# Aswath damodaran 16 from country spreads to corporate

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Aswath Damodaran 16 From Country Spreads to Corporate Risk premiums n Approach 1: Assume that every company in the country is equally exposed to country risk. In this case, E(Return) = Riskfree Rate + Country Spread + Beta (US premium) Implicitly, this is what you are assuming when you use the local Government’s dollar borrowing rate as your riskfree rate. n Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk. E(Return) = Riskfree Rate + Beta (US premium + Country Spread) n Approach 3: Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales) E(Return)=Riskfree Rate+ β (US premium) + λ( Country Spread)

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Aswath Damodaran 17 Estimating Company Exposure to Country Risk n Different companies should be exposed to different degrees to country risk. For instance, a Brazilian firm that generates the bulk of its revenues in the United States should be less exposed to country risk in Brazil than one that generates all its business within Brazil. n The factor “ λ ” measures the relative exposure of a firm to country risk. One simplistic solution would be to do the following: λ= % of revenues domestically firm / % of revenues domestically avg firm For instance, if a firm gets 35% of its revenues domestically while the average firm in that market gets 70% of its revenues domestically λ= 35%/ 70 % = 0.5 n There are two implications A company’s risk exposure is determined by where it does business and not by where it is located Firms might be able to actively manage their country risk exposures
Aswath Damodaran 18 Estimating E(Return) for Embraer n Assume that the beta for Embraer is 0.88, and that the riskfree rate used is 4.5%. (Real Riskfree Rate) n Approach 1: Assume that every company in the country is equally exposed to country risk. In this case, E(Return) =4.5% + 10.24% + 0.88 (5.51%) = 19.59% n Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk. E(Return) = 4.5% + 0.88 (5.51%+ 10.24%) = 18.36% n Approach 3: Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales) E(Return)= 4.5% + 0.88 (5.51%) + 0.50(10.24 %) = 14.47% Embraer is less exposed to country risk than the typical Brazilian firm since much of its business is overseas.

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Aswath Damodaran 19 Implied Equity Premiums n If we use a basic discounted cash flow model, we can estimate the implied risk premium from the current level of stock prices. n For instance, if stock prices are determined by a variation of the simple Gordon Growth Model: Value = Expected Dividends next year/ (Required Returns on Stocks - Expected Growth Rate) Dividends can be extended to included expected stock buybacks and a high growth period.
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