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In order to determine the cost of capital, Mr. Mitchell
utilized the capital asset pricing model (CAPM).30 In his CAPM
analysis, Mr. Mitchell determined a risk-free rate of return and
added this to the product of beta31 and a market risk premium.
Mr. Mitchell then added an unsystematic risk premium to account
for WLI’s status as a small company. Mr. Mitchell used a 7.5-
percent risk-free rate of return based on the market yield of 30-
year U.S. Treasury bonds as of the valuation date. He determined
the market risk premium using historical data published in
Stocks, Bonds, Bills and Inflation by Ibbotson Associates. On
30The capital asset pricing model (CAPM) is utilized to
estimate a discount rate by adding the risk-free rate, an
adjusted equity risk premium, and a specific risk or unsystematic
risk premium. The company’s debt-free cash-flow is then
multiplied by the discount rate to estimate the total return an
investor would require compared to other investments. See Estate
of Klauss v. Commissioner, T.C. Memo. 2000-191 (citing Furman v.
Commissioner, T.C. Memo. 1998-157).
31The application and utility of beta has been described in
the following terms:
Beta, a measure of systematic risk, is a function of
the relationship between the return on an individual
security and the return on the market as a whole.
Betas of public companies are frequently published, or
can be calculated based on price and earnings data.
Because the calculation of beta requires historical
pricing data, beta cannot be calculated for stock in a
closely held corporation. The inability to calculate
beta is a significant shortcoming in the use of CAPM to
value a closely held corporation; this shortcoming is
most accurately resolved by using the betas of
comparable public companies. * * * [Furman v.
Commissioner, T.C. Memo. 1998-157; citation and fn.
ref. omitted.]
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