There's a great debate going on now on the Valuation Group on LinkedIn on calculating cost of capital for small companies. Lots of interesting thoughts by Toby Tatum, Mary Ann Lerch, Bob Dohmeyer, Rusty Grunwald, Gary Fodor, Jim Zvosecz, and many others...
The discussion includes a wide range of opinions on:
- the lack of a size premie independent of other discounts
- levered vs unlevered beta (Prompted by a subscriber’s request, we asked the editor of the Journal of Applied Corporate Finance to republish an article from its current issue, “The Pitfalls of Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations,” that was cited in the most recent BVWire. The article, by Robert Holthausen (University of Pennsylvania) and Mark Zmijewski (University of Chicago), is now available at our free downloads page. The authors review the “routine steps” of quantifying beta in common cost of capital models and concludes that the “levering and unlevering formulas … are not appropriate for valuing many companies.” In fact, the authors say, substantial valuation errors can result from assuming the betas of debt and other preferred securities are equal to zero and/or ignoring the effects of equity-linked securities, such as employee stock options. By the way, the authors will have a new release of their book Corporate Valuation: Theory, Practice and Evidence (Cambridge Publishers) coming in February 2013. We’ll feature more information and a link to the hardcover edition soon.)
- whether personal guarantees on small business debt negate the use of WACC