Page 23 - Economic Damage Calculations

 Risk-free rate of return (Rf). The risk-free rate of return is "a rate of return available in the market
on an investment free of default risk." fn 5 Typically, the risk-free rate of return is calculated as
the rate available on U.S. Treasury securities, even though in practice there may be some risk of
default on these instruments. As previously noted, the expert may consider matching the duration
of the damage period to the term of the selected U.S. Treasury security.

 Equity risk premium (RPm). The general equity risk premium refers to the rate premium that is
demanded by an investor to invest in an equity security as opposed to a long-term government
bond. Typically, the equity risk premium is represented by the excess returns on investments in
public equity markets over the U.S. Treasury bond rate. This excess return is measured as an av-
erage of such long-term returns, often from 1926 to the present, given the availability of securi-
ties pricing data and the desire to capture the long-term relationship between risk and securities
pricing.

 Industry risk premium (RPi). Depending on the cost of equity capital model used by the expert, it
may be appropriate to apply an industry risk premium (discount) in the calculation of an equity
rate of return. This industry risk adjustment is calculated using market rates of return achieved by
publically traded companies in various industries. Data may be organized by North American In-
dustry Classification System (NAICS) code or by Standard Industrial Classification (SIC) code.
The expert may consider assessing the types of entities included in the selected code to ensure
sufficient comparability exists.

 Size risk premium (RPs). Investors in smaller companies may require an additional risk premium,
over and above the general equity risk premium, to account for the additional risk associated
with a smaller sized company. It may be appropriate to add a risk premium for size if this risk
has not been accounted for otherwise. The size effect (or small stock) risk premium is typically
calculated as the historical average return on small company stocks over the historical average
return on large company stocks.

 Company-specific risk. (RPc). This factor represents the unsystematic risk associated with an in-
dividual investment. The quantification of company-specific risk generally involves an assess-
ment based on the expert's professional judgment because there is no specific formula or equa-
tion commonly used to quantify this risk premium component. fn 6

The following sections provide a few examples of typical models that have been used to assemble these
inputs in the development of a cost of equity rate. fn 7

fn 5 Appendix B of SSVS No. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (VS sec. 100).

All VS sections can be found in AICPA Professional Standards.

fn 6 At the time of publication, certain empirical models such as the Butler Pinkerton Model—Total Cost of Equity and the Public
Company Specific Risk Calculator have recently been used to provide analytical support in the development of the company-specific
risk premium.

fn 7 Other models may be applicable, depending on the facts and circumstances. The discussion of such models is beyond the scope of
this practice aid.

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