Risk perception and cost of capital in emerging market projects using dynamic conditional correlation model

• Published in: International journal of Islamic and Middle Eastern finance and management Vol. 16; no. 2; pp. 253 - 273
• Main Authors: Afzal, Farman, Shehzad, Ayesha, Rehman, Hafiz Muhammad, Afzal, Fahim, Mukit, Mohammad Mushfiqul Haque Mushfiqul Haque
• Format: Journal Article
• Language: English
• Published: Bingley Emerald Publishing Limited 17-03-2023; Emerald Group Publishing Limited
• Subjects: Asset pricing; Averages; Budgets; Capital; Capital assets; Capital budgeting; Capital structure; Developing countries; Emerging markets; Funding; Infrastructure; LDCs; Perceptions; Political risk; Regulatory agencies; Risk perception; Risk premiums; Stochastic models; Value; Accounting; Financial analysis; Public–private partnership; Cost of capital; Country risk; Risk perception; DCC-GARCH
• ISSN: 1753-8394; 1753-8408; 1753-8394
• DOI: 10.1108/IMEFM-07-2021-0257

Purpose
Cost estimation is a major concern while planning projects on public–private partnership (PPP) terms in developing countries. To bridge the gap of the right approximation of cost of capital, this study aims to sermon a significant role of investor’s risk perception as unsystematic risk in PPP-based energy projects.
Design/methodology/approach
To investigate the effective mechanism of determining cost of capital and valuing the capital budgeting, a pure-play method has been acquired to measure systematic risk. In addition, dynamic conditional correlation (DCC) and generalized autoregressive conditional heteroscedasticity (GARCH) models have been applied to calculate weighted average cost of capital.
Findings
Initially, a joint cost of capital of energy-related projects has been calculated using DCC-GARCH and pure-play method. Investors risk perception has been discussed through market point of view using country risk premium modeling. Latter yearly betas have been calculated using DCC signifying the final outcomes that applying a dynamic model can provide a better cost estimation in emerging economies.
Practical implications
The findings are implicating that due to the involvement of international investors, domestic risk is linked with country risk. In such situations, market-related information is a key factor to find out the market performance, helping in the estimation of cost of capital through capital asset pricing model (CAPM). High dynamic nature of emerging economies causes an impediment in the estimation of cost of capital. Consequently, to calculate risk in dynamic markets, this study has acquired DCC model that can predict the value of beta factor.
Originality/value
Study contributes to the body of knowledge by addressing an important issue of investor’s risk perception and effective implication of CAPM using pure-play and DCC-GARCH when data is not promptly available in dynamic situations.