### S2_2 - Art Durnev

```CAPITAL BUDGETING ISSUES IN FASTGROWING ECONOMIES
PRACTICAL APPROACHES TO ESTIMATE
COST OF CAPITAL
1
Cost of Equity, Flexible Approach
General Model
where Rf denotes risk-free rate, MRP the world market risk premium,
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
1.
The Lessard Approach
2.
The Godfrey-Espinosa Approach
3.
The Goldman Sachs Approach
4.
The SalomonSmithBarney Approach
2
The Lessard Approach

measures specific risk (SR) as the product of a project beta (βp) and a
country beta (βc):
SR
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)
3
The Godfrey-Espinosa Approach

Two adjustments with respect to CAPM:
1)
Adjusting Rf by the yield spread of a country relative to the U.S. (YSc)
A = YSc
2)
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
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
The SalomonSmithBarney Approach

account for the risk of investing in Specific Industry and/or Country

adjustments with respect to previous models :
1)
Political risk (1: between 0 and 10)
2)
Risk of accessing capital markets (2: between 0 and 10)
3)
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
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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