The demand for external financing for projects in frontier markets
has increased the profile of valuation methodologies. In this paper, I
discuss the theory and practice of how the component costs of debt and
equity capital and the weighted average cost of capital (WACC) of a
specific project domiciled in a frontier country can be calculated. This
paper also discusses how the capital weights of debt and equity are
adjusted to reflect the structuring of the financing and the liquidity
facility provisions found commonly in financing covenants. Frontier
markets are those emerging markets considered very risky for
Keywords: Frontier markets; cost of debt; cost of equity capital;
weighted average cost of capital; capital weights; soft capital and
High rates of returns on investments in emerging markets continue
to soar as investors increasingly are attracted to projects in emerging
economies. The integration of markets and mobility of capital have had
dramatic impact on direct foreign investments and emerging markets
continue to offer large opportunities to investors in spite of economic
losses incurred by international investors in some markets in the 1980s.
According to the November 3, 2005 issue of Business Week, $14.8 billion
in new cash has been invested in emerging equity funds through October
5, 2005 compared to $2.8 billion for all of 2004. However, risk and
uncertainty represent a major problem in valuing emerging market
investments. The demand for external financing coupled with business
deregulation and privatization of markets have increased the profile of
valuation techniques in emerging markets.
This paper is concerned with estimating the weighted average cost
of capital (WACC) for projects in frontier markets. The International
Finance Corporation (IFC) describes frontier markets are those emerging
markets considered very risky when compared to the transitional emerging
markets of Brazil, Russia, India and China (BRIC) and other climbing
markets of Argentina, Taiwan, South Korea, Malaysia and Mexico etc. Many
foreign investors prefer not invest in frontier markets such as
Pakistan, Senegal, Nigeria, Nepal, Costa Rica, Maldives etc because of
the risk involved. Limited stock market information and the problem of
data availability are chronic in these markets. However, investment
companies such as IFC and other transnational financial institutions
that finance investments in these markets need to estimate the average
cost of capital for projects in these markets. Current research on
valuation has focused exclusively on the BRIC countries. This paper is
therefore a contribution to the literature on valuation because there is
no research study on frontier markets and the complex valuation problems
faced by analysts evaluating projects in frontier markets.
WACC is the basic measure of financial performance because it is
the minimum risk adjusted rate of return required by investors before
they invest in a project. Investment decisions can not be made without
estimating the project's WACC accurately. Therefore, the challenge
in valuing projects in emerging markets and particularly in frontier
markets is focused on estimating the appropriate WACC specific to a
particular project and not for all projects in the frontier market
economy. The estimation of the weighted average cost of capital for a
specific project in an emerging market is not a science and should
incorporate analysts' judgments. According to Harvey in Budyak
2006, "A long standing problem in corporate finance is the
calculation of the cost of capital in international capital markets.
There is widespread disagreement particularly among practitioners of
finance as to how to approach this problem. Unfortunately, many of the
popular approaches are ad hoc and as such difficult to interpret."
In section II of this paper, I review the theory on measuring
project risk and the challenges of using the capital asset pricing model
to estimate the cost of equity capital for emerging market projects. In
section III, I focus on how to estimate the component costs of capital;
specifically, the before tax cost of debt to reflect foreign exchange
rate risk and the cost of equity capital for projects in frontier
markets. I also show how standby liquidity facilities (i.e. soft
capital) affect the capital structure weightings in estimating WACC. The
rest of the paper proceeds as follows. Section IV highlights the
estimation of the component costs of capital and WACC for a hypothetical
emerging market project in a frontier country on an experimental
framework. Section V contains concluding remarks.
2. PROJECT RISK AND CAPM
Traditionally, investors assess business and economic risk and
political risk of investment opportunities. However, in business
valuation, the three distinct types of project risk are stand alone
risk, within-firm risk and market risk. Stand-alone risk views the risk
of the project in isolation and without regard to portfolio effects. It
is measured by the variability of the project's expected returns.
