Two Paths to CAPM for Cross-Border Valuations ⎹ FRIDAY DIGEST

The cost of capital model is typically built around a mature reference market, most often the country where the risk-free rate and market data are readily observable. Applying that same model to a target operating in a different country raises a basic construction question:

WHERE DOES THE TARGET COUNTRY'S RISK ENTER THE MODEL?

Let's consider a company operating in Poland as an example. Two internally consistent approaches are used in practice.

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Option A: Base country plus adjustment

This approach builds the cost of equity from a mature reference market, then adds Poland's incremental risk as a separate, identifiable layer:

• Start with the base country's risk-free rate, such as the German government zero rate.
• Add the base country's mature market-risk-premium (MRP), e.g. Germany, rather than a premium specific to Poland.
• Include an inflation differential to reflect the gap between euro and zloty inflation expectations. Since Poland sits outside the eurozone, this term is not a minor adjustment but a substantive part of the calculation, distinct from the country risk premium itself.
• Layer a country-risk-premium (CRP) on top, capturing the additional risk of operating in Poland specifically, over and above the base country's own risk profile.

Ke = Rf(Germany) + β × [MRP(Germany) + CRP(Poland)] + Inflation Differential

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Option B: Fully local construction

Poland's own zero rate and market risk premium are used directly, each already reflecting local conditions. Since Poland's zero rate is denominated in zloty, it already embeds local inflation expectations, so no separate inflation differential applies. Country risk itself already sits within both Poland's zero rate and its market risk premium, so no separate country risk premium layer is required.

Ke = Rf(Poland) + β × MRP(Poland)

Both are defensible constructions. The risk lies in mixing them: pairing a local risk-free rate with a mature-market premium, or the reverse, without an explicit adjustment for the resulting mismatch.

A related point worth keeping in mind: Damodaran's data is a common source of CRP for practitioners applying Option A. His methodology derives the CRP by scaling a sovereign bond default spread upward, since equity markets are typically more volatile than government bond markets. The bond spread is only the starting input, an observable proxy for sovereign risk drawn from the bond market, and the scaling factor converts it into an equivalent premium for equity investors.

Neither approach is universally correct. What matters is applying one consistently and documenting which was used.