Cost of Capital Calculation in a

Small, Privately-Held Business Environment

Phil Murray

December 10, 2006

Presented to:

Dr. D. Anthony Plath

The Belk College of Business Administration
The University of North Carolina at Charlotte

MBAD 6890

1
 Abstract

Modern financial theory does not properly address the many behavioral and financial issues
surrounding the operation of a typical small, privately-held business. Cost of capital calculation, an
important topic in finance, is difficult to accomplish appropriately using traditional models which rely on
publicly available information and adherence of the particular firm and investor to a certain set of
restrictive assumptions. Of particular concern is the cost of equity component of the cost of capital
calculation.

The cost of capital is first explained and defined, and its purpose inside and outside of a firm identified.
A review of traditional cost of capital models is undertaken, and then an expansive analysis of small
and large business differences is performed. After looking at a variety of adjusted models that have
been recently proposed which attempt to deal with these differences, a new model (Firm Orientation
Cost of Capital Model – FOCCM) is introduced and applied to a case study company which better
takes into account behavioral and financial considerations in the small, privately-held business
environment. The model provides what is believed to provide highly accurate "internal" cost of capital
figure for managers within a small firm to utilize in evaluating project investment.

Article Outline

INTRODUCTION

PART I: Definition and Traditional Calculation of the Cost of Capital

1. The Cost of Capital Defined

2. Purpose of and Uses of the Cost of Capital
3. Review of Traditional Models

PART II: Cost of Capital in the Small Business World

1. Examining the Small Business World: Differences between Large and Small Businesses
2. Adjusted Models that Account for Small Business Differences
3. Problems with the Traditional and Adjusted Models for Small Business

PART III: The Firm Orientation Cost of Capital Model (FOCCM)

1. Small Business Profiles in FOCCM

2. Objectives and Implications of FOCCM
3. Cost of Capital Calculation with FOCCM

PART IV: Application of Models to a Case Company

1. Introduction to the Case Company

2. Application of traditional and adjusted models
3. Application of FOCCM

CONCLUSION

2
 Introduction

Modern financial theory's fit to reality grows distant the further you move away from analysis of
and application to large, publicly-traded companies. This fact is certainly no truer than for a highly
empirical concept such as the cost of capital for a firm. The models designed to calculate the cost of
capital which currently exist make assumptions that simply do not hold for smaller or privately-held
firms.

The traditional cost of capital models break down when they are utilized in a small business
environment, where those models' assumptions fail. The purpose of this paper is to evaluate the
appropriateness of applying the existing cost of capital models to small privately-held
businesses, and then to put forth an improved model (for use within a small firm) which takes
into account both the motivational (behavioral) differences and financial differences present in
these types of firms. The primary purpose of this model will be to enable proper internal
decision-making about the use of funds within small businesses.

After defining cost of capital and explaining its purpose at the beginning of Part I, context for
the study will be provided by contrasting differences between large, publicly-traded companies and
small, privately-held ones. In Part II, existing models for cost of capital calculation will be analyzed.
Newer "adjusted" models will be evaluated, and problems with both the traditional and adjusted
models will be unearthed to close out the section.

The Firm Orientation Cost of Capital Model (FOCCM) will be proposed in Part III. The
FOCCM addresses the problem of cost of capital calculation in a small business environment but
makes use of a new approach. It first examines the orientation (profile) of the small business owner.
After an accurate business ownership profile is identified, it makes use of a corresponding formula to
develop a much more accurate estimate of the small business' true cost of capital than would have
been possible with the traditional and adjusted models that have been developed over the last few
decades. The traditional, adjusted, and FOCCM models will be applied to an actual case study
business, and the results compared and contrasted. Finally, the paper will be concluded with a
discussion of the means of usefulness of this information to the small business community.

PART I: Traditional Definition and Calculation of the Cost of Capital

The Cost of Capital Defined

3
 The cost of capital can be defined simply as the rate of return required to compensate
providers of those funds (Palliam 335). This definition, although expressed from the point of view of
the investor, has strong implications for the firm. It says that firms must generate returns on an
ongoing basis that meet or exceed the funds providers' expected return, or the providers (investors)
will divert funds away to what they believe to be better uses of those funds.

Roger Ibbotson of the well-known Ibbotson and Associates further clarifies the concept as
follows: "The cost of capital is a function of the investment, not the investor." (#6 on pg 8 of Pratt) In
other words, the cost of capital should represent investors' expectations about a particular investment.
These expectations include an assumption that they will receive at the very least a rate of return
reasonable for allowing the use of their funds in a riskless environment, and that they will receive
additional return to compensate for the risk they are taking on for that particular investment. If an
investor does not achieve a return equal to or greater than the investment's cost of capital, the investor
will divert funds away from that investment to one that generates a rate of return equal to or higher
than their required return. On the matter of risk just mentioned, it should be acknowledged that few
environments or investments are anywhere close to being considered "riskless", of course, and so
stockholders have expectations that several different types of risks will be accounted for in the
expected rate of return.

Shannon Pratt summarizes the main types of risk well (35). He first mentions maturity risk,
which is related to the change in interest rates (inflation/deflation) in the economy. Maturity risk is
greater the longer the length or term of the investment. Systematic risk, also referred to as market
risk, reflects the opportunity cost of investment due to the fact that the committed funds cannot be
invested by other means to receive at least a certain market or index-based acceptable return.
Unsystematic risk is the risk level unrelated to the market as a whole – in other words, the specific risk
attributable to the firm in question, or the firm's industry. Many scholars, including Brigham and
Ehrhardt, state that this type of risk only exists in a portfolio that is not diversified and term this type of
risk instead as "diversifiable risk" (219).

This is a heavily empirical topic which is more intuitive than it is calculable. It is easily
understood that those who provide funds to others, outside of philanthropy and charitable purposes,
will require a certain payment or compensation in return for the provision of those funds. Above, we
laid out clear reasons why that compensation is important and for what it provides. It is not always
clear, however, exactly how that level of compensation should be calculated. It is not as simple as just
asking an owner or investor what level of return they require. Investment decisions, particularly in

4
small businesses, are typically made for the long run and involve a variety of motives and
uncertainties.

In the simplest example, consider a banker who gives funds to an individual for some purpose
– to buy a vehicle, for example. He will not provide those funds now just to be repaid the same
amount in total over a timeframe that might extend over several years. He obviously needs to
generate profit to compensate him for the risk that the funds will not be repaid. This profit (or return)
must also compensate for the fact that the funds he has loaned out are tied up for a certain period of
time – in other words, the liquidity of those funds has decreased when the funds were converted from
cash into an automobile. These factors are readily understood and accepted and yet it must be
admitted that the calculation of the rate of return this banker requires becomes complex and uncertain
the more factors that are introduced. In addition, he needs to be compensated for other realities – the
lost opportunity cost of potentially higher interest rate loans, economic inflation which will make his
profits less valuable, among other issues.

Herein we find an irony in the calculation of the cost of capital: although it involves
significant considerations for risk and uncertainty, it is itself a somewhat imprecise and
uncertain calculation. And, as mentioned in the introduction, this uncertainly multiplies when
models which make big-firm, market-based assumptions are applied to small, privately held
firms – those small firms typically operate under much different circumstances. But why is this
calculation so important? That is the question that will be addressed in the next section.

Purpose of and Uses of the Cost of Capital Inside of the Firm

The cost of capital is important for businesses to understand for several reasons. First of all, it
provides a starting point for considering the baseline minimum level of return required to which they
can compare various investment opportunities such as various corporate infrastructure projects,
expansion plans, or potential acquisitions. Secondly, it provides a discount rate for valuing the
business which allows for easier consideration of corporate suitors' offers, valuation for buy/sell
insurance, or in the case of privately held businesses it allows valuation for the purpose of considering
an IPO at different points in time. I will explore each of these two primary uses of the cost of capital
measure further below.

Evaluating a Firm's Investment and Project Opportunities

5
 Within firms, this issue of deciding how to invest a company's funds in useful projects is a daily
challenge to managers. Various investment options are presented continually. Managers have a
variety of tools at their disposal with which they can properly evaluate an opportunity. Per McKinsey &
Company, however, the "enterprise DCF model is a favorite of academics and practitioners alike
because it relies solely on how cash flows in and out of the company" (116). The potential for
complexity is replaced with a simple question: did cash change hands, and if so then in what direction
1
did the cash move – in or out of the firm? But this analysis is not possible without a cost of capital to
use as a discount rate.

If managers lack a discount rate with which to use in an analysis of cash flows, decisions will
instead be made via judgment and intuition, experience, and other ego-related factors such as a
desire to grow the dominance of a business. Undoubtedly some of these tools (such as a manager's
extensive experience in his field) are indeed valuable and should be an integral part of the decision.
But a strong empirical analysis supporting the decision, even if not the tool used to initially come to the
decision, will still lend significant creditability to the proposal and will aid in the persuasion of others
involved in the making of the decision. If possible, even more subjective factors such as a manager's
judgment should be translated into quantitative figures – i.e. projected sales revenue or cost for the
first few years of the investment – and so those figures could then be plugged into your DCF
spreadsheet, with the confidence that a quality discount rate exists to apply to the analysis.

Firm Valuation

Firm valuation is a common task that depends heavily on the use of the cost of capital
measure. From the classic standpoint of an investor, this valuation may be done for the purposes of
discovering a company whose value is not fully reflected in their stock price (and thus represents an
opportunity for excess return potential). But within a company, firm valuation is practiced often during
the process of considering an acquisition or merger, and there is a need to properly value the
projected cash flows of one or both of the firms.

Certainly many other methods of firm valuation exist, including determining liquidation value or
examining a host of multiples, including price-to-earnings, EBITDA multiples, price-to-sales multiples,
etc. In fact, multiples valuation methods could be most helpful as "a useful check of your DCF
forecasts" (McKinsey 380). And yet, in order to perform a thorough valuation analysis of a target firm

1
The "DCF", or Discounted Cash Flow, model mentioned here makes use of future cash flow
projections for a certain timeframe, and then discounts each period's cash flow back to a present value
according to a certain cost of capital.

6
using a discounted cash flow (DCF) approach, it is mandatory that the cost of capital figure is known
and is accurate.

Differences and Similarities with Cost of Capital for Investment Opportunities vs. Valuation

An overall company cost of capital is most appropriately utilized in the valuation of that
business, or in the assessment of an investment opportunity considered to be of "typical" or "average"
risk for the company. Problems arise, however, when the overall cost of capital used to value a firm is
also applied to projects with very specific risks and circumstances.

Ross points out that companies often refer to the firm's cost of capital as a "corporate discount
rate" or "hurdle rate" (330). By doing so, those companies imply and even encourage the use of the
firms' overall cost of capital in the analysis of various projects and investments. Ross is in agreement
with virtually all other authors when he says that a project/venture should be assigned a an adjusted
discount rate that is commensurate with the risk level of that specific project, but he refers to this
adjustment as "necessarily ad hoc" (331). Ehrhardt is in agreement with the need for differing project-
specific discount rates and points out that the "academic literature is virtually unanimous in
recommending adjustments when evaluating projects with different levels of risk" (102). He then cites
the Brigham study (1975) which found that about one-half of 33 large companies surveyed did make
project-specific adjustments either directly to the cash flows or adjustments to the specific cost of
capital used.

Although significant differences exist between cost of capital for valuation purposes and cost
of capital calculation for project/investment evaluation, there is still value in the overall cost of capital
measure. Higgins reinforces the point made above while also demonstrating the link between the
overall cost of capital and a specific project's cost of capital:
We conclude that the cost of capital is an appropriate acceptance criterion only when the risk
of the new investment equals that of existing assets. For other investments, the cost of capital
is inappropriate; but even when inappropriate itself, the cost of capital frequently serves as an
important, practical keystone about which further adjustments are made. (288, emphasis
added)
This implies that for a typical company, the overall cost of capital should be known and used
throughout the organization, but should be viewed primarily as a starting point of adjustments and
analysis.

7
 The most important link between these two uses of cost of capital for our purposes,
however, is that the approach to valuation of and cost of capital calculation for a small
business is much more like that of a typical capital project! Authors mention this frequently,
including Palliam, who says a small business can be "thought of more as a capital project" (336).
Ehrhardt shares this opinion and lumps cost of capital calculation for a small privately-held company
into the same category as cost of capital calculation for a project within a larger firm (101). Pratt
makes a very similar comparison, relating small company cost of capital to divisional cost of capital in
a larger company (13). Another argument for the similarity of small business and capital project
assessment is that capital project approaches consider the investments within their common context of
very specific risk that cannot necessarily be diversified away, which is the very situation in which small
firms often find themselves. In addition, due to the common existence of behavioral motivations with
small business owners, a firm valuation approach using typical, market-contrast risk premiums, would
only be appropriate for certain potential acquirers to take in valuing the company. The small business
owner himself, however, cannot be so easily explained, as we will later see in Part II.

Review of Traditional Models

A few formulas have been developed to aid in the calculation of a firm's cost of capital. The
weighted average cost of capital (WACC) calculation provides an interest rate that takes into account
a company's cost of debt and cost of equity, or put another way, the rate of return required by the
firm's creditors and the rate of return required by the firm's stockholders. This formula is relatively
straightforward and standard. It is shown and described as follows (Brigham and Ehrhardt, 435):

Equation 1-1: Weighted Average Cost of Capital

WACC = wdkd(1-T) + wpskps + wcekce
Where:
wd : Weight of market-value debt financing in the company's capital structure
wps : Weight of market-value preferred stock in the company's capital structure
wce : Weight of common equity in the company's capital structure
kd : Weighted average cost of company debt
kps : Component cost of preferred stock2
kce : Cost of common equity

2
The component cost of preferred stock is calculated as Dps / Pn where Dps is the annual preferred
share dividend and where Pn is the "net issuing price" (preferred share price discounted by flotation
costs incurred for the stock listing) (Brigham and Ehrhardt, 424).

8
 T : Effective corporate tax rate

This formula is widely accepted and utilized, and can be found in any MBA-level corporate
finance textbook. Its calculation reduces even further in a firm making no use of preferred stock –
then, the calculation would boil down to the after-tax cost of debt combined with the cost of equity
(weighted, in both cases).

