This document discusses approaches to calculating the international cost of capital. It notes that while the capital asset pricing model (CAPM) is commonly used, it provides biased estimates in emerging markets due to unique country risks. The document evaluates 12 different models and recommends using a company's domestic cost of capital plus a country risk premium in basis points estimated through quantitative crisis signal and country rating models. It stresses the country premium should account for cyclical, exchange rate, solvency, political and business environment risks over various time horizons.

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International Cost of Capital
Introduction
A long-standing problem in finance is the calculation of the cost of capital in international
capital markets. There is widespread disagreement, particularly among practitioners of
finance, as to how to approach this problem.
Unfortunately, the students’ textbooks on international financial management do not tell
us a lot of this issue. For example, Eiteman, Stonehil, Moffet (2005), Shapiro (2006),
Madura (2006), Levich (2001).
Cost of Capital : Current Practice
A firm normally finds its weighted average cost of capital (WACC) by combining the cost
of equity with the cost of debt in proportion to the relative weight of each in the firm’s
optimal long-term financial structure.
Sukarnen
DILARANG MENG-COPY, MENYALIN,
ATAU MENDISTRIBUSIKAN
SEBAGIAN ATAU SELURUH TULISAN
INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa
diposting melalui website
www.futurumcorfinan.com

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kWACC = D/(E+D) kd (1-t) + E/(E+D) ke
where:
kWACC = weighted average after-tax cost of capital
ke = risk-adjusted cost of equity
kd = before-tax cost of debt
t = marginal tax rate
E = market value of the firm’s equity
D = market value of the firm’s debt
For cost of equity, the writers referred to (only) one approach, that is the capital asset
pricing model (CAPM), which defines the cost of equity of a firm using the following
formula:
ke = kf + j (kM – kf) + α
where:
ke = expected (required) rate of return on equity
kf = rate of interest on risk-free bonds (Treasury bonds, for example)
j = coefficient of systematic risk for the firm
kM = expected (required) rate of return on the market portfolio of stocks
α = unsystematic risk premium
The normal procedure for measuring the cost of debt requires a forecast of interest rates
for the next few years, the proportions of various classes of debt the firm expects to use,
and the corporate income tax rate.
We found that (only) approach mentioned is not surprising since in a survey of U.S.
Chief Financial Officers, Graham and Harvey (2001) find that 73.5% of respondents
calculate the cost of equity with the CAPM model.

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More specifically, the results are presented below:

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They also present evidence that many use multifactor versions of this model. In
countries like the U.S., the different methods often yield similar results. However, when
they move outside the U.S., particularly to developing markets, different methods can
produce widely varying results. Further, Harvey (2001) noted that there is considerable
disagreement as to how to approach the international cost of equity capital, and
unfortunately, many of the popular approaches are ad hoc and, as such, difficult to
interpret. The same paper then critically reviews 12 different approaches :
1. The world CAPM Model
2. The world multi-factor CAPM Model
3. The Bekaert and Harvey Mixture Model
4. The Sovereign Spread Model (Goldman Model)
5. The Implied Sovereign Spread Model
6. The Sovereign Spread Volatility Ratio Model
7. Damodaran Model
8. The Ibbotson Bayesian Model
9. The Implied Cost of Capital Model
10. The CSFB Model
11. The Expected Returns are the Same Globally
12. The Erb-Harvey-Viskanta Model
Harvey (2001), based on the review of each model, comes up with the recommendation:
 In developed, liquid markets, it is best to use either a capital asset pricing model
or a multi-factor model. It is important to allow for time-varying risk premiums.
From Graham and Harvey (2005), shows that the risk premium for the U.S. has
declined in recent years.