The within-firm risk also called corporate risk views the risk of
project within the context of the firm's portfolio of projects. It
is measured by the project's effect on uncertainty about the
firm's future earnings. Market risk or beta views a project's
risk within the context of the firm's stockholders'
diversification in the general stock market. It is measured by the
project's effect on the firm's beta coefficient. Theoretically
and in many cases all three types of risk are highly correlated,
thereby, if the performance of general economy is strong, the firm will
do well and so will most of the firm's projects. From a
theoretically perspective, market risk is the most relevant for well
diversified investors and can be estimated from the capital asset
pricing model (CAPM) because of its effect on stock prices.
Unfortunately, for investors that are not well diversified market risk
or beta for a project is the most difficult to estimate. In many
emerging markets, CAPM is not applicable as financial theory suggest
because of lack of data and measurement problems. It is also important
to note that CAPM ignores incorporate bankruptcy and/or expropriation
costs even though such costs can be substantial. Therefore international
investors should consider all three types of risk, but in practice it
may be appropriate to give more weight to stand alone and corporate risk
than financial theory suggests.
Estimating cost of capital in emerging markets is a challenge
because financial markets and data are thin or non existent. Despite
differences in culture, some of the important issues faced by analysts
in undertaking valuations in emerging markets include differences in
accounting practices, limited or lack of adequate market data, treatment
of risk and uncertainty, and dealing with inflation pressures and
2.1 Accounting practices and data limitation.
In spite of the increasing interest in international
standardization of accounting practices, substantial differences in
accounting practices still exist even in mature or developed markets.
Efforts to standardize accounting practices assumes compliance with
either the U.S. GAAP set by the Federal Accounting Standards Board
(FASB) or the International Accounting Standards (IAS) set by the
International Accounting Standards Committee (IASC). However the basic
challenge to valuation in emerging markets is the absence of capital
markets and the preference to use cash-based accounts in these markets
rather than accrual methods used in developed markets.
Most emerging markets are characterized by lack of relevant data.
The time spent by an analyst in developing and applying sophisticated
mathematical models could be more productively spent on improving the
data set in emerging markets. Therefore investors in emerging markets
need to think around the limitation of having imperfect data set with
the intent of unraveling a set of potential outcomes from differing
scenarios and developing a solid base case.
2.2 Risk and uncertainty.
The treatment of risk and uncertainty represent a major problem in
the estimation of cost of capital for an emerging market. In a total
risk perspective, the principle of corporate finance separates risk into
company specific (i.e. unsystematic risk) and market-related (systematic
risk) components. Systematic risk is non diversifiable and unavoidable,
but unsystematic risk is assumed to be diversifiable or avoidable. Some
of the sources of market risk are changes in the economy, tax reform,
changes in demand and supply of world energy. These risks can not be
diversified or avoided, so the investor who holds a well diversified
global portfolio will be exposed to this risk. Unsystematic or
diversifiable risks are often unique to a particular company and are
independent of the economic, political and other factors that affect
securities in a systematic manner. Examples of sources of unsystematic
risk are increased competition, potential expropriation of assets by a
foreign government and technological innovation.
Unsystematic risks can be factored into the valuation analysis by
means of alternative scenario analysis, whereas systematic risks are
built into the discount rate through the cost of cost of capital. In
international corporate finance, distinguishing these two types of risks
is often difficult because changes in exchange rates will affect both
the systematic and unsystematic components of risks. See Roger Mills
(1997) for more detailed treatment of other problems facing analysts
involved in valuations in emerging markets.
3. THE GENERAL FRAMEWORK OF WACC
The WACC equation is one of the basic finance decisions facing
corporations. Mathematically, WACC is:
WACC = [w.sub.d][k.sub.d](1- T)+[w.sub.ce][k.sub.d] or [k.sub.e];
where: [w.sub.d] = weight of debt, i.e., D / V.
[k.sub.d] = before tax component cost of debt.
T = tax rate.
[w.sub.ce] = weight of common equity, i.e., E / v.
[k.sub.s] = component cost of retained earned earnings.
[k.sub.e] = component of newly issued common stock.