Fortunately, the cost of debt is typically calculated fairly easily. Within a firm, this rate can be
determined very quickly by examining a debt schedule and weighing the interest rates according to the
values of the various balances. Even parties external to a firm can determine this by examining the
interest expense and long-term debt balances off the firm's financial statements in order to come up
with a figure. Alternatively, one could also look up the company's bond rating and then compare it to
typical bond rates of similarly rated bonds to develop a close approximation of the company's cost of
debt. In the cases of privately held businesses where financial information is not known by outsiders,
one could still estimate a fairly accurate cost of debt simply by examining public interest rate indices
such as LIBOR (London Inter-Bank Offer Rate) or Prime (an indicator used in consumer and small
business lending), and then surveying a commercial banker as to what a small firm of a given revenue
size in average financial condition could expect in terms of a rate, relative to one of those indices. Due
to banks' significant aversion to risk and the generally consistent lending guidelines existing from one
bank to another, it can be expected that such an approach would actually yield results with acceptable
accuracy.

The cost of equity (kce), however, is where most of the "heavy lifting" involved in cost of
capital calculation occurs. The two most widely referenced methods are the Discounted Cash Flow
(DCF) approach to cost of equity calculation, and an approach making use of the Capital Asset Pricing
Model (CAPM).

Cost of Equity – Discounted Cash Flow (DCF) approach

The Discounted Cash Flow method makes use of current market data as well as analysts'
growth expectations to produce a cost of equity figure. The subject company's cash flows are
examined, either by observing the current dividends paid to investors or by looking at cash flow
generated by the company's operations. Then, an estimated growth rate is combined with the
company's current value (stock price) and the company-generated cash flow or dividend payments to

9
determine the company's cost of equity. The Discounted Cash Flow cost of capital formula can be
3
stated as follows (Brigham and Ehrhardt, 431) :

Equation 1-2: DCF Cost of Equity using Dividends

k = D0 (1+g) / P
Where:
k : cost of capital
D0 : dividend per share paid in period 0 (the period immediately preceding the
current period)
g : expected long-term dividend growth rate
4

P : firm's current stock price

A firm with a current share price of $20, a recent dividend of $3.00 per share, and a growth rate of
5
4.0% as predicted by analysts, would accordingly have a cost of capital of 15.6% . Using this
approach, several assumptions are made, including that:
• the firm will continue to grow at the rate used in the formula – no faster or slower
• the firm's shares price properly values the firm and its expected cash flows as part of a
relatively efficient market
• the firm's dividend payout ratio is reflective of the company's earnings, and that the dividend
6
will continued unchanged into the future

This approach may be helpful in the case where those assumptions hold – it certainly makes for
an easy calculation. But what about firms who pay no dividends, or who pay dividends inconsistently
in frequency? Other firms may pay a "token" amount to appease stockholders. Indeed, as Shannon
Pratt points out, in these situations "theoretically, the growth component, g, will be larger than that of
an otherwise similar company that pays higher dividends" (112). In other words, stockholders are not
benefiting as directly and immediately as investors in other similar firms are benefiting. Any long-term
gains as a result of a firm's ability to grow faster from retaining cash would be theoretically realized at
a later time.

3
This formula is an algebraic re-writing of what is commonly known in the financial world as the
Gordon Growth model, which is used to determine the theoretical value of a firm's stock when the cost
of capital (as well as the dividend level, and growth rate is known. The Gordon Growth Model in its
original form is as follows: P = D0(1+g) / k-g
4
This is typically the growth rate as projected by company and/or industry analysts; often it will be
desirable to take an average of several analysts' growth rate projections for use in this model
5
[ 3 (1+.04) / 20 = 15.6% ]
6
The dividend payout ratio is defined as the percentage of a period's after-tax profits distributed by a
firm in the form of dividend payments to its stockholders.

10
 A common way to avoid this issue with dividend payments is to look at the total cash flow to equity
generated by the firm, regardless of the level of dividends actually paid out of this cash flow. This
approach takes a broader look at the cash flow situation of the firm and should fare better in firm-to-
firm comparisons. First, what is referred to as "Free Cash Flow" (FCF) for the firm is calculated. FCF
is typically calculated as follows (Pratt, 16):

Equation 1-3: FCF Calculation

Net Income After Tax
+ Non-cash charges (depreciation & amortization, deferred revenue/taxes)
- Capital Expenditures (necessary to support projected operations)
+ Increase in working capital from operations
- Decrease in long-term debt
-----------------------------------------------------------------------------------------------------
= Free Cash Flow to equity (FCF)

Next, the DCF equation presented earlier (Equation 1-2) is modified slightly to reflect Free Cash Flow
instead of dividend payments, and the value of the firm as a whole instead of looking at just a single
share price. With this modification, a better comparison can be made between similar firms with
differing dividend payment policies.

Equation 1-4: DCF Cost of Equity using FCF

k = FCF0 (1+g) / PMV
Where:
k : cost of capital

FCF0 : Free Cash Flow to equity in period 0 (the period immediately preceding the current
period) – see Equation 1-3
g : expected long-term dividend growth rate

PMV : present market value of the firm7

Now, the resulting cost of capital reflects all of the firm's cash flows to equity. In theory at some point
a firm should distribute most or all of its earnings to shareholders. Typically this point in time would
roughly coincide with a period of firm maturation and slower growth. This is, in fact, the ideal situation

7
This is commonly referred to as "total market capitalization". This can be calculated by multiplying
the current share price by the total number of shares outstanding. Alternatively, the Free Cash Flow
figure can be divided by the total number of shares outstanding to determine the FCF per share. This
figure could then be used (in place of FCF0) in conjunction with the individual share price (in place of
PMV) to complete the calculation.

11
in which this model would be applied. However, there are many situations in which a firm's growth is
predictably high in the short-term, but slower growth is just as equally predictable in the long-term. In
such cases a two or three stage Discounted Cash Flow calculation, with varying business stages and
8
growth rates, may be warranted . Regardless of whether a single-stage or multiple-stage model is
used, the output of the Discounted Cash Flow approach remains the same: the cost of capital is
determined by looking at company cash flow combined with growth rate projections.

Cost of Equity – the Capital Asset Pricing Model (CAPM) approach

Possibly the most common way of calculating a company's cost of equity is through use of the
Capital Asset Pricing Model, referred to commonly as "CAPM". The Capital Asset Pricing Model was
developed by William Sharpe in the early 1960's and although the model is not perfectly accepted by
all, it is by far the most broadly accepted in the academic and financial community in terms of cost of
equity calculation.

There are several assumptions that must apply in order to make use of CAPM in a given situation.
As Brigham and Ehrhardt state, the "primary conclusion of the CAPM is this: the relevant risk of an
individual stock is its contribution to the risk of a well-diversified portfolio". Embedded in their
statement is the assumption of minority ownership: that is, the assumption that a given investor is
piling money into a company's stock simply as one part of a well diversified portfolio. As a result, the
model makes no allowances for unsystematic risk, which was defined earlier as the risk level unrelated
to the market as a whole – the specific risk attributable to the firm in question or the firm's industry. In
addition to the significant assumption of ownership by minority investors with diversified portfolios, the
model also makes the following assumptions (Tesfatsion, 1):
• The company's stock is traded in a competitive, efficient market with no taxes or transactions
costs.
• There exists a risk-free return rate at which investors can freely borrow and lend
• Investors have a common time horizon for portfolio choice

With these assumptions now in place, the CAPM model is presented below (Brigham and
Ehrhardt, 230):

8
A multiple-stage DCF model allows one to calculate cost of capital for a company with several stages
of different rates of growth. For example, a firm may expect 20% growth for years 1-3, 10% growth for
years 4-5, and then 3% annual growth thereafter. This calculation is extremely complex when done
manually, but may be performed more practically may done through an iterative process using
Microsoft Excel or other spreadsheet/financial calculator. See Pratt (113-114) or Brigham & Ehrhardt
(433) for more information.

12
Equation 1-5: CAPM (traditional)
kce = krf + (RPm) B
Where:
kce : cost of equity for the firm

krf : risk-free rate

9

RPm : equity risk premium of the market as a whole

10

B : Beta coefficient for the company in question (see Equation 1-6)

Mechanically, the CAPM is doing several things. First, it identifies a "risk free rate" as a base marker
to start from. Secondly, it adds a premium that includes investors' expectation of what the market
would generate on average over that risk free rate. Finally, it takes into account the specific volatility
of the company in question relative to the comparison market through the Beta coefficient.

For illustrative purposes, consider the following example: A given firm is operating in an
environment where U.S. Treasury bonds are yielding 4.5% and where the market as a whole has
returned an average of 10.0% over the same time period (leading to an equity risk premium of 5.5%,
or the difference between the two values). The Beta for the firm has been calculated by regressing the
company's stock returns against the S&P 500 and has been determined to be 1.10. The cost of equity
11
for this firm would be 10.55% . The CAPM modifications that will be presented below are all
calculated in essentially with the same manner, except for some changes in the specific equation
terms included.

There has been a plethora of articles and debates through the years concerning CAPM, but
this last item mentioned – the Beta coefficient – is undoubtedly the most controversial. The CAPM
makes no provision for unsystematic risk because it assumes that is can be diversified away from; the
Beta coefficient, however, is the measure of the specific company's systematic risk. A Beta of 1.0
indicates perfect correlation with the comparison market; a Beta of 1.2 indicates a 20% greater degree
of movement than the market; a Beta of 0.80 indicates a 20% lesser degree of movement than the
market. The standard formula for Beta is as follows (Brigham and Ehrhardt, 221):

9
The risk-free rate is indicated by the returns on U.S. Treasury bonds. Brigham & Ehrhardt's text
mentions a ten or twenty year horizon (as does Pratt), Ehrhardt's Search for Value advocates only
short-term (90 day) rate usage, and Ross does not provide a strong opinion in his text other than to
suggest that the time periods for the risk-free rate and the equity risk premium should be similar.
10
The market equity risk premium is often expanded inside of the CAPM formula. It expanded form is
RPm = km - krf where km is the average return on the market over a given time period. Typically a
similar time period is used for km as the time period of the risk-free instrument referenced.
11
[ 4.5% + (5.5%)(1.10) = 10.55% ]

13
Equation 1-6: Market Beta calculation
B = ( StDevs / StDevm ) Corrsm
Where:
B : Beta coefficient for a given firm, indicating systematic risk

StDevs : Standard Deviation of the firm's stock returns over the observation period
StDevm : Standard Deviation of stock market returns over the observation period
Corrsm : Correlation of the firm's stock performance with market performance during
12 13
observation period

The implications behind this calculation are numerous. First of all, as the standard deviation of the
individual stock's returns increases, the systematic risk of that stock increases. Second, the higher the
correlation between the returns of the individual stock and the market, the higher the risk level of the
individual stock. It also indicates that a stock with a Beta of 1.0 would not only have to perfectly match
the market in the standard deviation of its returns, its returns would also have to correlate perfectly
with the market returns. This concept of Beta will be revisited later in the paper.

For a company whose stock is publicly traded, the CAPM may very well be a viable approach.
Whereas the DCF approach captures these multiple factors (risk, equity risk premium, etc.) into one
cost of equity number, the CAPM approach seeks to identify those components individually through
historical observation, and does not require the somewhat subjective growth projections demanded by
the DCF method. If the market within which the stock trades is stable and relatively predictable, then a
fairly accurate market risk premium can probably be determined with the CAPM approach. A stock
price history exists against which a market index may be regressed to determine a Beta. As we will
see later, however, the problems with the CAPM model arise when information is lacking (such as the
information deficiency that exists in a small firm environment), when the assumptions mentioned
earlier do not hold in the environment where it is being applied, and when returns do not correlate well
with a market index.

PART II: Cost of Capital in the Small Business World

12
The coefficient of correlation is calculated as follows: Cov(s,m) / [StDev(s) * StDev(m)] , where
Cov(s,m) is the covariance of the individual stock and market returns, StDev is standard deviation of
the stock (s) and market (m) returns.
13
Covariance, a required factor for calculating the coefficient of correlation needed to find beta, is
calculated as follows: Cov(s, m) = 1/n * (si - save) * (mi - mave) where the terms s i and mi are actual
values of the annual rates of return of an individual stock and the market respectively, taken over
several periods, n is the total number of values of mi and si used, and mave and save are the average
values of si and mi

14
Examining the Small Business World: Differences Between Large and Small Businesses

When one thinks of a "small business" or a "privately held business", they may think of their
Aunt Dottie's diner, their grandfather's machine shop, the empire of wildly-successful series of
children's books written by their neighbor, or think of what Goggle was just a few years ago before
their IPO. All of these would fall into that same category of a small privately held business, of course.
And yet one must admit that there are enormous differences between the companies, and that a
general stereotype of a small/private business does not exist that can completely encapsulate all of
their idiosyncrasies and yet separate them from the world of larger, publicly-held companies. Several
distinct differences between what for the purpose of this study signifies a large or small company
should be identified so as to come to terms with what exactly is meant by a "small business".

In the context of this study, a "small privately held business" (SPHB) will refer to a company which:
• Has an ownership structure consisting of 5 or fewer unrelated parties, or the ownership is
divided between any number of members of the same family (typically organized as an S-
14
Corporation or Limited Liability Company)
15
• Features majority ownership by U.S. citizen(s) or permanent resident(s)
• Is not traded on a public stock exchange, such as the NYSE, NASDAQ, AMEX, or a major
international exchange such as the London Stock Exchange
• Is not traded on secondary offering sources such as The Pink Sheets or other over-the-
counter clearinghouses
• Generates less than $100 million in annual total revenues
• Has no or limited financial information made available to the public through Dun &
Bradstreet or other information sources
Another way to group these differences would be to put them into categories of equity owner
differences, size differences, and informational differences. There are also other distinctives
mentioned frequently in the literature including business culture differences and capital structure
14
In some ways, the incorporation method of the firm is irrelevant to defining its status as a small or
large firm. However, the subchapter S-Corporation and Limited Liability Company structure have
certain tax characteristics that differentiate them from a typical C-Corporation (virtually all publicly-
traded firms are C-Corporations). The model proposed in this paper takes those taxation differences
into account.
15
This characteristic is included due to the behavioral components taken into account in the model
that is proposed herein. The assumption is made that desired behavioral outcomes of small business
ownership may differ significantly from one culture to another. It is true that there are multiple
"cultures" and differences even within individual nations, but an assumption of relative cultural
homogeneity within each of the categorizations of the model has been made. In addition, financial
and tax realities may differ for individuals not residing in the U.S., or businesses being operated
elsewhere. Such factors would unnecessarily complicate model formation.

