Discuss the various types of adjustments for risk that might be made to the global CAPM before valuing a target firm in an emerging country. Be specific.

Question

Quizplus · Accepted Answer

The Answer is To estimate the cost of equity for a firm in an emerging economy (k_e,em), the domestic CAPM can be modified for specific country risk as follows:
k_e,em = R_f + ß_{emfirm,global} (R_country - R_f) + FSP + CRP
where
R_f = Local risk free rate or the U.S. Treasury bond rate converted to a local nominal rate if cash flows are in the local currency; if cash flows are in dollars, the U.S. Treasury bond rate. (R_country - R_f) = Difference between expected return on a broadly defined equity index in the local country or in a similar country and the risk free rate.
ß_{emfirm,global} = Emerging country firm's global beta CRP = Specific country risk premium expressed as difference between the local
country's (or a similar country's) government bond rate and the U.S. Treasury bond rate of the same maturity. FSP = Firm size premium reflecting the additional return smaller firms must earn relative to larger firms to attract investors Note that the specific country risk premium should be added to the estimate of the cost of equity only if the U.S. Treasury bond rate is used as a proxy for the risk free rate. If the local country government rate were used, the risk free rate would already reflect risk specific to that country.

Discuss the Various Types of Adjustments for Risk That Might