234 Corporate Finance
APPENDIX 1: ESTIMATING DISCOUNT RATES IN
EMERGING MARKETS
In recent years, a great deal of research has been done on asset pricing in emerging markets. This appendix
explains three such studies.
Godfrey–Espinosa Approach
The Godfrey–Espinosa model to estimate the cost of equity in emerging markets suggests:
Ki = Rf, u.s. + Credit spreadi + 0.6 [σi/σm] [Risk premiumu.s.]where,
Rf, u.s.= risk free rate in the US = 6 percent,
σi= annualized equity market volatility of the country in question,
σm= annualized equity market volatility of the US, and
Credit spread = Difference in yields on the public debt of two countries denominated in common currency.Given here are the credit spread and other inputs for estimating cost of equity in India and other countries
in 1996:
Credit Annualized Cost of
Country spread volatility beta Adjusted equity
Argentina 4..percent 54.74 percent 3.39 28.7
Brazil 4.1.percent 53.75 percent 3.33 28.4
Mexico 3.8.percent 36.56 percent 2.26 22.3
Philippines 2.0.percent 32.05 percent 1.99 18.9
India 1.6.percent 29.95 percent 1.86 17.8
Indonesia 1.0.percent 27.19 percent 1.68 16.3
Source: Godfrey and Espinosa (1996).
Goldman Sachs Model^8
The Goldman Sachs model is specified as
R = Rus + premium
where,
Rus = risk free rate in the US.
They calculate premium in two steps:- The country risk spread, Rs, the spread over treasuries for sovereign, dollar denominated emerging market
bonds of similar maturity. - A leveraged measure of the US equity risk premium (Eu) defined as the equity risk premium in the US,
adjusted by the ratio of daily volatility (Sb) over the volatility of the US market (Su).
(^8) Jorge Mariscal and Kent Hargis (1999). ‘A Long-term Perspective on Short-term Risk’, Goldman Sachs Research, Oct.