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Source: Ibliotsou Assoc. Stocks, Bonds. Billsand Inflation: 1993 Yearbook.

Source: Ibliotsou Assoc. Stocks, Bonds. Billsand Inflation: 1993 Yearbook.

5 See Chapter 10 for a discussion of the relationship between size, beta, and cross-sectional returns.

Exhibit 18.17 Comparison of Company Size Across Countries

Exhibit 18.17 Comparison of Company Size Across Countries

dollar-based CAPM line for a country such as Denmark, which has a much smaller average company size than is found in the United States. The CAPM line (the dashed line) in the exhibit will have a steeper slope because the average company size is smaller.

Now consider an average Danish company. This company has a beta of 1.0 against the Danish CAPM line. Because the company is smaller than a typical U.S. company, it will have a higher beta relative to the U.S. index, say 1.3.

The cost of capital in dollars for this company can be calculated in two ways. Let's assume a U.S. risk-free rate of 6 percent and a U.S. market risk premium of 5 percent. One method would be to calculate the cost of equity

Exhibit 18.18 Global vs Local CAPM

relative to the U.S. market. The cost of equity would be 12.5 percent (6% + 5% x 1.3). The second method is to calculate the cost of capital relative to the Danish market. The cost of equity must again be 12.5 percent, according to the line on Exhibit 18.18. This implies that the market risk premium for the Danish market is 6.5 percent (when expressed in U.S. dollars). We assumed earlier that the company's beta relative to the Danish market is 1.0. Hence its cost of capital of 12.5 percent (6% + 6.5% x 1.0).

This means that if you use a beta relative to the local market, you should use a market risk premium that reflects the size of the local market. If you use a beta relative to the U.S. market or a global market, use a U.S. or global market risk premium. In theory, you should get the same cost of equity. You would rarely get such logical results using actual market data from countries with small illiquid markets and a short history. But in most cases, you are likely to have better data—both market risk premiums and betas for the global or U.S. market—so most often that is the approach to use. Don't forget to adjust for differences in the risk-free rate if you are using different currencies.

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