Fall 2014 issue of Horizons

FEATURE

stocks is based on historical returns of the S&P 500 Composite, with dividends reinvested.

stakeholders (i.e. equity and debt holders), as they are before any payments on debt or dividends.

The risk premium for size is an incremental addition to the cost of equity to reflect additional returns to stocks of companies smaller than those included in the S&P 500. The risk premium for the subject company is a judgmental factor that recognizes the general risks associated with an investment in a closely held business and the specific risks related to the subject company. General risks inherent in a closely held business include a lack of diversification, access to capital, management depth, and supplier pricing leverage. Specific risks include the company’s financial structure, earnings stability, competitive position, and future growth prospects. The cost of debt is the rate at which the company can borrow money from a bank or in the open market. The optimal capital structure considers factors such as the amount of assets the company has to borrow against and the company’s cash flow.

The value of the business is determined by computing the present value of:

∙ Forecasted future net cash flows over an appropriate period, normally 5 to 10 years AND ∙ Forecasted value of the business at the end of that period A discount rate (present value factor) is selected that is commensurate with the risk involved in receiving the future cash flows. Typically, the discount rate used is the company’s weighted average cost of capital (WACC), which represents the cost of equity and debt financing. The WACC is calculated by determining the company’s cost of equity and after-tax cost of debt and then estimating the company’s optimal capital structure. The cost of equity can be developed using a technique called the build-up or summation method. This method involves adding rates of return and return premiums based on market factors and a qualitative risk analysis of the subject company.

The formula for a discounted cash flow calculation is shown in Figure 1 on page 17.

Market Approach In using the market approach, the value of a business is determined by using one or more methods that compare the subject company to either similar businesses or to securities of similar businesses that have been sold.

The cost of equity is calculated using the formula shown below.

Risk free rate

Risk premium for large company common stocks

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This approach examines factors such as:

∙ Guideline businesses which have recently been sold

Risk premium for size

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Risk premium for subject company

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∙ Publicly traded stocks of companies which participate in the same general line of business The company or security used for comparison must have a reasonable basis for the comparison. Factors that are considered

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COST OF EQUITY

The risk-free rate is typically based on the current yield of a 20-year treasury bond. The risk premium for large company common

page 16 | horizons Fall 2014

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