Question

There are a number of different risk and return models in finance used to compute the cost of equity but they typically assume that the marginal investor is well diversified. If you use these models to estimate costs of equity for private or closely held firms, are you likely to under or over estimate the cost of equity? How would you fix the bias?

Answer 1

• Every model or methods has it's own advantages and disadvantage.
• In case of risk assessment in relating to systematic and unsystematic risks, we use different method for calculation of beta, similar in case of calculation of return we use Dividend Growth Model and Security Market Line(SML) methods.
• In case of dividend growth model, it will applies only to dividend paying companies and sml model takes risk into consideration.
• Some of the inputs used in the calculation are estimates based either on historical data or estimates of analysts.
• In case of private and closely held firms, availability of above data is also little bit impossible which leads to following thing.

1. Under/ Over estimation of cost of equity
2. In order to fix this we need to follow the particular industry(to which company belongs) cost of equity or previously cost of equity used by the company (as per the books) as cost of equity