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Small Business Economics

, Volume 12, Issue 4, pp 331–336 | Cite as

A Probability Based Approach to Estimating Cost of Capital for Small Business

  • Joe Cheung
Article

Abstract

While discount rates of listed companies can be readily estimated using "betas" and the Capital Asset Pricing Model, the same is not true for small business. Entrepreneurs often have to rely on subjective assessments of the financial viability of their business ventures. This paper suggests an alternative to estimate the costs of capital for small businesses. Costs of capital are derived from the probability of success for similar business. These required rates of return can be used as minimum hurdle rates to assess the viability and profitability of the business under consideration. Since risk neutrality is assumed of investors in this approach, the costs of capital established should only be regarded as minimum returns required by risk-averse investors. Therefore, this suggested approach attempts to provide a refined "rule-of-thumb" which may be of value to small business entrepreneurs and financiers, especially when detailed accounting and financial data of similar business are not readily available.

Keywords

Discount Rate Small Business Asset Price Industrial Organization Subjective Assessment 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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References

  1. Bierman, H. and J. E. Hass, 1975, ‘An Analytical Model of Bond Risk Differentials’, Journal of Financial and Quantitative Analysis (December), 757–773.Google Scholar
  2. Bierman, H., 1990, ‘Investing in Junk Bonds’, Journal of Portfolio Management (Winter), 60–62.Google Scholar
  3. Yawitz, Jess B., 1977, ‘An Analytical Model of Interest Rate Differentials and Different Default Recoveries’, Journal of Financial and Quantitative Analysis (September), 481–490.Google Scholar
  4. Yawitz, Jess B., Kevin J. Maloney and Louis H. Ederington, 1985, ‘Taxes, Default Risk, and Yield Spreads’, Journal of Finance (September), 1127–1140.Google Scholar

Copyright information

© Kluwer Academic Publishers 1999

Authors and Affiliations

  • Joe Cheung
    • 1
  1. 1.Department of FinanceUniversity of WaikatoHamiltonNew Zealand

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