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ISBN 978-0-470-94935-1 (ebk)

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Preface

Why did we add the Workbook and Technical Supplement to the Cost of Capital: Applications and Examples, 4th ed.? We wanted to further assist practitioners in better understanding how to estimate the cost of capital. This text adds more detailed examples to the Cost of Capital: Applications and Examples, 4th ed. It also contains questions and problems covering the material contained in the Cost of Capital: Applications and Examples, 4th ed. designed to help the reader better grasp that material.

This book uses the identical notation and abbreviations as those used in the text. Those can be referenced either in Cost of Capital: Applications and Examples, 4th ed. or on the companion web site (see later).

Part One contains technical supplements to several chapters. These will help the reader to be better able to implement the methods of analyses discussed in the main book.

Part Two contains an example of specific applications of applying the theory to the cost of capital for private investment companies, including one approach to incorporating the discount for lack of control and lack of marketability into the cost of capital. It also contains chapters extending the general concepts of developing cost of capital to real estate properties and real estate entities. These investments have their own set of terminologies unique to the industry, and we cover the terminology and methods of analysis commonly used in the industry in detail.

Part Three contains learning objectives, questions, and problems to help the practitioner better understand the content of the first 34 chapters of the Cost of Capital: Applications and Examples, 4th ed.

Part Four contains the answers to the questions and solutions to the problems presented in Part Three.

Finally, this book includes a companion web site, which can be found at www.wiley.com/go/coc4e. The web site includes the following:

About the Authors

Dr. Shannon P. Pratt, CFA, FASA, ARM, MCBA, ABAR, CM&AA, is the chairman and CEO of Shannon Pratt Valuations, Inc., a nationally recognized business valuation firm headquartered in Portland, Oregon. He is also the founder and editor emeritus of Business Valuation Resources, LLC, and one of the founders of Willamette Management Associates, for which he was a managing director for almost 35 years.

He has performed valuation assignments for these purposes: transaction (acquisition, divestiture, reorganization, public offerings, public companies going private), taxation (federal income, gift, and estate and local ad valorem), financing (securitization, recapitalization, restructuring), litigation support and dispute resolution (including dissenting stockholder suits, damage cases, and corporate and marital dissolution cases), and management information and planning. He has also managed a variety of fairness opinion and solvency opinion engagements. He regularly reviews business valuation reports for attorneys in litigation matters.

Dr. Pratt has testified on hundreds of occasions in such litigated matters as dissenting stockholder suits, various types of damage cases (including breach of contract, antitrust, and breach of fiduciary duty), divorces, and estate and gift tax cases. Among the cases in which he has testified are Estate of Mark S. Gallo v. Commissioner, Charles S. Foltz, et al. v. U.S. News & World Report et al., Estate of Martha Watts v. Commissioner, and Okerlund v. United States. He has also served as appointed arbitrator in numerous cases.

Previous Experience

Before founding Willamette Management Associates in 1969, Dr. Pratt was a professor of business administration at Portland State University. During this time, he directed a research center known as the Investment Analysis Center, which worked closely with the University of Chicago's Center for Research in Security Prices.

Education

Doctor of Business Administration, Finance, Indiana University.

Bachelor of Arts, Business Administration, University of Washington.

Professional Affiliations

Dr. Pratt is an Accredited Senior Appraiser and Fellow (FASA), Certified in Business Valuation, of the American Society of Appraisers (their highest designation) and is also accredited in Appraisal Review and Management (ARM). He is a Chartered Financial Analyst (CFA), a Master Certified Business Appraiser (MCBA) and Accredited in Business Appraisal Review (ABAR) by the Institute of Business Appraisers, a Master Certified Business Counselor (MCBC), and is Certified in Mergers and Acquisitions (CM&AA) with the Alliance of Merger and Acquisition Advisors.

Dr. Pratt is a life member of the American Society of Appraisers, a life member of the Business Valuation Committee of that organization, and a teacher of courses for the organization. He is also a lifetime member emeritus of the Advisory Committee on Valuations of the ESOP Association. He is a recipient of the magna cum laude award of the National Association of Certified Valuation Analysts for service to the business valuation profession. He is also the first life member of the Institute of Business Appraisers. He is a member and a past president of the Portland Society of Financial Analysts, the recipient of the 2002 Distinguished Achievement Award, and a member of the Association for Corporate Growth. Dr. Pratt is a past trustee of the Appraisal Foundation and is currently an outside director and chair of the audit committee of Paulson Capital Corp., a NASDAQ-listed investment banking firm specializing in small initial public offerings (usually under $50 million).

