'Much of what’s in academic textbooks on cost of capital is behind current research'

BVWireIssue #69-3
June 25, 2008

This was a comment from Roger Grabowski ASA (Duff & Phelps, Chicago) regarding levering and unlevering Beta in his “Update on the Cost of Capital” presentation at NACVA’s Fifteenth Annual Consultants’ Conference in Las Vegas in early June.  Theory tells us company risk includes operating and financial risk and that more financial risk (leverage) equates to a larger Beta.  Public companies used in the guideline public company method will probably have different leverage than your subject private company—so to better match the leverages, the appraiser unlevers the guideline company and relevers the guideline company to reflect the subject company’s leverage.

The more Roger investigated unlevering and relevering Beta, the more he “was astounded to learn how much I was behind.”  The Third Edition of the Cost of Capital – Applications and Examples, authored by Grabowski and Shannon Pratt CFA, FASA, MCBA, MCBC, CM&AA (Shannon Pratt Valuations, Portland, OR), includes the results of the authors’ research on the five different ways (Hamada Formula, Miles-Ezzell Formula, Harris-Pringle Formula, Practitioners’ Method Formula and the Fernandez Formula) to unlever and relever Beta.  What is worse, the authors discovered that many textbooks incorrectly describe the conditions when one should use a particular formula. The book also includes a helpful table listing guidance for applying the five formulas, along with several examples. 

Roger’s 110-slide presentation also included information on the criticism of subject company risk adjustments.  Roger said that “the subject of company specific risk premiums is an area where BVers are most susceptible to being justifiably attacked.”  If you haven’t read the Delaware Chancery’s decision in Delaware Open MRI Radiology Associates, P.A. vs. Kessler, et al., Roger said it is a must read.  BVR has posted the full text of the court decision to our Free Downloads page.  In that case, the judge wrote that one of the expert’s

…analysis also contains a subjective specific risk premium of 2%, the quantification of which cannot be explained by reference to objective factors…

The introduction of the Butler Pinkerton Model™ now offers appraisers the objective factors the courts seek.  Roger called this new Model a “very useful tool.”  To learn more about the Butler Pinkerton Model™, click here.

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