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For emerging markets, it is NOT SO SIMPLE. It really depends on the how segmented
the market is. Given that the assumptions of the CAPM do not hold, the writer avoids
using the world version of the CAPM in these markets. Moreover, the writer said that he
never uses the CSFB model, the Ibbotson model, or the sovereign spread volatility ratio
model. The writer will often examine a number of models, such as the sovereign spread,
Damodaran and the Erb, Harvey and Viskanta model and average the results.
Challenges and Issues in Estimating the International Cost of Capital
The question is what wrong with the current practice that widely adopt CAPM model?
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. As such financial parameters and results are
increasingly required for financial management and monitoring, many different methods
characterized by a heavy use of empirical inputs and conceptual simplifications have
been developed over the past few years in order to adapt the standard CAPM model to
developing countries.

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The major challenges in designing a method close to the CAPM for emerging markets
are related to two inter-related sets of issues: (1) the specific nature of risks in emerging
countries, and (2) the specific nature of the potential economic or financial shocks
registered by such countries, compared to what is usual in more mature countries.
1. What is the specific nature of risk in developing or emerging countries? In
industrialized countries, the inputs for the cost of capital computation are related
only to the risk-free rate and the company’s risk premium on both the debt and
equity markets. The situation is radically different in developing countries,
because of the existence of a specific country risk that is not related to the
company itself. Therefore, the measure for the company should therefore not be
strictly limited to a narrow definition of the cost of capital (and indeed, for a given
corporate, the cost of capital is identical wherever the investment project is), but
should include the cost of the risk associated to potential losses on funds
invested in a country where the global environment is by nature riskier than in the
company’s home market. This type of risk is much more difficult to assess
because it covers a wide range of events that can potentially lead to financial
losses.
2. The nature of the country-risk and the range of possible shocks that characterize
developing countries are very different from those observed in mature
industrialized countries. A country crisis (i.e. the materialization of the country
risk) can be broadly defined as any macroeconomic, macro-financial or political
event of such a magnitude that it can significantly derail the normal unfolding of a
business plan or operation whatever the specific qualities or characteristics of the
project, and induce a significant decline in the actual value of the funds invested.
With such a definition, the country risk to be measured is the probability of such
events occurring in the country.
The detailed examination of the various empirical adjustments that both academics and
practitioners have suggested to adapt the CAPM model to emerging markets invites to a
cautious reaction: not only do such adjustments contradict each other, but more
importantly, they usually fail to provide a satisfactory answer to the challenges described

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above. The difficulties and issues raised by these methodological adjustments can be
summarized in three key points:
a) They are based on the fundamental assumption that emerging countries’
financial markets are efficient for signaling the proper cost of risk. However, all
studies and research conducted on the subject strongly insist on the fact that
such market efficiencies are very rarely present in emerging markets, because
the required conditions in terms of liquidity, number of market participants and
role of the public authorities are not met. This notably implies that any measure
of an equity beta, on a company, an industry or a whole emerging stock market is
subjected to very high uncertainties, including instability over time, difficulties in
fully integrating the country’s specific financial characteristics, etc.
b) Many of the empirical adjustments have focused on the issue of measuring what
would be the cost of capital if the company were a local corporate (local equity
market characteristics, local risk-free rate). However this precisely conceals the
very peculiar nature of a foreign investment in a developing country, and what
such a nature implies for capturing precisely the country risk. Symmetrically,
other adjustments suggest using the country’s spread on its foreign currency
denominated international bonds, ignoring then the potential impact of a local
currency depreciation on the foreign company’s asset values.
c) None of the empirical methods is able to take into account the fact that financial
variables in emerging markets (equity prices, volatility, international spreads)
reflect two types of market anomalies:
 Either these markets are small and very modestly open to international
capital flows: in such a configuration, prices and volatility on the country’s
financial markets cannot be applied to an international company. Such
financial variables are usually heavily influenced by a very small number of
large institutions weighing strongly on indices; such countries usually do not
issue large international bonds, and when they do, the issues have many
specific technical characteristics making the spreads difficult to interpret in a
pure risk perspective (e.g. collateral, options for early amortization, etc.).