Publications

Dr. Pratt is the author of Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. (New York: McGraw-Hill, 2008); co-author, Valuing Small Businesses and Professional Practices, 3rd ed., with Robert Schweihs and Robert Reilly (New York: McGraw-Hill, 1998); co-author, Guide to Business Valuations, 20th ed., with Jay Fishman, Cliff Griffith, and Jim Hitchner (Fort Worth, TX: Practitioners Publishing Company, 2010); co-author, Standards of Value, with William Morrison and Jay Fishman (Hoboken, NJ: John Wiley & Sons, 2007); co-author, Business Valuation and Taxes: Procedure, Law, and Perspective, 2nd ed., with Judge David Laro (Hoboken, NJ: John Wiley & Sons, 2010); and author, Business Valuation Discounts and Premiums, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2009); Business Valuation Body of Knowledge: Exam Review and Professional Reference, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2003); The Market Approach to Valuing Businesses, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2005); and The Lawyer's Business Valuation Handbook, 2nd ed. (Chicago: American Bar Association, 2010). He has also published nearly 200 articles on business valuation topics.

Roger Grabowski, ASA, is a managing director of Duff & Phelps, LLC.

Mr. Grabowski has directed valuations of businesses, partial interests in businesses, intellectual property, intangible assets, real property, and machinery and equipment for various purposes, including tax (income and ad valorem) and financial reporting; mergers, acquisitions, formation of joint ventures, divestitures, and financing. He developed methodologies and statistical programs for analyzing useful lives of tangible and intangible assets, such as customers and subscribers. His experience includes work in a wide range of industries, including sports, movies, recording, broadcast and other entertainment businesses; newspapers, magazines, music, and other publishing businesses; retail; banking, insurance, consumer credit, and other financial services businesses; railroads and other transportation companies; mining ventures; software and electronic component businesses; and a variety of manufacturing businesses.

Mr. Grabowski has testified in court as an expert witness on the value of closely held businesses and business interests; matters of solvency, valuation, and amortization of intangible assets; and other valuation issues. His testimony in U.S. District Court was referenced in the U.S. Supreme Court opinion decided in his client's favor in the landmark Newark Morning Ledger income tax case. Among other cases in which he has testified are Herbert V. Kohler Jr., et al. v. Comm. (value of stock of The Kohler Company); The Northern Trust Company, et al. v. Comm. (the first U.S. Tax Court case that recognized the use of the discounted cash flow method for valuing a closely held business); Oakland Raiders v. Oakland–Alameda County Coliseum Inc. et al. (valuation of the Oakland Raiders); In re: Louisiana Riverboat Gaming Partnership, et al. Debtors (valuation of business enterprise owning two riverboat casinos and feasibility of plan of reorganization); ABC-NACO, Inc. et al., Debtors, and The Official Committee of Unsecured Creditors of ABC-NACO v. Bank of America, N.A. (valuation of collateral); Wisniewski and Walsh v. Walsh (oppressed shareholder action); and TMR Energy Limited v. The State Property Fund of Ukraine (arbitration on behalf of world's largest private company in Stockholm, Sweden, on cost of capital for oil refinery in Ukraine in a contract dispute).

Previous Experience

Mr. Grabowski was formerly managing director of the Standard & Poor's Corporate Value Consulting practice and a partner of PricewaterhouseCoopers, LLP, and one of its predecessor firms, Price Waterhouse (where he founded its U.S. Valuation Services practice and managed the real estate appraisal practice). Prior to Price Waterhouse, he was a finance instructor at Loyola University of Chicago, a cofounder of Valtec Associates, and a vice president of American Valuation Consultants.

Education

Mr. Grabowski received his BBA–Finance from Loyola University of Chicago and completed all coursework in the doctoral program, Finance, at Northwestern University, Chicago.

Professional Affiliations

He serves on the Loyola University School of Business Administration Dean's Board of Advisors. Mr. Grabowski is an Accredited Senior Appraiser of the American Society of Appraisers (ASA) certified in business valuation. He serves as Editor of the Business Valuation Review, the quarterly journal of the Business Valuation Committee of the American Society of Appraisers.

