Cost of Capital For Closely Held Non-Publicly Traded Businesses: Empirical Estimation For Dairy Farms

Abstract

Due to incomplete information on financial and operational conditions, research on non-publicly traded businesses cannot apply classic financial theories and models directly, even though these model may have been well established for many years. Because the cost of capital is an important factor in determining the investment activities of a firm, and is a challenge to estimate, steps to improve the existing models to estimate the cost of capital in closely held businesses could help the investment decision making of those business. This paper uses two modified models to estimate the cost of equity capital for closely held business. Total of four estimation methods are developed to estimate the cost of capital using a dataset containing observations of 50 New York State dairy farms over 16 years. The first improvement is a modification of the classic capital asset pricing model (CAPM), by implementing an extra compensation for the additional risks of non-public family business owners; a beta for calculating the market premium is estimated for each firm using individual firm's historical annual data. Another approach was to use cash flows as a proxy instead of unattainable variables of the CAPM for non-public businesses, like the beta, to estimate the cost of capital by using the model introduced by Lambert et al. (2007). The estimated results show that dairy farms' performances are correlated with the dairy industry's performance rather than the entire capital market's performance. Thus, a beta using non-public firm's historical data is estimated to find the cost of equity capital. Using the estimated parameters from the cost of capital estimates, relationships between estimated alpha and estimated industry beta, farm's characteristics and alpha and beta, and cost of debt and alpha, beta and capital structure are obtained.