The Company Risk Premium accounts for additional risks specific to an individual company that are not captured by the general market or systematic risks reflected in beta. It reflects the unique characteristics, challenges, or uncertainties associated with a particular business.
This premium is often added to the Cost of Equity calculation to account for risks such as:
Small company size
Concentrated customer base
Dependence on a single product or market
Volatile earnings or cash flows
Management quality or governance issues
Industry-specific challenges or competitive disadvantages
How is the Company-Specific Risk Premium Used in WACC?
The CSRP is added to the Cost of Equity as part of the build-up method or as an adjustment to the Capital Asset Pricing Model (CAPM):
Adjusted CAPM Formula:
Where:
rₓ: Risk-free rateβₑ: Levered BetaMRP: Market Risk PremiumCSRP: Company-Specific Risk Premium
Incorporation into WACC:
Once the adjusted Cost of Equity is determined, it is included in the WACC formula:
The higher the CSRP, the higher the Cost of Equity and, consequently, the WACC.
Why is the Company-Specific Risk Premium Important in WACC?
Addresses Unique Risks:
While beta captures market-wide risks, CSRP adjusts for company-specific risks that might not be diversified away in a portfolio.
Refines Cost of Equity:
Adding CSRP ensures the Cost of Equity better reflects the risks investors perceive in the company.
Impact on WACC:
A higher CSRP increases WACC, which raises the hurdle rate for investment decisions and lowers the present value of future cash flows in valuation.
Crucial for Smaller or Riskier Firms:
Smaller companies, start-ups, or firms with unique challenges often face risks not adequately captured by market-based metrics like beta.