Cost of Capital in Business Valuation – Comparison of Standards in the DACH Region

published on 20 February 2024 | reading time approx. 7 minutes

In the German IDW S1, the Austrian KFS/BW 1 and the Swiss Technical Note "Business Valuation", the calculation of the cost of capital in business valuations differs considerably in some cases. In the following, the differences, and similarities for each cost of capital parameter are shown on the basis of the valuation standards of the neighboring countries and valuation in practice is discussed. In addition, the article discusses the use of cost of capital premiums for country risk and company size.

Three countries – three valuation standards »
Valuation methods and cost of capital »
Cost of equity »
Cost of debt »
Cost of capital premiums »
Fungibility/Lack of diversification/Size premium/Country risks »
Conclusion »

Three countries – three valuation standards

In Germany, Austria, and Switzerland the respective professional associations of auditors have developed their own valuation standards. The German valuation standard IDW S1 ("Grundsätze zur Durchführung von Unternehmensbewertungen"), as amended in 2008, of the Institut der Wirtschaftsprüfer (Institute of Public Auditors in Germany) and the Austrian KFS/BW 1 ("Fachgutachten zur Unternehmensbewertung"), as amended in 2014, of the Kammer der Steuerberater und Wirtschaftsprüfer (Chamber of Tax Consultants and Auditors) are mandatory for the respective professions. In contrast, EXPERTsuisse, as the Swiss professional association, only recommends the application of the "Technical note on Business Valuation" for valuations as of July 1, 2022.

The valuation standards form the basic framework in the respective countries and are supplemented by further statements from the standard setters. In Germany, questions and answers on the practical application of IDW S1 in valuation practice are published. In Austria, KFS/BW 1 is now supplemented by seven recommendations issued by the Expert Committee. In both countries, special features of the valuation of investments must also be taken into account (see IDW RS HFA 10 and AFRAC 24). In Switzerland, EXPERTsuisse published an annotated version of the Technical Note "Business Valuation" with background information on the recommendations and supplementary information.

Valuation methods and cost of capital

The valuation method used determines the derivation of the cost of capital. The cost of capital for each valuation approach is as follows:

Source: own presentation

The methods listed in the table are permitted in all three countries. While the capitalized earnings method is widely used in Germany, a preference for the DCF-WACC method is emerging in Switzerland.

When determining the cost of capital, it is important to consider whether the valuation is before or after personal taxes. Given that valuation after personal taxes does not play a role in Swiss valuation practice and that there are numerous exceptions in Germany and Austria, only the calculation of the cost of capital before personal taxes is discussed below.

In Germany and Austria, the cost of capital must be derived from market data using the Capital Asset Pricing Model (CAPM). Although the Austrian valuation standard KFS/BW 1 contains an opening clause for other cost of capital concepts, these do not play a role in valuation practice. According to the Technical Note "Business Valuation", the cost of capital can generally be determined on the basis of market data and estimated subjectively. However, the commentary to the Business Valuation Technical Note indirectly suggests that the appraiser should use a market data-based calculation using the CAPM. Therefore, only the determination of the cost of capital using the CAPM is presented below.

Cost of equity

In addition to the risk-free interest rate (base rate), the market risk premium and the beta factor must be determined for the cost of equity.

The first differences already exist in the determination of the discount rate. According to IDW S1, the discount rate must always be determined using the Svensson method, whereas in Austria and Switzerland, the spot rate of a 30-year federal bond can be used in addition to the Svensson method. Furthermore, in Germany, a rounded 3-month average is used to determine the base rate in order to smooth out short-term market fluctuations and possible estimation errors. In Austria and Switzerland, the base rate as of the valuation date is used. Another difference results from the different currency areas. In Switzerland, the base rate is derived from Swiss government bonds, while in Germany and Austria it is derived from German government bonds.

Standard setters in Germany and Austria publish recommendations for determining the market risk premium. Both standard setters base their recommendations on analyses of market returns but take different approaches to the specific recommendation. The IDW Expert Committee for Business Valuation (FAUB) follows a pluralistic approach and publishes a recommended range for the market risk premium (currently: 6-8 percent before personal taxes). The FAUB leaves the determination within the range to the appraiser. The approach of the KSW Working Group on Business Valuation differs in that it publishes a recommended range for the market return (currently 7.5-9 percent). The market risk premium is calculated by subtracting the base rate from the market return. According to KFS/BW 1 Recommendation 7, implicit cost of capital studies should be considered in determining the range. An application note dated October 5, 2022 states that it may be appropriate to deviate from the upper limit of the recommended range in light of increased long-term inflation expectations. Thus, the Austrian standard-setter allows the appraiser to respond to increases in long-term inflation expectations as part of the valuation. There are no similar recommendations for determining the market risk premium in Switzerland. The commentary to the "Business Valuation" Note refers to historical studies of capital market returns on Swiss equities. According to these studies, a market return of 6-8 percent can be expected for Switzerland, although a market return of 7-8 percent is predominantly used in Swiss valuation practice. The explanations in the commentary implicitly lead to a recommendation by EXPERTsuisse for valuers in determining the market risk premium.