In many emerging markets, long term government bonds are not quoted
and even when there is a quoted market yield, it may not be default
risk-free as is the case in developed markets. Corporate debt and public
equities markets may be highly segmented or non-existent. In addition,
estimating cost of capital of investments in emerging markets without
factoring country risk, company risk, sector risk, and currency risk
would provide inaccurate estimates of cost of capital. It is also
important to examine the capital structure weights used in calculating
weighted average cost of capital (WACC) because to mitigate the risk of
investing, the financial market has developed structured mandatory notes
called standby liquidity facilities (i.e. soft capital). These liquidity
facilities are used for general purposes including payment of claims on
debt and equity financing. When international investing is structured to
include 'soft capital' provisions, the capital structure
weights, [w.sub.d] and [w.sub.CE], in the WACC equation need to be
adjusted to reflect the provision of soft capital when applicable.
3.1 Estimating the cost of debt capital.
The three main sources of international debt are international bank
loans, the structured notes called Euronotes and the international bond
market. An investor funding a project in an emerging economy through the
debt market is concerned about the currency of denomination, maturity of
the debt and the type of debt. To limit gap risk or repricing risk, the
debt is structured so as to match the maturity of the cash inflows
expected from the investments to the cash outflows servicing the debt.
Also currency matching minimizes cash flow exposures from foreign
exchange fluctuations and the resulting cost of debt.
The estimation of cost of debt capital is straightforward because
interest rates are readily observable. For new investments, the
appropriate cost of debt is the interest rate that the firm would issue
to finance the project. In estimating this cost, it is assumed that the
new debt is issued at its face value M so that the current yield
(INT/M), where INT is the annual coupon interest payment, equals the
yield to maturity or the internal rate of return on the debt. If the new
debt is issued at a price different from its face value, then the cost
of debt is its yield to maturity, assuming all other variables are
known. In other words the unknown yield to maturity (YTM) can be
[P.sub.B] = INT x (PVIF [A.sub.YTM,N]) + M([PVIF.sub.YTM,N])
where: [P.sub.B] = price of the debt.
INT = coupon interest payment.
YTM = yield to maturity.
N = years to maturity.
For example, suppose the U.S. interest rate cost of debt to fund a
five year project is 12.5% in U.S. terms and the principal amount is
$2,000,000. However, if the international investor requires a soft
capital provision of $250,000 secured in escrow account, the face value
of debt to the borrower becomes $2,250,000. The appropriate U.S. before
tax cost of debt is 9.26%:
$2,250,000 = (0.125 x $ 2,000,000) x [PVIF [A.sub.YTM,5]] +
($2,000,000) x [[PVIF.sub.YTM,5]]
Traditionally, the interest rate on the debt is the nominal
risk-free rate on U.S. Treasury security plus the premiums sufficient to
compensate debtholders for default risk, maturity risk, liquidity risk,
country risk, currency risk and sector risk. This nominal risk-free rate
incorporates the pure or real rate of return and the inflation premium.
But, emerging market debt may not be nominally risk-free because the
government debt of the emerging economy is not risk-free. Also,
governments of emerging markets may affect the cost of debt capital
through intervention in the foreign exchange market by imposing barriers
to free flow of capital across countries. As such, the yield on such
government debt can not be risk free.
