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Journal number 2 ∘ Beka Darakhvelidze
Comparative Analysis of the Cost of Equity Measurement Models for Developing Countries

doi.org/10.52340/eab.2024.16.02.06

When evaluating the value of a particular firm or asset, to calculate the final result objectively and consider the critical variables of the market conjuncture, it is necessary to select the optimal discount rate, which will be used to assess the riskiness of cash flows. The discount rate should reflect all possible premiums impacting the financial and non-financial riskiness of the evaluated asset. In particular, for calculating the value of the loan obligation, the discount rate must reflect the default premium, which implies the risk that the borrower will not be able to repay the obligation in the predetermined volume and term stipulated by the agreement. On the other hand, when investing with equity, the discount rate should reflect the equity risk premium. Therefore, a logical question arises: how do we measure the riskiness of default and investor's equity? It is rational to share the opinion that assessing the risk from the investors' point of view and subsequently converting it into a numerical indicator is a rather complex task, especially when it comes to developing countries, where the sources of market risk, measurability, are even more obscure and require additional observation and study. Therefore, the selection of the optimal model, which is as close as possible to reality and, at the same time, can quickly reflect all the risk factors that affect the investment, is critically important. This task is complex for an investor, but based on theoretical and practical knowledge, experience, and logic, it is possible to cope with this challenge. Financial and economic representatives unanimously agree that selecting an effective numerical model for calculating the cost of equity and reflecting relevant risk factors in it is beneficial both for local and global investors and for a developing country's stable economic growth. Improving the cost of capital methodology can transmit positive results to the economy and its agents through several channels.
Within the framework of the article, a comparative analysis of numerical models for measuring investment cost was carried out. In the first part of the article, the theoretical and practical numerical models in the financial and economic literature were reviewed in detail. After that, an analysis of the capital asset pricing model, arbitrage pricing model, multifactor, and alternative models was carried out, the shortcomings and advantages of each model were reviewed, as well as a discussion was made about how realistic the assumptions behind these models are and how materially damaging the existence of these assumptions can be to the numerical results, of the model as a predictor of expected returns. The next part of the article analyzed which numerical model should be used and what changes are needed so that the standard financial models for calculating the cost of equity would reflect the systemic risk environment of the developing country relevantly. The literature review shows several main directions to choose from when selecting a measurement model for expected returns. Within the article, the decision to choose a model for calculating the cost of capital in developing countries is based on theoretical and pragmatic considerations. During the selection of the methodology, further questions were asked: to what extent is it possible to obtain information about the variables required to use the numerical model, how simple and intuitive the essence of the model, and what the interpretation of the results derived from it will be for the reader, which model, as a determinant of future expected returns, is inclined to use in the empirical studies carried out in the financial field. After analyzing and evaluating the questions arising from all the factors mentioned earlier, a modified version of the capital asset pricing model was selected. Modifying the capital asset pricing model allows for a change in the standard approach and reflects all the additional risk factors that may characterize the economy of a developing country. The essence of the modification lies in including an additional premium in the numerical model, which will reflect and try to reflect local financial and non-financial riskiness in numerical indicators. Aswat Damodaran notes that the modified CAPM's main advantage is its simplicity and intuitiveness in assessing the relationship between risk and opportunities. Also, Damodaran emphasizes that more sophisticated and complex numerical models, such as arbitrage pricing, Fama and French 3-factor, and other models, despite being better explainers of historical trends, empirical research shows that they cannot offer Significantly improved forecasts of expected rates of return compared to CAPM, it is therefore not surprising that the capital asset pricing model is still the most popular and applicable to investors today.
Calculating the cost of equity is a rather complex and time-consuming process, which in turn requires a reliable information resource, in-depth knowledge of the field, and a detailed analysis of the features of the potential investment proposal. When an investment decision is made in the market of a developing country, all the circumstances mentioned above are associated with additional risk factors, such as access to historical databases, reliable information resources, the existence of political risks, low level of development of the country's financial infrastructure, low transparency of the market, increased signs of corruption and others. Hence, directly selecting and transferring the numerical model that is used in developed markets to the market of a developing country could be materially damaging and not lead to optimal financial decision-making for the investor. Based on this fact, within the framework of the article, a traditional, well-known capital asset pricing model was selected and recommended, which should be modified and include a premium relevant to a developing country's systemic risk. On the other hand, as mentioned at the beginning of the article, the numerical model for calculating the investment discount rate, which is consistent with economic and financial logic, is beneficial for the economy of a developing country in many ways, including effective allocation of resources among economic agents, support for the development of financial infrastructure, increasing the transparency of financial markets, and others.

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Keywords: Capital, investment, diversification, value, discounting, numerical model, risk premium
JEL Codes: E22, F21, O16, R53,