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 entrepre-
neurs and financiers, especially when detailed accounting and
financial data of similar business are not readily available.
The discounted cash flows methodology is the
standard valuation approach in Finance. The value
of an asset is calculated as the present value of
all future net cash flows. The capitalization rate
required to discount future cash flows can be
obtained using the Capital Asset Pricing Model
(CAPM). This approach is workable as long as an
appropriate measure of systematic risk (or “beta”)
is available so that CAPM can be applied.
Finding an appropriate beta is an easier task for
publicly listed companies than it is for private
small businesses. First, there is a lack of infor-
mation on market values of small businesses.
Second, a market index which includes values of
small businesses is unavailable. Both pieces of
information are required in estimating betas for
small business ventures. Although the beta of
similar projects undertaken by publicly listed firms
sometimes may be used as a substitute, the size
of most entrepreneurial business ventures is too
small to make such an approach practicable.
Although the CAPM approach may be relevant for
a venture capital fund which holds a diversified
portfolio of small businesses, it may not be appro-
priate from the point of view of the entrepreneur.
The entrepreneur is likely to be the sole investor
who has a high proportion of capital tied up in the
business. Diversification may simply be unattain-
able in that case. The entrepreneur has to bear both
unique and market risks, and needs to be rewarded
accordingly. These are some of the reasons why
further research is necessary to find the appro-
priate discount rates for small business ventures.
This paper derives probability based estimates
for minimum costs of capital for small businesses.
Section 2 looks at the probability of survival of
small businesses. Section 3 translates the proba-
bility of survival into a cost of equity capital. The
cost of debt is then derived in Section 4. Section
5 extends the analysis to a multi-period setting.
A summary of results follows in Section 6.
2. Probability of survival of small businesses
Default risk accounts for a significant portion of
risks borne by debt-holders. On the other hand,
entrepreneurs and equity investors assume the
residual risk which depends on, among others, the
nature of the undertaking, the macroeconomic
environment, and the managerial skills. The
outcome of a business venture can be defined in
A Probability Based Approach
to Estimating Costs of
Capital for Small Business
Small Business Economics 12: 331–336, 1999.
1999 Kluwer Academic Publishers. Printed in the Netherlands.
Final version accepted on March 3, 1999
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