Cost of Equity for Private Companies:The Integrated Pricing Model

Abstract

In this chapter we shall be setting out a model for estimating the cost of equity that is based on valuation techniques similar to those developed in the Fixed Income sector for estimating expected losses and for the pricing of junior subordinated notes relating to cash or synthetic securitization (also known as the Fixed Income Approach, or FIA). More precisely, the following phases are mapped: firstly, fixed income techniques are used to estimate the expected losses for shareholders of non-listed companies (in other words the probability of default and the loss given default (LGD)); next the way in which spreads of junior and subordinated notes are calculated is outlined; and finally results from using the FIA model are integrated with those from the CAPM (see Figure 3. 1), leading to the Integrated Pricing Model (IPM). The FIA is based on the assumed major valuation efficiency of credit market in respect to equity market (Blanco et al., 2005; Chan-Lau and Kim, 2005; Hull et al., 2004; Longstaff et al., 2005; Oricchio, 2011).