Which Risk free rate to use to calculate Cost of Equity?

tellmehowtoplay's picture
Rank: Baboon | 100

Got asked this in my interview.

Basically, they asked me how to calculate cost of equity, and when i brought out CAPM, they brought up a problem with the following details

  1. Company's main operations (99%) in the emerging markets (e.g. Brazil)
  2. Listed in London Stock Exchange
  3. Cash flows in USD

What Risk free rate to use? Would it be different if you were buying the equity on the London Stock Exchange or buying part of it's project finance debt of it's project in Brazil,

I said the risk free rate would be the USD 10y, given that the cash is in USD and investors would seek to replicate their returns in a similar currency, but then brings about the London Stock Exchange, and...... I wasn't too sure.

Appreciate the help.

Comments (8)

May 3, 2017

I wouldn't use CAPM for this. CAPM is pretty stupid anyway because beta =/= risk, but I digress.

Use a yield build-up method where you take your local RFR, add on country risk premium for Brazil and a currency premium for GBPUSD currency risk, and then add on your equity risk premium.

If you have to use CAPM, probably play it safe and go with the Brazilian RFR because that's where the operations are, and therefore where the business risk is located.

    • 3
May 3, 2017

Thanks for the reply.

Just to be sure regarding the yield build up method you suggested, how should i going about to get Country risk premium for Brazil and a Currency Premium for GBPUSD and finally the ERP?

Would think that I should use the following to get the aforementioned rates:

  • 10y Brazillian no Coupon government bond as the local RFR
  • For the Country Risk premium for Brazil, I will use local currency sovereign rating, and calculate default spread for that rating over the risk-free rate, or Obtain CDS spread for the country and subtract US CDS spread
  • Currency premium being the forward premium via spot and future GBP and USD rates according to this (http://www.investopedia.com/terms/f/forwardpremium...)
  • For ERP, I will use the Brazillian stock market to find the required market return and use correlation of the stock in the LSE for the beta

Would appreciate it if you could give feedback for my above suggested method.

Would also like to note that it's seemingly different from a previously suggested answer: https://www.wallstreetoasis.com/forums/what-is-the...
One of the replies said: "If the company's main operations are in Brazil but it is traded on let's say NYSE, use the U.S Government Treasuries as your risk free rate. The equity risk premium is where you account for the potential volatility the market prices in for emerging markets."

Just wondering what your thoughts are regarding that reply, Thank you.

Best Response
May 4, 2017

Methods for obtaining rates seem fine, although when I said local RFR I meant US (assuming you're based in US). You're already accounting for the Brazilian risk when you add on a country risk premium. Think of it this way:

Your minimum return for investing in anything at all + required additional return to invest in Brazil + additional required return to invest in a different currency + additional required return to invest in equities = discount rate for Brazilian equities denominated in Sterling for a US investor.

You may even go further and add on an additional risk premium if the company is small or operating in a particularly volatile sector.

The comment from that other thread is essentially saying the same thing, except they're amalgamating country risk + equity risk into one equity risk premium. You would not use the same cost of equity for a NYSE-listed US company as you would for a NYSE-listed Brazilian company.

Remember none of this is science and there is no 'correct' answer so as long as you can explain your thinking logically in an interview, you'll be fine.

    • 3
May 6, 2017

My answer would vary in detail and qualifying factors depending on the type of firm it is. Sell side/buy side? If buy side, equity long-short/macro/ etc?

May 6, 2017

lol is this really how analysts come up with recommendations of "buy" and "sell" for stocks? http://www.investopedia.com/terms/c/capm.asp <-do they just take those numbers out of their asses?? it is mathematically a very stupid formula. if you dont know what "beta" is, how will adding the other factors make the equation any more accurate? no wonder that a high school student could do better. do u think warren buffet used this formula when he started making his fortune at 14yo?

May 6, 2017
b333b:

lol is this really how analysts come up with recommendations of "buy" and "sell" for stocks?

No, they use multiples but still do DCF valuations to make sure that their price objectives make sense.

Just use historical figures. If you use the current risk-free rate, market risk premium, etc. you will get extreme valuations.

Feb 6, 2019
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