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Cost of Capital

The challenges in estimating the Cost of Capital in Emerging Markets

The computation of the cost of capital for a company located in a developed country when investing in a mature industrialized area is based on the well-established CAPM (Capital Asset Pricing Model) financial method, which integrates both equity and debt. Therein, CAPM utilizes values for the risk-free interest rate, the company’s spread over the risk-free rate, the company’s levered beta on its home stock market and the overall equity market premium (see Sharpe, W.F., Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, 1964).

However, fundamental research has clearly shown that such CAPM models provide systematically biased estimations for cost of capital in emerging markets (see notably Harvey C. R., Predictable Risk and Returns in Emerging Markets, Review of Financial Studies, 1995), with usually a result that is too low compared to the risks associated. Therefore, the standard definitions and formula simply do not work, and indeed are not used, for companies located in industrialized and emerging countries.

The major challenges in designing a method close to the CAPM for emerging markets are related to the specific constraints and characteristics of the local financial markets (low liquidity, limited number of listed company, etc.) and to the specific nature of potential economic or financial shocks registered by such countries.

Our approach

TAC’s approach to measuring the cost of capital in emerging markets is founded on two core principles:

More info on the page dedicated to our country risk assessment system, RiskMonitor.