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2010 International Cost of Capital Report


International Cost of Capital Report 2010

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International Cost of Capital Report 2010

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International Cost of Capital Report 2010

International Cost of Capital Methodology
In using the International Cost of Capital Report, please note that all cost of equity estimates are from the perspective of a U.S. investor. In other words, these statistics represent estimates of the cost of equity from the perspective of a U.S. based investor with an equity investment in different markets around the world. Country Risk Rating Model Most cost of equity models require market data in order to produce a cost of equity estimate, however, most countries lack sufficient data to incorporate into cost of equity models. As a solution to this and other modeling problems, Erb, Harvey, and Viskanto have proposed a model based on country credit ratings. The idea behind this approach is that given the risk ratings and financial returns of developed market economies, we can make inferences about expected returns in developing markets or non-market-based economies. From the entire sample of market based economies that have available returns and country credit ratings, a regression is performed using the return as the dependent variable and the country credit rating for the prior period as the independent variable. This equation is expressed as follows:

where:

Rt = α + β CCt ?1 + ε

Rt α βC

= the expected return of a country in period t; = the regression intercept; = the regression coefficient for the country credit rating of the prior period; C t ?1 = the country credit rating in the prior period, t?1; and, ε = the error term of the regression.

Country credit ratings are available for many countries back to 1979 on a semiannual basis.1 The entire history of available data is used for added statistical confidence. The resulting regression equation allows one to estimate the expected return of any country given its country credit rating, whether or not the country has available return data. We have presented two different versions of the Country Risk Rating Model, one on a linear scale and one on a logarithmic scale. The linear model assumes that risk increases in a linear fashion with the risk rating. The logarithmic model assumes that risk increases in a non-linear fashion with the risk rating. The logarithmic model focuses on the percentage movement in the risk rating as being a more relevant measure than the absolute movement in the risk rating. Credit Rating Source Twice each year, in March and September, Institutional Investor produces a country risk rating for over 170 countries based on a survey of lenders around the world.1 The survey provides a forward-looking measure of risk for a broad sample of markets. We utilize the entire history of ratings back to March 1980.

1

Instiutional Investor discontinued publishing March credit ratings in March of 2009; therefore, this report only incudes annual credit ratings through

September 2009.

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International Cost of Capital Report 2010

Source of Market Returns The stock market returns for developed market countries are those given by Morgan Stanley Capital International (MSCI). For emerging market countries the returns are those given by the S&P/IFCG (Global) Indices from January 1980 to October 2008 and the S&P Emerging BMI Indices from November 2008 to present. Semi-annual total return data was used from September 1980 to present. All returns are converted to U.S. dollars. MSCI Indices are designed to reflect the performance of the entire range of stocks available to investors in each local market. Each stock in the local index is weighted by market capitalization. Stocks are chosen for the indices by the following criteria: 1) The MSCI Indices aim for 85% coverage of the total market capitalization for each market. 2) The companies included in the indices replicate the industry composition of each global market. 3) The chosen list of stocks includes a representative sampling of large, medium, and small capitalization companies from each local market, taking into account the stocks’ liquidity. 4) Stocks of non-domiciled companies, investment trusts, and mutual funds are not eligible for country indices. 5) Companies with restricted float due to dominant shareholders or cross ownership are avoided. For the developed markets, indices with dividends reinvested provide an estimate of total return that would be achieved by reinvesting one-twelfth of the annual yield reported at every month-end. The series with gross dividends reinvested take into account actual dividends before withholding taxes, but exclude special tax credits declared by the companies. For additional and recently updated information, please refer to the Morgan Stanley Capital International website at http://www.MSCIBarra.com. Again, the total return data for emerging markets was taken from the S&P/IFCG (Global) database. The S&P Emerging Market Indices are widely recognized as the most comprehensive and reliable measures of the world’s emerging markets. The indices and their underlying database, which Standard & Poor’s acquired from International Finance Corporation (IFC) in 2000, have been maintained since 1975. Since their inception, the indices have grown to cover more than 2,000 companies in 58 markets. Indices in S&P/IFCG target an aggregate market capitalization of 70–80% of the total capitalization of all exchange-listed shares. For additional information, please refer to the S&P web site at http://www.standardandpoors.com. To qualify for S&P/IFCG, a company typically must be domiciled in an emerging market and be among the most actively traded securities in that market. Any security that represents an equity interest in a qualified company may be included in an S&P emerging market index. Types of securities include common stock, preferred stock, participation certificates, and other such securities, without regard to their voting rights status. The following share classes are ineligible for inclusion: fixed-dividend shares, investment trusts, unit trusts, mutual fund shares, closed-end equity or bond funds, convertible bonds, and equity warrants. REITs and other trust-like structures created for tax-advantage purposes are eligible for S&P index inclusion.