An accurate estimate of cost of debt capital in an emerging market
should be accompanied by substantial qualitative analysis beyond
financial modeling. The estimated cost of debt must be adjusted for
inflation, interest rates and taxes to reflect the firm's actual
capital cost. Mills (1997) suggested that the principle of purchasing
power parity and interest rate parity can be used as the starting point
when estimating the cost of debt. By applying purchasing power parity
whereby exchange rates adjust with the inflation rate differential in
the domestic market and the emerging market, an estimate of the cost of
debt capital can be obtained. Also the international Fisher effect which
focuses on interest rate parity states that nominal interest rate
includes an inflation premium sufficient to compensate investors for the
expected loss of purchasing power. By assuming that real rates of return
between countries are equal, cost of debt capital can be estimated by
incorporating the effects of the purchasing power parity and interest
rate parity. The cost of debt for an emerging market can be adjusted to
reflect the parity theorems and exchange rate risk. Assuming the parity
conditions hold and the global currency market is in equilibrium, the
cost of debt can be computed from either the perspective of the direct
foreign investor or the home country where the funded investment is
domiciled. In general terms, the relationship between the rate of return
to the direct foreign investor and the cost of capital to home country
can be expressed as:
(1 + [R.sub.H]) = (1 + [R.sub.F]) x ([S.sub.1] / [S.sub.0])
where [R.sub.H] = Home country return
[R.sub.F] = Foreign country return
[S.sub.1] = Expected exchange rate
[S.sub.0] = Initial exchange rate.
Now suppose the quoted cost of debt or investment return for a
specific investment in South Africa is 6.85 percent in rand terms and
the cost reflects the cash flow risk including sector risk. Suppose the
current exchange rate of the U.S. dollar to the South African rand
($/rand) is $0.1447/rand while the expected $/rand rate one year later
is $0.1522/rand. Then the return to the U.S. based direct foreign
(1 + [R.sub.H]) = (1 + 0.0685) x ($0.1522 / $0.1447)
[R.sub.H] = 12.39 percent U.S. based return.
The reliability of the estimated cost of debt depends on the
accuracy of the 6.85 percent cost of debt in rand terms and if it
reflects the country risk. Gendreau and Heckman (2003) suggested that
investors in emerging markets often rely on sovereign yield spreads as
indicators of country risk. It can be argued that sovereign yield
spreads vary with the market perception of the country's default
risk and the overall investment climate in the country. Estimating the
cost of debt capital for specific projects in an emerging market is not
a science. Therefore the cost of debt should be qualitatively adjusted
to reflect not only the country and currency risk but also the
unsystematic risk components including company risk and sector risk.
3.2 Estimating the cost of equity capital.
Earlier research studies in valuation methods are focused primarily
on estimating the cost of equity capital. The uniqueness of this
research paper is that not only do I discuss the problems in estimating
the cost of equity capital for a project in an emerging market or
frontier market but also this research paper relates how the overall
WACC can be estimated, taking into consideration the capital structure
weights of debt and equity including soft capital requirements.
The cost of equity capital is the minimum required rate of return
necessary to induce the equity investor to buy the firm's stock. It
is also the rate of return used by shareholders to capitalize the
residual income of the firm's cash flows which reflects the risk of
the firm's activities. Thus the cost of equity of a firm can be
used to value the future equity cash flows of the firm.
The Capital Asset Pricing Model (CAPM)--related models provide
inferior explanation of equity returns in emerging markets because they
focus mainly on correlations and understate the highly volatile markets
in emerging economies. Secondly, the lack of local currency-based
returns or the failure to acknowledge the relevance of currency risk,
financial distress and bankruptcy costs in projects in estimating
discount rates can result in inaccurate estimates of cost of capital for
emerging market projects. Other models that use the Bloomberg as a
source for estimating cost of equity capital in emerging markets are
also inadequate and not forward looking. According to Budyak (2006)
these models calculate the ratio of the historical volatility of the
emerging market to the U.S market, then incorporates the ratio as a
risk-adjustment factor to the U.S equity market risk premium or beta of
a specific country risk.
The country risk rating model (CRRM) developed by Erb, Harvey and
Viskanta (1996) is a broad based and forward looking model. It provides
a framework to estimate the cost of equity capital and takes into
consideration specific country risk, political risk, country ratings and
currency risk. CRRM permits an analyst to estimate expected returns for
investments in a particular country including emerging markets whether
market data is available or not. The model positively argued that there
is a strong correlation between country credit ratings and expected
returns. Country credit ratings are provided by Institutional Investor
based on a survey of leading international banks that rate each country
on a scale from zero (low credit rating) to one hundred (high credit
To use the CAPM to estimate the cost of equity capital for a
project requires three numbers--the nominal risk free rate of return,
the project's beta, and market risk premium. Theoretically, cost of
equity capital = Risk-free rate + Project's risk premium.