Compared to German IDW S1, the valuation standards of neighboring countries contain many statements on the beta factor. In Austria and Switzerland, the company-specific beta factor must be used for listed companies. If this is not meaningful or the company is not listed, the beta factor of comparable companies must be used (peer group beta). Alternatively, the use of a sector beta can be considered. KFS/BW 1 and the Technical Note "Business Valuation" differ in that KFS/BW 1 gives equal weight to peer group beta and industry beta. In Switzerland, however, the industry beta has a lower priority and should only be used if the peer group beta does not lead to reliable results. With regard to adjustment formulas, the Austrian and Swiss valuation standards do not specify any requirements, although a tendency towards risky tax shields can be seen in the comments to the Technical Note "Business Valuation". However, both valuation standards provide information on the consideration of debt betas. Both standards require a debt beta to be considered if the debt is risky. Supplementary explanations in both countries state that a debt beta of zero can be assumed for fully collateralized loans and automatic interest rate adjustments in the event of a deterioration in the economic situation. The German IDW S1, on the other hand, does not provide any information on debt beta; more detailed information can be found in IDW Valuation Guideline 5.011 ("Consideration of the Leverage Ratio in the Valuation of Companies"). We discuss this valuation guideline in detail here. Otherwise, the peer group beta is widely used in German valuation practice.

Under all valuation standards, the debt-related cost of equity is generally determined on an accrual basis, i.e., taking into account the debt in the period. The commentary to the Technical Note "Business Valuation" states that the period-specific determination of the cost of capital is not very common in Swiss valuation practice but is recommended for reasons of consistency.

When determining the leverage ratio or the weighting in the WACC approach, the market values for equity and debt must be used under all standards.

Cost of debt

For debt costs, all three measurement approaches use expected debt costs. These are determined at the measurement date and may differ from the contractual interest rates of existing interest-bearing liabilities. In its Recommendation 3, the Austrian KSW explicitly states that only systematic risks should be included in the expected cost of debt. As a result, the adjusted present value (APV) method must include a discount for unsystematic risk in the credit spread. In determining the weighted average cost of capital, the tax deductibility of debt must be taken into account. The weighting of the cost of capital in the WACC approach is also based on market values.

Cost of capital premiums

Source: own presentation

Fungibility/Lack of diversification/Size premium/Country risks

The inclusion of premiums in the cost of capital is intensively discussed in the literature and in valuation practice in all three countries. Country risk is highly relevant in practice. However, size premiums and illiquidity premiums are also discussed. The German and Austrian standards make no explicit reference to including premiums in the cost of capital. In contrast to Austria, however, the German FAUB at least commented on the consideration of country risks in a 2012 statement. Even if the FAUB generally recommends the consideration of country risks in the financial surpluses, the consideration in the cost of capital as a premium on the cost of capital calculated according to the CAPM is an alternative for reasons of simplification. The FAUB considers the spread of government bonds over (quasi) safe government bonds to be a suitable indicator of country risks.

In Germany, the application of additional cost of capital add-ons is not permitted in the determination of objectified business values.

In subjective valuations, cost of capital premiums are more common, depending on the reason for the valuation and the valuation object.

In Austria, there are no comparable statements by the standard setters. Since KFS/BW 1 is open to other capital market models in addition to the CAPM, it could initially be assumed that the inclusion of country risks or size premiums in the cost of capital is permissible. In view of the historical development of KFS/BW 1, however, this is not advisable. The 2006 version of KFS/BW 1 still provided for the possibility of adjusting the risk premium determined by the valuer using the CAPM. In the currently valid version of 2014, this option has been completely removed, so that even without an explicit announcement, it can be assumed that premiums of any kind are not permitted in the cost of capital according to KFS/BW 1. Risks should therefore be reflected in the financial surpluses according to KFS/BW 1.

While the German and Austrian standards are restrictive with regard to the inclusion of premiums, the Swiss standard setters are open to it. According to the Technical Note "Business Valuation", both country risks and size premiums can be included in the cost of capital. At the same time, the commentary makes it clear that premiums must be used with caution and must be justified in detail, particularly in the case of objectified valuations. If premiums are used, the "modified CAPM" method, which is widely used in the literature, should be applied. For the consideration of country risk premiums in the cost of capital, the commentary advocates the approach of Prof. Damodaran. For the consideration of the size premium, reference is made to the comprehensive studies of Prof. Peek.

The following table summarizes the cost of capital parameters:

Source: own presentation

Conclusion

While the German and Austrian standards are more closely aligned, the new Swiss valuation standard is more closely aligned with Anglo-American valuation practice. This gives the appraiser more freedom in deriving the cost of capital. In view of the associated potential for conflict, we believe that a well-founded cost of capital calculation based on market data is also necessary in Switzerland. In addition, a comprehensible justification and documentation of the selected parameters plays an important role in Switzerland. The country-specific characteristics require extensive knowledge in practical application. Not only the framework valuation standards, but also further statements and recommendations of the standard setters as well as discussions in the relevant literature have to be considered in the context of the valuation object and the reason for the valuation.

According to FAUB, the German valuation standard IDW S1 is currently undergoing a fundamental revision. The near future will show whether the existing similarities or differences to neighboring countries will increase.