In this class, we introduce the credit rating approach to estimating the cost of capital for emerging markets projects. 

We will also consider the differences in inflation rates across countries and the estimation of forward exchange rates using parity conditions.   

 


 



Assignment Sheet
Emerging Markets Finance

 

Class #7, Thursday, November 3, 2005

Topic: Incorporating country risk: credit rating approach

Case:  Paginas Amarelas, UVA-F-1210
Case: (technical note) Investing in Emerging Markets: Valuation, UVA-F-1455

File 1: UVA-S-F-1210 v. 2.0.XLS

File 2: Institutional Investor Country Credit Rating: 1979 through 2001. (Check your email for this file.)
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The idea for the credit rating approach is described in the following research article:

Campbell R. Harvey, Claude Erb and Tadas Viskanta, "Expected Returns and Volatility in 135 Countries" Journal of Portfolio Management, Spring 1996, pp. 46-58. (Download PDF file here.)

Based on this line of research, an updated formula for calculating the cost of equity is given below:

Using Institutional Investor Country Credit Rating (IICCR), the credit-rating-based required rate of return on equity for a project of average risk in a given country is:

Ke = Rf + 0.898 - 0.177*ln(IICCR)

where IICCR is the country's credit rating.

Here a project of average risk is a project that has a (levered) project beta of 1.

The leveled project beta is computed as
beta_project = beta_US_unlevered * ( 1 + (1-t) D/E )
where beta_US_unlevered is the unlevered beta of comparable companies in the US, t is the local marginal tax rate on corporate income, and D/E is the target market debt to equity ratio of the project.

For a project with a (levered) project beta, beta_project, the EHV project cost of equity can be computed as

Ke = Rf + beta_project * (0.898 - 0.177*ln(IICCR))
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Assignment Questions:

  1. What is the valuation problem here?  In what currency are the cash flows denominated?  In what currency should the discount rate be denominated?  Be sure you understand Exhibits 1, 2, 3, and 4 of the case.

  2. Please estimate the weighted costs of capital for the cash flows originating in Argentina, Brazil, and Chile, first using the Lessard formula, and then using the EHV credit rating formula. How would you estimate the cost of debt for the cash flows?

  3. Please estimate a long-term perpetual growth rate for the businesses in Argentina, Brazil, and Chile.

  4. Based on your answers to questions 4 and 5, and referring to Exhibits 2, 3, and 4, what is a reasonable range of value for Brasil Investimentos' "yellow pages" business?  What key assumptions underlie your suggested value range?