A Capital Lesson from Egypt

The political turmoil in Egypt is a reminder that the cost of capital in emerging markets has to be regularly reassessed.

For example, many cost-of-capital models require historical data on bond and stock market returns, which is used to get an idea of the returns investors demand in different markets. But some emerging countries don’t have stock markets, or their stock markets are not as diverse as those in developed countries, so one industry or company can have an inordinate impact on returns.

One example is South Africa, where mining and minerals companies predominate. “If I’m a food company in South Africa, the stock market data doesn’t help me see how my industry risks are being assessed in that country’s market,” says Grabowski.

Even if historical stock and bond market return data is available, emerging markets have much higher volatility. From 2001 to 2009, the average annual equity return in Egypt was 39.1%, but the standard deviation was 78.8%. Likewise, if you’re making an investment in Russia or China, the variability is so high that a mean (average) return is much less reliable, says Grabowski. That can indicate that finance needs to use more than one cost-of-capital model, says Harrington. “Instead of just relying on one model, one observation, increase the number of observations,” he advises.

Experts caution against simplifying the calculation of systematic risk. Just tacking a 10% premium onto a firm’s U.S. cost of capital in trying to size the country and industry risks in an emerging market, for example, can lead to bad decisions. It’s hard to calculate specific costs of capital for emerging markets; that is, reflect country-specific considerations in cash-flow projections, say Grabowski and Harrington. But it’s still very necessary to do so.

Companies like Apache can do little once they already have a sunk investment. The real issue then might be, “If I want to put more money in, make a bigger investment, is there more risk today?” says Grabowski. The answer is yes if the country is Egypt, according to the cost of insuring against a default on Egypt’s debt. The spreads in the country’s five-year credit-default swaps widened 100 basis points last week, although they have narrowed slightly again. Still, it’s an indicator that the market perceives that the risk of operating a business in Egypt has increased, says Grabowski.

“If I were confronted with the issue of investing in Egypt today, one of the questions I’d ask is, ‘Can I defer making my investment until things settle down?’” he says. “You often have that option.”


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