The Cost of Equity Capital in Emerging Market – The Case of Kenya

Abstract

Risk is often expressed as cost of
capital in the context of investment valuations.
The estimation of an appropriate discount rate to
evaluate investment cash flows in order to
determine its viability is the most important in
the capital budgeting process, whether it is a
multinational or small size company. From a
strategic point of view, determining the
appropriate cost of equity capital is critical in
reducing the uncertainty that multinationals
(MNCs) and domestic companies face when
investing in different countries. Differences in
risk and a lack of understanding of how
emerging African stock market returns are
influenced by the developed markets, as well as
lack of reliable long-standing historical market
data, are factors that international investors and
corporate managers have to cope with. Most
companies estimate their cost of equity capital
using the Capital Asset Pricing Model (CAPM).
However, the use of CAPM to estimate cost of
equity capital in emerging African capital
markets has numerous challenges, which are
discussed in the literature below. This study is
designed to empirically investigate whether the
CAPM is a sufficient asset pricing model to
estimate cost of equity capital in Kenya. A time
series methodology was followed and the result
showed that although the CAPM’s beta
significantly explains equity returns, there are
other risk factors not captured by CAPM. This
means corporate managers and investors must
beware.