Calculating the discount rate
Calculating the discount rate for a potential investment in a small business is not easy. While today’s interest rates may be low, the real rate outside investors will require will not be.
There are several factors these investors will account for. Most valuation professionals use Ibbotson’s SBBI Valuation Edition for RF, ERP, IRP, and SP. The CSP is the more subjective topic open to negotiation between buyer and seller. The cost of equity (K) is equal to the sum of the following discount factors (excluding risk-free rate, all figures vary by industry and business):
RF = risk free rate (2.5%)
ERP = equity risk premium (6.0%)
IRP = industry risk premium (2.5%)
SP = size premium (12.0%)
CSP = company specific risk premium (2.0%)
The conclusion here is that investors will likely require rates > 20% to buy or invest capital into a small business.