15
differences. Collectively, these differences/distinctives in fact are the primary impetuses for this paper
and the FOCCM model that will be introduced later. For now, let us explore these differences in more
depth.

Equity Owner (Motivational) Differences

The manner in which businesses are operated and in which decisions within those firms are
made varies greatly depending on the ownership structure of the business. In virtually all publicly-
traded firms, all of the equity owners are minority owners, meaning that no single owner owns more
than 50% of the outstanding shares. As a result, no one shareholder is able to control the hiring and
firing of board members who in turn make major decisions on behalf of the shareholders. In a SPHB,
there is often a controlling member or a group of unified owners who make up an ownership
percentage large enough to control the business. As a result, the majority owner's very active,
personal connection to the business will bias the decision-making of the firm in the direction of their
personal preferences, even to the possible detriment of other investors. And so the equity owner
difference is the reality of different motivating factors behind their ownership of the firm.

In the most common case of one or two individuals owning and operating a small company,
the reality of their owner-manager profile creates no conflict in the short run. In fact, any "selfish"
decisions made in the course of the running of the company (i.e. providing themselves perquisites
through the business, giving themselves a bonus, etc.) are in fact in the positive interest of the equity
holders – they are the equity holders and those benefits make up a portion of their expected return!
The claim that owners' personal preferences drive decision-making is well supported in the literature.
The relevant question here is: what are these preferences of small firm owners? A review of journal
articles commenting on this topic reveals a wide range of opinions and findings. These findings about
SPHB preferences range from the importance of independence and flexibility, to income and "prestige"
considerations. Petty and Bygrave make the following comment in a discussion on traditional small
businesses:
The concept of wealth maximization has reduced meaning, since there are so many
exogenous considerations influencing the decisions, besides that of economics. Utility
maximization becomes the rule, rather than the conventional wisdom of wealth
maximization. The objective is not so much to create value, but to provide a
"preferred" life style within the community. Even for the "successful" lifestyle firms,
there is little in the way of value created beyond providing a living for the owner and
his or her family (93, emphasis added).

16
 A return to the classic idea of utility maximization would indeed appear to be the conceptual
solution to the broad base of desires and motivations that may drive a given business owner. In a
publicly traded company, it would be impossible for a company to generate returns in a customized
way that would meet each of its shareholders' needs – securing a spot at a well-known retirement
home for one, giving another a vehicle, provide a sense of security and belonging to a stockholder,
provide children's educational needs to another, provide prestige within the community by virtue of
stock ownership, provide a sense of independence to a stockholder, etc. Because that is not possible,
the natural way of compensating each owner for their stake within the company is through the
payment of monetary dividends. The equity owners (stockholders) in turn can use the funds in
whatever way they see fit to accomplish their goals. But in a SPHB it is often feasible for such
"returns" to be provided directly by the company to its owner, or to its few owners. In fact, the very
ownership of the business may provide a "return" of community prestige that the owner may be unable
to achieve in any other way.

It may be appropriate to break out returns to a small business owner in two categories: that of
pecuniary (monetary) returns and non-pecuniary returns. This lines up with McMahon and Stanger's
suggestion:
The next step is to reconsider what is meant by 'utility' and 'consumption.' Basically,
utility arises from anything which yields an investor satisfaction. This mostly comes
from consumption of goods and services. However, consumption can be defined more
widely to include access to non-pecuniary (sometimes referred to as psychological or
psychic) benefits, which might provide satisfaction to a particular investor (28).
It is important to note, however, that at least some degree of pecuniary returns are required before any
non-pecuniary returns can be expected, as a company would cease to exist at some point if it failed to
generate pecuniary returns (profits) over the long run. Once the company ceases to exist, then
obviously neither pecuniary nor non-pecuniary benefits will continue. McMahon and Stanger weigh in
on this issue as well: "It is important to note that the investor can use the maximized pecuniary return
provided to acquire whatever non-pecuniary benefits he or she might desire. That is to say, pecuniary
returns are traded for non-pecuniary benefits after the pecuniary returns have been received (29)."
Boyer and Roth also remind us of that same fact: "It is offered that businessmen are sacrificing
opportunity return in exchange for behavioral satisfaction. There is, however, a limit to the size of the
behavioral return. The overall cost of capital in the long-run cannot fall below the weighted cost of
debt, or the owner will soon experience financial difficulties by accepting projects that are debt
financed and on which he is unable to meet the interest payments." (9).

Barton Hamilton (2000) compares small businesses owners' pay and returns to what their
peers in industry are being paid. His study makes use of many variables in an attempt to identify a

17
proper comparison pool in the workforce by examining many factors including work
experience/background, level of education, race, and marital status. Despite the appropriateness of
the use of many questionable variables, through the course of his research he did discover that
undeniably, significant factors beyond just financial returns contributed to the entrepreneurs' choice to
enter self-employment. In fact, a notable amount of research on a number of owner-manager
motivators has been performed and cannot all be conveyed here in detail. More empirical research
needs to be performed, however, to better understand the exact trade-offs that occur between these
non-pecuniary benefits and pecuniary benefits. The non-pecuniary benefits mentioned repeatedly in
the literature have been summarized in Figure 2-A below:

Figure 2-A: Non-Pecuniary Returns to Small Business Owner-Managers

as identified in recent literature
Type of Non-Pecuniary
Relevant factors
Benefit
Being secure in self-
SECURE EMPLOYMENT / employment, owning an
FUTURE investment transferable to
others
Retention of control; "Being
CONTROL
your own boss"
Preferred Lifestyle /
LIFESTYLE
Independence
Contributing to the wider
community, community
COMMUNITY
prestige, benevolence to
employees, philanthropy
Authors
Boyer and Roth, McMahon and
Stanger
Borland, Boyer and Roth, Brigham
and Smith, Forsaith, Gallo, B.
Hamilton, R. Hamilton and Fox
(1998), McMahon & Stanger,
Pandey and Tewary, Perry,
Shapero, Timmons, Van Auken
Berger and Udell, Boyer and Roth,
Brigham and Smith, Forsaith, R.
Hamilton and Fox (1987),
Hutchinson, McMahon and Stanger
Boyer and Roth, McMahon and
Stanger

Determining the level of non-pecuniary returns required as compared to the pecuniary returns
desired is one of the objectives of the FOCCM model that will be presented later in this paper. It is
interesting, however, that the degree of real trade-off that occurs between the pecuniary and non-

18
pecuniary benefits received is difficult to measure. Indeed, Forsaith demonstrates there may indeed
be some dissonance between the benefits that owner-managers claim to desire and the benefits that
in judging by their actions are actually the most important to them:
The owner-managers' willingness to trade off financial return for the reduction of unsystematic
risk factors is significantly less than would be expected from the owners' reports of the
importance they place on these factors. That is, the owners report that these factors are
important to them but they appear to be unwilling to give up much return to mitigate these
risks. The findings provide evidence that the owner-managers studied derive utility from a
wide range of inter-related sources and that their objective functions include a consideration of
the exposure to unsystematic sources of risk and the pursuit of non-financial returns. Within
the limitations of the study, the findings give some support to the proposition that small
enterprise financial management is not underpinned by wealth-maximizing assumptions alone.
(Forsaith, 11-12)
A piece of information in Boyer and Roth's data (who created a model we will investigate later) reveals
some similar evidence: one of the supposed behavioral (non-pecuniary) rewards cited as highly
important by the interviewed executives was described as "I control my income by my actions" – a
statement you could say implies a high degree of pecuniary reward! Nonetheless, it must be admitted
that considerable more non-pecuniary benefits seem exist in the SPHB environment (as they are
hugely motivating factors for SPHB owners) and therefore must affect decision-making to some
degree.

Size Differences

By definition, SPHB's are smaller in size than large publicly-traded companies. However,
exactly what this means for managers, owners, and investors is not completely clear. There is much
debate as to the relationship between firm size and expected returns, between firm size and cost of
capital, and between firm size and capital structure. In the case of expected returns and cost of
capital, there is little disagreement that a negative correlation exists (that is, the smaller the firm, the
higher the expected return and the higher that firm's cost of capital). There are significant differences
of opinion concerning capital structure specifics, however, with some authors claiming that debt in a
small firm composes a smaller percentage of the capital structure, and other authors claiming that it
makes up a higher percentage. But for all three issues, the biggest point under debate is the
explanation of why and how these differences exist.

All three issues are closely related, of course, as both the expected return of equity holders
and the capital structure weights (percentage debt and equity funding the business) are both inputs

19
into the cost of capital calculation. Recall that we put forth the WACC equation which accounts for
those weights earlier in Equation 1-1. We will examine the debate surrounding small business capital
structure decisions shortly, but for now let us look at some of the issues surrounding this debate on the
relationship between size and expected returns.

Ibbotson (2001) reports beta and return information for decile portfolios from the major U.S.
stock exchanges. I have reported the information from three of the deciles below in Figure 2-B.

Figure 2-B: Partial listing of return information for selected U.S. major stock exchange decile portfolios
(Adapted from SSBI 2001)

Realized Estimated Size Premium

Arithmetic
Decile Return in Return in (Return in
Beta Mean
Portfolio Excess of Excess of Excess of
Return
Riskless Rate Riskless Rate CAPM)
1 (Large Caps) 0.91 12.06% 6.84% 7.03% -0.20%
5 (Mid Caps) 1.16 15.18% 9.95% 9.03% 0.93%
10 (Smallest) 1.42 20.90% 15.67% 11.05% 4.63%

It should be noted that the Beta (a measure of volatility/risk) increases as firm size decreases,
and that the return of smaller company stocks also increases as firm size decreases. In Ibbotson's
Yearbook a complete table of information with information for all ten deciles is shown, and the
movement in the entire data set is consistent with the trend shown here. Rather than exploring the
fundamental differences underlying these figures, most of the research has focused instead on how to
take this information and use it to determine an expected return on an investment of similar size. The
problem with this approach is the assumption that is made that a generic size premium can be used in
a cost of capital calculation for another firm of the same size. Standard & Poor's reports comparative
operating margins for twenty five portfolios, the first made up of the largest companies all the way
down to a portfolio of the smallest companies, and the information is presented nicely in Pratt's book
(102). They calculated a standard deviation of returns between the firms in the largest company
portfolio of 17.53%. The same statistic for the smallest portfolio (out of twenty five) is 28.86%, with the
figures in between trending consistently higher as the portfolio size examined became smaller. The
standard deviation of the small companies' operating margins was over 50% higher than that of large
companies, despite the smallest portfolio being made up of twice as many firms as the largest (169 in
the small company portfolio compared to 84 in the large company portfolio). With such volatility even
within the group of small firms, it would be difficult to make any blanket assumptions about any
particular small firm's returns based only on the group performance compared to large company
performance. In addition, the 169 firms in the Standard & Poor's study, and the data of the hundreds

20
of stocks making up the lowest decile of Ibbotson statistics, were spread across dozens of industries,
each with different demand, business cycles, levels of risk, and market characteristics. To take an
approach as Heaton (1998) does, with a simple small company risk premium over treasury bill returns
based on historical evidence, is insulting to the realities of the challenges of running a small business.
Such a flippant approach produces an equally flippant result – actual returns for a given small
company may fall in the general ballpark of the prediction in a very expansive portfolio, but from a
standpoint of cost of capital calculation for a specific firm, this approach is simply inadequate. "Ex
post" returns for a portfolio of small company stocks with extremely diverse financial and industry
structure are not good predictors of future returns of a specific company's stock.

Alberts and Archer (1973) also discovered some negative correlation between company size
and cost of equity, but mentioned reasons for this difference being due to industry specifics and lack of
owner diversification.

Brigham and Smith's 1967 work, performed early on when evidence of any correlation
(positive or negative) between company size and cost of equity/return measures was scarce,
confirmed evidence of a negative correlation. And yet, in his conclusion, even he alludes to behavioral
factors as the realities behind the numbers. Other models have been developed that attempt to
address some of the particularities related to firm size, and will be discussed later.

Business Culture Differences

Small businesses are not as homogeneous as larger ones are in terms of their culture. There
are certain things about business processes and expectations that are relatively standard in larger
enterprises. This standardization can manifest itself in a large company's approach to planning,
budgeting, training, pay levels, facilities, financial management, marketing image, and in many other
ways. It could be argued that this fact is largely driven by the reality that large companies employee
most of the employees in the U.S. and consequently are typically competing with other large
companies for employees. Expectations that employees and customers have of the enterprise are
high. Also, the company's very size indicates a certain degree of strength and maturity in its industry,
which most likely allows for more spending in areas that small firms may not find necessary or
possible.

A significant way that culture differences manifest themselves is in the approach to financial
management and decision-making. Gallo (2004) has done a fair amount of research on family-owned
small businesses, and demonstrates that those businesses are more labor intensive (as family equity

21
holders removed from the daily operations of the business tend to be skeptical about capital
investments that might reduce variable costs) than non-family owned businesses, even though the
comparison businesses may also be relatively small. Gallo extensively discusses the tension between
family control and profits and says that often those goals are at odds with one another (resulting from
capital structure decisions relating to capital investments – more capital structure issues will be
discussed below). In addition, he highlights the problem of the lesser prospects of future
competitiveness of the family-owned firm as result of their "peculiar" financial management resulting
from control concerns.