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International Cost of Capital Report 2010

The dividend yield is the total of all dividends paid over twelve months divided by the total market capitalization at the end of the period. Beginning in the fall of 1994, IFC changed the methodology for dividend yield calculation by converting gross cash dividends to U.S. dollars at the same exchange rate used to convert market capitalization. Before 1994, dividends were converted into U.S. dollars using exchange rates on the ex-dividend date while market capitalization values were converted at the end of the period Effective November 1, 2008 the S&P/IFCG Composite Indicies have been discontinued and data folded into the new S&P Global BMI Indices. Enhancements to the S&P Emerging BMI methodology require included companies to have an annual dollar value traded of at least $50 million of the previous 12 months, up from $25 million in the S&P/IFCG Composite Indicies. For additional information, please refer to the S&P web site at http://www.standardandpoors.com. Country-Spread Model Another international model in current use is the country-spread model. While it takes many forms, this model adds a country-specific spread to a cost of equity determined from more conventional means. Typically, a cost of equity is determined using U.S. data, then a spread is added to “internationalize” the cost of equity. Ideally, the spread is between the yield on dollar-denominated foreign bonds in comparison to the yield on the U.S. Treasury bond. The spread between the bonds is intended to measure the additional return required to compensate for the additional risk inherent to the foreign investment. Though the spread may capture incremental returns due to currency risk and other country specific risks, it is important to note that there may be additional risks inherent in the equity market of a particular country that are not captured in the yield spread. However, this model does provide a good reference point to check against other models. For example, suppose the yield of a dollar-denominated foreign bond of an emerging-market country is 10.0 percent higher than the yield on an equivelant U.S. Treasury bond. If the estimated U.S. cost of equity using the CAPM is determined to be 11.25 percent (the yield as of December 31, 2009 on a U.S. Treasury bond with a maturity of approximately 20 years, 4.58 percent, plus the historical U.S. long-horizon equity risk premium, 6.67 percent), then the estimated cost of equity for this emerging-market country would be 21.25 percent (the U.S. cost of equity, 11.25 percent, plus the spread of 10.0 percent) using the country-spread model. Source of Spread Data Source of yields on U.S. Treasury bonds is the Wall Street Journal. Yields on dollar-denominated sovereign bonds were obtained from Morningstar Indices. For additional information, please refer to http://indexes.morningstar.com.

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International Cost of Capital Report 2010

International CAPM The principles of the capital asset pricing model (CAPM) can also be applied to the international market. The market definition can be expanded to include all countries. The CAPM states that the expected return on a security, asset, or country is equal to the risk-free rate plus the beta multiplied by the equity risk premium. Recall that the CAPM can be stated mathematically for individual companies as follows:

where: k s =rf +(β s ×E P) R ks rf βs ERP = = = = the cost of equity for company s; the expected return of the riskless asset; the beta of the stock of company s; and the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed that on the riskless asset.

To convert CAPM to a country-specific international format, the model can be modified so that the beta is specific to the country being analyzed and the equity risk premium is calculated on a worldwide basis. Beta is estimated using the world equity market as the market benchmark. One limiting factor with international data is the historical time period over which data is available. Key to the calculation of the CAPM is a determination of the appropriate equity risk premium. Equity risk premium calculations should cover a long historical time period. However, data for many international markets is only available over much shorter time periods. Step one in the application of an international CAPM is the determination of the world equity risk premium. Because extensive historical data is available in the U.S., it is desirable to estimate the world equity risk premium by relating it to the U.S. data. To do this we can divide the U.S. equity risk premium by the beta of the U.S. market in relation to the world:

E PW = R

E PU.S. R β U.S.,W.

where: ERP W = the world equity risk premium; ERP U .S. = the U.S. equity risk premium measured over the full history of available data; and β U.S., W = the U.S. market beta relative to the world measured over the common history of available data.

