country risk premium?

Chris Luke, CFA, is a senior analyst for Wilder International Investment Corporation (WIIC). Luke has been assigned to review companies in the country of Quijinn, for potential investment opportunities. Quijinn is a small, emerging country with a high rate of inflation. Luke has identified a potential investment opportunities in Quijinn, Giett Manufacturing. To prepare for his analysis of the company, Luke asks junior analyst Jaina Antilles, a Level 2 CFA candidate, to put together the information shown in Figure 1. Figure 1 Country = Quijinn Forecasted real GDP growth = 4.0% Market risk premium = 5.0% Historical real returns for companies with average risk = 12.0% Inflation Rate = 8.5% Antilles applies a real valuation model to Giett Manufacturing. Antilles recognizes that emerging market risks, such as the high inflation rate in Quijinn, require adjustments in the valuation process. Antilles tells Luke, “I am considering adjusting the required return I am using for discounting Giett’s cash flows. Companies in an emerging market tend to respond differently to country risks, and the best way to account for the difference is adjusting the discount rate.” Luke replies, “I do not think that adjusting the discount rate is going to be helpful in your process. Country risk is an example of systematic risk that cannot be diversified, and is therefore going to already be included in Giett’s cost of capital.” Antilles is preparing a valuation analysis of Giett Manufacturing and decides to use a real valuation approach that adjusts for Quijinn’s high rate of inflation. Antilles identifies four components of the valuation model that are impacted by her approach: Component 1: Cash taxes Component 2: Capital Spending Component 3: Net working capital Component 4: Depreciation 1, Which of the components does Antilles’ real valuation approach provide the least accurate answer? A) Components 1 and 4. B) Components 2 and 3. C) Components 1 and 3 2, Regarding their discussion about adjusting the discount rate to account for emerging market risks in valuing Giett Manufacturing: A) Antilles’ statement is correct; Luke’s statement is incorrect. B) Antilles’ statement is incorrect; Luke’s statement is incorrect. C) Antilles’ statement is incorrect; Luke’s statement is correct. 3, Assume that Luke and Antilles decide to calculate a value for the various companies they are analyzing by applying a country risk premium to the company’s WACC. What is the appropriate country risk premium to use for Quijinn? A) 11.5% B) 3.0%. C) 8.0% 4, One of the best ways to capture the impact of various macroeconomic variables on an emerging market company’s valuation is to develop: A) a historical financial statement using the temporal method. B) an inflationary cash flow forecast under nominal and real terms. C) a probability-weighted scenario analysis of cash flows.

  1. A 2. C 3. A or B, hmm… real valuation model. I’ll go with B. 4. B


Yes, CBBC. Can you explain why the answer for 3) is B? I don’t fully understand the answer from Schweser…

Post the explainations

1, C A real valuation approach estimates value using real cash flows that are discounted at the real required return. Using a real valuation approach will create realistic capital spending forecasts and the terminal value of the company will be calculated correctly – therefore components 2 and 4 will be calculated correctly. However, a real valuation approach will incorrectly calculate cash taxes, which are based on nominal financial statements, as well as net working capital. Components 1 and 3 will be calculated incorrectly. 2, B Both Antilles and Luke make incorrect statements. Although Antilles is accurate that companies respond differently to country risks, this is an argument for adjusting cash flows – not the discount rate. A general discount rate cannot be applied to every company within a country because every company has different operating characteristics. These different operating characteristics are best captured by adjusting forecasted cash flows. Luke is also incorrect. Country risks are examples of unsystematic risks that are diversifiable, and therefore should not be included in the cost of capital. Again, adjusting cash flows is a better way to reflect the impact of country risk. 3, B For an average systematic risk stock the real expected return using the CAPM model would be estimated as 4 + 1(5) = 9% Since the historical real returns for companies in Quijinn have averaged 12% the country risk premium should be close to 12 - 9 = 3% 4, C Better cash flow estimates for an emerging market company can be determined by using probability-weighted scenario analysis. This involves assigning probability estimates to the economic/operating states that the company is likely to encounter and making adjustments to its cash flows. Scenario analysis is an important tool in understanding the effects of different macroeconomic variables on the cash flows of an emerging market company. Scenario analysis involves assigning probabilities to various operating environments an emerging market company is likely to encounter.

Country risk premium = Expected Return - (Real GDP + Market Risk Premium) CRP = 12% - (4% + 5%) CRP = 12%- 9% CRP = 3%

Can I find this formula in the notes? Are the Real GDP and Market Risk Premium of country Quijinn? I thought it might be from global market or something.

Yes. Its based on the global market index. Based on the analyst forecasts: Real GDP =4% (given) Market Risk Premium = 5% (in the CFAI text, it recommends that analysts use an MRP of 4.5%-5.5% So real returns for the average company based on the global market index are 4% + 5% = 9% However, companies in Quijinn have earned 12% historically. This implies that companies in Quijinn require an additional premium over the global market. This premium is estimated as 12%-9% = 3%. I understand this 3% as the additional premium over the global market index and GDP growth. Read page 275-276 of the CFAI text books. I think they explain it pretty well.

Page 269, Book 4, CFAI: “Use the cost of capital to discount the cash flows in a probability-weighted scenario approach. Do not add any risk premium, because you would be double-counting risk.” Why is this?

CLT2 Wrote: ------------------------------------------------------- > Country risk premium = Expected Return - (Real GDP > + Market Risk Premium) > > CRP = 12% - (4% + 5%) > > CRP = 12%- 9% > > > CRP = 3% Is this Formula correct: Country risk premium = Expected Return - (Real GDP + Beta*Market Risk Premium)

^ yea, actually that’s how they solved it in QBank and they assumed beta = 1, so eventually it became the one stated by CLT2.