McMahon and Stanger (1990) reference a study that looked at small petroleum distributors,
tried to look at those owners' objectives, and then made assumptions about all small biz owners'
objectives. However, the author of this paper you have before you previously worked in the petroleum
distribution industry and from experience knows that the industry is dominated by many, small, family-
owned firms. Typically, these firms have few growth opportunities and may be owned by a second or
third generation family member. McMahon and Stanger report that net income was the important
objective of these owners, as would come to no surprise in a "sleepy" industry such as oil and
petroleum distribution. The point to be made here is this: the financial behavior and motivations of
individual SPHB's or even industries dominated by SPHB's is affected by the culture of the firm, which
is largely driven by the desired outcomes of the owner(s) of the business in question.

Capital Structure Differences

Because a business' cost of capital is large determined by its capital structure, it is important
to develop an understanding about the capital structures of SPHB's. This topic has been examined
extensively in the literature, with a wide range of findings resulting. Two contradictory views pervade
the literature: one set of researchers claim that small businesses in general carry a higher debt load
than large businesses; another group says that small businesses carry less debt in their capital
structure than do large businesses. Both groups reference use of internal funds as a strongly
preferred funding source.

Hamilton and Fox (1998) also find themselves among those who cite data showing that small
firms carrying higher debt levels, and they say this is due to those small businesses' non-equity
financing preferences. They reject any notion of a "supply problem" of finance for small businesses
existing in the market, but rather say that the demand is very high. Both the Forsaith and the Walker
and Petty's article show that small businesses use high levels of short-term debt financing (such as
operating credit lines), although Walker and Petty claim that they carry lower levels of debt in general.

22
R.W. Hutchinson speaks extensively about owner debt and equity preferences, and provides an in-
depth explanation as to why in virtually every situation, a small business owner will do whatever is
necessary to avoid additional equity issuance in order to avoid putting his control of the business in
jeopardy. This often means adding increasing debt to the business in order to fund growth without
adding to the ownership structure. Hutchinson does point out, however, that internal funds can still be
used to grow the business but does so with a disclaimer: "Here, however, [internal] equity capital still
has an opportunity cost. The owner-manager will only be willing to pursue this route in line with his
own attitude to risk, which if risk averse will result in a combination of investment and debt policy which
produces relatively low risk and hence a low return on equity" (235). In other words, if a small
businessman avoids equity issuance in order to avoid loss of control, his remaining option is to use
internal funds, or if internal funds are limited then he may fund the business through debt. If he does
not wish to add risk to the business, however, he will not issue debt and so as a result the growth of
his business and the profits it can generate may very well be limited.

Some authors in fact, such as Carpenter and Peterson and Lopez-Gracia, focus heavily on the
use of internal funds by small businesses. Carpenter and Peterson claim that internal funds are the
constraining factor to such firms although they provide no behavioral explanation for his claim. Their
empirical data all came from a 1982-1990 sample data set of manufacturing firms, and their conclusion
may have been appropriate for old cash-cow firms in a non-service industry (such as manufacturing),
but like the McMahon and Stanger article referenced earlier, created a "straw man" fallacy by throwing
up a very limited, restrictive sample and then applying his conclusion to the \world of small business as
a whole. Hutchinson's and Carpenter's views are in direct contradiction – Hutchinson says that
conservatism on the part of small business owners will lead them to issue debt, whereas Carpenter
claims that same attitude of conservatism will lead them to avoid debt! The source of this
contradiction can be explained by the sample used by Carpenter and Peterson already explained, in
combination with the fact that Hutchinson looked at small business owner behavior more holistically.
Hutchinson highlights the need for debt in small businesses depending on their life stage: "For most
owner-managed small firms, there is an additional emphasis on the need to finance expansion through
debt capital provided by banks because the use of equity in the early stages of development is limited
to an individual and/or his family's contributions" (233).

Berger and Udell (1998) show that small businesses within their sample were, on average,
financed by approximately 50% debt and 50% equity. In addition, they said that changes in capital
structure were due largely to accumulations in retained earnings, and not necessarily new equity
partners. Berger and Udell also demonstrate heavier use of debt in firms as "adolescent" businesses.

23
 Other authors put forth opposing findings. McConnell and Pettit (1984) say that small firms
have, in general, less debt as a percentage of their capital structure than do large firms. They look
through the lens of traditional financial theory to come to this conclusion, and claim this should be true
because:
1. small firms typically have lower marginal tax rates than larger firms, resulting in less of a
tax deduction benefit
2. small firms may have higher bankruptcy costs than large firms, increasing the risk of debt
3. small firms have difficulty "signaling" their health to creditors which in turns raises the
firm's cost of debt
Barton and Matthews (1989), on the other hand, question the application of such stoic financial theory
to the small business environment (as does Van Auken, 2005), and say that prior literature does not
sufficiently account for the strategic decisions in the operation of a small business that directly affect
the capital structure. They propose a variety of strategic choices that affect the small firm's capital
structure, including management goals, risk propensity of the owner-manager (including the realities of
personal debt guarantees on the part of the owners), and the preference for internal funds over
16
external funds with which to finance the business . Chaganti, Decarolis, and Deeds conclude that
"craftsmen entrepreneurs" (as they refer to trade-based businessmen with few managerial skills) will
make use of new equity before debt, but "managerial entrepreneurs" will prefer debt before equity.
Their "findings" fly directly in the face with the other research because they fail to consider control
issues in the small business environment.

In summary, however, it can be said that small and large firms have distinctly different
approaches to capital structure decisions. Small firm behavior in terms of debt and capital structure
seems to primarily be a function of the priorities and objectives of the owner(s).

Informational Differences

Little support should be needed for the assertion that financial and operational information
about SPHB's is very difficult to collect. Anyone who has ever attempted to gather such information
would agree readily. The difference in this matter when comparing large, publicly held businesses to
small, privately held ones is as dramatic as any mentioned here. The relationship between this SPHB
attribute difference and the other differences examined in this section is interesting, because it acts as
both a causal factor and result of the other differences. This can be well summarized in chart form:

16
Norton (1990) provides a good literature survey on this topic of small business capital structure
differences, and through use of a small business survey methodology also concludes that
management has the biggest influence on capital structure. He does not, however, provide an
explanation as to what drives these managers' decision-making.

24
 Figure 2-C: Relationship between Informational Differences and other
identified small / large business differences
Informational Differences
Informational Differences
compared to which Motivation
Relationship
attribute?
Equity Owner Differences In a SPHB you have one individual or
Equity Owner
RESULT in Informational small group of equity holders; no incentive
Motivational Differences
Differences to disclose information; no SEC regulation
The smaller the SPHB, the fewer the
Size Differences RESULT
people (internally and externally) who
in Informational Differences
have their hands on the numbers
Size Differences Put differently, a SPHB may find it difficult
Informational Differences
to grow and attract capital as a result of a
may CAUSE Size
desire to keep information close to the
Differences
vest
A tightly controlled, owner-managed small
Business Culture business will likely be less open with
Business Culture
Differences RESULT in employees about financial condition of the
Differences
Informational Differences firm, etc. The firm's finances are closely
linked to the owner's finances.
When no public stock or public debt
(SEC-regulated bonds, for example) has
Capital Structure been issued, then information reporting
Capital Structure
Differences RESULT in requirements are limited to only private
Differences
Informational Differences financing relationships (bank, other
primary creditors, the owner or small
group of owners, etc.)

Parties external to a SPHB will have significant difficulty accessing information about a firm,
particularly financial information, for the reasons shown above in Figure 2-C. One of the few sources
of information is Dun & Bradstreet, which even then just reports the information that is provided to
them by small businesses. It should be noted, however, that these informational differences will only
affect cost of capital from an internal perspective to the extent that a company's cost of debt increases
as a result of lack of complete and/or comparable information provided to outsiders. External parties'
attempts to calculate a company's cost of capital will be greatly affected by a lack of information.

25
 Also, remember that informational differences affect small firms in their relationship to other
small firms, as well. A firm will not be limited by the fact that it holds its financial results "close to the
vest" when attempting to calculate its cost of capital. But if for that process or for any other purpose
the firm wishes to examine industry competitors, it will encounter difficulty. Informational issues about
small firms is not just a problem outside of a firm, it is also a problem inside of an industry dominated
by small firms.

Adjusted Models for Small Business Differences

Finance scholars often struggle to explain market and "real-world" aberrations that do not hold
up against the theories inside their academic box. After all, much time and thought and analysis goes
into the formation of their models. Follow-up scholarly journal articles are written well into the future
either supporting or attempting to disprove the validity of any substantial idea put forth, and so the
academics pride themselves of the level of rigor in their analysis and subsequent critique.
Consequently, when a widely-accepted model such as the CAPM fails to hold true in certain
circumstances, there is often disbelief, or simple adjustments are created in order to fit a new problem
into an old mold. The problems with the traditional cost of equity models presented earlier when
applied to the small business environment are many, however, and those problems have not been lost
on all academics. A variety of models have been put forth in various attempts to capture the
differences between the large firm environments for which the traditional models have been designed,
and the small firm environment in which there are many more variables to be considered in a
calculation such as the cost of capital.

Variations of CAPM

As mentioned earlier, many finance researchers have examined historical data and
determined there needs to be a "size premium" taken into affect for small firms. But it was pointed out
that although a generally higher return level exists for small firms, this fact alone gives little guidance
to those trying to determine cost of capital for a small firm in an undiversified portfolio, as a small
business owner may hold. Heaton's "equity risk premium" mentioned earlier, which he applied to
small firms, is only one of dozens of similar suggestions that try to gross up large company returns by
adding a "small firm risk premium" to a point where the returns end up in the expected range for
smaller companies. But they do not take into account specific differences in the small business
environment and differences in the ownership structure. McMahon comments on the outstanding

26
questions of the CAPM for large enterprises, not to mention small enterprises with numerous special
considerations:
Because there is by no means universal agreement on the validity of the CAPM for large
business enterprises, let alone for small enterprises, it might be considered that such an ad
hoc extension to the CAPM as is described above [referring to a "small enterprise premium"
advocated by some] is not an appropriate means for making explicit the proposed liquidity,
diversification, transferability, flexibility, control, and accountability considerations in the
financial objective function of small enterprises. (McMahon 1995, 32).
And in his finance text published two years earlier, he drove home the point about the SPHB owner
diversification problem:
It is difficult to disregard the mounting evidence that as far as small enterprises are concerned,
the CAPM seems to be missing some vital explanatory factors which would account for the
relationship between return and risk in such concerns. The existence of the small firm effect
lends support for the possibility that these might include information, marketability and
transaction cost considerations. However, it does not shed light on the other important
deficiency of the CAPM in the context of small enterprise financial management—that contrary
to the underlying assumptions of the CAPM the typical small enterprise owner manager does
not hold a diversified wealth portfolio. (McMahon 1993, 115, emphasis added).
Consider the comments of a tax court judge, knowledgeable of CAPM, who made the following
comments as part of a business valuation case where a discount rate had been provided by an expert
witness based on the CAPM:
[The witness] followed the principles of CAPM and did not make any provision for [the subject
company's] unsystematic risk, based on the assumption that such risk was diversifiable…
[R]espondent and [the witness] have overlooked the difficulties in diversifying an investment in
a block of stock they argued is worth approximately $8.94 million. Construction of a diversified
portfolio that will eliminate most unsystematic risk requires from 10 to 20 securities of similar
value. See Brealey & Myers, supra at 137-139. Thus proper diversification of an investment
in the [the subject company] shares owned by petitioner, as valued by respondent, would
require a total capital investment of $89 million. We do not think the hypothetical buyer should
be limited only to a person or entity that has the means to invest $89 million in [subject
company] and a portfolio of nine other securities… (Pratt, 196, quoting from Estate of
Hendrickson v. Commissioner, T.C. Memo 1999-278, 78 T.C.M. (CCH) 322 (U.S. Tax Ct.
1999) (Oct 1999 J&L) (Oct 1999 BVU). ).

Although proven earlier in our discussion relating to size differences that a "small firm effect"
or "size premium" does indeed exist, hopefully it is clear that no single explanation exists for the
difference, and as such, a simple modification to the existing CAPM model based on differences

27
calculated on a large scale (hundreds of companies) will not prove to be an accurate predictor of
returns for a particular company. In addition, it has been demonstrated that the diversified portfolio
which the traditional CAPM demands is not always realistic or attainable by the small business owner.

One of the strengths of the CAPM, however, is its simplicity of use and its consideration of
numerous factors individually. Levy (1990) produced a significant work which both identified the
reason for the small firm effect (he says it existence is due to market segmentation related to the lack
of optimal investor portfolios, and the existence of transaction costs) and provided a modified version
of CAPM that takes into account this market segmentation reality. This Generalized Capital Asset
Pricing Model, or GCAPM, can be written as follows:

Equation 2-1: GCAPM

kce-pq = krf + (RPm) Bpq
Where:
kce : cost of equity for firm p in market segment q

krf : risk-free rate

RPmq : equity risk premium of market segment q

Bpq : Beta coefficient for firm p in market segment q

Levy's GCAPM model takes the same form as the traditional CAPM but restricts risk and return
information to a certain market segment, or industry. As unremarkable as this may seem at first
glance, it actually handles many of the issues present in a small business environment that are left
unaddressed in the traditional CAPM. McMahon's analysis of Levy's model, in fact, is quite good:
Unlike the CAPM, the GCAPM can address and accommodate the immobility of financial and
human capital invested in a typical small enterprise. The GCAPM would acknowledge that the
owner-manager of an unprofitable small enterprise may not be easily able to escape from it
and enter another pursuit due to the transaction costs involved, such as sale of the enterprise
at a distress price, brokering and legal fees, and relocation expenses. The GCAPM would also
recognize the possible existence and influence of incomplete information such as not knowing
the whereabouts of a buyer, not being aware of other opportunities available, and not having
the expertise required to become established in another field. (McMahon, 1993, 34).

The diversification problem pointed out by many authors (and tax court judges!) begins to be
addressed in Levy's model. Still, however, company-specific characteristics have no way of being
captured in Levy's GCAPM, but rather the model assumes that a company's unsystematic risk is

28
represented accurately by the unsystematic risk inherent to the broader industry within which the firm
operates.