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International Cost of Capital Report 2010

Using data from 1926 through 2009, the expected U.S. value is 6.67 percent. If we assume that the Morgan Stanley Capital International (MSCI) World Index represents a good proxy for world markets, we can regress the U.S. returns against the returns of the world index. The MSCI data is available from 1970 to present. The U.S. beta for 1970 through 2009 using this world market benchmark is 0.9199. If the U.S. equity risk premium is 6.67 percent and the U.S. market has a beta with the world of 0.9199, then the equity risk premium of the world is 7.25 percent (6.67 percent divided by 0.9199). Step two in the application of an international CAPM is the calculation of a country-specific beta. The beta calculation methodology for international markets is similar to the calculation methodology for domestic companies. A simple regression is performed with the returns of each country as the dependent variable and the returns of the world as the independent variable. Probably the largest assumption in this calculation is the determination of the appropriate historical time period over which beta is calculated. While a long period of historic data may be relevant for an established economy such as the United Kingdom, for developing markets or markets in transition such as Indonesia, it might be desirable to focus on shorter data windows. Less developed markets have less stable betas over time than developed markets. To remain consistent across countries, we have calculated betas using five years of monthly data for each country. All returns are converted to U.S. dollars. Once the beta of the country has been determined, it can be plugged into the capital asset pricing model to determine the estimate of the cost of equity. For example, if Canada has a beta of 1.30, then the expected cost of equity would be:
k s =rf +( β s ×E P ) =4.58 + (1.30×7.25)=14.01%* RW
*13.98% calculated without rounding parameters

Source of Market Returns The stock market returns for developed market countries are those given by Morgan Stanley Capital International (MSCI). For the emerging market countries, the returns are those given by S&P/IFC Global Indices from January 1970 to October 2008 and the S&P Emerging BMI Indicies from November 2008 to present. A detailed description of these data series can be found within the Country Risk Rating Model section.

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International Cost of Capital Report 2010

Globally Nested CAPM The idea behind Clare and Kaplan’s globally nested CAPM model is that if markets are not fully integrated, then regional risk will matter. For instance, if we were trying to calculate a cost of equity for Brazil, we would look at how Brazil reacts to the rest of the world, but we would also be interested in how Brazil reacts to the Latin American region as a whole. It is important to note that the regional risk measured here is residual regional risk not included in the world.

This model is expressed as: k C = r f +(β CW ×E PW ) +(β CR × δ R) R

where: kC rf βCw ERP w βCR the cost of equity for country C; the expected return of the riskless asset; the country’s covariance with world market risk; the expected world equity risk premium; the country’s covariance with regional risk; and = the risk premium associated with region R that is not part of the world equity risk premium. = = = = =

δR

This model focuses on measuring the country’s sensitivity to both a world and a regional proxy. The accuracy of this model is dependent upon the quality of the regional benchmarks against which it is measured. These regional benchmarks are typically constructed along geographical lines instead of focusing on economic relationships. Source of Market Returns Each country’s stock market returns are those given by Morgan Stanley Capital International (MSCI). A detailed description of these data series can be found within the Country Risk Rating Model section. The regional proxy is represented by MSCI Emerging Markets Latin America Free Index. MSCI Free indices exclude shares of certain stocks listed on exchanges that are not available to foreign investors.

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International Cost of Capital Report 2009

Relative Standard Deviation Model A simpler approach to calculating the international cost of equity is the relative standard deviation model. In this model, the standard deviations of international markets are indexed to the standard deviation of the U.S. market. Countries with higher standard deviations than the U.S. are given a higher expected equity risk premia in proportion to their relative standard deviation.

σ j,R =

σj σ U.S.

where:
σ j,R = the relative standard deviation of country j; σ j = the standard deviation of excess returns for country j; and σ U .S. = the standard deviation of excess returns for the U.S.

For example, the relative standard deviation of returns for Canada is 1.29 (5.8065 percent / 4.5133 percent). Therefore, the expected cost of equity for Canada would be:

kC =rf +( σ j,R× ERPU.S. ) =4.58+(1.29×6.67)=13.18%

where: kC = rf = σ j ,R = ERP U .S. = the cost of equity for country C; the expected return of the riskless asset; the relative standard deviation of country j; and the U.S. equity risk premium measured over the full history of available data;

One difficulty with this model is that it may produce unreasonably high cost of capital estimates for some international markets. Less developed markets tend to have considerably higher relative standard deviation statistics, which results in a considerably higher cost of capital estimate (i.e., Argentina at 37.19 percent). Source of Market Returns The stock market returns for developed market countries are those given by Morgan Stanley Capital International (MSCI). For the emerging market countries, the returns are those given by S&P/IFC Global Indices from January 1970 to October 2008 and the S&P Emerging BMI Indicies from November 2008 to present. A detailed description of these data series can be found within the Country Risk Rating Model section.

