Challenges in estimating the Cost of Capital in frontier markets


Article – Anup N. Amatya & Associates, professional Financial, Business & Management Consultants

This article tries to analyse the challenges and procedures in estimating the Cost of Equity and Weighted Average Cost of Capital (WACC) in frontier markets such as Nepal, Pakistan, Nigeria, Maldives etc. Many foreign investors do not prefer to invest in these markets because of the risks involved.

The problem exacerbates due to the lack of sufficient stock market information and data availability. Nevertheless, prospective investors and international financial institutions that finance investments in these markets need to estimate the Average Cost of Capital for investment projects in these markets. I have tried to elaborate on the issue based on theory and practice on the subject.

Estimating Cost of Equity and Weighted Average Cost of Capital, WACC becomes a very challenging and complex task in Frontier Markets

The most popular rating agencies such as Standard & Poor, Moody’s and Fitch have yet to rate Nepal for its Sovereign rating, for instance. This makes the estimate of Country Risk Premium – CRP used for WACC calculation very challenging and unreliable. Investors know that investing in frontier markets such as Nepal is risky, but the big question is how much risk is there in reality.

To alleviate the issue to some extent, the World Bank has come out with Shadow Sovereign rating for Nepal as well as other unrated countries. Nepal’s shadow rating is CCC+ (Caa1 as per Moody’s) which puts Nepal in “High Default Risk” category. Source: Economic Premise – Shadow Sovereign Ratings. THE WORLD BANK (PREM), August 2011. Available from:

Based on the Shadow rating of CCC+ (Caa1 as per Moody’s) and as per the calculations by Professor Aswath Damodaran, an authority on Valuation theory at the Stern School of Business, the updated Default Spread (01/01/2018) for Nepal and other similar rated countries was 769 bps (866 bps in 07/01/17). Source: Aswath Damodaran, Available from: Index of /~adamodar/pc/datasets – NYU Stern

As per Professor Damodaran, equities are on average 1.5 times riskier than bonds (implied by the standard deviation in returns from equity and bonds). Nepal’s Equity Risk Premium – ERP from a Global Investor’sperspective comes around: 16.54% = 5% (Mature Market premium) + (769*1.5; Country Risk Premium=11.54%).

An average Local Investor has fewer investment opportunities than a Global Investor

It, however, does not take into account that an average local investor has fewer investment opportunities than a global investor and hence a lower ERP. Assuming that a local investor has access to only 1/3 the investment opportunities compared to a Global investor, his/her ERP would be 8.85% = 5%+ (769/3)*1.5%.

Another challenge is the estimation of Beta factor, which measures the Systematic/Market Risk of the company’s cash flows (as well as particular share’s volatility in terms of market risk). It may be due to General Economic factors such as Tax rates, Interest rates, Inflation etc. and cannot be eliminated by holding a diverse portfolio of investments.

Since the specific data for Nepal is not available, we have to use the proxy Unlevered Beta (with only Equity portion included the capital structure) for the Emerging markets. E.g. Unlevered Beta for Hotel/Gaming industry, according to Professor Damodaran, is 0.84 (updated 5 Jan 2018). Fully diversified Foreign Investor can use this figure or nearby estimate, say 0.90, to estimate the Geared Beta (which includes Debt-Financial Risk in the Capital Structure).

I have assumed Asset Beta (with no debt) of 1.0 (0.98 in India for Completely Undiversified Investor, Hotel/Gaming industry). Source: Aswath Damodaran, Available from: Index of /~adamodar/pc/datasets – NYU Stern

Estimating the Cost of Equity and WACC in Frontier Markets

With these guesstimates, I have sought to estimate the Cost of Equity and WACC with 40% Debt and 60% Equity in the capital structure as follows:

Bg, Equity (Geared) Beta with 40% Debt in Capital Structure:

Unlevered/Asset Beta, Bu = Bg{Ve/Ve+Vd(1-t)}+Bd, debt beta considered 0

For Fully Diversified Foreign Investor:

0.90= Bg*{0.6/(0.6)+0.4*(1-0.25)}

Bg= 0.90/0.667 = 1.35

Here, Corporate Tax Rate, t = 25%

 For Fully Undiversified Local Investor:

1.0= Bg*{0.6/(0.6)+0.4*(1-0.25)}

Bg= 1.0/0.667 = 1.50

 Cost Of Equity Calculation:

(i) For a Fully Diversified Foreign Investor:

Keg = Risk-Free (Govt L.T. Bond) Rate + Geared Beta*(Mature Mkt. Risk Premium + Country Risk Premium)

 Keg =6% (2018) + 1.35*(5%; US+11.54%) = 28.33%

WACC= Keg*Ve/(Ve+Vd)+Kd(1-t)*Vd/(Vd+Ve)

Here, Keg = Cost of Equity with Debt in the capital structure, Ve =Value of Equity, Vd = Value of Debt, Kd = Cost of Debt, assumed Bank Borrowings = 12.5%.

Weighted Average Lending Rate as per Nepal Rastra Bank (NRB) = 11.9% (Mid Feb, 2018), Corporate Tax Rate, t = 25%


Hence, WACC= 20.75%

(ii) Assuming Local Investor having fewer Investment Opportunities(1/3) vs Global investor:

Keg = Risk Free (Govt L.T. Bond) Rate + Geared Beta*(Mature Mkt. Risk Premium + (Default Spread/3)*1.5; Volatility)

Here, 5%+ (769; Default Spread/3)*1.5% = Equity Risk PremiumERP = 8.85%

 Keg =6%(2018) + Bg; 1.5*(8.85) = 19.27%

WACC= Keg*Ve/(Ve+Vd)+Kd(1-t)*Vd/(Vd+Ve)


Hence, WACC=15.3%

Historical data usually overestimate Equity Risk Premium, ERP

It is imperative to note here that historical data usually overestimate Equity Risk Premium, ERP, since it does not take into account the maturing of the economy and hence Nepal’s ERP going forward, is likely to be lower than as estimated above.

It means that the Cost of Equity, as well as WACC, will be lower, for global investors and investments/projects would look more profitable, with more positive Net Present Values (NPVs) as a consequence.

This article elaborates the Challenges in Estimating the Cost of Capital (WACC), in Frontier Markets.

Anup N. Amatya & Associates, professional Financial, Business & Management Consultants

Author: Anup Narsingh Amatya