Application of a multi‐criteria model for determining risk premium

Abstract

PurposeFor publicly traded firms, calculating the cost of capital is predicated typically on information from the financial markets. Small businesses do not have the necessary market‐based information. As an alternative to traditional proxy approaches, this paper presents a multi‐criteria model to determine an appropriate equity risk premium, and thereby, a cost of capital.Design/methodology/approachThe study applies a multi‐criteria model – an analytical hierarchy process (AHP) – to determine the cost of capital for small businesses. It is a useful tool for the complex world in which small businesses function. Arbitrary and capricious ways of allocating resources is a luxury that small businesses can ill afford. The application of the model to a small business in South Africa is shown in this study.FindingsThe use of the AHP model is clearly a method to determine the equity risk premium and the cost of capital for small businesses.Research limitations/implicationsThe model requires small business managers to identify all information sources for the required input data. This prepares the managers in advance for their information need. Thereafter, management is required to offer subjective thoughts on qualitative oriented criteria. This is attractive particularly to small business management since AHP pairwise comparison procedure allows managers to provide relative rather than absolute preference assessment one at a time on those qualitative factors. The inconsistency checking mechanisms within the AHP model allows management to identify inconsistencies at early stages of the solution process.Originality/valueThe paper offers practical help to lenders and small businesses wishing to invest in new capital projects.