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LOS g: Explain the specific elements of discount rate estimation that are relevant in valuing the total capital or equity capital of a private company.

Which of the following best describes the use of size premiums when estimating the discount rate for private company valuations?

A)	The treatment is similar to that for public firms.

B)	When using data from comparable public firms, a distress premium may be inadvertently added in.

C)	A size premium is subtracted when calculating the discount rate.

For private company valuations, a size premium is often added in when calculating the discount rate. This is not typically done for public firms. To get the size premium, the appraiser may use data from the smallest cap segment of public equity. This however may include a distress premium that is not applicable to the private firm.

Which of the following best describes how debt is incorporated into the estimation of the discount rate for private company valuations, relative to that for public firms? In general, the cost of debt:

A)	is higher for private firms and debt capacity is lower for private firms.

B)	and debt capacity is the same for both private and public firms.

C)	is higher for private firms and debt capacity is the same for both private and public firms.

A private firm may not be able to obtain as much debt financing as a public firm. The small size of private firms may result in higher operating risk and a higher cost of debt.

Which of the following best describes projection risk in the estimation of the discount rate for private company valuations?

A)	Management will always be overly optimistic to increase the acquisition price.

B)	If the availability of information from private firms is poor, the uncertainty of projected cash flows may increase.

C)	Projection risk results in higher discount rates.

Projection risk refers to the risk of misestimating future cash flows. Given the lower availability of information from private firms, the uncertainty of projected cash flows may increase.

However, management may not be experienced with projections and may underestimate or overestimate future prospects. The discount rate would then be decreased or increased accordingly. So management is not always overly optimistic and projection risk does not always result in higher discount rates.