Principles of Private Firm Valuation

k=the cost of capital for each component of the capital

structure

T=the tax rate

The WACC is used in conjunction with the discounted free cash flow
method, which was used in Chapter 4 to value Tentex. The sections that fol-
low first focus on estimating the cost of equity capital. Although there are
two competing theories of estimating the cost of capital, and equity capital
in particular, the capital asset pricing model (CAPM) and arbitrage pricing
theory (APT), this chapter focuses on an adjusted version of the CAPM
known as the buildup method.The major reason is that this model is the
one most often used by valuation analysts when estimating the cost of
equity capital for private firms. Finally, we demonstrate how to estimate the
cost of debt and preferred stock for private firms.

THE COST OF EQUITY CAPITAL

The basic model for estimating a firm’s cost of capital is a modified version
of the CAPM, as shown in Equation 5.2.

ks=krf+betas[RPm] +betas− 1 [RPm]− 1 +SPs+FSRPs (5.2)

where ks=cost of equity for firm s
krf=the 10-year risk-free rate
betas=systematic risk factor for firm s
betas− 1 =betasin the previous period
RPm=additional return investors require to invest in a
diversified portfolio of financial securities rather than the
risk-free asset
RP(m−1)=RP in the previous period
SPs=additional return investors require to invest in firm
srather than a large capitalization firm
FSRPs=additional return an owner of firm srequires due to the
fact that the owner does not have the funds available to
diversify away the firm’s unique, or specific, risk

To estimate the cost of equity capital for firms,values for the para-
meters in Equation 5.1 need to be developed. Ibbotson Associates is the
source of several of these parameters.^1 The equity risk premium, RPm,is
calculated as the difference between the total return on a diversified port-
folio of stock of large companies as represented by the NYSE stock return
index, for example, and the income return from a Treasury bond that has

70 PRINCIPLES OF PRIVATE FIRM VALUATION