Corporate Finance

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Corporate Finance

Country premium = 1.75 × 3.2 = 5.6 percent

Cost of equity for the project = 5.1 + 6.1 + 5.6 percent

= 16.8 percent

Cost of equity can be used to discount free cash flow to equity investors to value the project.

Exhibit 11.10 Country ratings and default spread

Country Long term bond rating* Country risk premium

Argentina Ba3 4 percent
Australia Aa2 0.65 percent
Austria Aaa 0.00
Belgium Aaa 0.00
Brazil B2 5.5 percent
Canada Aa2 0.65 percent
Chile Baa1 1.2 percent
China A3 0.95 percent
India Ba2 3 percent
Indonesia B3 6.5 percent
Japan Aa1 0.60 percent
Pakistan Caa1 7.5 percent
Sweden Aa2 0.65 percent
Switzerland Aaa 0.00

• Spread between interest on foreign currency country bond and that on US corporates with similar rating.
  Source: Aswath Damodaran, ‘Estimating Risk Premiums‘, Working Paper, Stern School of Business.

Converting Discount Rates

Some academics suggest that the discount rate be calculated in home currency and then translated to host
currency. The conversion of home currency discount rate to host country discount rate involves application
of interest rate parity condition. Interest rate parity stipulates that the expected rate of change in the spot
exchange rate equals the ratio of the prevailing interest rates in the two currencies.

)1(

)1(

)1(

2

1

R

R

s

+

+

=∆+

where

∆s = expected change in spot rate.

R 1 and R 2 are yields on comparable government bonds denominated in the currencies in question. The weighted
average cost of capital in one currency can be converted into another by multiplying by the expected annual
change in the exchange rate. While changes in exchange rates may correspond with changes in the differential
in national inflation rates in the long run, there are sharp deviations from this parity relationship for shorter
intervals. The inflation rate in many emerging markets is much higher than that in stable economies. So dis-
counting foreign cash flows with interest rate in that country would be inappropriate. Likewise, managers in
low interest rate economies like Japan should not use the Yen rate. This will inflate the NPV of the investment.
One school of academics suggests that the discount rate is the interest rate which the home government
would pay in the host country plus a premium that reflects the spread over treasuries the company will have
to pay when at home. The average of interest rates over a cycle might be used to discount cash flows. It is im-
portant to understand that the interest rate used to discount should be distinguished from the currency borrowed
to finance the project to keep valuation and financing separate.