Discount Rates In Emerging Capital Markets

The estimation of the discount rate for an investment project in conditions of risk relies upon two crucial assumptions market completeness and well-diversified investors. Although, these two assumptions are tenable in developed capital markets, they are not suitable in emerging markets. In emerging markets, there are not enough twin securities to obtain a unique stochastic discount factor and therefore one project market value. Hence, investors usually face short selling and borrowing restrictions. Furthermore, these markets are plagued with non-diversified entrepreneurs that invest all their capital to undertake entrepreneurial adventures. In this research, one derives expressions for the project discount rate, using the fundamental pricing equation under incomplete capital markets in two extreme situations when investors hold a well-diversified portfolio, and when they are not diversified at all. Although both situations may apply in developed and emerging capital markets, they apply especially to emerging markets. In fact, well-diversified investors, such as foreign mutual funds, increasingly invest in emerging markets, while the bulk of firms involves either small or medium enterprises owned by a single or a group of non-diversified entrepreneurs. The study concludes that although the Capital Asset Pricing Model (CAPM) cannot hold under incomplete markets, it is still a good approximation for well-diversified investors in emerging markets. At the same time, it is necessary to use a hurdle rate, based on the project total risk for the case of non-diversified entrepreneurs.