Publications

Mr. Grabowski authors the annual Duff & Phelps Risk Premium Report. He lectures and publishes regularly. Recent articles include “The Cost of Capital,” Journal of Business Valuation, the Canadian Institute of Chartered Business Valuators, August 2009; “Problemas relacionados con el cálculo del coste de capital en el entorno actual: actualizaciòn,” co-authored with Mathias Schumacher, Análisis Financiero Internactional, Sumario N^o 137 Tercer trimestre 2009; “Cost of Capital Estimation in the Current Distressed Environment,” The Journal of Applied Research in Accounting and Finance, July 2009; “Cost of Capital in Valuation of Stock by the Income Approach: Updated for an Economy in Crisis,” with Shannon P. Pratt, Jahreskonferenz der NACVA, Bewertungs Praktiker, January 2009; “Problems with Cost of Capital Estimation in the Current Environment—2008 Update,” Business Valuation Review, Winter 2008 and Business Valuation E-Letter, February 2009; and “Cost of Capital in Valuation of Stock by the Income Approach: Updated for Economy in Crisis,” The Value Examiner, January–February 2009.

He is the co-author Cost of Capital: Applications and Examples, 3rd ed., with Shannon P. Pratt (Hoboken, NJ: John Wiley & Sons, 2008) and co-author of three chapters (on equity risk premium, valuing pass-through entities, and valuing sports teams) in Robert Reilly and Robert P. Schweihs, The Handbook of Business Valuation and Intellectual Property Analysis (New York: McGraw-Hill, 2004).

He teaches courses for the American Society of Appraisers including Cost of Capital, a course he developed.

Joanne Fong, CFA, CPA, is a Senior Manager in the Transaction Advisory Services–Valuation & Business Modeling practice in the Chicago office of Ernst & Young LLP. Ms. Fong holds a Master of Business Administration and a Bachelor of Business Administration, both from the University of Michigan, Ross School of Business.

Ms. Fong co-authored Chapter 7 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement.

William H. Frazier, ASA, is a principal and founder of the firm of Howard Frazier Barker Elliott, Inc, and manages its Dallas office. He has 30 years of experience in business valuation and corporate finance. Mr. Frazier has been an Accredited Senior Appraiser of the American Society of Appraisers (ASA) since 1987 and serves on the ASA's Government Relations Committee. He has participated as an appraiser and/or expert witness in numerous U.S. Tax Court cases, including testimony in Jelke, McCord, Dunn, and Gladys Cook. Mr. Frazier has written numerous articles on the subject of business valuation for tax purposes, appearing in such publications as the Business Valuation Review, Valuation Strategies, BV E-Letter, Shannon Pratt's Business Valuation Update, and Estate Planning. He is the co-author of the chapter on valuing family limited partnerships in Robert Reilly and Robert P. Schweihs, eds., The Handbook of Business Valuation and Intellectual Property Analysis (New York: McGraw-Hill, 2004). Mr. Frazier serves on the IRS Advisory Council (IRSAC) and the Valuation Advisory Board of Trusts & Estates Journal.

Mr. Frazier contributed Chapter 8 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement and the companion Excel worksheets that appear on the John Wiley & Sons web site.

Terry V. Grissom, PhD, CRE, MAI, serves on the faculty at the University of Washington. He just completed a faculty assignment at the University of Ulster, Built Environment Research Institute. He received his PhD in Business from the University of Wisconsin, Madison, majoring in Real Estate and Urban Land Economics, with minors in Finance/Risk Management and Civil-Environmental Engineering. He received an MS in Real Estate Appraisal and Investment Analysis, also from the University of Wisconsin, and an MBA in Finance, Real Estate, and Urban Affairs from Georgia State University. He did postdoctoral work at Texas A&M University in Econometrics and Statistics.

Dr. Grissom was formerly Professor of Real Estate and Urban Land Economics at Georgia State University, Atlanta, in the Robinson College of Business. Prior to his tenure at GSU, he was Vice-President of Investment Research for Equitable Real Estate Investment Management, an institutional investment advisory for pension funds, insurance companies, and other financial institutions. From 1992 through October 1994, he was the National Research Director for Price Waterhouse's Financial Services Industry Practice.

