An idiosyncratic view on ICC estimation methods

Regarding international cost of capital (ICC) estimation

I became involved in valuation via M&A transaction advisory services for mid-market industrial companies circa 1990. Because I was based in the Midwestern USA, many clients were involved in automobile and aerospace manufacturing, and in agri-business industries. Interestingly, even in the 1990s my clients were part of international supply chains, with—for example—significant exposures to Latin American supply risks and foreign exchange risks.

Back then—as now—incorporating risk premiums for international risk exposures was generally fairly ad hoc. In part, this was because the valuation profession was still relatively immature; but it was also because there was a general belief among corporate finance and valuation professionals that CAPM was a meaningful, valid asset pricing theory. Here is where the story gets interesting.

In 1995, I began doctoral studies at Michigan State University where much of my coursework was related to financial economics and econometrics. Much of my studies focused on asset pricing theory, which includes CAPM. I learned that CAPM had been, in simple terms, found inadequate and superseded by the simpler, more robust, empirically-demonstrable arbitrage pricing theory (APT) and risk-neutral pricing theory … and such theories and related methods had existed since about 1976. So, I learned that almost 20 years after CAPM-related methods were superseded by substantially-less-problematic theory and methods, we finance and valuation professionals were still using CAPM-based methods.

In 1999, I began an 11 year stint teaching accounting and finance-related courses at major US business schools, where I had also been conducting academic research based largely on asset pricing theory. During the mid-2000s, I also became involved in litigation-related valuation consulting and was surprised to observe that the valuation profession was generally still using CAPM-related models to estimate discount rates; now 30 years on.

In particular, a colleague in the Chicago office of the consulting firm I was working with was the resident, firm-wide expert on ICC estimation. This means he presumably knew more about ICC estimation than a number of the well-known valuation profession leaders who worked in our firm. His ICC estimation method for private equity interests consisted of adding together (i) a U.S. Treasury security yield, (ii) an assumed—rather than estimated—CAPM equity risk premium based on “comparable public equity securities” in the country where the business associated with the equity interest was domiciled, and (iii) country risk and small company risk premiums obtained from Ibbotson’s International Cost of Capital Yearbooks. The method was purely mechanical and had little, if any, basis in sound, empirically-demonstrable asset pricing theory. When I asked questions similar to “But how have we demonstrated that the discount rate for the private equity interest can actually be replicated in the markets [i.e., does it represent opportunity cost of capital]?” colleagues generally (though not all) rolled their eyes and told me not to worry: the ICC estimation method being used represented the state of valuation practice. In short, shut up and get back to doing billable work. Relatedly, my knowledge, skills, and experience were soon found to be no longer required … so I returned to my academic career.

I began living in Brazil part-time in 2008 to conduct capital market research and then moved permanently to Brazil in 2010. Since then I have worked full-time in international valuation consulting. Most Brazilian capital assets are exposed to a variety of cross-border risks, so ICC estimation methods are required in most all valuation projects here. Because APT can be used to empirically demonstrate no-arbitrage pricing, hedging, and diversification of international risk portfolios, I’ve used APT extensively in ICC estimation. In contrast to CAPM-based methods—which rely on a number of problematic, untestable assumptions about investors’ knowledge and beliefs—methods derived from APT rely on just a few highly plausible, empirically testable assumptions and result in clear, transparent, defensible ICC estimates.

And yet, lo, these many years later—now 40 years on—searches of and book sales websites suggest only three currently-in-print books exist circa 2018 that are either devoted to ICC estimation, or have a meaningful treatment of the topic. The books, however, do not present the estimation methods with a level of theoretical rigor sufficient for the reader to properly evaluate the (many CAPM-based) ICC estimation methods. Basically, the books present alternative ICC estimation methods along with mildly-worded caveats and allow readers to otherwise fend for themselves.

And so … I must routinely explain to (and argue with) CFOs, controllers, auditors, valuation consultants, and sometimes regulators about why I use APT rather than CAPM-based methods. And although I’ve never lost any such argument, the arguments cost me substantial amounts of time and, therefore, money. So here we are 40 years after new, improved asset pricing theory and related valuation methods were developed to solve the problems inherent in CAPM. But much of the finance profession still believes CAPM and related methods continue to be relevant, valid methods; especially for use in ICC estimation. I, however, believe it’s high time finance professionals benefit from theory and methods developed over 40 years ago, which are directly applicable to ICC estimation.

We all want progress–even if it’s 40 years late–no?

Malcolm McLelland Ph.D.
São Paulo, Brazil

Caveats.  Please note: (i) views presented above are my own and do not reflect those of others; (ii) like anyone, I’m not infallible and am responsible for any errors; (iii) I greatly appreciate being informed of any significant errors in facts, logic, or inferences and am happy to give credit to anyone doing so; (iv) the above article is subject to revision and correction; and, (v) the article cannot be construed as investment or financial advice and is intended merely for educational purposes.  MMc