New Method of Determining Cost of Equity in Private Equity Investments

Abstract

In this article, the author develops an equation to calculate the cost of equity when valuing private equity investments. The cost of ownership is employed as a discount rate when discount cash flow methodology is employed to determine the value of the capital of a company. The equation is built incorporating three factors: market returns, private equity index returns, and illiquidity. Illiquidity is essential, as private equity investments do not trade as readily as securities trading in public stock markets. By using different weights for each of the factors with boundary conditions, the author illustrates how different weights of elements can be used to influence the cost of equity in a private equity investment.

TOPICS: Private equity, security analysis and valuation, portfolio construction, statistical methods