The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions, Second Edition

APPENDIX C

Discount Rates

This appendix¹ relates to the valuation of emerging growth and lower-middle-market privately held companies using a discount rate derived from application of the capital asset pricing model (CAPM) adjusted for private companies. . .we will refer to this as the adjusted capital asset pricing model (ACAPM). A discount rate is defined as the rate of return an investor would require to be induced to invest in the cash flow stream being discounted, given the risks of that cash flow being achieved. The discount rates are affected by the market, vary with time, depend on what is being discounted, must be risk adjusted, are based on yields available on alternate investments, and are inflation adjusted.

If the model is applied to an earnings measure that is after interest expense, you are most likely valuing the equity portion of the company, whereas if the model is applied to cash flow before interest, you are valuing the enterprise, which, as we described previously, consists of equity and the interest-bearing debt of the company. To develop the discount rate to be applied to the enterprise valuation, we first calculate the expected rate of return for the equity in the business using the ACAPM formula below. This is in effect our discount rate or cost of capital for the equity, which we will call r_e.

The ACAPM formula modified for the target companies is:²

where: ...