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International Cost of Capital Report 2010

Bibliography Clare, Andrew D., and Paul Kaplan. “A Globally Nested Capital Asset Pricing Model,” Ibbotson Associates, July 1998. Erb, Claude, Campbell R. Harvey, and Tadas Viskanta. “Country Credit Risk and Global Portfolio Selection,” Journal of Portfolio Management, Winter 1995.

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International Cost of Capital Report 2010

International Cost of Capital Models

Country Risk Rating Log Model Linear Model Country Afghanistan Albania Algeria Angola Argentina Armenia Australia Austria Azerbaijan Bahamas Bahrain Bangladesh Barbados Belarus Belgium Belize Benin Bermuda Bhutan Bolivia Bosnia & Herzegovina Botswana Brazil Bulgaria Burkina Faso Burundi Cambodia Cameroon Canada Cape Verde Central African Republic Chad Chile China Colombia Comoros Congo Costa Rica C ? te d'Ivoire Croatia Cuba Cyprus Czech Republic Dem. Republic of Congo (Zaire) Denmark Djibouti Dominican Republic East Timor Ecuador Egypt El Salvador Equatorial Guinea Eritrea Estonia Ethiopia Fiji Finland France Gabon Gambia 43.24 26.66 20.09 27.49 30.20 26.30 12.35 12.35 22.65 16.27 16.61 33.69 17.92 32.20 12.43 31.89 31.65 14.07 29.28 31.77 30.04 17.57 17.41 21.21 32.70 43.84 31.29 31.89 11.49 28.77 46.62 45.51 14.37 14.93 19.97 40.82 35.86 20.79 37.47 20.12 42.43 15.05 14.91 44.46 11.81 34.24 26.61 35.71 37.56 21.54 22.76 31.00 44.59 19.73 38.07 27.58 11.77 11.85 27.78 39.25 09-09 34.11 26.94 21.57 27.49 29.10 26.70 11.94 11.94 23.90 17.35 17.77 30.83 19.29 30.13 12.06 29.98 29.86 14.46 28.58 29.92 29.01 18.89 18.71 22.63 30.37 34.26 29.67 29.98 10.57 28.28 34.90 34.65 14.89 15.65 21.44 33.44 31.74 22.23 32.35 21.60 33.89 15.80 15.61 34.41 11.09 31.07 26.91 31.68 32.38 22.93 24.00 29.52 34.44 21.20 32.56 27.55 11.03 11.15 27.67 32.95

Country Spread 03-10

International CAPM Model 12-09

Globally Nested CAPM 12-09

Relative Standard Deviation Model 12-09

Available Models 2 2 2 2 6 2 4 4 2 2 2 2 2 2 4 2 2 2 2 2 2 2 6 2 2 2 2 2 4 2 2 2 5 4 4 2 2 2 2 2 2 2 4 2 4 2 2 2 2 2

17.95

16.39 14.21 17.79

20.09

37.19 15.01 14.38

15.25

13.43

12.58

16.86

41.18

28.84

13.98

13.16

10.67 14.23 14.15

15.39

18.89 23.05 17.93

14.76 13.18

17.64 12.89

14.06

3 2 2 2 2 14.66 13.48 19.35 14.24 2 4 4 2 2

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?2010 Morningstar, Inc. All rights reserved. Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc.

International Cost of Capital Report 2010

International Cost of Capital Models

Country Risk Rating Log Model Linear Model Country Georgia Germany Ghana Greece Grenada Guatemala Guinea Guinea-Bissau Guyana Haiti Honduras Hong Kong Hungary Iceland India Indonesia Iran Iraq Ireland Israel Italy Jamaica Japan Jordan Kazakhstan Kenya Kiribati Kuwait Kyrgyzstan Laos Latvia Lebanon Lesotho Liberia Libya Lithuania Luxembourg Macedonia Madagascar Malawi Malaysia Mali Malta Mauritania Mauritius Mexico Moldova Mongolia Montenegro Morocco Mozambique Myanmar Namibia Nepal Netherlands New Zealand Nicaragua Niger Nigeria North Korea 30.31 11.60 28.77 15.05 29.23 23.87 42.21 42.43 33.97 42.66 29.34 13.47 19.58 21.91 18.25 21.98 29.13 35.63 13.91 16.36 14.24 27.16 12.41 23.64 22.09 31.65 31.53 15.03 34.17 33.49 23.79 31.17 28.02 46.19 21.71 21.11 11.39 24.74 34.74 36.65 16.19 32.96 14.62 37.90 20.59 17.23 32.58 28.41 25.52 20.91 32.39 47.20 21.41 33.76 11.56 13.09 38.25 35.86 27.63 55.91 09-09 29.16 10.76 28.28 15.80 28.55 24.91 33.83 33.89 30.95 33.95 28.61 13.61 21.05 23.27 19.65 23.33 28.49 31.65 14.25 17.47 14.70 27.27 12.03 24.72 23.42 29.86 29.79 15.77 31.04 30.74 24.85 29.61 27.82 34.80 23.08 22.54 10.42 25.57 31.28 32.04 17.25 30.49 15.22 32.50 22.05 18.50 30.31 28.06 26.15 22.36 30.22 35.02 22.81 30.86 10.70 13.06 32.62 31.74 27.58 36.41