Ki = [k.sub.rf] + ([k.sub.m] - [k.sub.rf])[[beta].sub.i]
where Ki = cost of equity capital for project i
[k.sub.m] = average historical on a stock market index (e.g.
S&P 500 index).
[k.sub.rf] = risk free rate of return on U.S.A Treasury bond.
[[beta].sub.i] = Project's beta.
([k.sub.m] - [k.sub.rf])[[beta].sub.i] = historical equity risk
premium for the project.
It has been argued by a number of researchers and practitioners
that the historical equity risk premium does not measure the forward
looking equity risk premium that equity investors expect to earn on
stocks purchased today (Shapiro 2005). In the case of estimating equity
returns for emerging market projects, the controversy on the historical
equity risk premium is more profound for three reasons. First, the
comparable government security in an emerging market may not be risk
free as is the case with U.S.A. Treasury bond and the government debt of
other developed countries such as UK. Secondly, there may be limited
and/or questionable estimate of average stock market return in most
emerging markets if a stock market exists; and thirdly, it may be
impossible to estimate [beta] i because the historical data or expected
future returns relative to predicted average stock market index returns
needed to estimate project's beta does not exist.
For special cases relating to sufficiency of market data, it is
necessary to distinguish between transitional economies of Brazil,
Russia, India and China from other less developed countries. Further
more, it may not be possible to find a comparable company in the
frontier (or emerging) market whose beta can be used as a proxy for the
project beta. Therefore, strict application of the CAPM would provide
inferior explanation of equity returns in emerging markets. Also, the
CAPM understates the highly volatile markets in emerging economies
because of its focus on correlations of specific country data with
another country or with the global portfolio.
The CRRM model does not factor in the correlation of specific
countries with another country or global portfolio because global market
portfolio beta has little influence on the expected returns in emerging
markets. According to Harvey, only 5% (one in 20) emerging markets have
a beta greater than one when measured against the global equity market
returns. Intuitively, emerging markets should have higher betas but that
is the case. Thus focusing on global CAPM that associates the
correlation of returns between the global portfolio and country betas
will be misleading even if the produce from the funded project has a
world wide market, for example, copper, coffee, oil and cocoa. The
problem is exacerbated if a global market does not exist for the funded
project such as microfinance projects, breweries, development of real
estate investment company, hotels etc. IFC and other transnational
financial institutions provide funding for a variety of such projects.
The importance of correlation in estimating discount rate is that
positive correlations of country returns are not commonly found in
emerging markets as is the case in developed economies. Evidence shows
that higher credit rating in developed countries is associated with
lower volatility of returns and lower credit ratings in emerging markets
is associated with higher volatility of returns. Thus market returns in
developed countries are more highly correlated than in emerging markets.
Therefore, the CRRM focuses on volatility of emerging markets as a more
important factor in explaining the risk and return of investments in
emerging markets because focusing on correlation can result in
Damodaran (2003) discussed three approaches used in estimating
individual project exposures to country risk premiums. The 3 approaches
are the bludgeon approach, the beta approach and the lambda approach.
The bludgeon approach assumes that all companies in the market are
equally exposed to country risk. Thus the cost of equity capital can be
[K.sub.s] = [K.sub.RF] + [beta](MatureMarketRisk Pr emium)
CountryRisk Pr emium
The beta approach assumes that a company's exposure to country
risk is proportional to its exposure to all other market risks and the
cost of equity capital can be expressed as:
[K.sub.s] = [K.sub.RF] + [beta](MatureMarketRisk Pr emium +
CountryRisk Pr emium)
Both the bludgeon and the beta approaches are not appropriate for
estimating project exposure to country risk because betas are not good
measure for country risk as betas may not be available for most firms
due to lack of data.
