Business valuation is a critical exercise for business principals, financial advisors, and legal counsel, among others. Perhaps the most critical aspect of any valuation analysis is the identification of the correct discount rate through a consideration of the cost of capital and corresponding risk premiums. In this chapter we will bring all those considerations together — the Buildup Method, the Capital Asset Pricing Model, the Country Risk Premium — and work through solid examples that demonstrate their use in practice.
1-The Cost of Capital
It is a measure of return that is expected by investors on the capital provided to the undertaking or business entity. It consists of two main components:
Cost of Debt: The effective rate a firm pays on its borrowed funds, after making tax adjustments.
Cost of Equity: The return required by equity investors, often estimated using the CAPM.
The Weighted Average Cost of Capital (WACC) is the average of these, weighed by their respective proportions in the company's capital structure:
𝑊𝐴𝐶𝐶=(𝐸/𝑉×𝑅𝑒) +(𝐷/𝑉×𝑅𝑑×(1−𝑇𝑐)).
2- Discount Rate
It is an element used to discount future cash flows to bring the value to the time at which it is being calculated. It is part of just about any valuation model, including the DCF analysis. The discount rate reflects more than just the time value of money but also the risk of investment. Although, in most cases, it equals WACC, the discount rate can be flexed to accommodate specific project risks or other factors.
3-Buildup Method vs. CAPM
a- Buildup Method
The Buildup Method adds various risk premiums to calculate a discount rate. The formula includes the following elements:
Risk-Free Rate (Rf): Return for an investment with no risk, generally long-term government bonds.
Equity Risk Premium (ERP): Extra return asked for by investors for bearing equity risk.
Size Premium: Additional risk of smaller companies.
Industry Risk Premium: Risks relevant in the given industry.
Company-Specific Risk Premium: Risks idiosyncratic to the particular company.
Illustration: For a small manufacturing company with the following premiums:
Risk-Free Rate: 3%
Equity Risk Premium: 6%
Size Premium: 2%
Industry Risk Premium: 1%
Company-Specific Risk Premium: 3%
The overall discount rate is given as 3%+6%+2%+1%+3%=15%
b- Capital Asset Pricing Model (CAPM)
CAPM estimates the cost of equity based on the linear dependency of systematic risk (beta) and expected return:
𝑅𝑒=𝑅𝑓+𝛽(𝑅𝑚−𝑅𝑓)
4- Country Risk Premium (CRP)
Country Risk Premium is the extra risk taken by investing in a given country emanating from political risk, economic risk, and other country-specific risk factors. The most relevant application is in emerging markets.
Determine CRP
Sovereign Spread on Yield Approach: It is the yield difference between the country's government bond versus a yield on a risk-free benchmark—for example, the yield on a U.S. Treasury bond.
Spread of Default: It can be best estimated depending on equity market consistency on credit default swap spread or sovereign bond spread.
Illustrative Example: Cameroon
A company in Cameroon, using the buildup method, gets the following:
Risk-Free Rate: 3%
Equity Risk Premium: 6%
Country Risk Premium: 5%
Size Premium: 2%
Industry Risk Premium: 1%
Company-Specific Risk Premium: 3%
The discount rate is: 3%+6%+5%+2%+1%+3%=20%
Conclusion
The cost of capital and discount. The Buildup Method and CAPM offer strong frameworks for applying in multiple scenarios. Especially, the Buildup Method is of use in small, privately held companies, and in emerging markets for which the Country Risk Premium will be added to capture all the factors involving risks in international investments. Business owners, financial advisors, attorneys, and other participants in business valuation will, therefore, be in a better position to make proper decisions if they master the issues associated with these concepts.
The Washington Valuation Group
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