Country-Risk & Inflation ??

The reading on valuing emerging market companies confuses me somewhat. Mainly becuase, most of the reading the text tells you to match the real rate with real cash flows and the nominal rate with nominal cash flows…i get that, be consistent.

However, then the text addresses either adjusting the WACC for country-specific risks (such as inflation) but explicitly says either include this consideration (and the other country-specific risks) in the WACC in the form of a premium or adjust the cash flows, BUT NOT BOTH.

So why must we pair a nominal WACC when discounting nominal cash flows if the book then says we can either capture the risk of inflation in one or the other ??? Are they referring to inflation in two different lights here?


That’s because country-specific risk does NOT equal inflation. Inflation is built into BOTH the prices (cash flows) and the discount rate so you can leave them as is or inflation-adjust before valuing. Same can’t be said for country-specific risk - like any other risk you need to factor this into your valuation using EITHER the WACC OR cash flows. Recommendation is to adjust cash flows since NOT all firms are impacted by the same country risk (i.e. using a single adjusted WACC for all firms).

that is not the intent.

they are saying two different things.

  1. Pair up nominal WACC with nominal cash flows or real WACC with real Cash Flows.

That is 1 part of the equation.

  1. What about where should the inflation and country risk be taken?

Should it be on the cashflows … yes. If you do that, do not include in the WACC as well (that would be double counting)…

Should it be on the WACC? … could be. (This is the PREMIUM on the WACC) If you do that … do not include effect in the Cash flows as well.

Should it be on both? Definitely not.

So CPK, to your first point then, why do we in the nominal case include inflation in the cash flows and in the nominal WACC…is that not double counting??

Does it not seem odd, that in one instance we are saying to adjust both wacc and cash flows but then when considering country specific risks (which also includes inflation) they say to do one or the other!! Isn’t the inflation already captured in the first part?

Generally speaking, you capture risk in either a.) the cash flows or b.) the WACC but NOT BOTH, correct? The nominal wacc and nominal cash flow requirement in your first point is akin to tax affecting the cash flows and using an after-tax wacc, those are not risks…just realities that need to be applied consistently?

I think Trekker pointed it out right…

read his post. ignore my rambling there after.

CPK, what do you think about this last part, agree/disagree?