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Risk is a given in any investment. It is incorporated into valuation in the cost of equity and debt which flows into the discount rate. International projects are considered higher risk given the potential for political and/or currency fluctuations. Therefore risk premium is added on international projects. This page looks at why this is so.

We address two questions here: How do you estimate country risk premiums? And – Name three methods to estimate country risk premiums.

Globalization has caused more correlation in world markets. Does that mean risk has increased? Or does higher correlation in international economies reduce risk?

We address this question today: “Has globalization over the last three decades enhanced risk and therefore the discount rates?”

Risk is a given in any investment. It is incorporated into valuation in the cost of equity and debt which flows into the discount rate. A risk premium is added on international projects. This page looks at why this may NOT be a good idea.

We address this question here today: “What is the argument for NOT using a country risk premium?”

Risk is a given in any investment. It is incorporated into valuation in the cost of equity and debt which flows into the discount rate. A risk premium is added on international projects. This page looks at why this is so.

This page answers the question: “When do you use a country risk premium? What is the argument for using a country risk premium?”

Estimating a market risk premium is challenging due to many reasons. None can predict the future! So we default to historical market risk premiums. Even when we agree that we can look to the past to arrive at an estimate of the market risk premium, there is significant disagreement on the time frame to be used. There is disagreement on the frequency to be used: daily, weekly? There is also disagreement on the method to be used: geometric average or arithmetic average as well as the market to be considered: US or London market or another one? Given these issues with market risk premium, do we have an alternative?

We address this question here: “Given the issues in estimating a market risk premium, can you suggest an alternative metric or method to arrive at risk premiums?”

We need the market risk premium to arrive at the cost of equity when using the CAPM model. Finance professionals estimate market risk premium by looking at historical returns. Is that appropriate? Is that accurate? Does it serve the purpose?

We examine the appropriateness or inappropriateness of estimating market risk premium by looking at historical returns. by examining this question today: “What are the issues you face in estimating a market risk premium?”

You need the risk free rate to arrive at the WACC or discount rate at which you will discount your cash flows in a DCF valuation model. How will you pick your discount rate?

We address on this page the question: “How would you estimate risk free rate when valuing an international firm?”

The CAPM, Fama-French, APM and multi-factor models methods of estimating the cost of equity are built on assumptions. What are the assumptions? Do these assumptions reflect real-life situations? We examine these models to evaluate if they systematically over estimate or under estimate the cost of equity.

We examine the question: “Do the CAPM, Fama-French, APM and multi-factor models methods of estimating the cost of equity generally overestimate or underestimate the equity cost? Why?”

You need the value of debt and equity to arrive at WACC. This ratio of debt and equity gives you the weights of debt and equity to arrive at WACC. In many cases, the company may have a temporary debt and equity structure. An example is a leveraged buy-out – where excessive amounts of debt is loaded for the LBO transaction. This level of debt is not sustainable and so the company pares down the debt quickly. How do you estimate the “normal” level of debt the company will work towards so you can arrive at the appropriate discount rate? The target debt ratio is the debt ratio that you assume the firms will move towards over time from the current mix of debt and equity.

We address this question today: “What is the target debt ratio of a firm? How do you arrive at it?”