ABV ABV Discount Rates & Capital Structure 2

Question 1

What is the Capital Asset Pricing Model (CAPM) formula for the cost of equity?

Accepted Answer

Ke = Rf + Beta × (Rm – Rf)

Answer

CAPM states that cost of equity equals the risk-free rate plus beta multiplied by the equity risk premium (market return minus risk-free rate).

Question 2

In CAPM, what does beta measure?

Accepted Answer

A company's systematic (market) risk relative to the overall market

Answer

Beta measures how much a stock's returns move relative to the broader market; a beta of 1.2 means 20% more volatility than the market.

Question 3

What is the 'build-up method' for estimating the cost of equity in a private company valuation?

Accepted Answer

An additive model that sums the risk-free rate, equity risk premium, size premium, industry risk premium, and company-specific risk premium

Answer

The build-up method is preferred for private companies where no observable beta exists, stacking individual risk components to arrive at a total required return.

Question 4

Which published source is most commonly cited for the historical equity risk premium and size premium used in U.S. business valuations?

Accepted Answer

Duff & Phelps (now Kroll) Cost of Capital Navigator / SBBI Yearbook

Answer

The Kroll/Duff & Phelps Cost of Capital Navigator and the historical SBBI data are the standard U.S. sources for ERP and size premium estimates.

Question 5

What is the 'company-specific risk premium' (CSRP) in the build-up method?

Accepted Answer

An adjustment for idiosyncratic risks unique to the subject company not captured by other premium components

Answer

The CSRP captures risks such as key-person dependency, customer concentration, or weak management that are not reflected in systematic risk measures.

ABV - Accredited in Business Valuation Practice Test

ABV - Accredited in Business Valuation Practice Test

ABV ABV Discount Rates & Capital Structure 2