Merger and acquisition valuation expert Frank Evans tackles this problem by proposing what
he terms a "Modified Capital Asset Pricing Model" (MCAPM), which adds a term to account for the
"small firm effect" mentioned earlier, and then an additional term to account for unsystematic risk
specific to the firm in question (Evans, 125):

Equation 2-2: MCAPM

kce = krf + (RPm) B + SCP + SCRP
Where:
kce : cost of equity for the firm

krf : risk-free rate

RPm : equity risk premium of the market as a whole

B : Beta coefficient for the company in question

SCP : "Small company" premium

SCRP : "Specific company" risk premium

And so although the model does address specific company (unsystematic) risk unlike many of the
other traditional and newer adjusted models, Evans advocates a fairly subjective approach to
determining the specific company risk premium in which various aspects of company structure (such
as marketing capacity, breadth of products and services, purchasing power, vendor relations, etc.) are
identified and a percentage attributed to each.

The problems inherent in this approach are readily apparent, however. First of all, there are
no standards by which to compare each of these issues, and no empirical data to suggest what size
adjustment should be made for each. Secondly, Evans' model makes use of a "small company
17
premium" which we identified earlier as questionable . One on hand Evans is using a heavily
empirical measure with no explanation (SCP), and then on the other hand is he utilizing a very
subjective measure with no empirical support (SCRP). These two inputs confuse the issue and could
lead to a calculated result with little empirical support and few company or benchmark comparisons.

Shannon Pratt, a respected valuation and cost of capital expert, presents virtually the identical
model as Evans, calling it instead the "Expanded CAPM Cost of Capital Formula". Pratt considers that

17
Evans references Ibbotson data for the appropriate portfolio decile to determine the "small company
premium.

29
formula a modification of a "Build-Up Model" he pulls from SSBI (125), which is essentially the
MCAPM/Expanded CAPM with the Beta coefficient excluded but with the addition of an industry risk
premium (Pratt, 76):

Equation 2-3: Ibbotson/Pratt "Build-Up" Cost of Equity Model

kce = krf + RPm + RPs + RPi + RPu
Where:
kce : cost of equity for the firm

krf : risk-free rate

RPm : equity risk premium of the market as a whole

RPs : size premium

18

RPi : industry risk premium (or a negative figure would represent an industry risk
19
discount)
RPu : company-specific risk premium (unsystematic risk)

In this model, Pratt clearly separates industry risk and company specific risk and describes company-
specific risk as that which is true unsystematic risk. This distinction is important, because in the same
way that one avoids risk in one industry by investing in others, another way to diversify from
investment in a stock is to simply invest in another firm, either in the same industry or a different
industry. Except in the case of oligopolies in small industries (where few companies would exist with
different risk levels than the broader market, but also are very similar to one another in size and
performance), it is unlikely that industry and company-specific risk will be identical from one firm to
another, or easily lumped together, as Levy attempts to do in his GCAPM. The Build-Up model
presented here does take such distinctions of industry-specific and company-specific risk into account,
although Pratt goes into no explanation whatsoever as to how RPu should or would be calculated,
simply deferring to valuation consultants' discretion.

Take note of what Pratt's says regarding one difference between the Build-Up and the
GCAPM/Expanded CAPM: "The value of the company-specific risk premium [used in the Expanded
CAPM], however, is likely to differ from that used in the build-up model, because some portion of the
company-specific risk may have been captured in beta." (76). His comment highlights the difficulty

18
Pratt also references Ibbotson data for the appropriate portfolio decile to determine the "small
company premium".
19
No clear guidance is given as to how the industry risk premium should be calculated, although Pratt
explains (126) that Ibbotson's Yearbook already referenced in this paper since 2001 has provided
industry data down to the three-digit SIC (Standard Industrial Classification Code) level. Pratt
suggests that through use of this data, the industry risk premium can be determined

30
involved with calculating the risk of an investment as diverse in nature as a small business, when
systematic and unsystematic risk both exist with imprecise measures of each in play.

Proxies for Beta in CAPM

As we have seen above, some academics and practitioners have made modifications to the
CAPM in an attempt to account for small firm differences. Others have suggested alternative or
substitute ways of calculating Beta that could be used within the normal CAPM structure to calculate
cost of capital in a small firm environment. Two of the most common proxies (substitutes) for a market
Beta are the pure play technique and the accounting beta.

The "pure play" method involves identifying a similar publicly traded company, preferably a
competitor, and using its published Beta as a proxy for the small business. This may work to some
degree if the SPHB actually operates within an industry with publicy-traded firms or competitors.
Otherwise, this method will not be possible.

The "accounting beta" method requires a set of time series data consisting of both a measure
20
of a company's earning power (such as Return on Assets ) and consisting of market index data for
that same time series. A regression analysis would be run against the data set to compute Beta
(replacing market returns in Equation 1-6 with these accounting returns). Accounting returns are a
somewhat decent predictor of company cash flow, and consequently, stock price. It should come as
no surprise then that there is widespread agreement on the association between accounting and
market Betas, although there are differences of opinion as to the degree of association between the
different Betas (Palliam, 339).

However, as Ralph Palliam points out, "neither the 'pure play' nor the 'accounting beta'
technique considers the many non-systematic risk factors that should be included in estimating the
cost of capital for a small business." (Palliam, 339).

Methods that combine Behavioral and Financial Return

Boyer and Roth did some significant work in 1976 in which they asserted that the cost of
equity in a small owner-managed firm was a function of both monetary return and behavioral reward.
Small business owners were surveyed and interviewed to determine to what degree they were willing

20
Could be calculated as EBIT / Total Assets; EBIT represents earnings before interest and taxes.

31
to sacrifice monetary reward in order to retain behavioral rewards (consisting of such things as shown
in Figure 2-A earlier). This was Boyer and Roth's conclusion:

The survey responses strongly indicate that the cost of equity capital for a small business is a
function not only of the required rate of return of a pecuniary nature, but also of returns
consisting only of psychological rewards or those behavioral in nature. The cost of equity is
dependent on factors which motivate the owners to forego opportunity return for behavioral
satisfaction. If an opportunity return–the ability to earn more on an equally risky investment
outside the firm—exists, which was the case in many instances, rational behavior would
suggest that behavioral rewards must constitute the difference (7).

Equation 2-4: Boyer's Cost of Equity formula, considering financial and non-financial benefits
kce = ROEo – ROEb
Where:
kce : cost of equity for the firm

ROEo : opportunity return on owner's investment

ROEb : return of a non-monetary or behavioral nature

Boyer and Roth explain that this cost of equity calculation could not be less than zero, since the
"overall cost of capital cannot fall below the weighted cost of debt" (7). Accordingly, then, there is a
limit on the degree of behavioral return an owner can achieve over the long run, otherwise the owner
at some point would fail to meet debt service payments. The value in this model is that it recognizes
that the desiring of behavioral returns may result in a reduction of opportunity return. The authors say
the exact level of reduction should be determined by surveying the business owners to determine
which behavioral factors they are willing to sacrifice return for, and how much for each factor they are
willing to sacrifice up to an overall cap. Rather than taking the questionable, difficult-to-measure
returns of non-monetary benefits as a challenge to the cost of capital issue and one that adds more
risk (and thus more cost), Boyer and Roth see it as an issue which reduces the demand on the
company to produce as high of a profit level as an owner with lesser non-monetary reward desires
may have demanded.

Ralph Palliam, mentioned earlier for his suggested alternate Beta calculation methods,
realizes the significant shortfalls inherent to the CAPM as it pertained to the small business
environment. He advocates use of an Analytical Hierarchical Process (AHP) model which has been
put forth in literature in the past focused specifically on complex decision-making in non-financial
arenas. Palliam is to be commended for his "out of the box" thinking with this approach, and
admittedly the model does allow for a calculation based on the many subjective and behavioral issues

32
relating to business operations along with financial health considerations. Unfortunately, it requires
the user to first identify the cost for several "levels" of risk, and then requires one to identify the risk
level for each of the functional areas considered for the company, as well as the "intensity" or
importance of each area. The combination of these three very subjective measures (pre-defined risk
cost percentages, risk level of each area of the company's operations, and importance of each area of
the company's operations) could lead you to a calculation of a company's cost of equity (and
ultimately, cost of capital) that may have little or nothing to do with the actual hard return dollars
demanded or expected by the owner(s).

Problems with the Traditional and Adjusted Models

Despite the good intentions of the finance scholars who developed these models we have
examined, they still fail to fully consider the range of exceptions that arise in small business financial
environment. Miller and Modigliani's model, although considered a breakthrough in the world of
finance, contained such restrictive assumptions as to entirely exclude small and/or privately held
businesses from consideration. Cheung, Forsaith, Boyer and Roth, and Palliam are among just a few
of the many authors that point out the failure of those traditional models in the small business
environment. And yet many of the adjusted models explained so far are built in some way on the
assumptions of the M&M model.

Behavioral/motivational issues along with unique issues specific to each small business have
been identified as the key factors preventing use of the traditional models. Several "adjusted" models
have been examined that have attempted to move beyond traditional models by taking these
behavioral issues into account, but the bulk of them still advocate a building on to the CAPM. Few if
any authors have advocated anything other than a "one size fits" strategy, even thought their strategy
may be a unique one to them. In fact, throughout this paper criticism and shortfalls in several of the
models have been identified. Problems still remain with the adjusted models examined earlier,
however, and warrant mention before a new model is proposed:
• Most of the modified approaches attempt to calculate a universal cost of capital for the
company that both explains their internal behavior (investment selection, etc.) as well
as provide an outside practitioner with an appropriate discount rate for valuation
purposes, etc.
• Most of the authors proposing adjusted models, despite mentioning the problem of
diversification on the part of small business owners, still imply that diversification is an
option by using broad market comparisons and market risk premiums in their models

33
 • Their view of "risk and return" from an external perspective leads them to build models
that assume that a small firm's cost of capital is necessarily higher than a larger firm's
by use of models that add size premiums to a traditional calculation. They are
undoubtedly influenced by the "small firm effect" documented in the literature and may
feel the need for their model to fall in line with what has proven to be true in the
market, even though the large majority of small firms are not publicly traded and are
not even included in the comparable data that reveals that "small firm effect". With
that considered, they are then only really building a model that may help in cost of
capital calculation for smaller publicy-traded firms.
• The adjusted models that do attempt to identify what true utility is for the small
firm owner still convert that measure into an objective cost premium, rather
than allowing it to instead affect their overall approach to the calculation

These authors' rejection of the traditional models' approach is ironic, because in the process
of trying to present a model that takes into account all of the peculiarities of a small business, they
each still only present one approach that is supposedly the "silver bullet". As just described, in many
cases they are still failing to address the very unique attributes of small business ownership and
management that they identify! It is clear that different industries, small business sizes, timeframes,
and owner profiles pervade the research samples of the scholarly articles on this topic and as of yet
no one has attempted to classify significant differences between small firms and then to direct
cost of capital/cost of equity model selection accordingly.

PART III: The Firm Orientation Cost of Capital (FOCCM)

Small Business Profiles in FOCCM

Recall the banker introduced in the illustration early in Part I. Let us suppose that he had
actually started a bank that specialized in consumer loans – or even more specifically, vehicle loans.
He enjoyed his career, and was able to make use of knowledge and skills developed in his past career
in automobile sales. Because the banker was formerly involved in automobile sales, understands the
business, and really only has access to people looking for automobile loans, he will continue to make
those loans to others when other lenders or investors may not. The rate of interest that new borrowers
may be able to pay could drop over time for various economic reasons, and yet under these restrictive
circumstances the lender will continue to make those loan, as he lacks what he considers to be
desirable alternative uses of his funds.

34
 I hope that the analogy to certain small business owners is readily apparent. A small business
owner (Patricia) that starts a printing company because it is what she knows and loves is unlikely to
quickly withdraw her invested funds just because her business return for the year is a percent or two
below what was expected. Much of her return is non-pecuniary and so his investment decision is not
purely empirical – it is fact heavily weighted by behavioral realities. Therefore, Patricia's company's
cost of capital is undeniably lower than it would be in a situation where the majority investor has few
personal, emotional, experiential, and vocational ties to the business. Patricia's experience not only
narrows her market of comparison investments, one could also argue that her experience and long-
term commitment to the business even reduces her risk level to some extent. Over time, if she is able
to grow the company, attract customers and competent employees, she will likely find that the
business is a source of monetary and "non-monetary" returns for her. She is willing to take on some
risk to continue to grow the company (and her wealth!) but still highly values the independence and
control she exerts over the company

On the other hand, imagine an entrepreneur (Matt) who starts a web-based technology
company in order to capture an emerging business opportunity, quickly grow market share, and rapidly
take the company to an IPO. Matt will have a different level of risk tolerance, a different type of
commitment, and will likely have multiple investment alternatives such as another business idea, real
estate investments, or stock market or mutual fund investing. The point here is that the profile of this
individual differs, and as a result the required return is different – his motivation is more closely related
to financial return than to other lifestyle decisions. Matt's decision to start a business was based on
opportunism, a relatively easy exit strategy, and the financial returns that a successful venture would
bring about.

Swinging back down the other extreme from the high tech entrepreneur, we find an owner of a
small plumbing company (John) who has operated his business for years by doing what he loves
every day, like the printing company operator. There is a difference, however. John has half a dozen
employees – four plumbers who call on customers (as he does as well for part of each day), his
daughter-in-law who answers phones and keeps the book current, and one shop employee that keeps
the inventory, trucks, and tools in good shape. John has little desire to grow the business, but has
enjoyed the relatively good income the business has provided him with over the last twenty years. He
looks forward to his retirement in just a few years, when he expects to turn the business over to one of
his sons. He can increase his community involvement even further at that point, and he knows that
will bring him much satisfaction.

