Calculating Political Risk Premium for WACC

We show here how we can calculate the fluctuating political risk premium of any country. This company specific idiosyncratic premium is to be added to the WACC of a company to adjust it for time variant political situations. It has many important ramifications during these times, including for strategic and tactical asset allocations for it may be extended to sectors too.

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What is Missing in WACC in Politically Unstable Countries?

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In this series we highlight an innovative methodology that helps isolate and calculate an explicit Political Risk Premium – a vital input for arriving at the correct cost of capital for firms operating in politically charged countries, during and after the coronacrisis.

  • The cost of equity is generally the expected cost of equity.  It includes expected dividends and expected capital gains.  The expected cost of equity is generally measured using the Capital Asset Pricing Model (CAPM)) as: expected return = r = riskless rate + beta*[risk premium].
  • The cost of debt is expected return to bondholders.  If debt is safe and priced at par, the coupon rate is cost of debt.  Otherwise, the expected cost of debt is more elusive.
  • The weighted average cost of capital (WACC) is a weighted average of the cost of debt and equity where the weights are the relative market values of the debt and equity.  The formula for WACC is:  WACC =(1-tax rate)* kD*(D/V) + kE*(E/V) where  kD is he expected return on debt, kE is the expected return on equity, D is the market value of debt, E is the market value of the equity, and V is the market value of the debt and equity (V=D+E).
  • For  developing and politically unstable unstable countries we need to add an explicit political risk premium.

Complexities in Estimating Political Risk Premium

India recently got downgraded. Rating agencies have been slow to catch up with fast changing political events, given corona crisis induced stresses, in developing and emerging markets. We have developed a framework to isolate, estimate and price sovereign country political risk that improves on rating agency assumptions and outlook.  This premium may be used to arrive at country specific cost of capital for corporate finance projects. We will be sharing our approach in  a forthcoming series of blog postings.

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