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General Model

CAPITAL BUDGETING ISSUES IN FAST-GROWING ECONOMIES PRACTICAL APPROACHES TO ESTIMATE COST OF CAPITAL. Cost of Equity, Flexible Approach. General Model where R f denotes risk-free rate, MRP the world market risk premium,

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General Model

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  1. CAPITAL BUDGETING ISSUES IN FAST-GROWING ECONOMIESPRACTICAL APPROACHES TO ESTIMATE COST OF CAPITAL

  2. Cost of Equity, Flexible Approach • General Model • where Rf denotes risk-free rate, MRP the world market risk premium, • SRspecific 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

  3. The Lessard Approach • measures specific risk (SR) as the product of a project beta (βp) and a country beta (βc): • where βpand βccapture 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

  4. 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

  5. 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 SBis 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

  6. 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

  7. 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

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