Applying the Scenario DCF Approach  695
Finally, most of us underestimate the impact that even a small country risk 
premium has on valuations, as we will show in the next section.
Applying the Scenario DCF Approach
The preceding analysis of the Brazilian cost of equity masks a wide variation 
in P/Es across the economy. That’s where the scenario DCF approach proves 
its advantages; it allows you to assess the risk of each company based on 
company-specific risk factors. At a minimum, model two scenarios. The first 
should assume that cash flow develops according to conditions reflecting busi-
ness as usual (i.e., without major economic distress). The second should reflect 
cash flows assuming that one or more emerging-market risks materialize.
Exhibit 35.3 compares the valuation of a company with a European factory 
and an emerging-market factory with a similar outlook except for the emerg-
ing-market risk. In the example, the cash flows for the European factory grow 
steadily at 3 percent per year into perpetuity. For the factory in the emerging 
market, the cash flow growth is the same under a business-as-usual scenario, 
but there is a 25 percent probability of economic distress resulting in a cash 
flow that is 55 percent lower into perpetuity. The emerging-market risk is 
taken into account, not in the cost of capital but in the lower expected value of 
future cash flows from weighting both scenarios by the assumed probabilities. 
The resulting value of the emerging-market factory (€1,917) is clearly below 
the value of its European sister factory (€2,222), using a WACC of 7.5 percent.
EXHIBIT 35.2  Returns on a Diverse Emerging-Market Portfolio
600
500
400
300
200
100
0
–100
Country A
Country B
Country C
1985
1989
Index ROIC
1993
1997
2001
Select individual emerging-market returns on capital1
600
500
400
300
200
100
0
–100
1985
1989
Index ROIC
1993
1997
2001
Combined portfolio returns on capital2
Country D
Country E
Emerging markets
Developed markets
1981
1981
1 In stable currency and adjusted for local accounting differences.
2 Combined portfolio included additional countries not reflected here.
Source: Company information.

EXHIBIT 35.3  Scenario DCF vs. Country Risk Premium DCF
€
Net present value for identical facilities in . . .
. . . a European market
. . . an emerging market
Probability
Cash flows in perpetuity1
Probability
Cash flows in perpetuity2
Scenario
approach
Year 1
2
3
4
. . .
Year 1
2
3
4
. . .
100%
“As usual”
100
103
106
109
75%
“As usual”
100
103
106
109
 0%
“Distressed”
25%
“Distressed”
45
46
48
49
Expected cash flows
Expected cash flows
100
103
106
109
86
89
92
94
Cost of capital
7.5%
Cost of capital
7.5%
Net present value
2,222
Net present value
1,917
86% of European NPV
Cash flows in perpetuity1
Cash flows in perpetuity2
Country risk
premium
approach
Year 1
2
3
4
. . .
Year 1
2
3
4
. . .
“As usual”
100
103
106
109
“As usual”
100
103
106
109
Cost of capital
7.5%
Cost of capital
7.5%
Net present value
2,222
Country risk premium
0.7%
Adjusted cost of capital
8.2%
Net present value
1,917
86% of European NPV
1 Assuming perpetuity cash flow growth of 3%.
2 Assuming perpetuity cash flow growth of 3% and recovery under distress of 45% of cash flows “as usual.”
696