International WACC

Step 1: Base (Domestic) Cost of Equity

Re (USD) = 4.0% + 1.10 × 5.5% = 4.0% + 6.05% = 10.05%

This is a standard CAPM cost of equity — it prices only market-wide (systematic) risk as observed in the home market. It says nothing about the extra risk of operating in a different country, which is exactly why it can't be used as-is for an emerging-market subsidiary.

Step 2: Country Risk Premium

Where: Sovereign Bond Spread = the extra yield investors demand on the country's USD-denominated government bonds over US Treasuries (a market-based proxy for default risk); Volatility Ratio = country equity index volatility divided by country bond index volatility.

Using the sovereign spread (2.5%) and the volatility ratio (1.3x):

Country Risk Premium = 2.5% × 1.3 = 3.25%

This is the Damodaran-style relative volatility approach: a raw bond spread only reflects default risk as priced by bondholders, but equity holders are exposed to more risk than bondholders in almost every market. Scaling the bond spread up by the equity/bond volatility ratio converts a debt-market risk signal into an equity-market one — using the bond spread directly would understate the premium equity investors actually require.

Step 3: Country-Adjusted Cost of Equity

Re (USD, country-adjusted) = 10.05% + 3.25% = 13.30%

This figure is still denominated in USD — it answers "what would a USD investor require to hold equity risk in this country," but it hasn't yet been translated into the currency the cash flow forecast is actually built in.

Step 4: Currency-Adjusted Cost of Equity

Where: the Fisher relation converts a discount rate from one currency into another using the inflation differential between the two currencies.

Using the country-adjusted cost of equity (13.30%), local inflation (6.0%), and USD inflation (2.5%):

Re (Local Currency) = (1 + 13.30%) × (1 + 6.0%) / (1 + 2.5%) − 1 = 1.1330 × 1.06 / 1.025 − 1 = 17.17%

The discount rate and the cash flow forecast must be denominated in the same currency, or the valuation silently mixes two different inflation assumptions. Since the subsidiary's cash flows are forecast in local currency, the discount rate has to be converted into local-currency terms using the Fisher relation rather than applied directly in USD.

Step 5: Illiquidity-Adjusted Cost of Equity

Re (Final) = 17.17% + 1.5% = 18.67%

The illiquidity premium compensates investors for the lack of a liquid public market to exit the position — relevant here because the subsidiary itself isn't separately traded. It's added to the cost of equity specifically, since it's the equity holders who bear the illiquidity risk, not the lenders.

Step 6: WACC

Where: Re = Cost of Equity, Rd = Cost of Debt, E = Market Value of Equity, D = Market Value of Debt.

Using the target Debt/Equity ratio of 0.50: E/(D+E) = 1 / 1.50 = 66.7%, D/(D+E) = 0.50 / 1.50 = 33.3%. After-tax cost of debt = 8.0% × (1 − 25%) = 6.0%.

WACC = 66.7% × 18.67% + 33.3% × 6.0% = 12.45% + 2.00% = 14.45%

This is the fully adjusted discount rate: it reflects the domestic market risk (CAPM), the extra risk of the country the cash flows are exposed to, the currency the cash flows are actually forecast in, the illiquidity of the position, and the tax-shielded cost of debt at the target capital structure.

Final Results

• Base (Domestic) Cost of Equity: 10.05%
• Country- and Currency-Adjusted, Illiquidity-Adjusted Cost of Equity: 18.67%
• Fully Adjusted WACC: 14.45%

This WACC is the discount rate applied to the local-currency free cash flow forecast in the DCF, giving an internally consistent enterprise value for the emerging-market subsidiary — internally consistent because every input (currency, country risk, liquidity) now matches the cash flows it's discounting.

Would you like to explore what happens if you skip the currency adjustment and discount the local-currency cash flows at the original USD-based rate instead — and why that shortcut quietly misprices the valuation?