A Practical Approach To Calculating Costs Of Equity For Investments In Emerging Markets

While most financial economists argue that multinational corporations (MNCs) should use discount rates that reflect only “systematic” or “covariance” risks when evaluating offshore projects, the managers of most MNCs do not appear to follow this prescription of the CAPM. Instead they favor use of discount rates that reflect the “total risk” of emerging‐market investments (as evidenced, for example, by the comments of the executives in the Roundtable discussion that immediately precedes this article). The authors defend this practice by noting that emerging countries are generally in the midst of profound economic and political transformations; and, although an MNC's shareholders may be willing to accept considerably lower rates of return on emerging‐markets projects because of the expected portfolio diversification benefits, the managements of MNCs are likely to find that using higher discount rates for emerging‐markets investments does a better job of accomplishing what a capital budgeting system is supposed to do—namely, to send strategic planners clear signals of the full extent of project risks and to set high standards of profitability for overseas operating managers. After describing the “total‐risk” focus of corporate planners, the authors present a “practical model” for calculating discount rates for emerging countries that incorporates two dimensions of risk: (1) credit quality, which is intended to capture political or “sovereign” risks; and (2) business volatility, which reflects primarily the commercial risks of operating in a given country. Credit‐quality risk is measured by the credit spread (over U.S. Treasuries) of a country's sovereign debt denominated in dollars or other reserve currency. Business volatility is captured by an additional risk premium that reflects the volatility of the local stock market relative to the volatility of the domestic (U.S.) market. And, because these two sources of risk are not completely independent, the authors propose a downward adjustment to compensate for any “double counting” inherent in the method.