How To Estimate The Cost of Capital and Equity for a Privately Owned Business

Description
The models and practices for estimating the cost of capital are generally are designed for publicly traded companies. The cost of equity and capital for these companies are built on two principals: the fact that marginal investors are diversified and the fact that market prices are observable.

However, in privately owned businesses, these two principals are different: the owners and potential buyers tend not to be diversified and there is no observable market value for the equity because private businesses are not traded. As such, a different approach to estimating the cost of capital must be taken for a privately owned business. In this video, Professor Aswath Damodaran sets out how this estimate can be achieved.

Aswath then demonstrates the process of estimating the cost of capital for a privately owned business using a simple example, to show how to get round the different challenges.

Aswath shows how modelling for a privately owned business differs from a traditional Capm or an arbitrage pricing model. Aswath shows how the algebra problem should be approached from the context of a private company, and how this approach differs from the standard one. This emphasises how you should view units of risk differently depending on whether it is a publicly trading company or a privately owned business. This will show you how to estimate company specific risk for your privately owned business. You will learn how to find the market beta for the business that your private company is in and get a measure of how much of the risk in the firm comes from the market and how much is firm-specific. This will help you to create a complete estimate for a total risk beta.

Next, Aswath shows you what to do if there is no market value. He suggests three different approaches:

- A target debt ratio: if you have a business owner
who has a target debt ratio in mind, use this.
- Industry average debt ratio: use the average debt
ratio for public companies in the same business
- Use your own estimates: Aswath demonstrates
how you can construct your own estimate for
market equity.

Aswath then demonstrates how to use one of these approaches in a business context, making the process much easier to understand.

Aswath then finally demonstrates how to get from cost of equity to get cost of capital. He shows how you can use some of the techniques used when doing this for publicly trading companies in this context in order to calculate the long term current cost of debt.

Having calculated all of the key figures, Aswath then demonstrates the equation that you can use to calculate your total cost of capital for your privately owned business.