Business Valuation 615Victoria tells Bob that the capital asset pricing model is widely used by
analysts for investment management where a specific investment’s risks can be
eliminated through portfolio diversification. Business valuation theory uses
CAPM but modifies it to consider a specific company’s unsystematic risks in
addition to the systematic risks. Unsystematic risk represents those risks
uniquely associated with an investment that cannot be avoided through port-
folio diversification. ACME’s unsystematic risks are discussed next.
Studies have shown that investments in small companies typically have
more risk than those in large companies. Generally, small company earnings
and stock prices are more volatile than those of larger companies. Over the
long term, investors in smaller companies have received higher rates of return
than investors in the larger Standard & Poor ’s (S&P) 500 companies. Empirical
data from Ibbotson Associates shows that the smallest 20% of public com-
panies have yielded an extra 2.2% rate of return above the returns of S&P 500
companies since 1926. Therefore, Victoria adds a premium of 2.2% to ACME’s
required rate of return for the risks associated with its size as compared to
S&P 500 companies.
Finally, the differences between ACME and small publicly traded com-
panies are considered. Victoria previously identified the quantitative and qual-
itative attributes of ACME that are considered negative and positive risk
factors for the company. These were presented earlier in the chapter. After re-
viewing her quantitative and qualitative analyses, she determines that ACME
is somewhat more risky than small public companies. In Victoria’s judgment,
she adds a 2% specific company risk premium as an additional required rate of
return for an investor in ACME.
In summary, Victoria determines ACME’s cost of equity using the modi-
fied CAPM as shown Exhibit 18.8.
Cost of Debt
Victoria analyzes ACME’s audited financial statements, including the foot-
notes, and interviews management to determine the company’s interest rate on
long-term financing was 9%. This was comparable to market interest rates.
Since interest paid by the company is tax deductible, the after-tax effective
EXHIBIT 18.8 ACME Manufacturing Inc.:
Cost of equity.
Risk-free rate 6.4%
Overall equity risk premium 8.1%
Multiply by Beta 0.99
ACME’s equity risk premium 8.0%
Small company risk premium 2.2%
Specific company risk premium 2.0%
ACME’s cost of equity 18.6%