35
 Authors who have worked on the adjusted models examined so far have used a variety of
company data sample sets, including sets that would encompass the entire range of firms as
described above, and others that may contain exclusively one of those types. The chart below
formalizes these small business profiles, taking into account findings from the researched examined
thus far:

Figure 3-A: Detailed description of three proposed small business profiles

Small Firm Orientation Profile

Small
Business Diagnostic PROFILE #3:
PROFILE #1: PROFILE #2:
Differentiating Question "Fast Track"
Aging Small Vibrant, Enduring
Factor Entrepreneurial
Business Small Business
Venture
- Rapid sales growth
- Strong sales growth
- Survival - Near-term IPO
Equity Owner What is considered that is profitable along
- Continue current - High level of
by the owner(s) to the way
Motivations - level of profits income/return achieved
be "financial - Consistent growth in
Financial - Maintain personal through eventual IPO
success"? business value
income and growth of stock
- Grow personal income
value
- Continue provision - Enjoys achievement,
What other goal (or - Idea of
of employment for independence and
Equity Owner utility measures) success/industry
owner and others, control
does the owner dominance
Motivations - family - Anticipates
have for the firm to - Still manifested
Behavioral - Independence and development of strong
accomplish for him primarily or entirely in
control personal/company
or her? financial results
- Community standing reputation

- probably < $10 Could be anywhere from

How large (in - $5 to $100 million in
million in annual $0 to $100 million in
revenue, assets, annual revenue
Firm Size revenue sales, characterized not
employees) is the - could have dozens, or
- less than 100 by current size but by
firm? hundreds of employees
employees size potential

Possibly a few or larger

How much is debt Probably 1-3 owners,
Capital group of deep-pocketed
relied on by the or numerous family Debt utilized for growth;
owners; anticipates
Structure firm? Few or many members as owners; Probably 1-3 owners
selling to another group
owners? little debt utilized
or an IPO

Changing, risk-taking
How much is the
Owner runs the show; Empowered workers; environment; focus on
business controlled
Business few key employees; owners delegating relatively quick exit;
by the owners?
policies of all kinds significant management prestige and reputation
Culture How structured is
developed and responsibilities; basic will be accomplished by
the firm and its
enforced informally systems put in place success and potential
operations?
exit strategy
Little information Information made
Little or no information
Is information available about the available to potential
Informational available about the
readily available company; may compete investors as an IPO
company; operates in
Differences about the firm and with a product line of a approaches; some
an industry with no
its competitors? publicly-traded firm, or market comparables to
public firms
with a smaller public firm the firm exist

36
Objectives and Implications of the FOCCM

It should be clear that the wide-ranging profiles of small businesses and their owners that exist
in the economy, such as the ones described above, cannot be lumped into just one traditional or
updated/adjusted model for cost of capital calculation. It should also be obvious that the cost of
capital, from each of these owner's perspectives, is likely very different from that which potential
suitors or other external parties would consider it to be for the firm.

The Firm Orientation Cost of Capital Model (FOCCM) addresses these differences within the
small business world. Specifically, the FOCCM seeks to accomplish these objectives:
1. Take into account the business owner's desire or ability, or lack of desire or
ability, to diversify investments
2. Reflect the level of return the different types of small business owners require
3. Look at the business owner's monetary return from an income standpoint, taking
into consideration salary, dividend payments, and other costs covered by the
company
4. Identify the cost of capital for the firm from an internal perspective, so that the
calculated cost of capital is appropriate for internal project/investment decisions
based on the reality of the owner's objectives, which include both financial and
21
behavioral objectives

Now that the objectives of the model have been presented, a couple of things should be said
about the three profiles generated above. First of all, understand that these are of course
generalizations, generated from the realities of small businesses examined in the literature referenced
throughout this paper. Remember that the improvement in this approach is that we are
generalizing at a much lower level (putting small businesses into separate classes or profiles),
rather than committing the large-scale error that even adjusted models make –putting all small
businesses into the same category and simply throwing on a "risk premium" to account for
differences.

Second, it is admitted that not all small businesses of course will fall perfectly into one of these
profiles. These profiles are meant to guide the reader to the column that most closely fits the firm in
question. Also, it is suggested that no small business can operate for long periods of time outside of

21
Note that the model may or may not lead you to calculation of a cost of capital that would be
appropriate for external parties' use. Throughout this paper, our focus has been on finding the true
cost of capital for a firm under its current ownership structure and existing behavioral realities.
Although this approach is in conflict with what Pratt, Ibbotson and others say (that cost of capital is a
function of the investment, not the investor), it more accurately explains behavior and decision-making
within a firm where other equity investments are not an option (or at least a desired one) for the owner.

37
one of these categories. It is also asserted that businesses may shift from one profile to another from
time to time. A wildly optimistic entrepreneur with thoughts and hopes of an IPO, but little true passion
about their product may over time develop a really enjoyment of the business or industry, and may
move more towards the center profile, where "behavioral" return is more important, and where he
decides to keep his company privately-held over the long term and enjoy a mix of financial and
behavioral return. More than anything, the model returns to the true definition of utility as explained
earlier and seeks to consider all sides of that concept in the cost of capital calculation from an "inside-
the-firm" perspective.

Financial / Rate of Return Implications

Building on the profiles that have been put forth above, in Figure 3-B the specific financial
characteristics of each of those owners are more succinctly identified. The reader will notice that on
the last row of the chart, proposed calculation methods are shown. These methods are part of the
FOCCM model and will be explained in detail in the next section.

Figure 3-B: Financial Characteristics of FOCCM Profile Business Owners

Small Firm Orientation Profile

Financial PROFILE #1: PROFILE #2: PROFILE #3:
Characteristic "Aging" Small Vibrant, Enduring "Fast Track"
Business Small Business Entrepreneurial Venture

Dramatic increase in
Primary Expected
Owner's Total company value (at time of
Source of Monetary Owner's Total Income
Income exit through IPO or sale
Returns
of business)

Risk Tolerance Level Low Medium High

Retained Earnings,
Preferred Financing Retained Earnings, Retained Earnings,
Potentially Significant
Methods Some Debt Equity, Some Debt
Debt

"Acceptable" Rate of High rate of return

Owner's Current Increase in Owner's
Return Comparison compared to other public
Total Income Current Total Income
Benchmark market

38
Behavioral
Considerations Many Some Few or None
Affecting Return

Proposed Calculation FOCCM Perpetual FOCCM Growing FOCCM Exit Target /

Method ROE ROE Industry Framework

It should be generally accepted, that due to the return expectations and level of risk tolerance
indicated by these profiles, the owners' actual returns may vary from their expected returns. Indeed, in
the absence of a diversified portfolio they are already exposing themselves to higher risk than others.
Look at the relative difference in circumstances between these three different profiles in Figure 3-C
below:

Figure 3-C: Owners' tolerated/expected return vs. actual possible return outcomes

39
Note the following about the relative returns comparison chart above:
• It allows for the possibility that the optimism of profile 2 and particularly profile 3 owners in
their search for very strong returns will be realized as we cannot generally say this will never
happen – it often does, and a new hot company is born
• It asserts that owner expectations in general are optimistic, relative to the situation they could
find themselves in
• It demonstrates the reality that the "Profile #3" firm that has been described thus far, with its
propensity for higher debt levels and desire for higher returns, is in the most risky scenario,
with a wide range of possible returns
The purpose of this graph is not to project a range of rates of return for any of these types of small
businesses, but rather to show the relative comparison of what might be expected between the various
firm profiles. The owner of an "Aging" Small Business, because one of its primary objectives is merely
survival, may tolerate very low return levels, even though the goal would be to maintain the current
level. Such a business owner will not "jump ship" just because returns were low (even very low) in a
given year due to the high degree of behavioral factors involved in his ownership and management of
his business. The owner of the "Vibrant" profile small business also has some degree of tolerance for
low returns, but in that case the owner is also betting on growth in returns over time, and if the
business does not realize that potential, he will either swing left or pursue other options – possibly
employment for another firm or even the founding of a new small business. The "Fast Track" profile
owner will behave similarly to the "Vibrant" business owner, except that his return expectations are
much higher and with too much failure under circumstances of potentially very significant losses, few
behavioral factors exist to prevent him from leaving the business.

Cost of Capital Calculation with the FOCCM Model

After a profile has been determined to be the best fit for a company in question, the practitioner will
next perform a calculation. The three FOCCM profiles were linked at the bottom of Figure 3-B to
specific calculation methods suggested by the FOCCM model. Each calculation method will now be
examined in detail, beginning with the method for Profile #1, moving to the other extreme for Profile
#3, and then landing back in Profile #2, the middle case.

Profile #1: "FOCCM Perpetual ROE"

The method suggested for us for Profile #1 is the "FOCCM Perpetual Return on Equity". This
approach makes the assumption that the current business owner, due to the high level of importance

40
he assigns to behavioral factors, simply wants his total income to continue at the level it has been. It
also assumes he will be willing to sacrifice that income to some extent to maintain those behavioral
factors.

In order to determine FOCCM Perpetual ROE, we must first define what is meant by "Total
income" to a small business owner. It is proposed that Total Income should actually be modified and
then referred to as "Minimum Total Income". The question here is "What is the total annual return
required by the business owner in order to convince him to continue operating the business?" For a
business owner of this profile class, this is his current total income less any return he is willing to
sacrifice in order to maintain his behavioral rewards (these behavioral rewards were well-documented
earlier in this paper, and could range from community prestige to independence). The FOCCM
Minimum Total Income calculation, then, is proposed as follows:

Equation 3-1: FOCCM Minimum Total Income

22
Business Net Income After Tax
23
- Year's Profits Retained in the Business [A]
+ Salary Paid to Owner by the Business
24
+ Value of Owner's Perquisites Provided by the Business
-----------------------------------------------------------------------------------------------------
= FOCCM Total Income
25
- Profits Willing to be Sacrificed in Order to Maintain Behavioral Rewards [B]
-----------------------------------------------------------------------------------------------------
= FOCCM Minimum Total Income

22
Net Income After Tax is used here due to the fact that tax affects of small businesses on their
owners are far-reaching and hard to generalize. In addition, it is assumed that the business bears the
owner's tax burden since the owner's finances are likely intertwined with the business. With those
assumptions in place, the only relevant number to examine is Net Income After Tax.
23
The assumption made here is that in a stable, slow growth business (Profile #1) there is sufficient
cash flow to meet ongoing needs, and because growth is not an objective then theoretically all Net
Profits may be withdrawn in the form of dividend payments; however it is realized that the owner may
not withdraw all Net Profits in anticipation of future costs or needs for cash. Owners of Profile #2
businesses may also require that more profits be retained to accomplish their growth goals.
24
This could include a company-provided vehicle, items used mutually for business and personal
reasons, etc. Anything that provides at least some degree of personal benefit to the owner that would
not be automatically provided if the owner pursued employment in the same field for another business
should be considered.
25
No one can determine this figure except for the business owner themselves. They could be
questioned on this topic in percentage terms, but it must be converted to a dollar amount for this
calculation.

41
In this equation, the assumption is made that the current level of Total Income to the owner can
continue perpetually without any reduction in behavioral reward. If this is indeed the case, then last
calculation would have no affect, and "Minimum Total Income" would be the same as "Total Income".

Note that the larger the value of [B], the lower the "Minimum Total Income" and therefore the lower the
value of ke1. It is critical to understand, however, that the possibility of profit sacrificing for the sake of
continued behavioral rewards in this firm can continue indefinitely, assuming that the value of [A] is
greater than the value of [B]. If [A] is less than [B], then company reserve funds (previous year's
retained earnings) must be accessed in order to continue to provide the owner with the minimum level
of return he expects. If there are no reserve funds and if [B] is greater than [A], the continuation of the
26
business could be at stake .

After the Minimum Total Income figure is derived, then FOCCM Perpetual ROE would be calculated as
follows:

Equation 3-2: FOCCM Perpetual ROE method

k1 = wd1kd1 + wd3k e3 where ke1 = [ FMTI / LV ]

Where:
k1 : cost of capital for the Profile 1 firm (Aging Small Business)

wd1 : weight (percentage) of business funded by debt

kd1 : weighted average cost of debt

27

we1 : weight (percentage) of business funded by owner's equity

ke1 : cost of equity for the Profile 1 firm (Aging Small Business)

FMTI : FOCCM Minimum Total Income (from Equation 3-1)

LV : Liquidation value of the firm

Some immediate questions arise in the mind of the reader upon examining this equation. It should
first be stated that for a business of this type, the FOCCM model proposes that the owner's Total
Income (calculated in Equation 3-1 and represented by FTI in this equation), when combined with the
liquidation value of the firm, is the most accurate measure of return from within the firm. This

26
In this type of environment, this could very easily occur as the owner's financial conservatism may
have prevented them from investing in capital improvements and expansion plans that would have
helped to improve the firm's chances of survival
27
Note that no interest tax deductibility is accounted for here, as it was already included in the Net
Income After Tax calculation in Equation 3-1. Because this analysis is done from an internal cost of
capital perspective, there is no value in stripping net income of financing effects.

42
divisional calculation generates a Return on Equity-type number (from which the "Perpetual ROE"
method derives its name) with the denominator of the owner's equity value represented by liquidation
value. Liquidation value is used because in the mind of the small business owner, this is the value
they know they could get if they absolutely had to exit the firm. Book equity would certainly be a very
conservative measure to use, but probably too conservative for a business this old and established.
However, determining a market value may be extremely difficult and really has no part in the owner's
calculation of what the return on his investment actually is.

Profile #3: "FOCCM Exit Target/Industry Framework"

Next let us move to the other extreme – Profile #3. Remember that in this scenario, the owner
is highly focused on an exit strategy via an Initial Public Offering (IPO) or sale to some other group.
We identified earlier in Figure 3-B that his gaze is on the market and he is not necessarily looking back
on his own performance and simply wanting to continue that performance level or just slightly
improving it. And so, the "FOCCM Exit Target/Industry Framework" is the suggested calculation in this
scenario. In this case, the business' cost of debt will be considered and weighed. For the cost of
equity component, however, the figure will be determined by starting with a "target" rate of return as
specified by the entrepreneur, and then combing that with an industry risk factor.

