Country Risk and the Cost of Equity∗
January, 2002
In October, 2001, Aero-Products, Inc., a U.S.-based recreational aircraft
manufacturer was looking for an overseas site to build a greenfield engine
plant using internal funds. Based on their own research, the company had
eliminated all but two sites: an industrial park in St. Petersburg, Russia,
and an industrial zone just outside of Buenos Aires, Argentina. Cash flow
projections showed that both sites had IRRs well over 25%. Eliza Euling, the
CFO and a recent MBA graduate from a top business school in the United
States, understood the drawbacks of comparing IRRs and wanted to compare
the NPVs obtained by discounting the cash flows using the opportunity cost
of equity. Conceptually, she thought that the cost of equity should incorporate both the time value of money and the risk premium commensurate with
the risk of investing in each of the two countries. “The discount rate has got
to be higher in Argentina or Russia than here,” said Eliza’s father, the CEO
and founder of the company. The company that has traditionally used little
debt and has a beta of 1.1.
The job of estimating the cost of capital naturally fell on Eliza. She
remembered the Lessard and the Godfrey-Espinosa articles that she studied
in school. She found the articles in the attic and started to read them. As she
read, she took notes on what data she would need and what steps she should
take to estimate the cost of equity. She called one of her b-school classmates
∗
This case was prepared by Professor Wei Li. This case was written as a basis
for class discussion rather than to illustrate effective or ineffective handling of an adc
ministrative situation. Copyright 2002
by the University of Virginia Darden School
Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
dardencases@virginia.edu. No part of this publication may be reproduced, stored in a
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electronic, mechanical, photocopying, recording, or otherwise—without the permission of
the Darden School Foundation.
1
working in an investment bank in New York, who promptly emailed her the
needed data in an excel spread sheet.
According to Lessard, Eliza wrote in her note, the cost of equity for an
investment project in an emerging market is the sum of
1. the risk-free discount rate, Rf ,
2. the yield spread of sovereign debt over U.S. Treasuries, YSCountry ,
3. country beta (βCountry ) * beta of comparable U.S. project (βProject )
* market risk premium (MRP).
or
Cost of Equity = Rf + YSCountry + βCountry βProject MRP
(1)
The yield on U.S. 10-year note on October 31, 2001 was 4.263%. The beta
for a comparable project in the United States (βProject ) is 1.1. Assume that
the market risk premium (MRP) is 6%.
Eliza needed data on sovereign yield spreads and on the Argentine and
Russian country betas. For the yield spreads, Eliza’s had JP Morgan’s EMBI
yield spreads (Exhibit 3). But she would have to estimate the country betas,
using the S&P/IFCI total return indices for Argentina and Russia and the
MSCI world total return index (Exhibit 2). The MSCI world index is widely
used as a benchmark index of the world stock market. She jotted down on
her notepad the following steps for estimating the country beta.
1. Compute the monthly total returns on each country’s stock index and
on the MSCI world index.
2. Compute the standard deviation of the monthly returns on the Argentina stock index (σArgentina ), the standard deviation of the monthly
returns on the Russia stock index (σRussia ), and the standard deviation of the monthly returns on the world index (σWorld ).
3. Compute the coefficient of correlation between the Argentina monthly
returns with the world monthly returns (ρArgentina ) and the coefficient of correlation between the Russia monthly returns with the world
monthly returns (ρRussia ).
2
4. The country betas for Argentina and Russia are then
σArgentina
βArgentina = ρArgentina
,
σWorld
σ
βRussia = ρRussia Russia .
σWorld
Following these steps, she estimated the country betas. She then estimated the costs of equity for the Argentina project and the Russia project.
Eliza knew that Godfrey and Espinosa proposed a modification on the Lessard
formula. For comparison, she decided to also estimate the cost of equity using
Godfrey-Espinosa’s formula, which she wrote down as
Cost of Equity = Rf + YSCountry + 0.6
3
σCountry
β
MRP.
σWorld Project
(2)
Exhibit 1. Data on stock indices and sovereign spreads
The indices:
Emerging market country indices are from S&P/IFC's Emerging Market Database
(EMDB). The indices were first created by International Finance Corporation
(World Bank) and were later acquired by Standard & Poor. The MSCI (Morgan
Stanley Capital International) world stock index is a comprehensive index of
global stocks. It is widely considered the global equivalent of the S&P 500 index.
