Question

You want to estimate the country risk premium (over and above the base equity premium) to charge for a company listed in Indonesia, and have been supplied with the following information:  ndonesia is rated BB by S&P, and the corporate bond spread over the treasury bond rate for BB rated bonds is 3.0%.  The standard deviation in Indonesian equity prices over the last year has been 84%, while the standard deviation in Indonesian government bond prices has been 21%. a. Estimate the country risk premium for Indonesia. b. You are now trying to estimate the cost of equity, in nominal Rupiah, for an Indonesian paper and pulp firm. The firm has a beta of 0.75. In addition, it derives 80% of its revenues in US dollars, whereas the average Indonesian firm derives only 20% of its revenues in US dollars. Estimate the cost of equity for this firm, if the Indonesian Rupiah riskfree rate is 15%, and the risk premium for mature equity markets is 5.5%.

Answer 1

Solution to a: Estimation of Country Risk Premium (CRP)

Given Information:

Corporate bond spread over the treasury bond rate for BB rated bonds = 3.0%.

Standard deviation of Indonesian equity prices = 84%

Standard deviation of Indonesian government bond prices = 21%.

Indonesia is rated BB by S&P. Hence, the spread of Indonesia's sovereign debt yield will be equal spread of corporate bond over treasury bond rate for BB rated bonds.

(Note: Spread is the difference of two benchmark returns. In the above case, the spread represents the difference of corporate bonds yield denominated in Indonesian Rupiah and the treasury bond yield of that country. As Indonesia is rated BB, we can use the spread of BB rated bonds which is given at 3%)

Country Risk Premium (CRP) of Indonesia = Spread on Indonesia's sovereign debt yield x Standard deviation of Indonesia's equity index / Standard deviation of Indonesia' sovereign bond market or index

CRP = 3% * 84% / 21% = 12%

(Note: Country Risk Premium represents the premium required by investors to compensate them for the higher risk associated with investing in a foreign country, compared with investing in the domestic market. CRP is generally higher for developing markets than for developed nations as investing in developing nations is associated with a higher risk due to factors such as volatile currency, political instability, higher inflation etc.).

Answer to a: CRP = 12%

Solution to b: Estimation of Cost of Equity (R_e)

Additional Information:

Risk Free Rate of Return (R_f) = 15%

Risk Premium for mature equity markets (R_m - R_f) = 5.5%

Firm Beta (β) = 0.75

Cost of Equity will be estimated using Capital Asset Pricing Model. However, an updated formula will be used to factor the Country Risk Premium as well as the firm's exposure to revenues in US dollars.

The firm derives 80% of its revenues in US dollars. Hence, the firm's exposure to revenues in Rupiah is only 20%. Exposure of an average Indonesian firm to revenues in Rupiah is 80% (100% - 20% of US dollar return). The relation between the above exposures is termed as lambda (λ).

λ = % of the firm's revenue in indonesian rupiah / % of average firm's revenue in indonesian rupiah

λ = 20% / 80% = 0.25

R_e = R_f ​+ β (R_m​ − R_f​) + CRP​ (λ)

(Note: CRP * λ represents the exposure of paper & pulp firm to earnings in indonesian rupiah).

R_e = 15% + 0.75 (5.5%) + 12% (0.25)

R_e = 22.125%

Answer to b: Cost of Equity = 22.125%