Juana Alonso Cañadas

The Discount Rate in Valuing Privately Held Companies

To value privately held companies, considered as nonquoted companies and thus with low marketability, two methods can be applied to adjust the business value for extra risk: (1) reducing the calculated value by the transaction costs or (2) raising the minimum expected rate of return by investor. The Spanish Accounting and Business Administration Association suggests use of the second method. This article examines its proposal in an empirical way, concluding that the discount rate estimated is 2.45% higher than that calculated by the traditional CAPM model, which implies a drop in company value of nearly 20%. In other words, the AECA’s proposal can be considered a valid method for appraisers to calculate the discount rate in the context of valuing privately held companies.

Discount Rate and Cost of Capital: Some More about the Puzzle

The aim of this paper is to contribute to a deeper knowledge of the CAPM in the framework of company valuation based our reasoning on the differentiation between the so-called purely financial investor and economic risk investor. Our argument is that CAPM is not a good reference to be applied in the valuation of unlisted companies because there is not a market beta for them, so the use of this traditional method to estimate the cost of capital is a wrong way. Further, we show that total beta, as an estimate of market beta when companies are not diversified, is not as good as some experts suggest, because there is no a clear correlation between company return and market return.Moreover, according to Modigliani and Miller (1958), we show that the company can be considered as a mixed portfolio composed by a riskless asset and a risky portfolio, and so the total return of the a privately held company and, in general, for unlisted companies, is a summative discount rate which include an idiosyncratic risk.Finally, we empirically demonstrate that the application of this discount rate contributes to reduce the company value according with practice and, therefore, the use of CAPM overestimates the company between 28% and 40%, depending if the companies are listed or not.

A Note on the Operating Return of a Company Under Modigliani-Miller Assumptions

In this paper, under Modigliani-Miller assumptions and according to the equilibrium theory of capital markets, we have demonstrated that the assets of a company can be considered as a portfolio composed by the risk-free asset and another risky portfolio. Consequently, its operating return is deduced to be the aggregate of the risk-free rate and the market risk premium adjusted by the variability of the risk company with respect to the market.