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Furthermore, she estimates Acme‟s equity risk premium is 8.0% (the general equity risk premium of
8.1% multiplied by the average industry beta of 0.99).
Victoria tells Bob that the capital asset pricing model widely used by analysts and portfolio
managers assumes a stock‟s unsystematic risks can be eliminated by portfolio diversification. But
owners of private firms often do not (or cannot) diversify their portfolios and therefore do not avoid
the unsystematic risks of an investment. Business valuation theory has modified the common CAPM
to add a premium for unsystematic risks of a private firm investment. Acme‟s unsystematic risks are
discussed shortly.
Research has shown that the returns of small public company stocks are higher than those of large
public company stocks over the long run. Many argue that these higher returns occur because smaller
firms are riskier than larger ones. Historical data from Morningstar‟s Ibbotson Associates shows that
the smallest 20% of public firms have produced an extra 2% to 4% return above the returns of
companies in the S&P 500 index over the long run. Business valuation theory adopts this idea and
adds a premium in the modified CAPM for the extra risk from a private firm‟s smaller size relative to
S&P 500 companies. Based on her research, Victoria adds a premium of 2.2% to Acme‟s cost of
equity for the risks associated with its size.
Finally, differences between Acme and small public firms are analyzed. Victoria has identified
Acme‟s features that are positive and negative risk factors (these factors were discussed earlier in this
chapter). After reviewing her analysis, she determines that Acme is slightly more risky than small
public firms. In Victoria‟s judgment, she adds a 2% premium to Acme‟s cost of equity.
In summary, Victoria estimates Acme‟s cost of equity using the modified CAPM, as shown in
Exhibit 16.8.
Exhibit 16.8 Acme Manufacturing, Inc.: Cost of equity.
Exhibit 16.9 Acme Manufacturing, Inc.: Cost of debt.
Cost of Debt