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INTRODUCTION
An organization's financial capital represents the funds used to finance its assets and operations. The cost of capital is the rate of return required to compensate providers of those funds. An organization's cost of capital provides both a benchmark to evaluate the firm's performance and a discount rate for evaluating capital investments. Therefore, a reasonable estimate of a firm's cost of capital is essential for good decision-making. In practice, however, this cost is difficult to estimate (Brigham and Gapenski 1994).
The capital of an organization consists of two main components debt and equity. The cost of the equity component is the more difficult to estimate, and is the focus of this paper. The cost of equity represents compensation to investors for time and for risk While the rate for time (i.e., the "risk free rate") changes constantly, and varies with the term of the capital commitment, it is the same for all organizations. The level of compensation for risk (i.e., the "risk premium") depends, though, on the particular characteristics of the firm using the capital. Hence, a method for incorpor-ating the risk dimension is requisite to computing an organization's risk premium and cost of capital.
Assessment of the risk associated with a firm depends on the perspective from which risk is viewed. The external capital market considers only the "systematic" risk in a well-diversified investment portfolio. This risk is commonly represented by an organization's "market beta." A beta can be estimated from historical return data or through fundamental analysis, and then used in the capital asset pricing model (CAPM) to determine an appropriate risk premium.
Owners and managers in a privately held firm, however, do not usually view their organization as part of a diversified portfolio, but more as a capital project. From this internal perspective, "nonsystematic" risk factors are also critical to operating, investment, and financing decisions. Moreover, these nonsystematic factors have serious implications for the organization's financial statements and on investor and lender perceptions (Findlay, Gooding and Weaver 1976). Consequently, consideration of "total risk" is more relevant to estimating a cost of capital for these firms, and that is the perspective taken in developing the model presented in this paper.
In assessing the risk of an enterprise, an analyst would benefit from...