Estimating the Cost of Capital, Article Critique Example

Ralph Palliam’s article “Estimating the Cost of Capital: Considerations for Small Business” (2005) explores a proposed “analytical hierarchy process (AHP).” The AHP is intended to calculate the cost of capital in relation to small business. According to Palliam, the  method that is used by publically traded companies is not applicable to small business because capital cost for publically traded companies is based on market information. Pelliam’s model is an attempt to go beyond the scope of “proxy approaches”  (Palliam, 2005, p. 335). in order to generate a reliable system for estimating capital cost and thereby making the job of both small business operators and lenders more functional and profitable.

Palliam’s argument for the need for a process such as the AHP is very p[persuasive. he remarks that “When financial analysts evaluate capital investment projects or securities, they need to come up with some estimate of the required rate of return  […] The required rate of return should reflect the individual riskiness of specific projects or securities. (Palliam, 2005, p.337).  This statement shows that Palliam understands risk-aversion to be a primary issue in small business. He ties the idea of risk-aversion to capital costs through the proposed AHP process. However convincing Palliam’s argument is for the need for a system to calculate the capital cost of small business, his explanation for his proposed method, the AHP, is slightly less convincing.

The main reason for this is that the financial components of a given typical small business are so complicated and so dependant on subjective variables that any system designed to assess the capital cost structure seems inadequate. For example, Palliam p[points out that for many small business the issue of business capital is so deeply tied to the personal finances of the business owner that it is almost impossible to separate the two. Additionally, the  admission by Palliam that any method “would benefit from a method that incorporates both quantifiable and non-quantifiable risk factors”  (Palliam, 2005, p. 338) shows that the complexity of the task is beyond the scope of any readily defined system. That said, Palliam’s basic ideas and conclusions are sound and are fully and logically supported throughout the article.

Reference

Palliam, Ralph. (2005). Estimating the cost of capital: considerations for small business The Journal of Risk Finance 6. 4 (2005): 335-340