CPA expert 2004 fall

              CPA
Expert
AICPA Newsletter for Providers of Business Valuation & Litigation Services
Fall 2004
Contents
4 When the Whistle Blows and There is No Foul: Managing the Misguided Whistleblower
8 In the Know...
8 Discussion Memorandum on Forensic Accounting Services
9 Q&A: The Question of Contingency Fees
12 FYI...
APEX®
AWARDS FOR PUBLICATION EXCELLENCE
AICPA
COST OF CAPITAL CONTROVERSIES
Part I: It’s Time to Look Behind the Curtain
By James R. Hitchner, CPA/ABV, ASA and Katherine E. Morris
The determination of the cost of capi­tal for a business is fraught with contro­versy. Many valuation analysts find safety and comfort in using data sources that are widely recognized. These data sources are indeed helpful, but analysts should understand thor­oughly how the data is derived, what choices there are in selecting such data and what the strengths and weaknesses of the data are. This article is the first in a four-part series that deals with all the components of the Weighted Aver­age Cost of Capital (WACC).
In calculating the WACC of a closely held company, the analyst must make choices in five major categories. We know that the WACC formula, excluding preferred stock, is as follows:
WACC = Wd X dpt (1 - tax rate) +
We X ke
We also know that ke (the required rate of return for a com­pany’s equity capital) for a small to medium-sized closely held company is usually derived by using either the Modified Capital Asset Pricing Model (MCAPM) or the Build Up Model (BUM). Let’s focus on MCAPM first. The WACC equation is now expanded as follows:
WACC = [Wd X dpt (1 - tax rate)] +
[We X (Rf + B (RPm) + RPs + Rpu)]
MCAPM
For the BUM we have:
WACC = [Wd X dpt (1 - tax rate)] +
[We X (Rf + RPm + RPs + Rpu + Rpi)]
BUM
Under both equations, the analyst must make decisions on nine cate­gories that have a direct influence on the WACC and thus on value. The difference is that beta is used in the MCAPM, and some analysts use an industry risk premium in the BUM. Nothing is new here in terms of the categories. Plenty is new, however, in the choices to determine the amount that goes into each category. Before we get into those choices, which are the main focus of this article, let’s define the above-mentioned cate­gories of the WACC.
Wd
Fair market weight of debt in the capital structure
dpt
Pre-tax cost of debt
Tax rate
Company-specific tax rate
We
Fair market weight of common equity in the capital structure
Rf
Risk free rate of return
Beta
Measure of risk using volatility
RPm
Risk premium in the marketplace
RPs
Risk premium adjusted for size, also known as size premium
Rpu
Risk premium for unsystematic risk, also known as specific company risk
Rpi
Risk premium for the industry