Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 16

Company-specific Risk¹

Introduction

Matching Risk and Return

Adjusting for Difference in Market Risk

Adjusting for Other Risk Factors

Risk Differences Often Cannot Be Adjusted for in Net Cash Flows

Matching Fundamental Risk and Return

Using the Duff & Phelps Risk Study

Relationship of Measures of Size and Risk

Market Pricing of Other Company-specific Risk Factors

Research on Other Risk Factors

Total Beta

Cost to Cure

Other Company-specific Factors

Bias in Projections

Frameworks for Analyzing Company-specific Risk

Summary

INTRODUCTION

Quantifying a company-specific risk premium (C-SRP) is one of the most controversial and elusive areas of business valuation. As Chancellor Strine of the Delaware Court of Chancery stated:

Much more heretical to CAPM, however, the build-up method typically incorporates heavy dollops of what is called “company-specific risk,” the very sort of unsystematic risk that the CAPM believes is not rewarded by the capital markets and should not be considered in calculating a cost of capital. The calculation of a company-specific risk is highly subjective and often is justified as a way of taking into account competitive and other factors that endanger the subject company's ability to achieve its projected cash flows. In other words, it is often a back-door method of reducing estimated cash flows rather than adjusting them directly.

To judges, the company-specific risk premium often seems like the device experts employ to bring their final results ...