{"id":21833,"date":"2021-09-30T10:59:16","date_gmt":"2021-09-30T10:59:16","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=21833"},"modified":"2026-05-30T20:26:29","modified_gmt":"2026-05-30T20:26:29","slug":"discount-rate-estimation-elements","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/discount-rate-estimation-elements\/","title":{"rendered":"Discount Rate Estimation Elements"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/LLxHIyf6cUs\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>Challenges in estimating a required rate of return:<\/p>\n<ul>\n<li>\n<p>Size premium<\/p>\n<p>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.<\/p>\n<\/li>\n<li>\n<p>Use of the CAPM<\/p>\n<p>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.<\/p>\n<\/li>\n<li>\n<p>Expanded CAPM<\/p>\n<p>The expanded CAPM adds a premium for small size and company-specific risk when valuing private companies.<\/p>\n<\/li>\n<li>\n<p>Elements of the build-up approach<\/p>\n<p>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.<\/p>\n<\/li>\n<li>\n<p>Relative debt availability and cost of debt<\/p>\n<p>Estimating of a private company&apos;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&apos;s smaller size may also increase the cost of debt.<\/p>\n<\/li>\n<li>\n<p>Discount rates in an acquisition context<\/p>\n<p>In an acquisition, the cost of capital should be the target&apos;s and not the acquirer&apos;s even though a mature public company would be expected to have a smaller discount rate compared to a riskier private company.<\/p>\n<\/li>\n<li>\n<p>Discount rate adjustments for projection risk<\/p>\n<p>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.<\/p>\n<\/li>\n<\/ul>\n<blockquote>\n<h2>Question<\/h2>\n<p>Which of the following is <em>least likely<\/em> a challenge when estimating the required rate of return?<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li>Application of size premium.<\/li>\n<li>Target\u2019s discount rate.<\/li>\n<li>Easy access to debt.<\/li>\n<\/ol>\n<h3>Solution<\/h3>\n<p><strong>The correct answer is C.\u00a0<\/strong>Compared to public companies, private companies have less access to debt capital and will therefore require more equity financing.<\/p>\n<p><strong>A is incorrect.\u00a0<\/strong>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\u2019 relatively smaller size.<\/p>\n<p><strong>B is incorrect.\u00a0<\/strong>The discount rate that should be used to value the target company should be the one associated with the risks of the target\u2019s cash flows.<\/p>\n<\/blockquote>\n<p>Reading 27: Private Company Valuation<\/p>\n<p><em>LOS 27 (d) Explain factors that require adjustment when estimating the discount rate for private companies.<\/em><\/p>\n<div style=\"text-align: center; margin: 30px 0;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 26px; border-radius: 9999px; background: #1e5bd8; color: #ffffff; font-weight: bold; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"> Start Free Trial \u2192 <\/a> <\/p>\n<p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">Access CFA Level II equity study notes, practice questions, item sets, and video lessons to strengthen your understanding of discount rate estimation elements. <\/p>\n<\/p><\/div>\n","protected":false},"excerpt":{"rendered":"<p>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&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[216,402],"class_list":["post-21833","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-cfa-level-2","tag-equity-valuation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.6 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Discount Rate Estimation Elements | AnalystPrep<\/title>\n<meta name=\"description\" content=\"Learn how discount rates are estimated using the expanded CAPM, build-up approach, and other methods for valuing private companies.\" \/>\n<meta name=\"robots\" content=\"index, follow, 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