Required Rate of Return Models
The CAPM $$\begin{align*}\text{Required return on equity}&= \text{Risk-free rate} \\&+ (\text{Beta} \times \text{Market risk premium})\end{align*}$$ The CAPM is generally inappropriate for private entities. Expanded CAPM $$\begin{align*}\text{Required return on equity} &= \text{Risk-free rate} + (\text{Beta} \times \text{Market risk premium}) \\&+ \text{Small stock…
Discount Rate Estimation Elements
Challenges in estimating a required rate of return: Size premium When valuing private companies, size premiums are used in developing equity return requirements. Estimating a premium using small public firms may have an upward bias since many of them are…
Uses of CDS
Investors exploit the arbitrage opportunities created by the differences in pricing between asset and CDS markets, or differences in pricing of different products in the market. Credit Basis A CDS basis is the difference between a bond’s credit spread and…
Use of CDS to Manage Credit Exposures
The credit curve shows the credit spreads over a risk-free benchmark rate for a range of maturities of a firm’s debt. A credit spread rewards bondholders for assuming credit risk. The shape of the CDS credit curve can be explained…
Market Price of CDS
The value of a CDS depends on the probability of default, i.e., the likelihood of non-payment of promised interest and/or principal on a bond. The default probability typically increases with time. However, in a CDS context, the probability of default…
Credit Events
A credit event is an event that triggers the default of a bond. The CDS seller must purchase the defaulted bonds at their face value from the CDS buyer in case of a credit event. The International Swaps and Derivatives…
Earnings Normalization and Cash Flow Estimation Issues
Private company valuations may require adjustments to estimate the company's normalized earnings as their reported earnings reflect discretionary expenses. This results in differences between reported earnings and normalized earnings. Normalized earnings are economic benefits adjusted for nonrecurring, non-economic, or other…
Private company valuation approaches
There are three major approaches to valuation: Income approach: This values an asset as the present discounted value of its expected income. Market approach: This values an asset based on pricing multiples from sales of assets viewed as similar to…
