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Vol. 17, No. 12, December 2011

International Cost of Capital: Cost of Equity/CAPM

By Nancy Czaplinski, CPA/ABV, CFA, ASA

There are many approaches to the development of both the equity and debt components of the cost of capital for countries other than the U.S. This article focuses on a select number of approaches applicable to development of the equity component of the international cost of capital using the capital asset pricing model (CAPM). The CAPM models discussed here are limited to the following: 1. Local CAPM model 2. Yield spread 3. Volatility spread 4. Local country risk exposure model (Prof. Damodaran) A. Country default spread added on to CAPM, and B. Adjusted for relative standard deviation of equity/bond markets 5. Country credit rating method (Erb-Harvey-Viskanta) There are many points for business appraisers to consider when applying each of these models, as summarized below. Local CAPM model. Local CAPM is our first choice in developing a cost of capital in situations where information is available and the cash flows are in local currency. The local CAPM is used to develop a cost of equity in the local currency and

begins with a local risk-free rate, a beta based on local exchanges and a local equity risk premium (EP). The local CAPM must be applied to local cash flows (local to local). Therefore, practitioners must make additional adjustments relating to exchange rate, business, specific industry, or sector risks as deemed necessary. A good source of government risk-free rates of return is Bloomberg, but the practitioner must take into consideration the fact that some country/ local government debt may not be free of default risk. Some countries, such as Venezuela, do not have government debt in local currency, thereby providing a challenge to application of the local CAPM model. Challenges result when the EP for some countries is not available or is deemed unreliable. An EP can be calculated if bond and equity markets have enough history, but valuation practitioners need to be careful about the composition and concentration of bond and equity markets in a country. Calculations based on historical results from exchanges with short histories and volatilities may not be deemed applicable to the longer-term outlook. If EP is still not available, it is possible to use that of another comparable country if a published source is available as a benchmark. Morningstars International Equity Risk Premia Report provides EPs for 16 countries. A country must have at least five years of quality equity and risk-free return data to be included in Morningstar. Another source that might be considered is Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers (see sidebar for complete citation).

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International Cost Of Capital: Cost Of Equity/capm

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CHRISTINE BAKER CPA/ABV/CFF PARENTEBEARD NEW YORK, NY NEIL J. BEATON CPA/ABV, CFA, ASA GRANT THORNTON SEATTLE, WA JOHN A. BOGDANSKI, ESQ. LEWIS & CLARK LAW SCHOOL PORTLAND, OR NANCY J. FANNON ASA, CPA/ABV, MCBA FANNON VALUATION GROUP PORTLAND, ME JAY E. FISHMAN FASA, CBA FINANCIAL RESEARCH ASSOCIATES BALA CYNWYD, PA LYNNE Z. GOLD-BIKIN, ESQ. WOLF, BLOCK, SCHORR & SOLIS-COHEN NORRISTOWN, PA LANCE S. HALL, ASA FMV OPINIONS IRVINE, CA JAMES R. HITCHNER CPA/ABV, ASA THE FINANCIAL VALUATION GROUP ATLANTA, GA THEODORE D. ISRAEL CPA/ABV/CFF, CVA ECKHOFF ACCOUNTANCY CORP. SAN RAFAEL, CA JARED KAPLAN, ESQ. MCDERMOTT, WILL & EMERY CHICAGO, IL GILBERT E. MATTHEWS CFA SUTTER SECURITIES INCORPORATED SAN FRANCISCO, CA Z. CHRISTOPHER MERCER ASA, CFA MERCER CAPITAL MEMPHIS, TN JOHN W. PORTER, ESQ. BAKER & BOTTS HOUSTON, TX RONALD L. SEIGNEUR MBA CPA/ABV CVA SEIGNEUR GUSTAFSON LAKEWOOD, CO BRUCE SILVERSTEIN, ESQ. YOUNG, CONAWAY, STARGATT & TAYLOR WILMINGTON, DE JEFFREY S. TARBELL ASA, CFA HOULIHAN LOKEY SAN FRANCISCO, CA GARY R. TRUGMAN ASA, CPA/ABV, MCBA, MVS TRUGMAN VALUATION ASSOCIATES PLANTATION, FL KEVIN R. YEANOPLOS CPA/ABV/CFF, ASA BRUEGGEMAN & JOHNSON YEANOPLOS, P.C. TUCSON, AZ

Yield spread model (country spread). This model may be used for a subject company in a specific country, but not a multinational subject company. The model is easy to use because it starts with the U.S. risk-free rate and the U.S. EP and adjusts for yield spreads between U.S. and local country government bonds. The model is also useful if local country government debt is issued in U.S. dollars (Venezuela is an example of a country that issues government debt in U.S. dollars rather than local currency). When employing this approach, valuation professionals should remember that the country must issue dollar-denominated debt. If it doesnt, practitioners may use the countrys credit rating to find countries with comparable country credit ratings and then utilize that countrys dollar-denominated risk-free yield as a proxy for the subject country. The practitioner should keep in mind that comparable credit ratings may not always serve as a proxy for the subject countrys risk-free yield and they should proceed with caution. In addition, issues such as government credit quality may prevent use of the country government yield. Lastlybecause yield spreads are based on debt, which is less volatile than equity markets keep in mind that debt is not necessarily a proxy for equity, and this model could possibly underestimate the CAPM. As with some of the other models, the currency risk must be either in the cash flows or an additional adjustment to the discount rate. Furthermore, the use of dollar-denominated or euro-denominated debt is not an accurate reflection of the equity and currency risk of the subject country, and a lower CAPM may result. Volatility spread model. This model is easy to use because it starts with the U.S. risk-free rate and the U.S. EP and adjusts the EP based on specific country stock market volatility to that of the (mature) U.S. stock market. As with the yield spread model, we use this method for a countryspecific subject company valuation, not a multinational subject company. The model is useful if the stock market in the local country is diversified
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Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. The annual subscription price for the Business Valuation Update is $359. Low cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same address. Contact our sales department for details. Please feel free to contact us via email at customerservice@BVResources.com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2011, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR.

