Chapter 16 • Small businesses
smaller ones. Similarly the smaller businesses tended to use the rather discredited
non-discounting approaches (PBP and ARR) more than larger businesses. Larger busi-
nesses tend to use more than one method to a greater extent than smaller ones.
The difference between the relative usages of the four methods is usually ascribed
to less sophistication and expertise at play with smaller businesses. This seems plaus-
ible and likely to imply that businesses that are even smaller than the ones that were
included in the Arnold and Hatzopoulos survey would be still further away from the
investment appraisal practices of larger businesses.16.6 Risk and the discount rate
On the face of it, it seems reasonable to conclude that the discount rate that should be
applied to NPV appraisals with small businesses should be similar to those that might
be applied by large ones. This would probably be invalid for two reasons:
l It is thought to be true that investors in large businesses typically hold a relatively
small proportion of each business’s total equity as a relatively small proportion
of a reasonably well-diversified portfolio of equities. (Casual observation shows
this broadly to be true: nearly 80 per cent of equities of businesses listed on the
London Stock Exchange that are held by UK residents are owned by the investing
institutions, which tend to hold large, well-diversified portfolios.) For this reason
investors would be exposed to relatively little specific risk, and only systematic risk
need be taken into account. Typically, equity investors in small businesses will not
be well diversified. For shareholders in the typical small business, it is likely that
this investment will represent a large proportion (by value) of their total invest-
ment. If the small business were to fail, most of their wealth might be lost.
Since shares of small businesses tend not to be held in efficient portfolios, the dis-
count rate that should be applied to the small business’s investment opportunities
should take account of specific as well as systematic risk.
l It seems that there is a higher bankruptcy risk with small businesses, which makes
them more risky investments than larger ones.
Logically, this means that a higher discount rate should be applied by a small busi-
ness than by a larger one to cash flows that are similar in nature. It seems reasonable
for a small business to base its cost of equity on the average cost of equity for listed
businesses whose main activity is in the area of the investment being appraised by the
small business. For the two reasons that we have just discussed, this value needs to be
increased. The amount of this premium is a matter of the judgement of the small busi-
ness concerned.Risk diversification within the business
In our previous discussion of diversification and risk reduction, particularly in
Chapters 6 and 14, the point emerged that, with large businesses, the shareholders
are generally not advantaged by attempts by the business to diversify its operations
internally. The evidence supports this point.
Shareholders are not advantaged by diversification within the business because
they can, and do, diversify their security portfolios to achieve the same effect. For the
reason mentioned above, shareholders in small businesses may not be able to do this