Privately Held Company Valuation and Cost of Capital

Abstract

The aim of this paper is to contribute to a deeper knowledge of the discount rate in the framework of privately held company (PHC) valuation. Their main purpose is to test if the expected rate of return on equity differs between PHCs and quoted companies and if their accounting rate of return is greater than the cost of equity capital. This paper contributes in two different ways: first, distinguishing between the so-called purely financial investor and the economic risk investor to construct a model that permits to calculate the PHC’s cost of equity capital; second, assuming rational economic behavior. It is argued that in the valuation of non-quoted companies, investors need to be able to choose a model that goes beyond the beta of the capital asset pricing model (CAPM), proposing the three-component model based on Rojo-Ramírez, Cruz-Rambaud and Alonso Cañadas (2011). The empirical analysis leads us to conclude that the use of this model improves the overestimated value of a company by applying the discount rate of the CAPM (between 28% and 49%), which is consistent with professional practice.