Executive Summary
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Following the piece on “Measuring Country Risk,” we focus on a related question: Once we have estimated a country risk premium, how do we evaluate a company’s exposure to country risk?
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In the process, we will argue that a company’s exposure to country risk should not be determined by where it is incorporated and traded.
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By that measure, neither Coca-Cola nor Nestlé are exposed to country risk. Exposure to country risk should come from a company’s operations, making country risk a critical component of the valuation of almost every large multinational corporation.
Introduction
If we accept the proposition of country risk, the next question that we have to address relates to the exposure of individual companies to country risk. Should all companies in a country with substantial country risk be equally exposed to country risk? While intuition suggests that they should not, we will begin by looking at standard approaches that assume that they are. We will follow up by scaling country risk exposure to established risk parameters such as betas (β), and complete the discussion with an argument that individual companies should be evaluated for exposure to country risk.
The Bludgeon Approach
The simplest assumption to make when dealing with country risk, and the one that is most often made, is that all companies in a market are equally exposed to country risk. The cost of equity for a firm in a market with country risk can then be written as:
Cost of equity = Risk-free rate + β (Mature market premium) + Country risk premium
Thus, for Brazil, where we have estimated a country risk premium of 4.43% from the melded approach, each company in the market will have an additional country risk premium of 4.43% added to its expected returns. For instance, the costs of equity for Embraer, an aerospace company listed in Brazil, with a beta1 of 1.07 and Embratel, a Brazilian telecommunications company, with a beta of 0.80, in US dollar terms would be:
Cost of equity for Embraer = 3.80% + 1.07 (4.79%) + 4.43% = 13.35%
Cost of equity for Embratel = 3.80% + 0.80 (4.79%) + 4.43% = 12.06%
Note that the risk-free rate that we use is the US treasury bond rate (3.80%), and that the 4.79% figure is the equity risk premium for a mature equity market (estimated from historical data in the US market). It is also worth noting that analysts estimating the cost of equity for Brazilian companies, in US dollar terms, often use the Brazilian ten-year dollar-denominated rate as the risk-free rate. This is dangerous, since it is often also accompanied with a higher risk premium, and ends up double counting risk.
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