The lambda approach, assumes that project's exposure to
country risk is different from its exposure to all other risks. Thus the
cost of equity capital is a two factor model and can be estimated as:
[K.sub.s] = [K.sub.RF] + [beta](MatureMarketRisk Pr emium) +
[lambda] (CountryRisk PR emium)
where [lambda] refers to project's risk. When [lambda] = 1.0,
the project's risk is average risk when compared to country risk,
and a lambda greater than one indicates that the project risk is above
Estimating the component cost of equity capital of a project in a
frontier market is critical in the overall estimation of the WACC of the
project. The equity cost of capital for a project in a frontier market
can be estimated to capture country and currency risk based on the
country's credit rating, company risk based on the risk of
project's cash flows as well as sector risk. Overall, the cost of
equity capital depends on three factors: the adjusted base rate of
return, equity risk premium for mature market and project risk premium.
Accordingly the cost of equity capital can be expressed as:
[K.sub.s] = [K.sub.ADJ.] + [beta](MMRP) + ([P.sub.J] RP); where
[K.sub.ADJ] = adjusted base rate of return = [K.sub.RF] DYspread
(i.e., default yield spread).
DYspread = yield on bond issued by the frontier country minus yield
on U.S. Risk-free Treasury bond. If an equity market exists in the
frontier country, the default yield spread can be estimated by comparing
the average return of the equity market, [K.sub.EM] to the average
return of the bond market, [K.sub.BM].
[beta] = beta of a comparable company in a developed market (US, UK
MMRP = Mature market risk premium ([K.sub.M] - [K.sub.RF]) as
[P.sub.J] RP = Project risk premium; (RSD of project) x ([K.sub.M]
- [K.sub.RF]); and RSD = E ([[sigma].sub.PR]) / E ([[sigma].sub.DR]);
RSD = relative standard deviation; E ([[sigma].sub.PR]) is the
expected standard deviation of revenues from project and E
([[sigma].sub.DR] is the standard deviation of revenues of comparable
company in a developed market.
The cost of equity capital for specific projects in frontier
markets can be estimated with the above model. To estimate the adjusted
base rate of return, the yield on bond issued by the frontier country is
calculated. The yield on debt issued by a frontier country depends on
its country risk. In contrast to traditional methods of risk measurement
which are based on historical volatility of returns, country credit
rating is forward looking and is a good proxy for measuring sovereign or
country risk. Thus the adjusted base rate of return is the spread
between the yield on debt of the frontier country and the risk free rate
of return on U.S. Treasury bond. The second factor is the equity risk
premium in a mature market (e.g. U.S. equity market) which compensates
an international investor assuming investment was made in U.S dollars.
Finally, the third factor integrates the project's risk premium
which takes into consideration the company and sector risks because the
project is domiciled within a company and the produce of the project
within a sector. Note also that [P.sub.J] RP reflects additional
compensation to the international investor based on the risk of the
project's expected cash flows in contrast to Damodoran's
lambda model that incorporates country risk premium in stead of project
risk premium. In as much as there is some relationship between specific
project risk, company risk, sector risk and country risk, the estimation
of the cost of equity capital for a particular project needs to reflect
the risk premium specific to the project.
4. EXPERIMENTAL ANALYSIS:
The process of estimating WACC for a project in a frontier markets
is more than a mathematical model and should consider qualitative
The following discussion in the paper represents a fictitious
project in South Africa used to illustrate the estimation of WACC
including adjustments in capital structure weights to account for
provisions of soft capital, the adjusted cost of debt and cost of equity
including project risk premium. The overall method and evidence is worth
considering by investment and evaluation officers when considering the
financing of frontier project.
To begin, I assume a chemicals project being considered for
development in South Africa. The total project cost is estimated to be
$385 million. The proposed investment will comprise of $155 million in
loans from an international investor like IFC and $230 million in equity
investment. The general technique used to estimate the WACC will include
--Based on the debt and equity components, the capital structure
weights are 40% debt and 60% equity. For now, I assume there no soft
--The before tax cost of debt estimated at 12.39% from section III
of paper. The applicable tax rate is assumed at an effective rate of
--The standard deviation of expected revenues from the project is
20% while the standard deviation of comparable project in a developed
market is 15%. Thus the relative standard deviation is 1.33.
