Contrast the models for estimating the return required on private company equity, such as the build-up approach, the CAPM and the expanded CAPM
The idea
Three approaches estimate the required return on private company equity. The CAPM, r = rf + β × equity risk premium, needs a beta, usually from guideline public companies, and may miss size and company-specific risk. The expanded CAPM adds premiums: r = rf + β × ERP + size premium + company-specific premium, plus an industry premium only if the beta does not already capture industry risk. The build-up approach, used when no suitable beta exists, takes the risk-free rate and adds the equity risk premium with an implicit beta of one, a size premium, an industry premium if appropriate and a company-specific premium. Every premium involves judgement. The traps are multiplying the equity risk premium by a beta in the build-up method and leaving out a size premium in the expanded CAPM.
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