What is the Company Specific Cost of Capital | The Cost of Capital typically used for a business valuation is the Ibbotson’s Build-up method which comprises several risk factor elements discussed in a previous article. The company specific risk factor for the cost of capital is presented below.
Company Specific Risk Factors
A potential major portion of the overall risk and cost of capital is the risk associated with the specific subject company. For the Company Specific Risk formula derived by NACVA’s certified valuator, Mr. Richards, there are ten specific risk factors used to determine specific risk related to the management and operations of the Company. These ten factors provide summary perspective of the various risks to potential investors or buyers inherent in the operations and of small privately held businesses. Seven of the factors are directly related to the prospects of business success, and the last three are direct measurements of that success. A discussion for each level of risk is shown below.
To assess the level of that risk, a four-stage scale has been developed. The level of risk associated with each factor is then measured using selected criteria summarized in the following pages. The Table below shows the Subject Company Specific Risk Factors. When appropriate each factor may be weighted to emphasize added risk associated.
Discussion of Company Risk Factors – The Table below shows the summary of the ten elements used to determine company specific risk.
- Depth and quality of management
- Importance of key personnel
- Stability of the industry
- Diversification of the product lines
- Diversification of the customer base
- Diversification and stability of suppliers
- Geographic location
- Earnings stability
- Earnings margin
- Financial structure
The cost of capital is one of the single most important elements of consideration in a business valuation. Errors in the cost of capital can cause significant errors in the value of a business. If you company is valued at $5-15 million and an error of 10% in the cost of capital occurs the value can be off by over $1 million to $5 million or 20% to 33%. It is always best to have a certified valuator assist you in your valuation and the important cost of capital calculation.