Cost of capital is an important factor in determining the value of a business. The market rewards a business that can raise money more cost effectively than its peers. Such a company is deemed to have a competitive advantage and hence a higher fair market value.
But cost of capital is more than the ability to raise money on the cheap. It also represents the expected rate of return that investor’s require based on the risk of the underlying business. In other words, cost of capital is a market driven rate balancing risk and reward.
For private companies, business valuators have long used the so-called build-up method to develop a company’s cost of capital. This method takes a risk-free rate and then adds various risk premiums – an equity risk premium, small company size premium and specific company risk premium – to determine the cost of capital. Two out of three of these premiums - the equity risk premium, which represents the premium that investors demand to invest in stock rather than a government bond, and the size premium- are determined by reference to public company data.
This approach to determining cost of capital has been argued to be inadequate for private companies since the markets for public versus private capital are much different. And yet, without the ability to access comparable private company data, there has been no alternative but to use the available public company data.
In the summer of 2009 the Pepperdine University School of Business completed a survey of the cost of capital for private companies. This survey captured the rate of return expectations for each of the private capital market segments (VC firms, private equity groups, mezzanine funds, asset-based lenders and senior lenders). The survey is being updated semiannually with the latest report dated February 2010.
The availability of private company return data has enabled development of a new model to value private cost of capital. For business valuators and owners alike, this is an exciting development that will provide more meaningful appraisals of private companies and thereby guide owners to making more intelligent decisions regarding their use of funds.
As a private company business owner, board member, or CFO, it’s important that you get a handle on your company’s cost of capital. In so doing you will have gained new insight into how the market views your risk/reward equation. This not only allows you to better set valuation expectations, it allows you the means to determine how to change your company’s profile to tip the scales in your favor.
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