614 Making Key Strategic Decisions
Investments in closely held businesses are widely considered to be long-
term rather than short-term investments. Accordingly, the risk-free rate,the
first element in the modified CAPM, is based on the 20-year U.S. Treasury
bond yield as of the valuation date. U.S. Treasuries are considered risk-free in-
vestments and the 20-year bond is considered a long-term investment bench-
mark for purposes of valuing closely held businesses. At the valuation date, the
risk-free rate is 6.4%.
Victoria explains that the second element of the modified CAPM is the
equity risk premium.The equity risk premium is the additional rate of return
investors in stocks require above a risk-free rate of return because of the
higher risks of investing in equities. Ibbotson Associates of Chicago, Illinois,
has performed annual empirical studies of the equity risk premium that in-
vestors have received dating back to 1926. As of ACME’s valuation date, the
historic equity risk premium since 1926 has been 8.1% above the risk-free
rate. Again, since investments in closely held businesses are considered long
term, the equity risk premium is also measured on a long-term basis.
The CAPM uses the sensitivity of a company (investment) as compared to
swings in the overall investment market. The risk that is common to all invest-
ment securities that cannot be eliminated through diversification is called sys-
tematic risk.When using CAPM, the systematic risk of a particular investment
is measured by beta.Beta is a measure of the relationship between the returns
on an individual investment and the returns of the overall market as typically
measured by an index such as the Standard & Poor ’s 500. For example, the
market prices of some investments have a tendency to rise and fall faster than
the overall market. The base measure of beta is 1.0. When an investment’s
beta is greater than 1.0, its returns have tended to be more than the market re-
turns. Also, the investment’s losses have tended to be greater than the market’s
losses. An investment with a beta of less than 1.0 has had returns that tend to
be less than the market returns. In summary, beta measures an investment’s
return volatility as compared to the overall market. If an investment has a beta
greater than 1.0, its returns are more volatile and carry more risk than the
market. If beta is less than 1.0, its returns are less volatile and carry less risk
than the market.
One way to estimate the beta of a closely held company is to use the aver-
age beta of guideline publicly traded companies. Beta is a coefficient used by
financial analysts that adjusts the general equity risk premium to a specific in-
vestment in the CAPM. A complete discussion of beta is beyond the scope of
this chapter but it is widely available in finance literature. The beta of publicly
traded companies is generally available from investment publications and from
empirical studies such as the one conducted by Ibbotson Associates.
Victoria’s research analysis indicates the average beta of publicly traded
companies in ACME’s industry is 0.99 as of the valuation date. She concludes
that this average is a reasonable estimate of ACME’s beta for use in the CAPM.
Therefore, the equity risk premium for ACME is 8.0% (the general equity
risk premium of 8.1% multiplied by the beta of 0.99).