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 experiencing financial distress.

Use of the CAPM

Small companies that have little prospect of going public or being acquired by a public company may not be comparable to the public companies for which market-data-based beta estimates are available.

Expanded CAPM

The expanded CAPM adds a premium for small size and company-specific risk when valuing private companies.

Elements of the build-up approach

The build-up approach may be used when there are no comparable public companies. It is similar to the extended CAPM but excludes the application of beta to the equity risk premium.

Relative debt availability and cost of debt

Estimation of a private company’s debt capacity is another challenge since the company may have less access to debt capital than public companies which may require them to rely more on equity financing. A private company’s smaller size may also increase the cost of debt.

Discount rates in an acquisition context

In an acquisition, the cost of capital used should be the target’s and not the acquirer’s even though a mature public company would be expected to have a smaller discount rate compared to a riskier private company.

Discount rate adjustments for projection risk

The availability of limited information about private companies compared to public companies introduces uncertainty and leads to higher discount rates. Projections made by managers may be overly optimistic or pessimistic.

Question

Which of the following is least likely a challenge when estimating the required rate of return?

1. Application of size premium.
2. Target’s discount rate.
3. Easy access to debt.

Solution

The correct answer is C. Compared to public companies, private companies have less access to debt capital and will therefore require more equity financing.

A is incorrect. Application of size premium is a challenge when estimating the required rate of return. They are required in developing equity return requirements due to private companies’ relatively smaller size.

B is incorrect. The discount rate that should be used to value the target company should be the one associated with the risks of the target’s cash flows.

Reading 27: Private Company Valuation

LOS 27 (f) Explain factors that require adjustment when estimating the discount rate for private companies.