Should you being using a higher discount rate for a smaller company?
Can someone enlighten me on why this is so, if so? Thanks!
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From first principles...
WACC consists of cost of debt and cost of equity.
Cost of debt is what you can get. Other things being equal, banks will charge higher interest to smaller companies, so WACC would be a higher a result.
Cost of equity is risk free rate + company beta x (expected market return - risk free rate).
So size of company only impacts cost of equity if size of the company influences beta of the company's earnings. This will depend on nature of the company's earnings and their correlation to the expected market return - ie beta is a measure of systemic risk.
Size of company may impact on the cash flows you are discounting, which are the probability weighted cash flows. If a company's business is risky and the nature of risk is such that you could diversify away that risk via portfolio selection, that non-systemic risk specific to the business should be reflected in the probability weight cash flows, not the discount rate.
Note my answer is based on theory.
In IB practice, people happily include non-systemic considerations in their choice of discount rate eg adding a country risk premium. Often, IB models only have one base case cash flow forecast rather than probability weighted cash flows.
We I-bankers abuse the theory our "science" rests on, often without appreciating how much we're producing junk results.
That's all good, though, because we ultimately back solve our results to numbers that mean the client does the deal which means we get paid our fee. No deal, no fee, no bonus.
there is usually a size premium you supply, so yes if it's a small cap company the discount rate will be higher in most cases, all else equivalent
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