Estimating SMEs Cost of Equity Using a Value at Risk Approach (eBook)

Federico Beltrame is a Lecturer in Banking and Finance at the University of Udine, Italy. He graduated in Economics from the University of Udine and received a PhD in Business Science from the same university. His main research interests are related to SMEs cost of capital and mutual guarantee credit institutions.Roberto Cappelletto is a Full Professor in Corporate Finance at the University of Udine, Italy. He has also taught at Ca' Foscari University (Venice) and Bocconi University (Milan). His main research interests are related to financial analysis and rating systems.Gabriele Toniolo holds as PhD in Corporate Finance from the University of Trieste and is a financial and business advisor. He graduated in Economics from Ca' Foscari University (Venice). His main research interests are related to SMEs cost of capital, credit risk and rating systems.

Cover 1
Half-Title 2
Title 4
Copyright 5
Dedication 6
Contents 8
List of Tables 12
List of Figures 14
Acknowledgements 16
About the Authors 17
Introduction 18
1 The Financial Structure of Small and Medium Firms and the Impact on the Cost of Capital 23
1.1 Introduction 23
1.2 Literature review 24
1.3 Capital markets and growth: the equity gap 29
1.4 Business financing: a framework of reference 34
1.5 Options for growth and cost of capital 40
1.6 Conclusions 44
2 Valuation of Small and Medium Enterprises: Critical Aspects of Method and Evaluation of Credit Risk 48
2.1 Valuation of the firm 48
2.2 The valuation of small and medium enterprises: critical aspects 49
2.2.1 The comparable approach: stock market multiples 50
2.2.2 The comparable approach: correction of the Beta 51
2.2.3 Excess debt 55
2.2.4 The liquidity of the investment 56
2.2.5 Critical aspects of use 57
2.3 Cost of debt and cost of equity: a comparison 58
2.4 Models for debt pricing used in estimating the cost of equity 60
2.4.1 Probability of default 61
2.4.2 Loss given default 62
2.4.3 The models for estimating the cost of equity 64
2.5 Unexpected losses in equity returns 68
2.5.1 Value at Risk 71
2.5.2 Pricing unexpected loss 73
3 The Capital at Risk Model: Theoretical Aspects 76
3.1 Unlevered firms and totally levered firms 76
3.2 The Value at Risk Approach for pricing 77
3.3 Determination of the expected returns through a structural model 83
3.3.1 The expected returns by creditors for the levered firm 83
3.3.2 The required return by creditors for the totally levered firm 85
3.4 Determination of expected returns on debt: a practical example 86
3.4.1 Expected returns on debt for the levered firm 86
3.4.2 Expected returns on debt for the totally levered firm 88
3.5 Expected returns for levered firms 91
3.5.1 The model for estimation of the cost of equity without risky debt 92
3.5.2 Model for estimation of the cost of equity with risky debt 93
3.5.3 The general formula for quantification of the cost of equity: an example 93
3.6 The Capital at Risk Model with corporate taxes 96
3.7 Corollary: optimal capital structure 97
4 Application of the Capital at Risk Model to Small and Medium Enterprises 102
4.1 The unlevered firm: expected returns 102
4.2 The capital at risk 102
4.2.1 Probability distribution of the operating earnings and the returns 104
4.2.2 The historical ROCE probability distribution 105
4.2.3 The construction of future scenarios to determine capital at risk 109
4.3 The loss rate for the shareholders 111
4.4 Cost of debt 114
4.5 Cost of capital for the indebted firm 115
4.6 The Capital at Risk Model: an example 115
4.6.1 Cost of equity for unlevered firms and without taxation 115
4.6.2 The cost of the third-party capital 118
4.6.3 The cost of the equity capital for the levered firm 119
4.6.4 The model with corporate tax 120
5 The Capital at Risk Model Applied to the Firms Alpha, Beta and Gamma 122
5.1 Introduction: objectives and presentation of the ADI rating 122
5.2 Alpha 125
5.2.1 Qualitative analysis 125
5.2.2 Economic–financial analysis 128
5.2.3 Quantification of the cost of capital 130
5.2.4 Economic and financial plan 135
5.2.5 Valuation of Alpha through discounted cash flows 138
5.2.6 Use of the cost of unlevered capital obtained with the CAPM/total Beta method 138
5.2.7 Use of the cost of unlevered capital obtained with the CaRM method 140
5.2.8 Valuation of the costs of financial distress 141
5.3 Beta 142
5.3.1 Qualitative analysis 142
5.3.2 Economic–financial analysis 145
5.3.3 Quantification of the cost of capital 147
5.3.4 Economic and financial plan 152
5.3.5 Valuation of Beta through discounted cash flows 154
5.3.6 Use of the cost of unlevered capital obtained with the CAPM/total Beta method 156
5.3.7 Use of the unlevered cost of capital obtained with the CaRM method 157
5.4 Gamma 158
5.4.1 Qualitative analysis 158
5.4.2 Economic–financial analysis 161
5.4.3 Quantification of the cost of capital 163
5.4.4 Economic and financial plan 169
5.4.5 Valuation of Gamma through discounted cash flows 171
5.4.6 Use of the unlevered cost of capital obtained with the CAPM/total Beta method 173
5.4.7 Use of the unlevered cost of capital obtained with the CaRM method 174
5.5 Conclusions 175
Appendix A 184
Appendix B 203
References 214
Index 221