Company Specific Risk Premium in Discount/Capitalization Rates

1. Company Specific Risk Premium in Discount/Capitalization Rates AGN International 2009 North American Regional Meeting Denver, Colorado May 18, 2009 Richard Gray, CPA/ABV, CVA, ASA Director of Business Valuation Services Daszkal Bolton LLP Boca Raton, Florida

2. Objective To assist the valuation analyst in defining and measuring the company specific risk (CSR) premium applied in the determination of discount and capitalization rates.

3. Introduction “ To judges, the company specific risk premium often seems like the device experts employ to bring their final results into line with their clients’ objectives, when other inputs fail to do the trick.” Delaware Open MRI Radiology Associates v. Howard B. Kessler, et al

4. Introduction Cost of Capital – Expected rate of return that market participants require in order to attract funds to a particular investment, a.k.a., Discount Rate

5. Introduction Three Types of Risk – • Maturity Risk • Systematic Risk • Unsystematic Risk

6. Introduction Beta = Systematic Risk

7. Introduction Total Beta = Total Risk

8. Discount / Capitalization Rate – Build-up Method Ke = Rf + ERP + IRPi + SP + CSR Ke = Cost of equity Rf = Risk-free rate ERP = Equity risk premium IRPi = Industry risk premium SP = Size premium CSR = Company specific risk

9. Unsystematic Risk Primary Sources • Leverage • Size • Volatility of earnings (cash flow) • Macroenvironment • Industry • Specific company attributes

10. Unsystematic Risk Specific Company Attributes Management depth Management expertise Access to capital Customer concentration Customer pricing leverage Customer relationships Competition Supplier concentration Supplier pricing advantage Product diversification Life cycle of current products Geographical distribution Demographics Labor Employee stability Regulatory environment Fixed assets Intangible assets Distribution system IT system Litigation issues Currency risk

11. Company Specific Risk (CSR) Qualitative Analysis vs. Quantitative Analysis

12. Qualitative Analysis – Component Detail Method

13. Qualitative Analysis – Component Observation Method

14. Qualitative Analysis – Component Summary Method

15. Qualitative Analysis – Risk Rate Component Model Primary Factors • Competition • Financial strength • Management ability and depth • Profitability and stability of earnings

16. Qualitative Analysis – Risk Rate Component Model Economic Effects • National • Local

17. Qualitative Analysis – Value-Netex (Black/Green Model) • Quantitative Categories of Risk • Liquidity • Leverage • Operations • Cost control • Growth • Qualitative Categories of Risk • Competition • Management • Stability

18. Qualitative Analysis – S.W.O.T. Analysis Internal Factors • Strengths • Weaknesses External Factors • Opportunities • Threats

19. Qualitative Analysis – The Porter Model Five Forces • Rivalry between current incumbents • Threat of new entrants • Bargaining power of customers • Bargaining power of suppliers • The threat of substitute products

20. Qualitative Analysis – The McKinsey 7-S Model • Strategy • Structure • Systems • Skills • Staff • Style • Superordinate goals

21. Qualitative Analysis – The Dupont Model ROE = ROA x EM

22. Quantitative Analysis • Morningstar (Ibbotson) Industry Risk Premia • Duff & Phelps Risk Premium Report • Finison / Dailey Model • Butler / Pinkerton Model

23. Morningstar (Ibbotson) Industry Risk Premia • Use full-information betas • Does not capture total CSR

24. Duff & Phelps Risk Premium Report • Part II • Three measures of risk • Operating margin • Volatility of operating margin • Volatility of return on equity

25. The Finison / Dailey Model • www.bvlibrary.com • S.W.O.T. approach • 5 point quantification scale • Default range -3% to 15% Pcs = C - (∑ (SW%,OT%) X ((Rmax - Rmin)/4)))

26. The Butler / Pinkerton Model • www.bvmarketdata.com • Calculate CSR – public companies • Total Beta • CSR can never be <0% Tß = ß / R = σs / σm

27. Questions?

28. Thank You! Richard Gray, CPA/ABV, CVA, ASA Director of Business Valuation Services Daszkal Bolton LLP 2401 NW Boca Raton Boulevard Boca Raton, Florida 33431 Direct: 561.953.1468 Cell: 561.400.1552 Email: rgray@daszkalbolton.com