Given a dollar‐based valuation and a global approach

 Dollar‐based risk‐free rate (10‐year US Treasury yield)  Dollar‐based world market risk premium (5–6%)

• Given a global approach, betas are estimated with

respect to the world market

• Country betas and industry/sector betas
• Political risk is approximated with the yield spread
• Political risk = YSc

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• Lessard
• Replace beta by ‘offshore beta’
• Project beta (βp) with respect to the world market

 Beta of the project’s industry/sector (MSCI, S&P, …)

• Country beta (βc) with respect to the world market

 Beta of the country on which the project is based

• Offshore beta

 βp·βc

• Model
• R = Rf + MRP⋅(βp·βc)

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• Godfrey‐Espinosa
• Adjust the risk‐free rate by the yield spread (YSc)
• Rf + YSc
• Replace beta by the ratio of standard deviations
• σc /σw
• Adjust for double counting of risk
• (0.6)·(σc /σw)
• Model
• R = (Rf + YSc) + MRP⋅{(0.6)⋅(σc/σw)}

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• Goldman Sachs
• Very similar to the Godfrey‐Espinosa model
• Better double‐counting adjustment
• Eliminate fixed adjustment (0.6)
• Replace by dynamic adjustment (1–ρSB)
• This yields an adjusted beta → (1–ρSB)·(σc /σw)

 If ρSB = 1 ⇒ Adjusted beta = 0  If ρSB = 0 ⇒ Adjusted beta = σc /σw

• Model

Go

• R = (Rf + YSc) + MRP⋅{(1–ρSB)⋅(σc/σw)}

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• SalomonSmithBarney
• Distinctive features
• Global CAPM

 Global market risk premium  Global beta

• Unadjusted political risk premium

 Yield spread

• Subsequent adjustment

 Subjective/ad‐hoc

• Unlike the other models, it yields a subjective DR

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Models

• SalomonSmithBarney (Cont.)
• Adjusted political risk premium
• γ1 → Access to capital markets

 0–10, with 0 indicating best access

• γ2 → Susceptibility of investment to political risk

 0–10, with 0 indicating no susceptibility

• γ3 → Importance of investment for the company

 0–10, with 0 indicating that the project involves a small proportion of the company’s capital

• Adjusted political risk premium

 {(γ1+γ2+γ3)/30}·YSc

• Model

Go

• R = {Rf + [(γ1+γ2+γ3)/30]⋅YSc} + MRP⋅βp

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Appendix

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Goldman Sachs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

SalomonSmithBarney

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

SalomonSmithBarney

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