Corporate Finance

Risk Analysis in Capital Investments 
 231

The resulting beta estimate would be biased. The investor, in this case, is a multinational company. As
there is no international index,^4 one could use the home country stock market index as a market portfolio. If
we assume that the systematic risk of a project in, say Chile, is about the same as that elsewhere (which is not
true), the problem boils down to finding the beta in the home country.^5
The risk premium for a foreign project could be expressed as:^6

Risk premium = base premium for a mature market + country premium

Cost of equity = Rf + β (base premium for mature market like the US) + country premium

where

Rf = T – bond rate, a proxy for risk free rate.

Base premium is the geometric average premium (i.e., Rm–Rf) earned by stocks over bonds over a long
period of time, 6.1 percent in case of the US. The country premium is added on the assumption that country
risk cannot be diversified due to cross market correlation. Put differently, a major portion of the country risk
is systematic. The equity risk premium of a country is a function of country default risk and the volatility of
equity market relative to the country bond market.

Country equity risk premium = Country default spread * [σequity/σcountry bond]

The country risk can be measured by the credit rating given by international credit rating agencies like
Standard & Poor and Moody’s.^7 These agencies publish default spread over the T-bond rate and spread over
corporate bonds with similar rating in the US. Exhibit 11.10 presents Moody’s country ratings and the
default spread. Either the corporate spread or the country spread could be used as default risk premium. The
default risk premium should be translated into equity risk premium.

Country equity risk premium = Country default spread × [σequity/σcountry bond]

where

σequity is the standard deviation of returns on the country’s stock market index, and

σcountry bond is the standard deviation of country bond prices.

Assume the following data:

Rf = T – bond rate in the US = 5.1 percent

Beta = 0.7

Base premium = 6.1 percent

Country default spread over US companies with same rating = 1.75 percent

σequity/σcountry bond= 3.2

(^4) We can probably take the Morgan Stanley Capital Index as the best proxy.
(^5) Shapiro (1983) points out that the systematic risk would not be much higher for a project in LDC vis-à-vis those in
industrialized countries.
(^6) See Aswath Damodaran, ‘Estimating Risk Premiums’, Working Paper, Stern School of Business. Also see, Godfrey S and
R Espinosa (1996). ‘A practical approach to calculating cost of equity for investments in emerging markets’, Journal of
Applied Corporate Finance, Vol. 9, No. 3
(^7) See http://www.moodys.com.