Page 24 - Economic Damage Calculations

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a model for identifying an investor’s expected return on an
equity investment based on a single measure of risk (beta). The CAPM is extensively researched by
economists, financial experts, and statisticians. The CAPM is built on the idea that the impact of unsys-
tematic risk on publicly traded portfolio returns can be eliminated through asset diversification, while
the impact of systematic risk cannot.

The CAPM illustrates the expected return on a given equity security, E(Ri), in the following equation:

E(Ri) = Rf + (Bi × RPm)

If unmodified, the CAPM only recognizes one risk factor: systematic risk. The CAPM does not account
for other risk factors, including the risk factors specifically related to the subject. Accordingly, an expert
may consider adjusting the CAPM to account for additional known risks, for example in situations in-
volving small or medium-sized businesses—particularly privately owned businesses. This is because
one of the theoretical assumptions underlying the CAPM is that investors seek to hold efficient, well-
diversified portfolios.

In many privately held companies, equity owners do not hold diversified portfolios and the company-
specific risk has not been diversified away. In addition, there may be a difference between a private
company owner's assessment of an appropriate discount rate and an outside investor’s assessment. This
may be affected by, for example, the ability of the owner of a private company to control management
decisions at a company, while shareholders of publicly traded companies typically do not enjoy such
control.

The CAPM is based on assumptions about investor behavior and subject investments, including that a
business or business interest is one of many investment options available in the capital markets, and the
price of the business should be subject to the same relationships that govern the prices of other assets.
Additionally, it assumes that investors are risk averse, prefer efficient and diversified portfolios, and
have common expectations about future returns. Also, it assumes similarities for lending and borrowing
money, including the rates available and holding periods, and it assumes that investments are divisible
and liquid. Finally, price volatility is attributed to risk and return, and there are no transaction costs or
tax consequences within the model.

Modified CAPM

The modified CAPM expands the CAPM to increase its applicability in circumstances when company or
investment-specific risks are evident. The most notable modification is that it explicitly considers risk
premia for size and for industry-specific factors associated with the subject company. The typical modi-
fied CAPM formula is as follows:

E(Ri) = Rf + (Bi × RPm) + RPs + RPc

Build-Up Model

The build-up model is another commonly used model to estimate the cost of equity. The typical build-up
model formula is expressed as follows:

E(Ri) = Rf + RPm + RPs + RPi + RPc

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