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General Model

This document discusses various practical approaches to estimate the cost of equity in fast-growing economies, emphasizing different models that account for specific risks. It outlines four key methodologies: The Lessard Approach, The Godfrey-Espinosa Approach, The Goldman Sachs Approach, and The Salomon Smith Barney Approach. Each model incorporates unique factors such as country risk premiums, market volatility, and political risk, enabling investors to calculate the appropriate discount rates for projects in emerging markets. Understanding these models can provide critical insights for decision-making in capital budgeting.

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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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