- 28 -
Mr. Shelton's analysis and conclusions. Although we do not rely
on any aspect of Mr. Shelton's opinion, we will discuss some of
the major shortcomings for the sake of completeness.
We do not believe that CAPM and WACC are the proper
analytical tools to value a small, closely held corporation with
little possibility of going public. CAPM is a financial model
intended to explain the behavior of publicly traded securities
that has been subjected to empirical validation using only
historical data of the two largest U.S. stock markets. Raabe &
Whittenburg, "Is the Capital Asset Pricing Model Appropriate in
Tax Litigation?", Valuation Strategies 12-15, 36 (Jan./Feb.
1998); see Brealey & Myers, supra at 166 (citing Fama & MacBeth,
"Risk, Return and Equilibrium: Empirical Tests," 81 Journal of
Political Economy 607-636 (1973)). Contrary to the assumptions
of CAPM, the market for stock in a closely held corporation like
FIC is not efficient, is subject to substantial transaction
costs, and does not offer liquidity. Mr. Shelton did not
increase our confidence in his choice of method when he computed
the cost of equity using an unsubstantiated risk-free rate and
risk premium that were not in conformance with the amounts
stipulated, and when he arbitrarily assigned a beta to FIC's
common stock. Beta, a measure of systematic risk,10 is a
10 For purposes of capital market theory, risk is defined as
the degree of uncertainty that expected future returns will be
realized. Capital market theory divides risk into two
components: Systematic risk and unsystematic risk. Systematic,
(continued...)
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