The Country Risk Premium
When the net present value, NPV, of an investment project is estimated, expected cashflows must be discounted at the rate of opportunity cost of capital, which is defined as the return that could be obtained in the market assuming a similar risk to that of the aforementioned project. Assuming the investment project being evaluated has a similar risk to that of the
Table 15.1 Main variables that influence country risk (Author’s own composition) Political situation Geopolitical risk of the region
Risk of internal or external political conflicts Political stability, government efficiency,
strength of institutions Debt payment culture Level of corruption
Macroeconomic situation GDP growth rate, with consumption, investment and savings detail
Inflation rate and monetary policy instruments Nominal and real interest rates
Public sector balance (in % of GDP)
Internal and external public debt (in % of GDP) Size of local bonds market (in % of GDP) Unemployment rate
Economic structure GDP composition by economic sector Size of the population
Profit distribution, measured by the Gini index Profit per capita in $
Exportation of one primary product (in % of total exports)
Energy imports (in % of primary energy consumption)
Banking sector Poor quality credits (in % of total credits) Solvency and profit ratios
Foreign bank penetration
Assets and liabilities in foreign banking currency Banking supervision and deposit insurance
agency
External sector Balance of commercial and current accounts Exchange rate regime and devaluation history Payment and refinancing history in the Paris Club Existence of exchange control
Level and structure of external debt
Foreign exchange reserves and import hedges (no. of months) and short-term debt Foreign direct investment and portfolio
investment
Market indicators Of sovereign debt, collected in the EMBI Plus or EMBI Global index
Credit default swap spread Long-term sovereign rating in
foreign currency
Moody’s
Standard and Poor’s Fitch Ratings
company, the opportunity cost of capital for this project can be estimated by the average cost the company pays to be financed, a cost which is known as the weighted average cost of capital or WACC.
Thus, as discussed previously, the investment project being evaluated will be accepted if the NPV of the project, discounted at the average rate of WACC, is positive or, equivalently, if the internal rate of return, IRR, that the project provides is greater than the WACC.
As will be discussed in later chapters, the WACC is calculated by WACCẳKe
CAA
CAAỵDỵKdð1Tị D CAAþD
where:
• Keis the rate of return required by the shareholders of the company and can be estimated using the capital asset pricing model (CAPM) or the Gordon–Shapiro share valuation model.
• Kdis the cost (IRR) of debt issued by the company.
• CAA is the capital contributed by shareholders and is defined as the market value of the company’s shares, that is, the market capitalisation of the company if it is traded in the stock market.
• Dis the market value of debt issued by the company.
• Tis the corporate tax rate.
Importantly, capital values (CAA) and debt values (D) must be expressed in market values and not in accounting values because, as is known, sometimes accounting values deviate substantially from market values. Thus, the market value of a company’s shares, the capitalisation of the company, is usually considerably greater than its accounting value, since the latter is a historical cost which reflects neither the value generated by the company since its establishment nor its future growth expectations.
Also, the market value of debt does not have to coincide with the accounting value; for example, if the market considers the risk of default to be high, the debt securities issued by the company will be listed in the market at a value below their accounting value. Similarly, the calculation
of rates of return on equity (Ke) and debt (Kd) will be carried out using market capitalisation values and market debt values respectively.
It must also be noted that in the calculation of WACC the cost of debt is multiplied by (1T) due to tax savings (tax shield) which provide the company with financing through debt, that is, the more indebted a company is, the more interest it will pay; the more interest paid, the lower the taxable income; and finally, the lower the taxable income, the lower the tax payable. Therefore, the real cost of debt, after taking into account the tax savings, is notKd, butKdwithout the tax savings, that is, KdKd*TẳKd* (1T).
From the above expression it can be concluded that the two key determinants of WACC are the cost of equity (or return required by shareholders),Ke, and the cost of debt,Kd,and both values depend on the type of investment project being evaluated and the country in which the project is developed. Therefore, the WACC has a clear dependence on the country where the investment project is developed since the greater the country risk, the larger the WACC. Thus, for a given investment project the country risk premium can be defined as the difference between the WACC of this project and the WACC that the project would have if it were developed in a country of the OECD.
In the same way, the risk premium of an investment project can also be defined as the difference between the WACC of the project and the risk-free interest rate, a premium in which, of course, country risk and all other risks associated with the project are included.