Both the S&P/IFC country indices and the MSCI world index are investable or
free indices, meaning that their constituent stocks are accessible to foreign
investors. All indices included here are TOTAL RETURN indices, denominated
in US$. The total return on a stock combines both capital performance (stock
price change) and reinvested income from dividends. Using the indices, total
returns can be computed as follows.
Suppose that I t is a country’s total return index at time t . The total return
from time t to time t + 1 can be computed as
I −I
Rt = t +1 t .
It
Sovereign spreads
Data on sovereign spreads are obtained from J.P. Morgan via Bloomberg. Listed
here are the J.P. Morgan EMBI (Emerging Markets Bond Index) sovereign spreads
for Argentina and Russia.
Exhibit 2. Total Returns Indices
Date
199512
199601
199602
199603
199604
199605
199606
199607
199608
199609
199610
199611
199612
199701
199702
199703
199704
199705
199706
199707
199708
199709
199710
199711
199712
199801
199802
199803
199804
199805
199806
199807
199808
199809
199810
199811
199812
199901
199902
199903
199904
199905
199906
199907
199908
MSCI
world
index
219.2
224.1
225.0
228.5
234.1
234.3
235.6
226.8
229.6
238.1
239.0
251.8
248.1
252.3
255.8
250.6
258.7
274.1
288.1
301.2
280.0
295.0
277.4
281.7
285.4
291.6
311.6
324.9
327.9
321.7
327.5
327.6
281.7
287.3
313.6
332.6
348.0
355.2
346.2
361.8
377.4
364.1
382.2
380.7
380.2
S&P/IFC investable total
return country index
Argentina
Russia
1872.13
100
2091.36
93.67
1822.36
82.95
1892.41
86.04
2078.54
111.1
2150.96
150.71
2184.34
214.26
1893.48
207.16
1859.42
251.74
2028.94
227.52
2024.9
257.16
2169.99
254.88
2289.98
261.13
2465.04
357.77
2500.63
448.74
2466.52
436.41
2559.09
441.29
2742.55
466.19
2813.38
533.44
2995.65
650.66
2944.23
664.35
3013.61
769.46
2457.51
730.72
2614.45
568.54
2746.23
638.7
2501.39
441.16
2711.68
491.34
2808.26
524.7
2760.45
506
2428.34
305.94
2280.58
238.14
2447.19
234.5
1651.99
87.94
1870.67
48.34
2135.66
74.05
2245.99
105.39
2032.5
81.53
1871.62
77.24
1893.9
105.93
2063.69
126.09
2717.75
140.74
2604.43
153.4
2508.53
188.57
2377.82
178.58
2521.71
155.46
199909
199910
199911
199912
200001
200002
200003
200004
200005
200006
200007
200008
200009
200010
200011
200012
200101
200102
200103
200104
200105
200106
200107
200108
200109
376.1
395.1
407.4
441.4
417.6
419.0
446.5
426.5
415.4
429.5
416.9
429.9
406.2
398.3
373.6
379.9
389.5
356.7
332.7
356.9
352.9
342.1
336.7
321.3
291.9
2648.21
2657.3
2686.19
2795.82
2872.45
3214.01
2920.2
2626.82
2422.03
2600.25
2534.75
2506.23
2427.52
2269.32
2066.3
2150.06
2737.12
2251.09
2296.15
2248.12
2269.49
2113.95
1682.07
1668.66
1284.53
129.41
151.22
176.76
280.02
262.65
276.7
349.95
332.9
294.99
270.94
300.45
359.24
293.89
276.29
203.52
212.16
248.2
234.55
235.98
260.57
303.94
316.13
293.32
298.29
256.84
Exhibit 3. JP Morgan Euro EMBI Global Government Bond Yield
Spread Over U.S. Treasuries
Date
7/30/2001
8/30/2001
9/28/2001
10/31/2001
JP Morgan Euro EMBI
Global Government
Spread
Argentina
Russia
12.58%
12.84%
14.08%
30.24%
5.82%
5.14%
5.96%
5.70%
0
