LOS d: Estimate the cost of capital for emerging market companies, and calculate and interpret a country risk premium.

Over the long run, it is assumed that the country-risk premium will approach zero as the emerging market becomes integrated into the international markets.

The sovereign risk premium consists of both credit and country-risk premiums.

Start by calculating each country’s risk-free-rate:

Risk-free-rate = 10 yr. U.S. govt bond + (local inflation – U.S. inflation)

The risk free rate for each country is:

Penance Sands	7.35% = 5% + 4.35% ? 2%
Misty Land	8.00% = 5% + 5.00% ? 2%
Happy Valley	7.75% = 5% + 4.75% ? 2%

The cost of equity = risk-free rate + beta(market risk premium)

The cost of equity for each company is:

AAA	10.55% = 7.35% + 1.6(2%)
BBB	10.40% = 8.00% + 1.2(2%)
CCC	10.35% = 7.75% + 1.3(2%)

AAA’s high beta offsets Penance Sand’s low inflation, yielding the highest cost of equity.

Pricing power is difficult to ascertain without specific data, but the information presented above provides enough clues to deduce the proper order. Quintile Fusion appears to be a company in decline, reinventing itself, worried about rivals, and dependent on commodities for production. Both Blevins and Karnack Analysis appear to have more market leverage. Blevins’ concerns about its brand momentum, coupled with what appears to be fairly small barriers to entry, suggest pricing power is limited. Karnack differentiates by specialization, one key to charging high prices. Large barriers to entry, and a rise in capacity utilization suggests demand is rising faster than supply, potentially supporting higher prices. Concern about the acceptance of new products could be a negative indicator for prices, but Karnack has the most positive data regarding pricing power, and Quintile Fusion has the most negative data. (Study Session 11, LOS 38.f)

The list of plant upgrades is useful for estimating Kenton’s production, but an industrywide chart of orders and backlogs illustrates more than demand trends. By considering both orders and backlogs, an analyst can back into supply analysis and draw useful conclusions about the current supplies and industry production capacity. While cost-cutting initiatives will have an effect on profit margins, particularly in the short term, of more importance in the long term is the company’s ability to produce items the market wants. Kenton’s list of products and niches has substantial value for determining whether the company can continue to operate profitably. (Study Session 11, LOS 38.f)

Blevins’ growth rate suggests it is not on the decline. In some ways Blevins looks like a growth company, but companies can post solid growth within a mature industry, particularly if they are taking market share. And Blevins’ profit margins and concerns about the erosion of an already powerful brand are characteristic of an established company in a mature industry. Karnack’s difficulty in funding expansion hints at high capital needs, and concerns about new products suggest it is in a pioneer industry. (Study Session 11, LOS 38.b)

Inflation and political instability will have a similar effect on companies throughout a country. Some industries are more vulnerable to privatization than others, and simply reducing cash flows for all companies by a set amount will probably understate the cash flows of companies in industries not likely to be privatized. (Study Session 11, LOS 39.c)

The cost of equity = the risk-free rate + beta × market risk premium. First, the risk-free rate. We can’t use the U.S. risk-free rate, and Llaho bills may be illiquid or denominated in another currency. So we start with the 10-year Treasury yield, then add the difference between Llaho’s inflation and U.S. inflation.

4% + 2.5% + 25% ? 3.5% = 28%.

For beta, we use the industry beta, not the beta derived from stock returns. The market risk premium is the global premium.

Thus, the cost of capital is 28% + 1.6 × 9% = 42.4%. (Study Session 11, LOS 39.d)

The weighted average cost of capital equals (equity / assets) × cost of equity + (debt / assets) × after-tax cost of debt.

We have equity, assets, debt, and cost of equity values. To calculate the cost of debt, we start with the local risk-free rate plus the U.S. credit spread on comparable debt, or 15% + 1.3% = 16.3%. Then we multiply 16.3% by (1 – marginal tax rate). 16.3% × 70% = 11.41%.

Here is the entire equation:

($85.2 million / $279.5 million) × 25.4% = 7.74%.
($194.3 million / $279.5 million) × 11.41% = 7.93%.
7.74% + 7.93% = 15.67%.

(Study Session 11, LOS 39.d)

The analyst has most likely correctly estimated the risk free rate, the pre-tax cost of debt, the marginal tax rate, and the capital structure weights. However, she has most likely incorrectly estimated the market risk premium and beta. The best recommendation for estimating the market risk premium is to use a long-term average risk premium on a global market index. The topic review suggests a range of 4.5% to 5.5%. The market risk premium is overestimated using 6.0% based on recent risk premiums in the equity markets. Beta should be estimated based on a regression of the industry's stock returns on a global market index. The analyst has overestimated both beta and the market risk premium. The result is that she has also overestimated the cost of equity capital and the WACC.