Build-Up method is one of the important tools for business valuation. It is widely used by the income approaches to evaluate the market value of the property or the asset. The rate of discount on the net cash flow after paying all the taxes is estimated through the Build-Up method.
The capitalization rates are also related to these estimations.A number of sources are used by Build-Up method to collect information that is used for the purpose of estimation. There are a number of risk factors that are related to the properties or assets. These risks are collectively represented by the Build-Up method.
The main belief behind the Build-Up method is that all kinds of investment in the assets where the risk factors are high are expected to produce high returns. There are three factors that are related to the Build-Up method and these three are jointly known as the systematic risks.
Risk free rate is one of these three elements and this rate is mainly related to the government bonds designed for long term. Again there are the investors who are interested in the equity stocks.
These equities carry huge amounts of risk unlike the government bonds. Because of this risk factor, the investors always expect high returns from these stocks. Because of all these, the equity risk premium is also considered as an important factor for the Build-Up method.
The average return rate from the shares of large public companies is predicted jointly by the equity risk premium along with risk-free rate. At the same time, another factor termed as “size premium” is also very important for the Build-Up method. The size premium is an expected rate of return that is expected by those who invest in small cap shares. These small cap shares are more risky than others and so these are expected to yield highly.
The combination of size premium, risk-free rate and the equity risk premium is used by the investors and the analysts for predicting the required rate of return from the stocks of several small public companies. Another important factor for predicting the required rate of return of stocks from small companies is the unsystematic risks. The specific company risk and the industry risk premium should be considered to predict the required rate of return from certain stocks.
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