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The cost of debt for foreign investors is simply the global industry cost of debt adjusted for the company's target capital structure and local inflation. Adding known components, the risk-free rate, the rating premium, and the inflation differential, you can assemble the cost of debt. For global investors, it is important to keep in mind that country risk can be diversified away in a bond portfolio, so no country-risk premium should be included. Coca-Cola and Colgate Palmolive, for example, have costs of debt no higher than their U.S.-focused competitors, even though much of their profits and investments are in emerging markets. Let's set up an example of how the cost of debt could be calculated. Assume that the rating for most global steel companies is BB+ but the capital structure for the local company is more heavily debt laden than the global capital structure, implying that its rating might be BB. You can use the risk-free rate for the country plus the premium required for a U.S. corporate bond rated BB versus the U.S. government bond yield.

Here's how we calculated the cost of debt for Pao de A9ucar:

10-year U.S. government bond yield to maturity 5.2%

Brazilian 10-year inflation differential 4.4

Brazilian risk-free rate 9.6%

Yield differential between 10-year U.S. government debt and B+

10-year U.S. corporate debt 3.6

Cost of debt for Pao de A^car 13.2%

In many emerging markets, the capital markets for debt are even more inefficient than for equity. The cost of financing, if in fact financing can even be obtained, is often substantially different from the cost of debt we are suggesting here. In cases such as these, you may want to consider estimating the tax shields on debt directly as the cost of financing gradually declines to reflect the true cost of debt. The cash flows would be discounted at an unlevered cost of equity and the net present value of the tax shields would be added to the cash-flow value.

The marginal tax rate in emerging markets can be very different from the effective tax rate, which may include investment tax credits, export tax credits, taxes, equity or dividend credits, and operating loss credits. Many of these do not provide a tax shield on interest expense. Only taxes that apply to interest expense should be used in the discount rate. Other taxes or credits should be modeled directly in the cash flows.

In emerging markets, many companies have an unusual capital structure for their industry. Anomalies in the local debt or equity markets often cause the difference. In the long run, when the anomalies are corrected, the companies should expect to converge to a capital structure similar to their global competitors. You may want to forecast the company evolve to a global capital structure.

Exhibit 19.13 Cost of Capital—Pao de Açûcar

Exhibit 19.13 Cost of Capital—Pao de Açûcar

Summarizing the Cost of Capital in Emerging Markets

An example of a complete calculation of an emerging markets cost of capital is shown for Pao de Ajucar in Exhibit 19.13. Again, we assume the use of local currency cash flows. Many investment banks and industry practitioners would probably estimate the cost of capital for Pao de Ajucar in the 14 percent to 23 percent range, higher than the cost of capital we find. Note, however, that these results are not directly comparable since they are presumably not using probability-weighted scenarios, as we are.

Summary

In this chapter, we discussed how to value companies in emerging markets. While the valuation concepts applied to developed markets and emerging markets are similar, the application can be somewhat different. Since the value is often more volatile, we recommend comparing multiple approaches and using a range of values based on integrated scenario analysis. An example of the output of this work is summarized for Pao de Ajucar in Exhibit 19.14. The complete value range is actually 0.9 to 1.6 billion Reais, but it has been narrowed using probability weights to 1.0 to 1.3 billion Reais.

Exhibit 19.14 Comparison of Results—Pao de Ajucar

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