ALTERNATIVE WAYS TO ESTIMATE COST OF CAPITAL

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ALTERNATIVE WAYS TO ESTIMATE COST OF CAPITAL
I think you should be more explicit here in step two...

Cost of Equity in Emerging Markets
General Model where Rf denotes risk-free rate, MRP the world market risk premium, SR specific risk of the investment, and A some additional adjustment. Four Different Models two inputs (Rf and MRP) on the basis of worldwide markets are shared by all four models two other inputs SR and A differ across the models The Lessard Approach The Godfrey-Espinosa Approach The Goldman Sachs Approach The SalomonSmithBarney Approach 2

Cost of Equity in Emerging Markets
The Lessard Approach measures specific risk (SR) as the product of a project beta (βp) and a country beta (βc): where βp and βc capture the risk of industry and country, respectively. cost of equity when investing in industry p and country c is: βp (βc) is estimated as the beta of the industry (country) with respect to the world market, and no further adjustment ( A is assumed to be zero) SR 3

Cost of Equity in Emerging Markets
The Godfrey-Espinosa Approach Two adjustments with respect to CAPM: Adjusting Rf by the yield spread of a country relative to the U.S. (YSc) A = YSc Measuring risk as 60% of the volatility of local market relative to world market (σc/σw) SR = (0.60)·(σc/σW) where σc and σw are the standard deviation of returns of stock market of country c and world, respectively. cost of equity when investing in industry p and country c is: this model ignores the specific nature of the project, but all that matters is the country in which the foreign company invests 4

Cost of Equity in Emerging Markets
The Goldman Sachs Approach one adjustments with respect to Godfrey-Espinosa Approach : replacing 0.60 by one minus the observed correlation between the stock market and bond market of the country c. SR = (1–SB)·(σc/σW) where SB is the correlation between stock and bond markets. cost of equity when investing in country c is: intuition of the model SB = 0  no correlation, two sources of risk (stock and bond) SB = 1  YSc captures all relevant risk 0<SB<1  the model incorporates both risk from bond and stock markets, but not double counting sources of risk 5

Cost of Equity in Emerging Markets
The SalomonSmithBarney Approach account for the risk of investing in Specific Industry and/or Country adjustments with respect to previous models : Political risk (1: between 0 and 10) Risk of accessing capital markets (2: between 0 and 10) Financial importance of the project (3: between 0 and 10) A = { (1+ 2+ 3) / 30}·YSc intuition of the model 1 is a rough estimate of the likelihood of expropriation (e.g., oil industry) 2 is low for large firms and high for small undiversified firms 3 is low for large firms investing in relatively small projects and high for small firms investing in relatively large projects 6

Cost of Equity in Emerging Markets
The SalomonSmithBarney Approach – continued intuition of the model worst scenario A = YSc; the best case A = 0 For example, a large international firm investing a small proportion of its capital in an industry unlikely to be expropriated (A = 0) A small undiversified company investing a large proportion of its capital in an industry likely to be expropriated would have to incorporate a full adjustment for political risk (A = YSc) quantify SR (specific risk) with the project beta, then the cost of equity when investing in industry p and country c is: this model, different from three previous ones, can allow discount rate to depend on not only specific project but also the company 7

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