Relevance of Country Risk Premium in Cost of Equity Estimation

Antonio Sanvicente ()

RAC - Revista de Administração Contemporânea (Journal of Contemporary Administration), 2015, vol. 19, issue spe1, 38-52

Abstract: A common practice in business valuation and the determination of fair rates of return by regulatory agencies is to use the capital asset pricing model (CAPM) with the ad hoc addition of a country risk premium. The present paper documents this practice in the valuation reports required in public acquisition offers available on the CVM (Brazilian Securities and Exchange Commission) website. Multiple linear regression is used with monthly returns for stock shares of 204 firms listed on the BM&FBovespa (Brazilian Stock Exchange). The period covered is from January 2009 to December 2013, and the results indicate that there is a premium for Brazilian risk that is not completely reflected in Ibovespa returns for only 17 securities. Hence, if one uses the local market index when estimating a firm's cost of equity, it would be both redundant and incorrect to add a country risk premium. The paper concludes with a real company example in which the adoption of the conventional approach - with a country risk premium added - would lead to a 17% pricing error.

Date: 2015
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