Dr. Grissom has published more than 100 academic and professional articles, monographs, and working papers in his career to this point. He has also authored, co-authored, and edited four books concerning real estate appraisal and investment analysis, market analysis, and real estate development and land economics. He has also authored chapters in books on real estate development, investment analysis, business and property valuation techniques, and education theory and practice for both academics and practitioners and for both domestic and international audiences.

Dr. Grissom co-authored Chapters 9 and 10 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement.

Jim MacCrate, MAI, CRE, ASA, owns his own boutique real estate valuation and consulting company, MacCrate Associates, LLC, located in the New York City metropolitan area, concentrating on complex real estate valuation issues. Formerly, he was the Northeast regional practice leader and director of the Real Estate Valuation/Advisory Services Group at Price Waterhouse LLP and Pricewaterhouse Coopers LLP. He received a BS degree from Cornell University and an MBA from Long Island University, C. W. Post Center.

Mr. MacCrate has written numerous articles for Price Waterhouse LLP, “The Counselors of Real Estate,” and has contributed to the Appraisal Journal. He initiated the Land Investment Survey that has been incorporated into the PricewaterhouseCoopers Korpacz Real Estate Investor Survey. He is on the national faculty for the Appraisal Institute and adjunct professor at New York University.

Mr. MacCrate co-authored Chapters 9 and 10 in the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement.

Harold G. Martin Jr., CPA/ABV/CFF, ASA, CFE, is the Principal-in-Charge of the Business Valuation, Forensic, and Litigation Services Group for Keiter, Stephens, Hurst, Gary & Shreaves, P.C., in Richmond and Charlottesville, Virginia. He has more than 25 years of experience in financial consulting, public accounting, and financial services. He has appeared as an expert witness in federal and state courts, served as a court-appointed neutral business appraiser, and also served as a federal court–appointed accountant for receiverships. He is an adjunct faculty member of the College of William and Mary Mason Graduate School of Business and teaches forensic accounting and valuation in the Master of Accounting program. He is also a guest lecturer on valuation in the MBA program.

Prior to joining Keiter Stephens, he served as a Senior Manager in Management Consulting Services for Price Waterhouse and as a Director in Financial Advisory Services for Coopers & Lybrand. He currently serves as an instructor for the American Institute of Certified Public Accountants National Business Valuation School and ABV Exam Review Course and also as an editorial advisor and contributing author for the AICPA CPA Expert. He is a former member of the AICPA Business Valuation Committee, former editor of the AICPA ABV e-Alert, and a two-time recipient of the AICPA Business Valuation Volunteer of the Year Award. He is a frequent speaker and author on valuation topics and is a co-author of Financial Valuation: Applications and Models, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2006).

Mr. Martin received his AB degree in English in 1979 from the College of William and Mary and his MBA degree in 1991 from Virginia Commonwealth University.

Mr. Martin contributed Chapter 10 of the companion Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement and the companion Excel worksheets that appear on the John Wiley & Sons web site.

James Morris, PhD, AM, received his PhD in Finance from University of California, Berkeley. He is a professor of finance at the University of Colorado at Denver, where he teaches courses in business valuation, financial modeling, and financial management, and he has also served on the finance faculties at the Wharton School of University of Pennsylvania and at the University of Houston and taught finance courses at business schools in England, France, and Germany.

Dr. Morris's recent publications include Introduction to Financial Models for Management and Planning with J. Daley (CRC Press, 2009); “Life and Death of Businesses: A Review of Research on Firm Mortality,” Journal of Business Valuation and Economic Analysis (2009); “Firm Mortality and Business Valuation,” Valuation Strategies (September–October 2009); “The Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital When Capital Structure is Changing,” Appendix 7.2 in Pratt and Grabowski, Cost of Capital: Applications and Examples, 3rd ed. (Hoboken, NJ: John Wiley & Sons, 2008); “Growth in the Constant Growth Model,” Business Valuation Review (Winter 2006); “Understanding the Minefield of Weighted Average Cost of Capital,” Business Valuation Review (Fall 2005); and “Reconciling the Equity and Invested Capital Methods of Valuation When the Capital Structure is Changing,” Business Valuation Review (March 2004). In addition, his research articles have been published in the Journal of Finance, Journal of Financial & Quantitative Analysis, Journal of Applied Psychology, Academy of Management Journal, and Management Science, among others. In addition to teaching, he provides valuation services to the business community.