--The Treasury bond risk free rate of return, [K.sub.RF] as of the
evaluation date is 4.61%.
--The yield on a South African Government Bond (in U.S. terms) is
6.85%; the default yield spread is 2.24%, thus the [K.sub.ADJ] = 6.85%.
- Based on this analysis and considering the subject industry, I
assume a beta, [beta], of 1.05.
--The estimate of the mature market risk premium historically
average about 5%. Support for this estimate is beyond the scope of this
--The Chemical project risk premium is 6.65% (1.33*5%).
Based on the above assumptions and estimates, the components costs
of WACC are:
After tax cost of debt, [K.sub.D] (1-taxrate)) = 12.39 % x (1-
The cost of equity, [K.sub.s] = 6.85% + 1.05 x (5%) + 6.65% =
WACC = 0.40 x[8.86]+ 0.60 x [18.75%]=14.79%.
If soft capital of $25 million is required, the total capital for
the project increases to $410 million from $385 million with debt
amounting to $180 million and equity financing at $230 million. The
appropriate capital structure weights become 44 percent ($180/410) of
debt and 56 percent of equity. The resulting WACC is:
WACC = 0.44 x[8.86] + 0.56 x [18.75%] = 14.40%.
Investments in emerging markets particularly in frontier markets
yield high rates of return and continue to be attractive to diversified
foreign investors. However, the estimation of the weighted average cost
of capital as the discount rate applicable to specific projects in
frontier markets is a central issue in evaluating projects in emerging
markets. In this paper, I discussed four key issues related to the WACC
of a specific project in a frontier market.
First, international investing in frontier markets is very risky.
As such, foreign investors sometimes require soft capital provisions as
a standby liquidity facility. Soft capital is not a component cost,
rather it is a standby liquidity provided by the borrower to the
investor as a covenant to the loan agreement. In such situations, the
standard capital structure weights used in estimating WACC need to be
adjusted to reflect the soft capital components. The paper concludes
that as the dollar amount required as soft capital increases, the
estimated WACC decreases. Intuitively, this makes sense because cost of
debt is cheaper than cost of equity and as the capital weight of debt
increases and weight of equity decrease, the overall WACC declines.
Secondly, estimating the component costs of debt and equity for a
specific project in a frontier market requires specific adjustments to
reflect country risk, currency risk, company risk and project risk.
The interest rate on emerging market debt is not risk-free rate
because governments of frontier countries sometimes intervene in their
capital markets. The estimated cost of debt must be adjusted for
inflation, interest rates and taxes to reflect the firm's actual
capital cost and should also be accompanied by substantial qualitative
analysis beyond financial modeling.
Thirdly and fourthly, most analysts use the CAPM to estimate the
cost of equity in spite of its shortcomings. Because of inadequate data
in frontier countries a rigorous estimation of the cost of equity
capital should adjust the risk free rate of return on U.S. Treasury
bond, RF K to reflect the default yield spread in the frontier country,
plus the equity risk premium in a mature market (such as the U.S.
market) plus project risk premium. It is expected that the project risk
premium takes into consideration both company and sector risks since the
project is domiciled within a company and the produce of the project
within a sector. In all, a practical solution for estimating the WACC of
a specific project in a frontier country should incorporate quantitative
estimates as well as analysts' qualitative judgment. An area of
further research may compare the similarities and differences of
estimating WACC across market types such as developed markets, BRIC and
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Corporate Finance, April, 1997.
Shapiro, A.C., Capital Budgeting and Investment Analysis, Pearson
Prentice Hall, Upper Saddle River, New Jersey, 2005.
Dr. Vivian O. Okere earned his Ph.D. at the University of Rhode
Island, Kingston, in December 1987. Currently he is an assistant
professor of finance at Providence College, Providence, and was a former
Senior Director at Fitch Ratings, New York.
Vivian O. Okere, Providence College, Providence, Rhode Island USA