Equation 3-3: FOCCM Exit Target/Industry Framework

k3 = wd3kd3(1-T) + we3k e3 where ke3 = [ kt (Ri) ]

Where:
k3 : cost of capital for the Profile 3 (Fast Track Entrepreneur-style) firm

wd3 : weight (percentage) of business funded by debt

kd3 : weighted average cost of debt

28
T : tax rate for the firm
we3 : weight (percentage) of business funded by owner's equity

ke3 : cost of equity for the Profile 3 (Fast Track Entrepreneur-style) firm

kt : owner's target rate of return on his original investment at hopeful exit date
29

Ri : industry risk factor

28
Note that this may be very low or non-existent if the firm is not realizing positive net income yet.
Also, often times such fast growing entrepreneurial ventures will be structured differently than other
small businesses and so the assumption that the owner's finances will be intertwined with the
business as was done with Profile #1 would not be as safe of an assumption
29
This rate is expressed in annual terms, not in terms of the total holding period.

43
The assumption here is that investment decisions must be made throughout the course of this firm's
operation that leads it in the direction of an expected return at the very least equal to the
founder/owner's target rate of return upon exit. It should also be noted that if the hopeful exit date
passes without realization of the owner's hopes, the owner may close the business, reorganize, or
look for alternative investments, rendering this calculation irrelevant. This calculation assumes
optimistic progression towards the owner's exit strategy goal. It also assumes that the owner initially
took into account the risk-free rate as well as alternate market investments in determination of his
30
"target" rate of return .

The industry risk factor is accommodates for additional risk that the entrepreneur may have
not accounted for initially within the industry in which he is operating and wishes to enter in the public
markets. The risk level of the owner's industry may have changed since they originally set their target
rate of return level (presumably when the company was started), and so this factor accounts for that
possibility. This factor is multiplicative in nature and so it would be recommended that an industry beta
for the industry in which this firm would land in the public market would be utilized. If no such figure
exists, then a subjective estimate could be used or the owner could attempt to increase his target rate
of return in order to account for those industry changes.

The point of this model is to recognize that with such a hopeful exit strategy in mind, the cost
of capital is essentially the owner's target return (upon exit) combined with the cost of debt being
utilized.

Profile #2: "FOCCM Growing ROE"

But what about the business that lands in Profile #2? This business owner is excited about
the present and the future of their company. He experiences a significant degree of behavioral reward
from his business but expects continual company growth and increasing levels of income to accrue to
him year after year.

Because this business owner is focused on developing his business over the long-run, and
with no deliberately planned exit strategy on the table, his financial arrangement is similar to that of the
owner of a Profile #1 company. As such, we will use a modified version of the model developed for
the Profile #1 company. The main difference, then, is that degree to which a Profile #2 business

30
Any changes in the risk-free rate or alternate investment options after the initial investment decision
should be reflected in a change in the owner's target rate of return.

44
owner is willing to sacrifice profits for behavioral rewards should be less. In addition, the cost of equity
calculation must take into account desired growth from the current base of income he is experiencing,
as this business owner's objectives land him somewhere in between the models for Profile #1 and
Profile #3.

For the FOCCM Growing ROE model, we begin with the concept of "FOCCM Total Income",
from the middle of Equation 3-1. We then determine:

Equation 3-4: FOCCM Minimum Total Income, Modified for Profile #2

FOCCM Total Income (from Equation 3-1)

+ 1-Year Desired Income Growth ($) [C]
-----------------------------------------------------------------------------------------------------
= FOCCM Total Growth Income Expected
- Profits Willing to be Sacrificed in Order to Maintain Behavioral Rewards [D]
-----------------------------------------------------------------------------------------------------
= FOCCM Minimum Total Income, Modified for Profile #2

The main difference between Equation 3-4 and the Equation 3-1 explained earlier in the "Perpetual
ROE" model is that for Profile #2 owners who desire and expect growth, we must first increase the
total income by the level of income growth desired in the coming year. We also deduct off profits the
owner determines he is willing to sacrifice in order to maintain behavioral rewards. A key rule of this
model, however, is that [D] MUST NOT EXCEED [C]. In other words, the assumption is made that
this business owner is so committed to income, and the growth of that income, that his behavioral
rewards requirements will never lead to his income decreasing. It may, however, result in his personal
income remaining the same as business decisions are made which perfectly trade off profits for
behavioral rewards. But those trade-offs will never result in a net decrease in annual income. The
result of equation 3-4, then is inputted into this final equation to calculate the cost of capital using the
"FOCCM Growing ROE" method:

Equation 3-5: FOCCM Growing ROE method

k2 = wd2kd2 + we2k e2 where ke2 = [ FMTI2 / EMV ]

Where:
k2 : cost of capital for the Profile 2 firm (Vibrant, Enduring Small Business)

wd2 : weight (percentage) of business funded by debt

45
 kd2 : weighted average cost of debt
31

we2 : weight (percentage) of business funded by owner's (book) equity

ke2 : cost of equity for the Profile 1 firm (Vibrant, Enduring Small Business)

FMTI2 : FOCCM Minimum Total Income, Modified for Profile #2 (from Equation 3-4)
EMV : estimate (conservative) of the market value of the firm

You will note that this equation is very similar to equation 3-2 used for the Profile #1 firm. The
differences in the calculation of FMTI were detailed in Equation 3-4 and already discussed. The other
noteworthy change is that of the last term, EMV. The assumption being made here is that in the much
more stable business environment, some value could be assessed to the business beyond just its raw
liquidation value. It is important that this be an estimate the owner agrees on and believes in, because
we are assuming that he compares his expectations of annual income with the prospects of the sale of
his firm (even though that is not an overriding motive). And so regardless of whether the EMV as
determined by the Profile #2 owner is accurate or not, it is important to understand that their personal
income requirements may be largely driven by that perceived business value. Again, it is proposed
that a very conservative measure (such as two years' profits, for example) be used.

Note that although we used a modified version of the model developed for the Profile #1
company, it may be appropriate in many cases to use the Profile #3 (Exit Strategy/Industry
Framework) model, inputting a future target rate of return rather than an "exit" rate of return.
Alternatively, you could calculate the Profile #2 owner's cost of equity using both models (FOCCM
Perpetual ROE the Exit Strategy/Industry Framework) and let each figure weigh into determining the
overall cost of capital.

PART IV: Application of Models to a Case Company

Introduction to the Case Company

How do the traditional, adjusted, and FOCCM models covered in this paper hold up when put
under the fire of live data? That is the question this section of the paper will attempt to answer. The
author of this paper was fortunate enough to gain access to a small business located in the
Southeastern United States. The business has the following characteristics:

31
Note that no interest tax deductibility is accounted for here, as it was already included in the Net
Income After Tax calculation in Equation 3-1. Because this analysis is done from an internal cost of
capital perspective, there is no value in stripping net income of financing effects.

46
 • Provides products to residential construction companies in 10 metropolitan areas and 8
states around the Southeast
• Has annual sales revenues exceeding $10 million
• The ownership structure is made up of two individuals who are both heavily involved in the
business
• Employs over 100 individuals in various labor, management, and administrative roles
• Experiencing a varying degree of competition in the various territories where they work
• Has no outside equity holders involved in the company
• Make use of a short-term credit line from their bank, and also has some long-term debt
financing for machinery and some facilities
• Has recently experienced strong growth in revenues and profits
• Has been in business for longer than 10 years

In interviews with the firm's owners and company managers, it quickly became clear that this
business would be considered, in the terminology of the FOCCM, a Vibrant, Enduring Small Business
(Profile #2). The business owners, although desirous of a strong future for their business, are
concerned about their income today as well. They have delegated most of the daily and periodic
decision-making to managers which run the various functional silos of the business. They make use
of debt to meet growth-related challenges, but are more careful in use of debt than they were in their
less-experience, harrowing days as new entrepreneurs. For the purposes of this paper, we will refer
to the subject firm as the alias name (and alias industry) of Lawson Landscaping.

Application of Traditional and Adjusted Models

Before we run Lawson Landscaping through the FOCCM model, it would be appropriate to
attempt calculation of its cost of capital using some of the traditional and adjusted models introduced
earlier in this paper. In Figure 4-1 below you can see the outcome of running this business through
some of the traditional and adjusted models presented earlier (note that much of the information
necessary for the calculations in this section are summarized in Appendix B).

Figure 4-1: Traditional Model Usage for Sample Company Cost of Capital Calculation

Model Name Model-Specific Inputs Result

47
 Risk Free Rate (10-Year US T-Bond Rate -
4.63% as of 12/9/06)
CAPM 16.01% Cost of Equity
Risk Premium (20-Year US Stock Market 33
Equation 2-1 19.36% Overall Cost of Capital
Return of 10.10% - Risk Free Rate)
32
Beta of 2.08

MCAPM Same inputs as with CAPM, with addition of 22.01% Cost of Equity
34 35
Equation 2-2 a SCP of 4.0% and a SCRP of 2.0% 24.34% Overall Cost of Capital

Same inputs as with CAPM and MCAPM as

"Build-Up" Model 18.10% Cost of Equity
needed, with the addition of a 2% industry
Equation 2-3 21.21% Overall Cost of Capital
risk premium per the equation

Notice the outcome of applying these traditional models to this particular small business. In all three
cases a relatively high cost of capital figure resulted. And these calculated return levels have nothing
to do with the specifics of the company in question. They result from the fact that the models started
with typical stock market return and risk premium expectations, and then added additional premiums
to take systematic, unsystematic, and even industry risk. From an external perspective, this high of a
cost of capital calculation may not be alarming, and in fact it may not even be high enough. Because
when an external party develops a cost of capital for the firm, it is likely to be done for valuation
purposes. And for a small business with such informational (among other) differences, a high
discount/cost of capital rate probably should be used in valuing that firm. But for small business
managers, it is much more important to understand the true cost of capital (largely driven by
their owner's income demands) than to understand what type of risk level an outsider would
perceive when determining the business' value.

It is significant to note that two modified models used above (the MCAPM and the Build-Up
Model) still approach the problem of a small firm's cost of capital in a similar manner as does the

32
This is the beta of the residential construction industry from a selected 21 publicly-traded residential
construction firms (see Appendix A). Due to the continually growing nature of the company's returns,
and the fact that its stock is not publicly traded, its target customer base beta was utilized instead, as
this is probably the closest proxy to market-affecting forces on the company.
33
Overall cost of capital, then, was calculated with the WACC equation (equation 1-1) which made use
of debt and equity weights as provided by the company based on a Spring 2006 company valuation
performed by the company CFO, as well as other inputs as shown in Appendix B. The detailed DCF
worksheet was not able to be disclosed due to privacy issues (again, typical of the small business
world)
34
This is what Evans determines should be a "typical" small firm risk premium, based on the decile
portfolio data described earlier in this paper, which is discussed in his book and Pratt's book.
35
This Specific Company Risk Premium of 2.0% was based primarily on the firm's customer
concentration, as that is the primary risk that was able to be identified based on Evan's suggested list
of factors to consider (128-132).

48
CAPM – from a market-based perspective. But for a small business owner, income is likely to be the
biggest concern, not necessarily overall firm value.

So how does the FOCCM model perform for Lawson Landscaping? That is the question to be
answered in the next section.

Application of FOCCM

The fact that Lawson Landscaping most closely lines up with the "Vibrant, Enduring" business
profile (profile #2) is significant, and will drive our approach in calculating its cost of capital. Clearly, a
different figure would result if a different FOCCM profile model was applied to this company. But the
assumption is that the different figure would more accurately reflect the organization's true cost of
capital under those differing profile assumptions, despite the underlying numeric inputs remaining the
same. This in fact is how the world of small business works, as we have heard from the various
authors cited throughout this paper. Their decision-making, even in financial matters, is largely
behaviorally-drive – not market-driven. And so it is important to identify the financial and behavioral
factors important to the owner and let that influence our approach to calculation.

Our calculation of FOCCM Growing ROE (which profile #2 calls for according to Figure 3-A) is
detailed in Equation 3-5. This calculation, if you will recall, requires a value for FMTI2 (FOCCM
Minimum Total Income, Modified for Profile #2) which is calculated from Equation 3-4. Let us begin by
calculating this FOCCM Minimum Total Income, Modified for Profile #2 (recall that the figures used
here were provided by the company and come from Appendix B):

36
$ 957,528 Business Net Income After Tax
- 616,530 Year's Profits Retained in the Business
+ 162,400 Salary Paid to Owner by the Business
+ 75,400 Value of Owner's Perquisites Provided by the Business
-------------------------------------------------------------------------------------------------------------------
= $ 578,978 FOCCM Total Income
37
+ 115,760 1-Year Desired Income Growth ($) [C]
----------------------------------------------------------------------------------------------------------------

36
These first four lines (leading to "FOCCM Total Income") come from Equation 3-1. This FOCCM
Total Income figure is "plugged into" Equation 3-4 to complete the calculation of FOCCM Minimum
Total Income, Modified for Profile #2. All of the lines from the two equations are presented here
together. Explanatory footnotes on each can be found in the formal presentations of Equations 3-1
and 3-4 earlier in this paper.
37
[ $578,978 x 0.20 (desired growth rate indicated by owners in Appendix B) = $115,760 ]

49
 = $694,558 FOCCM Total Growth Income Expected
- 31,320 Profits Willing to be Sacrificed in Order to Maintain Behavioral
38
Rewards [D]
-----------------------------------------------------------------------------------------------------
= $663,238 FOCCM Minimum Total Income, Modified for Profile #2

Now, the appropriate figures are inserted into what was presented earlier as Equation 3-5 to calculate
FOCCM Growing ROE. You may refer back to that equation for explanation of the terms used. Again,
remember that the figures used in this calculation for Lawson Landscaping are all presented together
in Appendix B:

From Equation 3-5: k2 = wd2kd2 + we2k e2 where ke2 = [ FMTI2 / EMV ]

cost of equity = ke2 = [ $663,238 / $7,730,000 ] = 0.0858

cost of capital = k2 = (0.17)(0.081) + (0.83)(0.0858) = 0.084984 = 8.5%

The FOCCM Growing ROE model, then, leads to a cost of capital calculation of 8.5% for the case
company, Lawson Landscaping. One may question the low figure arrived at through this
calculation. But I would challenge the skeptic to answer this question: will this small business owner
truly abandon their business in search of alternate investments if indeed their business generates
8.58% (the cost of equity component above) for them? Of course not! – because that is indeed what it
generated for them last year, a record year for the company according to company executives, when
measured on the basis of income. It is proposed, therefore, that a measure that looks at hard
cash put into the hands of owners, versus what they expect to receive, is a far-superior
measure of determining the true cost of capital for a business as compared to using market-
based figures.