Dr. Morris contributed Chapter 6 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement and the companion Excel worksheets that appear on the John Wiley & Sons web site.

David M. Ptashne, CFA, is an Associate Director with Ceteris, a global economic consulting firm that provides transfer pricing and business valuation services. Mr. Ptashne has performed numerous valuation studies of businesses, interests in businesses, and intangible assets across various industries, including advertising and communications, consumer products, technology, financial services, integrated oil and gas, retail, and health care. He received a Bachelor of Science degree in Finance with High Honors from the University of Illinois at Urbana-Champaign.

Mr. Ptashne contributed Chapters 2 and 4 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement.

Mark Shirley, CPA/ABV/CFE, has earned advanced accreditations: Certified Valuation Analyst and Certified Forensic Financial Analyst. After leaving the Internal Revenue Service in 1984, Mr. Shirley's consulting practice has concentrated on the disciplines of business valuation, forensic/investigative accounting, and financial analysis/modeling. Professional engagements have included business valuation, valuation of options/warrants, projections and forecasts, statistical sampling, commercial damage modeling, personal injury loss assessment, and the evaluation of proffered expert testimony under Daubert and the Federal Rules of Evidence.

Since 1988, his technical contributions have been published by Wiley Law Publications, Aspen Legal Press, and in professional periodicals, including Valuation Examiner, BewertungsPraktiker Nr. (a German-language business valuation journal), Practical Accountant, CPA Litigation Services Counselor, Gatekeeper Quarterly, Journal of Forensic Accounting, and local legal society publications. Since 1997, Mr. Shirley has authored courses for NACVA's Fundamentals, Techniques & Theory; Forensic Institute, and Consultant's Training Institute. He also has developed several advanced courses for the NACVA in applied statistics and financial modeling.

A charter member of the LA Society of CPA's Litigation Services Committee, Mr. Shirley has remained active since the committee's formation. He has been an adjunct faculty member at the National Judicial College, University of Nevada, Reno, since 1998. Mr. Shirley also serves on the Advisory Panel for Mdex Online; The Daubert Tracker, an online Daubert research database; and the Ethics Oversight Board for the NACVA.

Since 1985, Mr. Shirley has provided expert witness testimony before the U.S. Tax Court, Federal District Court, Louisiana district courts, Tunica-Biloxi Indian Tribal Court, and local specialty courts. Court appointments have been received in various matters adjudicated before the Louisiana Nineteenth Judicial District Court.

The NACVA has recognized Mr. Shirley's contributions to professional education by awarding him the Circle of Light in 2002, Instructor of the Year in 2000–2001, and multiple recognitions as Outstanding Member and Award of Excellence.

Mr. Shirley contributed Chapter 3 of the Cost of Capital: Applications and Examples, 4th ed. Workbook and Technical Supplement and Appendix III of the Workbook and Technical Supplement which appears on the John Wiley & Sons web site.

Acknowledgments

This book has benefited immensely from review by many people with a high level of knowledge and experience in cost of capital and valuation. These people reviewed the manuscript, and the book reflects their invaluable efforts and legions of constructive suggestions:

In addition, we thank:

• Dustin Snyder and Elizabeth Anderson for assistance with editing and research, including updating of the bibliography; updating and shepherding the manuscript among reviewers, contributors, authors, and publisher; typing; obtaining permissions; and other invaluable help.
• David Fein of ValuSource for contributing Appendix II of the Workbook and Technical Supplement on ValuSource Pro.
• Noah Gordon of Shannon Pratt Valuations, Inc., for general editorial assistance.

We thank all of the people singled out for their assistance. Of course, any errors are our responsibility.¹

Shannon Pratt

Roger Grabowski

1. Any opinions presented in this book are those of the authors. The opinions of Mr. Grabowski do not represent the official position of Duff & Phelps, LLC. This material is offered for educational purposes with the understanding that neither the authors nor Duff & Phelps, LLC, are engaged in rendering legal, accounting, or any other professional service through presentation of this material. The information presented in this book has been obtained with the greatest of care from sources believed to be reliable, but is not guaranteed to be complete, accurate, or timely. The authors and Duff & Phelps LLC expressly disclaim any liability, including incidental or consequential damages, arising from the use of this material or any errors or omissions that may be contained in it.