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 Or, on the contrary, the markets are larger and more open to international
capital flows. Liquidity is better (for both equity and international bond
markets), but the relative size and influence of international investors are
usually very large. In such circumstances, changes in market variables very
often reflect as much specific asset allocation considerations by these
investors (global risk aversion or appetite, market arbitrage, speculative
behavior) as a clear-cut risk pricing.
The bottom line is that a measure of the cost of capital when investing in an emerging
country based on local markets’ signals cannot provide the required information
assigned to the cost of capital in an industrial or medium-term investment perspective.
Particularly, Harvey (2005) reminds that there are other important issues that need to be
addressed in addition to the basic choice of model, one of the most important is the
term structure of country risk. Emerging markets, in particular, are subject to crises. In
and around the crisis, risk spikes. However, as Erb, Harvey and Viskanta (1996), there is
evidence of mean reversion in country risk ratings. This implies that it would be
inappropriate to use the current risk to evaluate cash flows for, say, 10 years of a project
life. And there are still many other issues that take us well beyond the standard asset
pricing frameworks. For example, Stulz (1995, 2005) argues that variation in the degree
of agency costs will induce differences in the cost of capital across countries. Stulz’s
analysis suggests that differences in corporate governances and the general institutional
environment need to be explicitly accounted for in making statements about the cost of
capital.
Recommendations
Based on the above discussions, we recommend the following two core principles that
need to be taken into an approach in measuring the cost of capital in emerging markets:
1. 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 U.S. as it is commonly accepted that the U.S. Government bond yield is the

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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.
2. This 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.
Keeping the same definitions and conventions as previously, this leads to the following
equations
Kd adjusted = kd + Pm
Ke adjusted = ke + Pm
where Pm is the translation of the country risk premium in basis points, measuring the
potential consequences of a country shock on the net present value of the invested
funds. This measure is based on an econometric relation between country risk ratings
and smoothed-relative spreads on a sample of emerging markets’ international spreads.
Finally, this allows computing the WACC for investing in an emerging country with a full
account of the risk characteristics of the country, through the following equation:
kWACC = D/(E+D) kd adjusted (1-t) + E/(E+D) ke adjusted
The next question that need further research is on how to compute this
country/emerging markets risk premium Pm.
Ideally, this measurement of an adequate country risk premium should cover the
following :
1. A Crisis Signal model built on a set of non-linear quantitative models to a wide
range of past emerging market crises over the past 25 years, and providing
reasonably accurate indications of the economic and financial risks

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characterizing a developing country, including prediction of the probability of the
occurrence of a major cyclical reversal, a collapse of the exchange rate or a
financial default / transfer controls preventing outflows of foreign currency from
the country. The concept behind the model is that almost all contracts and
counterparts or partners would be significantly affected by such a shock
regardless of their specific characteristics.
2. Country Ratings measuring the overall economic and financial qualities of a
developing country regarding three types of potential difficulties able to impact a
foreign investor (cyclical performances, exchange rate valuation and solvency /
payment issues).
Both the Country Ratings and the Crisis Signals are estimated for three different time
horizons (less than one year, 1 to 3 years, and 3 to 5 years) and three types of economic
and financial difficulties (Cyclical, Exchange Rate and Solvency / payment).
Starting from here, the “country premium” to be integrated in the computation of the
WACC has to include the following elements:
1. It has to cover the cost of the “country risk”, i.e. the probability that the
country registers a deterioration in its economic and financial performances
that can affect the value of the assets or of the future income flows related to
the company’s investment in the country analyzed. The relevant outputs
include therefore the Country Ratings on one side, and an extra premium in
case of Crisis Signals on the other side.
2. From an industrial investor’s perspective, it has also to cover a more explicitly
defined political risk premium, which should encompass both the strict issue
of political stability and the more subtle elements of the business environment
regulations. These political inputs reflect the possibility of sovereign decisions
that can have a significant impact on the company’s asset or ability to transfer
funds out of the country.

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3. Lastly, the country risk premium has to be simultaneously related to observed
market values (notably the market spread on foreign currency bond issues
above the risk-free U.S. bond yield), and independent from the short-term
market movements, since such movements reflect more the investors’
behavior and risk appetite than the changes in country risk.
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