Watch for Business Valuation Review article on cost of capital changes

BVWireIssue #102-3
March 16, 2011

Rick Warner, the intrepid editor of the ASA’s Business Valuation E-letter, alerted his readers last week to an article from Roger Grabowski in the Business Valuation Review coming out soon. Rick’s analysis:

Roger Grabowski, ASA provided me with a draft of an article that is scheduled to appear in an upcoming issue ofBusiness Valuation Review.  The article itself is an excerpt from discussions that appear in Chapters 7 and 9 of Cost of Capital: Applications and Examples 4th ed., by Shannon P. Pratt and Roger J. Grabowski (John Wiley & Sons, Inc., 2010) with an update through December 2010.

The article discusses the development of a cost of capital, in particular the choice of a risk-free rate of return and the estimation of a forward-looking equity risk premium during times of economic turmoil.  Roger focuses on the period from late 2008 and 2009, and also the summer of 2010 as periods characterized by a “flight to quality” by investors.

Roger’s discussion of the choice of a risk-free rate of return and the estimation of an equity risk premium covers concepts that are probably familiar to many of us, however it is a good review and in particular does a great job of discussing investor expectations and the relationship (if any) with realized risk premiums.

One new discussion point that I was not aware of that Roger introduces is the possibility of a WWII interest rate bias that has the effect of raising historical, realized equity risk premiums by perhaps as much as 50 basis points.

If you are looking for a concise discussion of these and other cost of capital concepts including an update on the expected equity risk premium as of December 31, 2010, keep your eyes open for this upcoming article, again in the Business Valuation Review.

Please let us know if you have any comments about this article or enhancements you would like to see.