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International Cost Of Capital: Cost Of Equity/capm

and has history. For example, Thailand, India, and Germany have fairly diversified stock markets that are somewhat comparable to the U.S. Other stock markets, such as in Russia, China, Brazil, and South Africa, are not as diversified and have concentrations in specific industries that result in a lack of comparability of stock market volatilities. Valuation professionals should consider how diversified the stock market is and be careful of the stock market/index used. Volatility of the country stock market above that of the U.S., however, implies a country level risk. Generally, this method is applied to U.S. dollar net cash flows and the exchange rate risk must be treated in either the expected cash flows or as an adjustment to the discount rate. Sources for additional information on International Cost of Capital Methods
Damodaran, Aswath. Equity Risk Premiums (ERP): Determinants, Estimation and Implications, The 2011 Edition, updated Feb. 2011. Stern School of Business. Internet: www.stern.nyu.edu/~adamodar/ pdfiles/papers/ERP2011.pdf Fernandez, Pablo, Javier Aguirreamalloa, and Luis Corres Avendano.Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers. April 25, 2011. Internet: papers.ssrn.com/sol3/papers. cfm?abstract_id=1822182 Harvey, Campbell R. 12 Ways to Calculate the International Cost of Capital, Oct. 14, 2005. Internet: faculty.fuqua.duke.edu/~charvey/...2006/ Harvey_12_ways_to.pdf International Cost of Capital Report 2011. Morningstar. Internet: corporate.morningstar.com/ib/asp/subject. aspx?xmlfile=1423.xml International Equity Risk Premia Reports. Morningstar. Internet: corporate.morningstar.com/ib/asp/subject. aspx?xmlfile=1424.xml Pratt, Shannon, and Roger Grabowski. Cost of Capital, Fourth Edition. Internet: www.bvresources. com/bvstore/selectbook.asp?pid=PUB195

Local c ount r y r isk exp o su r e mo d e l (Damodaran). This model is easy to use because it starts with the U.S. risk-free rate and the U.S. equity premium. It is also useful if the local country has a viable equity market and the government debt is issued in U.S. dollars. The models theory is to utilize the country default spread as adjusted for the standard deviation of the local equity market to the local bond market. This adjusted default spread is then added to the U.S. CAPM. To estimate the long-term country default spread, the practitioner should start with the country credit rating (from Moodys: www.moodys.com) and compare that to the country credit rating of a mature market, such as the U.S. The difference in the ratings can be measured in points, arriving at the default spread. The standard deviation of the local equity market and the local bond market can be calculated if both markets have adequate history and would not necessarily be deemed emerging economies. For situations where there is not enough history to develop standard deviations or if markets are in such turmoil that current calculations may not be deemed representative of the long term, a benchmark such as 1.5, may be appropriate. The model is applied to net cash flows expressed in U.S. dollars, and exchange risk must still be considered as either an adjustment to cash flow or to the discount rate. It is important to note that the country default spread may not be an adequate indicator of risk in the equity markets. Country credit rating model (Erb-HarveyViskanta). The CCRM model is the easiest of nonlocal models to apply. It can be applied across many countries, including developed and emerging markets. This model works well for valuation work with legal entities or reporting units in multiple countries, and where a reported equity premium is not available, such as Thailand; where government debt issued in local currency in nonexistent, such as Venezuela; and where local stock market industry diversification is in question, such as Russia, Venezuela, Brazil, and China.

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International Cost Of Capital: Cost Of Equity/capm

CCRM is based on a regression model that relates market returns with country credit ratings. The country credit rating is the independent variable, and the historical equity returns are the dependent variable. Although many countries do not have data for risk-free debt or equity returns denominated in local currency, country credit ratings still exist. CCRM considers actual equity returns, which are converted to U.S. dollars, historical volatility and forward-looking country credit ratings from Institutional Investor via Morningstar. Two CCRM models are available: the logarithmic model and the linear model. The logarithmic model focuses on the percentage movement in the risk rating as a more relevant measure than the absolute movement in the risk rating. When using this model, we start with the development of a U.S.-based CAPM and add to that the difference between the subject country credit rating and the U.S. (mature market) credit rating.

The model incorporates currency and exchange risk but does not necessarily incorporate company and industry risks. Practitioners must also be careful of the cash flows used and how risk is presented in the cash flows. CCRM is forward looking with the use of country credit ratings, but the subjectivity of the credit ratings is a disadvantage. Conclusion. As evidenced by the above, there are a number of available models that can be used to develop a country-specific CAPM. The valuation practitioner is encouraged to apply as many models as possible, thereby allowing for a more comprehensive approach to the countryspecific CAPM. It is with much thought as to the country, the company, and the industry that the cost of equity is concluded. Nancy Czaplinski is vice president & managing director at American Appraisal Associates. She can be reached at 414-225-1035 or nczaplinski@ american-appraisal.com.

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December 2011