Cost of Capital
The challenges in estimating the Cost of Capital in Emerging Markets
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 CAPM (Capital Asset Pricing Model) financial method, which integrates both equity and debt. Therein, CAPM utilizes values for the risk-free interest rate, the company’s spread over the risk-free rate, the company’s levered beta on its home stock market and the overall equity market premium (see Sharpe, W.F., Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, 1964).
However, fundamental research has clearly shown that such CAPM models provide systematically biased estimations for cost of capital in emerging markets (see notably Harvey C. R., Predictable Risk and Returns in Emerging Markets, Review of Financial Studies, 1995), 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 and emerging countries.
The major challenges in designing a method close to the CAPM for emerging markets are related to the specific constraints and characteristics of the local financial markets (low liquidity, limited number of listed company, etc.) and to the specific nature of potential economic or financial shocks registered by such countries.
TAC’s approach to measuring the cost of capital in emerging markets is founded on two core principles:
- The weighted average cost of capital (WACC) is applied to an investment in an emerging market by using the cost of capital of the company in its home or reference market, to which a « risk premium » expressed in basis points. 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.
- This risk premium is 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. TAC’s measures are based on a comprehensive, sophisticated and robust country risk measurement tool called RiskMonitor.