The build-up approach. Could it be an alternative to the CAPM?
DOI:
https://doi.org/10.26485/SPE/2023/126/5Keywords:
discounted cash flows, CAPM, build-up approach, valuation, risk-free rate.Abstract
Background: The paper contains the economic background for implementing the build-up approach as an alternative method to the Capital Assets Pricing Model (CAPM).
Research purpose: This study aims to consider company-specific risk premium that makes cost estimation unique, subjective, and different within the economic factors that may be considered and used for entity cost of equity estimation, valuation, or other economic metrics.
Methods: The author analyzes the most recent literature on companies’ cost of equity and estimating specific risk premiums. Each component of the cost of capital in the build-up approach was analyzed and interpreted. The petroleum industry was analyzed between 2011 and 2021. The Mercer model for specific risk was used.
Conclusions: The build-up approach seems the best choice to calculate equity costs in a turbulent economic environment. However, due to its mathematical structure, it could be criticized for the huge subjectivity in the assessment risk premium rate. The key to using this method is to make it less subjective. This paper suggests an approach that minimizes the subjectivity in the build-up model. So far, there is no comprehensive analysis of the Polish market that has been prepared from the perspective of the petroleum industry’s specific risk premium. This research creates possibilities for further comprehensive analysis related to models to calculate company risk premiums and the factors that affect them.
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