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The CAPM model is popular due to its relative ease of use. One of the critical assumptions underlying
CAPM is that investors prefer to hold well-diversified portfolios and that diversification eliminates any
"unsystematic risk" in an investor’s portfolio. Unsystematic risk is the uncertainty of future returns due
to company-specific factors not related to the general market. Because CAPM is based entirely on quan-
tifying systematic risk (because it assumes that rational investors will hold well-diversified portfolios),
there is little to no impact from company-specific or unsystematic risk. Accordingly, some practitioners
argue that measuring the equity of a company in distress using only the CAPM model would not ade-
quately compensate investors for the specific risk they would face by investing in the assets of a dis-
tressed company. Other practitioners assert that, although such risk exists, it is not compensable by the
market.

Financially distressed businesses, whether in or out of bankruptcy, are more highly leveraged (in other
words, they have higher levels of debt relative to equity) than healthy companies. As leverage increases,
the equity in a business becomes more risky and requires a greater expected return than at lower levels
of leverage, all else being equal. Adjustments can be made to beta to capture the higher level of risk in-
herent in higher leverage. Although a discussion of the techniques used to adjust beta for higher or lower
levels of leverage is beyond the scope of this practice aid, analysts can consult other reference materials
to develop such calculations. fn 2

The build-up approach is similar to the CAPM in application. The principal difference is that in the
build-up approach the market risk premium is not multiplied by beta and an industry risk factor is in-
cluded instead.

Company-Specific Risk

Because the CAPM quantifies only systematic risk, the traditional CAPM formula is often modified to
incorporate company-specific risk and unsystematic risk related to the subject company’s size. fn 3 The
modified capital asset pricing model (MCAPM) is simply the traditional CAPM with an additional ad-
justment for unsystematic or company-specific risk, typically referred to as alpha.

Both the MCAPM and the build-up method include a component a (alpha), which is a measure of the
unsystematic or company-specific risk. This risk is not captured in beta or the equity risk premium.

Many practitioners assert that quantifying the effect of unsystematic risks is especially important for
companies in financial distress for three reasons. First, the presence of company-specific risk factors can
be more pronounced for companies in financial distress than for comparable companies not in financial
distress. Second, the effect that unsystematic risks can have on bankrupt companies is more pronounced.
Companies in financial distress are less able than healthy companies to withstand the effects of negative
events caused by these risk factors. Finally, the risk factors themselves tend to be accentuated for a
company in bankruptcy. For example, key supplier risk (discussed later) is generally heightened for
bankrupt companies because suppliers often put bankrupt customers on COD delivery or stop delivering
products until overdue invoices are paid. Key person risk (discussed later) is also pronounced for bank-

fn 2 For example, see Shannon P. Pratt and Roger J. Grabowski, Cost of Capital: Applications and Examples, 5th ed. (Hoboken, NJ:
John Wiley & Sons, Inc., 2014), chap. 12.

fn 3 It is generally accepted that size represents a company-specific risk factor that is compensable by the market. Differing opinions
exist about whether other company-specific risk factors are compensable by the market.

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