Applying the Scenario DCF Approach  697 We assumed for simplicity that if adverse economic conditions develop in the emerging market, they will do so in the first year of the plant’s opera- tion. In reality, of course, the investment will face a probability of domestic economic distress in each year of its lifetime. Modeling risk over time would require more complex calculations yet would not change the basic results. We also assumed that the emerging-market business would face significantly lower cash flows in a local crisis but not wind up entirely worthless. We can also see from Exhibit 35.3 how easy it is to overestimate the coun- try risk premium. As you can see, despite the 25 percent chance that the cash flows would be 55 percent lower than the base case, the equivalent country risk premium is only 0.7 percent (estimated by reverse engineering the valu- ation and solving for the discount rate based on the base-case cash flows). If we had used a country risk premium of 3 percent, the implied probability of economic distress would be 70 percent, versus 25 percent in the example. Exhibit 35.4 gives an indication of the premium required for different com- binations of the probability and size of an investment’s permanent cash flow reduction. The premium is easily overestimated. For example, if there is a probability of 50 percent that future cash flows will be permanently lower by 40 percent, the risk premium should be just 1.5 percent. Actual premiums will also vary, depending on the underlying cash flow profile and cost of capital.3 Nevertheless, the table allows for some calibration of premiums and risks. While estimating probabilities of economic distress for the base case and downside scenarios is ultimately a matter of management judgment, there are indicators to suggest reasonable probabilities. Historical data on previ- ous crises can give some indication of the frequency and severity of country EXHIBIT 35.4  Probability of Economic Distress Given Small Variations in Risk Premium Risk premium that reflects given conditions, % Size of cash-flow reduction, % 20 40 60 80 100 10 0.1 0.2 0.4 0.5 0.7 20 0.2 0.5 0.8 1.1 1.5 Probability of lower cash flow, % 30 0.4 0.8 1.3 1.9 2.6 40 0.5 1.1 1.9 2.8 4.0 50 0.7 1.5 2.6 4.0 6.0 A 1.5% risk premium is assuming even odds that an investment will lose 40% of its value. A 6% risk premium is assuming even odds it will lose all its value. Note: Chart assumes a smooth cash-flow profile, 8% weighted average cost of capital, 2% terminal growth, binomial outcome. Source: R. Davis, M. Goedhart, and T. Koller, “Avoiding a Risk Premium That Unnecessarily Kills Your Project,” McKinsey Quarterly (August 2012). 3 The higher the cash flow’s growth rate, the stronger is the impact of a risk premium on the DCF value. 698  Emerging Markets risk and the time required for recovery. We analyzed the changes in GDP of 20 emerging economies since 1985 and found that they had experienced eco- nomic distress, defined as a real-terms GDP decline of more than 5 percent, about once every five years. This would suggest a 20 percent probability for a downside scenario. Another source of information for estimating probabilities is prospective data from current government bond prices.4 Academic research suggests that government default probabilities in emerging markets such as Argentina five years into the future were around 30 percent in nondistress years.5 In our example, we could simply reverse engineer the country risk pre- mium, because the true value of the plant was already known from the sce- nario approach. But for practical purposes, there is no agreed-upon approach to estimate the premium. Estimates from different analysts usually fall into a wide range because of the different methods used. The country risk premium is sometimes set at the so-called sovereign risk premium: the spread of the local government bond yield denominated in U.S. dollars and a U.S. govern- ment bond of similar maturity. However, that is reasonable only if the returns on local government debt are highly correlated with returns on corporate in- vestments. In our experience, this is rarely the case. From an operational viewpoint, using scenarios forces managers to discuss emerging-market risks and their effect on cash flows, thereby gaining more insights than they would secure from an arbitrary addition to the discount rate. By identifying specific factors with a large impact on value, managers can plan to mitigate these risks. Estimating Cost of Capital in Emerging Markets Calculating the cost of capital in any country can be challenging, but for emerging markets, the challenge is an order of magnitude greater. This section provides our fundamental assumptions, background on the important issues, and a practical way to estimate the components of the cost of capital. General Guidelines Our analysis adopts the perspective of a global investor—either a multina- tional company or a global investor with a diversified portfolio. Of course, some emerging markets are not yet well integrated with the global market. In China, for example, local investors may face barriers to investing outside 4 See, for example, D. Duffie and K. Singleton, “Modeling Term Structures of Defaultable Bonds,” Review of Financial Studies 12 (1999): 687–720; and R. Merton, “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” Journal of Finance 29, no. 2 (1974): 449–470. 5 See J. Merrick, “Crisis Dynamics of Implied Default Recovery Ratios: Evidence from Russia and Argentina,” Journal of Banking and Finance 25, no. 10 (2001): 1921–1939.