Country Spread 03-10

International CAPM Model 12-09 14.38 16.48

Globally Nested CAPM 12-09

Relative Standard Deviation Model 12-09 13.94 19.37

Available Models 2 4 2 4 2 2 2 2 2 2

12.67 18.97 17.23 13.03 14.72 13.59 13.85 10.42 8.16 17.59

20.08 21.09 17.32 24.87

2 4 4 2 4 5 2 3 4 2 4 2 4 4 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

14.59 15.41 13.94 13.24

10.67

17.85

4 2 2 2 2 6 2 2 2 2 2 2 2 2 4 4 2 2 2 2

12.58

14.87

16.84

21.31

13.91 12.92

12.78 15.30

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International Cost of Capital Report 2010

International Cost of Capital Models

Country Risk Rating Log Model Linear Model Country Norway Oman Pakistan Panama Papua New Guinea Paraguay Peru Philippines Poland Portugal Qatar Romania Russia Rwanda S ? o Tomé & Príncipe Saudi Arabia Senegal Serbia Seychelles Sierra Leone Singapore Slovakia Slovenia Solomon Islands Somalia South Africa South Korea Spain Sri Lanka Sudan Suriname Swaziland Sweden Switzerland Syria Taiwan Tajikistan Tanzania Thailand Togo Tonga Trinidad & Tobago Tunisia Turkey Turkmenistan Uganda Ukraine United Arab Emirates United Kingdom United States Uruguay Uzbekistan Vanuatu Venezuela Vietnam Yemen Zambia Zimbabwe Total 11.41 16.44 35.11 19.85 28.41 30.04 19.02 22.54 16.09 13.89 14.64 21.14 17.98 37.56 39.82 15.68 28.92 24.90 39.72 43.72 12.06 14.93 13.36 36.49 58.00 18.31 15.56 13.57 31.47 47.35 29.39 30.59 12.11 11.36 31.11 14.42 40.92 31.11 19.31 40.51 33.49 16.61 19.10 21.18 31.47 29.76 29.66 14.69 12.51 12.10 22.36 32.32 31.35 25.82 23.16 31.95 31.41 56.67 178 09-09 10.45 17.56 31.43 21.32 28.06 29.01 20.47 23.81 17.13 14.22 15.25 22.57 19.35 32.38 33.13 16.62 28.37 25.70 33.10 34.23 11.49 15.65 13.46 31.98 36.66 19.71 16.46 13.76 29.76 35.05 28.64 29.31 11.58 10.36 29.58 14.95 33.47 29.58 20.78 33.35 30.74 17.77 20.56 22.60 29.76 28.85 28.79 15.31 12.18 11.55 23.66 30.19 29.70 26.36 24.33 30.01 29.73 36.51 178

Country Spread 03-10

International CAPM Model 12-09 16.52 7.87

Globally Nested CAPM 12-09

Relative Standard Deviation Model 12-09

Available Models 3 2 4 3 2 2 5 5 4 4 2 2 3 2 2 2 2 2 2 2

18.98

12.89

12.57 13.16

16.40 11.48 17.54 12.18

19.62 19.19 27.10 15.00

11.71

14.77

16.61

4 2 2 2 2 4 4 4 2 2 2 2 4 4 2 2 2 2 4 2 2 2 2 5 2 2 2 2 4 4 3 2 2 3 2 2 2 2

15.19 16.14 13.57

17.04 21.01 14.29

14.76 11.02

15.01 12.51

13.84

19.66

13.16

17.67 10.27

31.29 12.46

11.98 10.99 13.18

14.20 11.25

19.75

13

43

4

43

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