Discount Rate and Cost of Capital: Some More about the Puzzle

Abstract:     
The aim of this paper is to contribute to a deeper knowledge of the CAPM in the framework of company valuation based our reasoning on the differentiation between the so-called purely financial investor and economic risk investor. Our argument is that CAPM is not a good reference to be applied in the valuation of unlisted companies because there is not a market beta for them, so the use of this traditional method to estimate the cost of capital is a wrong way. Further, we show that total beta, as an estimate of market beta when companies are not diversified, is not as good as some experts suggest, because there is no a clear correlation between company return and market return.

Moreover, according to Modigliani and Miller (1958), we show that the company can be considered as a mixed portfolio composed by a riskless asset and a risky portfolio, and so the total return of the a privately held company and, in general, for unlisted companies, is a summative discount rate which include an idiosyncratic risk.

Finally, we empirically demonstrate that the application of this discount rate contributes to reduce the company value according with practice and, therefore, the use of CAPM overestimates the company between 28% and 40%, depending if the companies are listed or not.

Number of Pages in PDF File: 19

Keywords: Firm valuation, CAPM, cost of capital, beta, equity premium, economic risk investor, financial investor

JEL Classification: G10, G12, G309

working papers series