An Examination of the Applicability of the Build-Up Method in Estimating the Cost of Equity Capital for Small, Closely-Held Businesses

This study examines the build-up method in estimating the cost of capital for valuing small, closely held businesses. Cost of capital is the rate of return expected from an investment. The build-up method adds the risk-free rate, the equity risk premium, the firm size premium and subject-specific risks. The risk-free rate is the 20 year U.S. Treasury coupon bond yield. Equity risk premium is the return in addition to the risk-free rate. Size premium accounts for risks attributable to company size.This study analyzes the relationship between firm size and cost of capital. From the BIZComps® database, all transactions within SIC code 5812 (Restaurants) were selected. We defined expected cost of capital (yield) as seller discretionary cash flow divided by sale price: Yield=SDCF/SP.A regression analysis with the independent variable annual sales (AS) and dependent variable Yield, resulted in a R2 of 0.02. The intercept was 0.6239 with a 95% confidence interval between 0.5904 and 0.6574. The slope of the regression was slightly negative (-3E-07). The resultant model was y=-3E-07x 0.6239.Within the range studied, there was no significant size premium. Variation in yield would more likely be explained by unsystematic risk. However, an interesting finding was that the total expected yield ranged around 60 percent