Chapter 5 Capitalization/Discount Rates
It is generally accepted that the capitalization rate is equivalent to the discount rate less:
long-term sustainable growth rate Capitalization Rate = Discount Rate - Long Term Sustainable Growth
A Weighted Average =
(Each Year's Earnings x Weight assigned for each year) / Sum of All Weights Ex. 1999 saw $10 in sales with a weight of 1 2000 saw $15 in sales with a weight of 2 2001 saw $3 in sales with a weight of 3 Weighted Average = ($10+$30+$9) / 6 = $8.17
The price earning ratios for five public companies are: 8.20, 4.60, 5, 4.86, and 2.10. The after-tax capitalization rate is:
20.19% 1/average of price earning ratios 8.2+4.6+5+4.86+2.1= 24.76 24.76/5 = 4.952 1/4.952 = %20.19
What is the Discount Rate?
A rate of return used to convert a series of future income amounts to their present value.
To calculate the weighted average cost of capital (WACC)
Calculate the after-tax weighted cost of debt and add the weighted cost of equity. cost of capital = after tax weighted cost of debt + weighted cost of equity.
If a valuation analyst uses WACC and is valuing only the equity of the company, the valuation analyst would:
Capitalize invested capital the subtract existing debt.
Read the Duff & Phelps Risk Premium report.
Chapter 5, Page 15
What are the four general risk factor categories of risk rate component model (RRCM)?
Competition, Financial Strength, Profitability and Stability of Earnings, Management Ability and Depth
A capitalization rate and a discount rate are essentially the same thing. True or False?
False! Discount rates are applied to convert a series of future income amounts to present value. Capitalization rates are applied to a single-period benefit stream to convert to a value.
What is the Capitalization Rate?
Divisor (or multiplier) used to convert a defined stream of income to present value.
An estimate of long-term sustainable growth rate should:
Equal inflation plus the real volume of growth that can be achieved without additional capital investment. Theoretical basis for long-term sustainable growth is that it cannot exceed the outlook for inflation plus the outlook for growth in the real GDP.
WACC can add versatility to the valuation, in that a valuation analyst could change the capital structure of an entity when valuing a non-controlling (minority) interest. True or False?
FALSE! Because the non-controlling interest, by its nature, does not have the ability to change the capital structure of an entity.
What are the internal factors that may influence the capitalization or discount rate?
General Expectations, Size, and Nature of the business.
With a weighted average of $100, a calculated discount rate of %15, and a long-term growth rate of %3, what is the indicated value based on a single-period earnings method?
Increase weighted average by long term growth rate. Then, divide that amount by the difference of calculated discount rate and long term growth rate. $100 x .03 (Long Term Growth) = $103 $103 / .12 (Calculated Discount Rate - Long Term Growth) $858
The primary formula for the Capital Asset Pricing Model (CAPM) is:
Look in Chapter 5 and read it repeatedly.
Is Beta included in Ibbotson Build-up Method?
No! Beta is a component of the capital asset pricing model and is not included in the Ibbotson Build-up Method.
To convert a pre-tax capitalization rate to after-tax capitalization rate:
Pre-tax capitalization rate x (1 - expected tax rate)
Which component of the Ibbotson Build-up Method relates to the "unsystematic risk" associated with a particular business entity?
Specific company risk premium.
Earnings per share is:
The net income less preferred stock dividends divided by the number of common shares outstanding. (Net Income - Preferred Stock Dividends) / Number of Common Shares Outstanding
If a modified CAPM valuation analyst determines beta = 1.08, this means...
The subject company is more volatile than the industry. A beta greater than 1 indicates that the security's price tends to be more volatile than the market. A beta of less than 1 means it tends to be less volatile than the market.
Doe the CAPM assume that all investors have identical holding periods?
Yes!