With this sample company, however, we cannot perform a direct application of the profile #1 or profile
#3 model to the company's financial situation to determine a cost of capital. To do so would be
inappropriate and in direct violation of a key principle of FOCCM – that is, that the model selected to
calculate the "internal" cost of capital must align with the profile of the business. Clearly, testing of
profile #3's cost of capital model in particular (FOCCM Exit Target/Industry Framework), with a
significantly different focus of the owner, must be performed on a company who fits well within that
profile and the results scrutinized in order to further test the assumptions and outcomes of this model.

38
This figure was calculated by taking the $26,100 "sacrifice" amount as provided by the company in
Appendix B and increasing it by 20% (the stated growth desire) to adjust it for the situation in 2007

50
 Conclusion

Academics have rarely been able to escape the publicly-traded, big business "box" in their
thinking about cost of capital. The insistence that it be a consideration of the investment and not the
investor by some scholars and practitioners may prove valuable when external parties are attempting
to value small businesses. But inside of a small business, when faced with regular decisions about
expansion and capital investments, a market-based figure provides little guidance for a financial
business manager in such an environment.

Adjusted models have indeed been designed so as to account for the risks, uncertainties, and
behavioral differences present in small firms, as were examined in this paper. Boyer and Roth's 1978
work made major strides in the direction of behavioral reward identification for business owners, and
was followed up on over the three decades by authors such as Norton, Cheung, Palliam, R. Hamilton,
McMahon, and others. These authors consistently dismissed the traditional CAPM method as
irrelevant for small businesses and proposed new ways of dealing with the issue for small businesses.
However, they still largely took approaches that implied that "one size fits all". Such an assumption is
precarious in any environment, not to mention when brought into the small business world. Small
business owners' motives and desired outcomes vary greatly, and must be taken into consideration in
any significant attempt at analysis or study of the business.

The Firm Orientation Cost of Capital Model (FOCCM) presented in this paper acknowledges
Boyer and Roth's findings and the concerns expressed by the other authors just mentioned. It seeks
to discover the true, internal cost of capital that the owners actually rely on to maintain or grow their
personal income and behavioral rewards. Rather than using a modified risk measure that backs into
typical small business returns in an "ex post" fashion, however, the FOCCM instead seeks to identify a
profile type of the specific small business in question. After a profile is chosen, then a model
appropriate to that small business' circumstances is utilized to calculate the firm's cost of capital as it
really is.

It is firmly believed that such an approach will often result in a lower cost of capital figure than
one would calculate using one of the adjusted models proposed for use with small businesses as
suggested in the literature. In fact, in this way the FOCCM may very well provide an explanation as to
how and why certain industries continue to be "difficult to crack" for outsiders. From the perspective of
the small business owner, their business may not really be all that risky. Their risk as they perceive it
is actually quite low, as they probably know, understand, and enjoy the business immensely. The
control and independence they exert within the firm hardly seems uncertain or unstable. The return

51
they demand is measured first by their personal income and benefits, with company value largely
considered secondarily, if at all. Outsiders valuing such a small business with a high, market-based
cost of capital approach and with high return expectations from the firm are simply trying to force a
market-based perspective into a small business culture that is typically not driven by such
comparisons.

Clearly much more remains to be learned about the dynamic, crucial portion of our national
economy that is made up by small businesses. It is a world not measured on a day to day basis like
the DOW or S&P 500. It is a world where owners can normally do what they like, when they like, and
how they like to do it completely outside the scrutinizing public eye. How could anyone argue that
models typically applied to transparent, large organizations should be rigged for use in such a different
type of environment? Models must be used that, even within themselves, take into account the
differences inside of small businesses. Nowhere is this truer than in the cost of capital metric.
Certainly one thing is clear: there is much more than meets the eye in the world that is small business.

52
 Appendix A

Residential Homebuilders used to develop industry beta estimate

for case company CAPM calculation

Avatar Holdings Inc. (AVTR)

Beazer Homes USA Inc. (BZH)
Brookfield Homes Corp. (BHS)
Calton Inc. (CTON.OB)
Centex Corp. (CTX)
CET Services Inc. (ENV)
Comstock Homebuilding Companie (CHCI)
Dominion Homes Inc. (DHOM)
DR Horton Inc. (DHI)
Hampton's Luxury Homes, Inc. (HLXH.OB)
Heartland Inc. (HTLJ.OB)
Hovnanian Enterprises Inc. (HOV)
KB Home (KBH)
Lennar Corp. (LEN)
M/I Homes Inc. (MHO)
MDC Holdings Inc. (MDC)
Meritage Homes Corp. (MTH)
NVR Inc. (NVR)
Orleans Homebuilders Inc. (OHB)
Pulte Homes Inc. (PHM)
Ryland Group Inc. (RYL)

53
 Appendix B

39
Case Company (Lawson Landscaping ) Informational Inputs

Weighted Average Cost of Debt 8.10%

40
Weight of Debt in the Capital Structure 17%
Weight of Equity in the Capital Structure 83%
Effective Corporate Tax Rate 25%

2006 Business Net Income After Tax $957,528

2006 Profits Retained in Business $616,530
2006 Total Salaries of Owners $162,400
2006 Total Owner Perquisites $ 75,400

2007 Profits Willing to be Sacrificed by

Owners in order to maintain
41
existing "behavioral rewards" $ 26,100

Desired growth rate in profits for 2007 20%

Market value of business as estimated by

company CFO in Spring 2006 $7,730,000

39
As explained in the body of the paper, the name of this firm is fictional. In addition, it should be
understood that all of the dollar values here have been adjusted by a percentage known only to the
author of this paper at the request of company management in order to maintain confidentiality of what
they consider to be sensitive financial figures. Also, 2006 figures are projected as the year has not yet
ended, although company management believes these projections are extremely close to what the
actual year-end totals will actually be.
40
Debt and Equity weights both based on market values (market value of equity used was the market
value shown on this page as estimated by the company CFO).
41
The conceptual basis behind this figure was explained to company management, who determined
this dollar amount based on the method of dividend (profit) distribution to owners and based it on the
owners not receiving a particular "bonus dividend" they reward themselves in the case of spectacular
performance. The assumption made by the managers was that given the choice between giving up all
of the "behavioral rewards" the owners enjoy, they would expect the owners instead to give up this
"bonus dividend" if necessary to maintain the other lifestyle/behavioral benefits.

54
 Endnotes

Alberts, W.W. and S. H. Archer (1973). "Some Evidence on the Effect of Company Size on the Cost of
Equity Capital," Journal of Financial and Quantitative Analysis 8(2), 229-242.

Barton, Sidney L. and Charles H. Matthews (1989). "Small Firm Financing: Implications from a
Strategic Management Perspective," Journal of Small Business Management, January 1989, 1-7.

Berger, Allen N. and Gregory F. Udell (1998). "The Economics of Small Business Finance: The Roles
of Private Equity and Debt Markets in the Financial Growth Cycle," Working paper. Board of
Governors of the Federal Reserve System, U.S.A.

Bloomberg.com: Rates & Bonds. Website accessed December 9, 2006. URL:

http://www.bloomberg.com/markets/rates/index.html

Borland, C. (1974). "Locus of Control, Need for Achievement and Entrepreneurship," unpublished
paper. Auckland, New Zealand: University of Auckland.

Boyer, P, and H. Roth (1978). "The Cost Of Equity Capital For Smail Business," American Journal of
Small Business 2(1), 1-11.

Brigham, Eugene.F., and K.V. Smith (1967)."Cost of Capital to the Small Firm," The Engineering
Economist (Fall), 1-26.

Brigham, Eugene.F.(1975). "Hurdle Rates for Screening Capital Expenditure Proposals," Financial
Management 4(3), 17-26.

Brigham, Eugene F. and Michael C. Ehrhardt (2002). Financial Management: Theory and Practice,
10th Edition. Mason, OH: South-Western/Thomson Learning.

Carpenter, Robert E. and Bruce C. Petersen (2002). "Is the Growth of Small Firms Constrained by
Internal Finance?" Review of Economics and Statistics 84(2), 298-309.

Chaganti, Rajeswararao, Dona Decarolis, and David Deeds (1995). "Predictors of Capital Structure in
Small Ventures," Entrepreneurship: Theory and Practice 20(2), 7-18.

55
Cheung, Joe (1999). "A Probability Based Approach to Estimating Costs of Capital for Small
Business," Small Business Economics 12: 331-336.

Chittenden, Francis, Graham Hall, and Patrick Hutchinson (1996). "Small Firm Growth, Access to
Capital Markets and Financial Structure: Review of Issues and an Empirical Investigation," Small
Business Economics 8, 59-67.

Ehrhardt, Michael C. (1994). The Search for Value. Boston, MA: Harvard Business School Press.

Evans, Frank C (2001). Valuation for M&A: Building Value in Private Companies. New York, NY: John
Wiley & Sons, Inc.

Forsaith, David M., Mark R. Lecornu, Richard G.P. McMahon, and Anthony M.J. Stanger (1996). "The
Small Enterprise Financial Objective Function: An Exploratory Study," Journal of Small Business
Management 34(3), 1-14.

Gallo, Miguel Ángel, Josep Tàpies and Kristin Cappuyns (2004). "Comparison of Family and
Nonfamily Business: Financial Logic and Personal Preferences," Family Business Review 17(4), 303-
318.

Hamilton, R. (1987). "Motivation and Aspirations of Business Founders," International Small Business
Journal 6(1), 70-78.

Hamilton, R. and Mark A. Fox (1998). "The financing preferences of small firm owners," International
Journal of Entrepreneurial Behaviour & Research 4(3), 239-248.

Hamilton, Barton H. (2000). "Does entrepreneurship pay? An empirical analysis of the returns to self-
employment," Journal of Political Economy 108(3), 604-631.

Heaton, Hal (1998). "Valuing Small Businesses: The Cost of Capital," The Appraisal Journal, January
1998, 11-16.

Higgins, Robert C. (2004). Analysis for Financial Management, 7th Edition. New York, NY: McGraw-
Hill/Irwin.

Hutchinson, R.W. (1995). "The capital structure and investment decisions of the small owner-managed
firm: Some exploratory issues," Small Business Economics 7(June), 231-239.

56
Levy, H. (1990). "Small firm effect: Are there abnormal returns in the market?" Journal of Accounting,
Auditing and Finance 5(2), 235-276.

Lloyd's Investment Blog. Website acccessed December 2006. URL:

http://lloydsinvestment.blogspot.com/2005/02/housing-market-price-trends.html

Lopez-Gracia, Jose and Cristina Aybar-Arias (2000). "An Empirical Approach to the Financial
Behaviour of Small and Medium Sized Companies," Small Business Economics 14, 55-63.

McConnell, J. J. and R. R. Pettit (1984). "Application of the Modern Theory of Finance to Small
Business Firms," Small Business Finance: Problems in Financing of Small Business (42), Part A.

McKinsey & Company: Tim Koller, Marc Goedhart, David Wessels (2005). Valuation: Measuring and
Managing the Value of Companies. Hoboken, NJ: John Wiley & Sons, Inc.

McMahon, R. G. P., Holmes, S., Hutchinson, P. J., and Forsaith, D. M. (1993). Small enterprise
financial management: Theory and practice. Sydney, NSW; Harcourt Brace.

McMahon, Richard G. P. and Anthony Stanger (1995). "Understanding the Small Enterprise Financial
Objective Function," Entrepreneurship: Theory & Practice 19(4), 21-39.

Norton, Edgar (1990). "Similarities and differences in small and large corporation beliefs about capital
structure policy," Small Business Economics 2(3): 229-245.

Palliam, Ralph (2005). "Estimating the cost of capital: considerations for small business," The Journal
of Risk Finance 6(4), 335-340.

Palliam, Ralph (2005). "Application of a multi-criteria model for determining risk premium," The
Journal of Risk Finance 6(4), 341-348.

Pandey, J., and N.B. Tewary (1979). "Locus of Control and Achievement Values of Entrepreneurs,"
Journal of Occupational Psychology 52, 107-111.

Perry, C. (1980). "A Small Business Model for Australian Policy Makers," working paper, Queensland,
Australia: Queensland Institute of Technology.

57
Petty, J.W., and W.D. Bygrave (1993). "What Does Finance Have to Say to the Entrepreneur?" The
Journal of Small Business Finance 2(2), 125-137.

nd
Pratt, Shannon P (2002). Cost of Capital: Estimation and Applications, 2 Edition. New York, NY:
John Wiley & Sons, Inc.

Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe (2005). Corporate Finance, 7th Edition.
New York, NY: McGraw-Hill/Irwin.

Shapero, A. (1975). "The Displaced, Uncomfortable Entrepreneur," Psychology Today 9 (6), 83-88,
133.

Stocks, Bonds, Bills, and Inflation 2001 Yearbook, Valuation Edition. Chicago: Ibbotson Associates,
Inc.

Stocks, Bonds, Bills, and Inflation 2002 Yearbook, Valuation Edition. Chicago: Ibbotson Associates,
Inc.

Tesfatsion, Leigh. Iowa State University. "Notes on Portfolio Choice and Asset Pricing," Website
accessed on December 2, 2006. URL:
http://www.econ.iastate.edu/classes/econ353/tesfatsion/portfolio.htm

Timmons, J.A. (1978). "Characteristics and Role Demands of Entrepreneurship," American Journal of
Small Business 3 (1), July, 5-17

Van Aueken, Howard E. (2005). " A Model of Small Firm Capital Acquisition Decisions," International
Entrepreneurship and Management Journal 1, 335-352.

Walker, Ernest W. and J. William Petty, II. (1978). "Financial Differences Between Large and Small
Firms," Financial Management (Winter), 61-68.

Yahoo! Finance. Website accessed in November and December 2006. URL:

http://finance.yahoo.com

58