The Cost of Capital in a Business Valuation

In performing a business valuation, deciding whether to use the weighted average cost of capital (WAAC) or a build-up method depends on the circumstances. Both methods are appropriate in valuing a business. 

The WAAC represents the rate of return an investor expects that includes all investors, debt, and equity. It can be useful when the company has:

1. A Complex Capital Structure and you need to distinguish the different rates of returns for costs of equity and several types of debt.
2. Consideration of an acquisition and the buyer expects to pay off the debt and equity and refinance the entire debt and equity structure.
3. The objective is to value the equity of a business. The value of the Market Value of Invested Capital (value of debt and equity) is appropriate when a company is highly leveraged to understand the equity separate from the debt holders.
4. Capital Projects are situations where the WAAC can provide answers to what could be available to finance capital projects. This would be based on debt capacity.

The Build-Up Method is another way to estimate the cost of capital when valuing a privately held business. It is commonly used for small, privately held companies and involves “building up” various risk premiums of market rates of returns. The Build-Up Method is appropriate when.”

1. Small privately held companies where market data may not be readily available.
2. When there is no comparable market data to determine beta or market risk premiums.
3. Unique risk factors that can be accounted for in a more customized risk premium addition.
4. Early-stage companies that do not have stable capital structures.

Some common mistakes when calculating the WAAC and the Build Up Method

WAAC

1. Using the historical cost of debt instead of current market cost of debt. If a buyer is going to retire the debt and refinance, they will want to know what the current debt structure looks like.
2. Failing to account for the tax deductibility for the interest expense.
3. Using the average tax rate vs the marginal tax rate can lead to incorrect calculations.

Build-Up

1. Using a risk-free rate that does not match the time horizon, for instance, using a 20-year bond when the investment horizon is 10 years.
2. Using a general equity risk premium when more specific content is available. 
3. Over reliance on subjective information without justification.

The choice of how a discount rate and/or capitalization rate is going to be calculated can be a difficult decision, but choosing an experienced business valuation analyst will go a long way.

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 1 -Cost of Capital, 5th Edition, Shannon Pratt, p 544