Chapter 5: Capitalization/Discount Rates

To convert a pre-tax capitalization rate to after-tax capitalization rate: a. Multiply the pre-tax capitalization rate by 1 minus the expected tax rate b. Divide the after-tax capitalization rate by 1 minus the expected tax rate c. Multiply the pre-tax capitalization rate by 1 plus the expected tax rate d. Divide the after-tax rate by 1 plus the expected tax rate

A is Correct—The formula to convert an after-tax capitalization rate to a pre-tax capitalization rate is to multiply the pre-tax capitalization rate by 1 minus the expected tax rate.

What are the four general risk factor categories of the risk rate component model (RRCM)? a. Competition, financial strength, profitability and stability of earnings, and management ability and depth b. Competition, national economic effects, local economic effects, and depth of management c. Local economic effects, financial strength, market stability, and profitability and stability of earnings d. National and local economic effects, financial strength, management ability, and competition

A is Correct—The primary factors of the RRCM include competition, financial strength, management ability and depth, and profitability and stability of earnings.

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 (i.e., minority) interest. a. True b. False

B is Correct—A non-controlling (i.e.,minority) interest, by its nature, would not have the ability to change the capital structure of an entity.

Which variable below is NOT included in the Build-Up Method? a. Risk free rate of return b. Beta c. Size premium d. Specific company risk

B is Correct—Beta is a component of the capital asset pricing model and is not included in the Ibbotson Build-up Method

A capitalization rate and a discount rate are essentially the same thing. a. True b. False

B is Correct—Discount rates are applied to convert a series of future income amounts to present value whereas capitalization rates are applied to a single-period benefit stream to convert to a value.

General expectations of the particular business being valued, the size of the business being valued, and the nature of the business being valued are examples of: a. External factors that may influence the capitalization or discount rate b. Internal factors that may influence the capitalization or discount rate c. Investment factors that may influence the capitalization or discount rate d. Marketability factors which affect the capitalization or discount rate

B is Correct—General expectations, size, and nature of the business being valued are internal factors that may influence the capitalization or discount rate. c. Investment factors that may influence the capitalization or discount rate

What component of cost of capital using a build-up method would the Duff & Phelps data help you determine? a. Company specific risk b. Equity risk premium c. Risk free rate d. Beta

B is Correct—The Duff & Phelps data was developed to measure the equity risk premium in determining the cost of capital.

The Duff & Phelps equity risk premium measurements are sorted into ___________________ measures of size. a. five b. eight c. ten d. twelve

B is Correct—The Duff & Phelps equity risk premium measurement data is sorted into eight (8) measurements of size.

What is a capitalization rate? a. The calculated external factor and internal factor multiplied by the investment factor b. Divisor (or multiplier) used to convert a defined stream of income to present value c. The price/earnings ratio divided by the dividend paying capacity d. Rate of return used to convert a series of future income amounts to their present value

B is Correct—The capitalization rate is a divisor or multiplier used to convert a defined stream of income (or benefit stream) determined by the valuation analyst to its present value. c. The price/earnings ratio divided by the dividend paying capacity.

It is generally accepted that the capitalization rate is equivalent to the discount rate less: a. Short-term growth rate b. Long-term sustainable growth rate c. Equity risk premium d. Risk free rate

B is Correct—The discount rate less the long term sustainable growth rate equals the capitalization rate.

If a valuation analyst uses the weighted average cost of capital (WACC) and is valuing only the equity of the company, the valuation analyst would: a. Capitalize equity and ignore the debt b. Capitalize invested capital then subtract existing deb c. Determine the present value of the debt only d. Capitalize the cash flow net of debt

B is Correct—Using the WACC method and valuing only the equity of the company the valuation analyst must calculate the value of the company's entire capital structure and then subtract the debt.

The price earnings ratios for five public companies are: 8.20, 4.60, 5.00, 4.86, and 2.10. The after tax capitalization rate is: a. 16.00% b. 18.08% c. 20.19% d. 24.76%

C is Correct— The formula to determine a capitalization rate from a series of price/earnings ratios is: 1/(sum of P/E ratios / number of P/E ratios). Here the calculation is 1/((8.20 + 4.60 + 5.00 + 4.86 + 2.10)/5) = 20.19%

To calculate the weighted average cost of capital (WACC): a. Calculate the cost of debt plus the cost of equity in proportion to their book values b. Calculate the weighted average earnings and divide by the ratio of debt to equity c. Calculate the after-tax weighted cost of debt and add the weighted cost of equity d. Calculate the interest rate on a mid-range treasury bond and divide by beta

C is Correct—Formula for weighted average cost of capital is cost of capital = after tax weighted cost of debt + weighted cost of equity. The weights of both the debt and equity components are measure at fair market value.

The primary formula for the Capital Asset Pricing Model (CAPM) is: a. Expected return = risk-free rate divided by beta multiplied by the expected return on a market portfolio b. Expected return = risk-free rate multiplied by beta multiplied by the expected return on a market portfolio less the risk-free rate. c. Expected return = risk-free rate plus beta multiplied by the expected return on a market portfolio less the risk-free rate. d. Expected return = beta divided by the risk-free rate multiplied by the expected return on a market portfolio less the risk-free rate

C is Correct—Some valuation analysts substitute the average pre-tax return on equity for the market portfolio in CAPM. The valuation analyst needs to define which is used and why.

An estimate of a long-term sustainable growth rate should: a. Equal inflation plus the real volume growth that can be achieved with additional capital investment b. Equal inflation less the real volume growth that can be achieved with additional capital investment c. Equal inflation plus the real volume of growth that can be achieved without additional capital. Investment d. None of the above

C is Correct—The theoretical basis for long-term sustainable growth is that it cannot exceed the outlook for inflation plus the outlook for growth in the real gross domestic product (GDP).

Using the Modified Capital Asset Pricing Model a valuation analyst determines beta = 1.08. This means: a. The subject company is no more or no less volatile than the industry b. The subject company is less volatile than the industry c. The subject company is more volatile than the industry d. The subject company has no relative market risk

C is Correct—When beta is 1.08 this is representative that the company is more volatile or more risky than the overall industry.

What is a discount rate? a. The calculated external factor and internal factor multiplied by the investment factor b. Divisor or multiplier used to convert a defined benefit stream to present value c. The price/earnings ratio divided by the dividend paying capacity d. A rate of return used to convert a series of future income amounts to their present value

D is Correct—A discount rate is the rate of return used by the valuation analyst to convert a series of future benefit streams to their present value.

The criteria for companies included in the measurement data used to determine the equity risk premiums found in the Duff & Phelps Risk Premium Report would include all EXCEPT: a. Must be publicly traded for 5 years b. Must have sales greater than $1 million in any of the previous 5 years c. Cannot be a financial service company d. EBITDA can either be negative or positive based on the most recent 5 year average

D is Correct—Companies must have a positive 5 year average EBITDA for the previous five fiscal years

Which of the following is NOT an assumption of the Capital Asset Pricing Model (CAPM)? a. Investors are risk averse b. There are no taxes and no transactional costs c. The rate received from lending money is the same as the cost of borrowing d. All investors do not have identical investment holding periods

D is Correct—The Capital Asset Pricing Model assumes all investors have identical holding periods.

Which component of the Build-Up Method relates to the "unsystematic risk" associated with a particular business entity? a. Risk free rate b. Equity risk premium c. Beta d. Specific company risk premium

D is Correct—The specific company risk premium relates to the unsystematic risk of a particular business entity.

Earnings per share is: a. The price of risk less the difference between the expected rate of return on a portfolio and the reasonable rate b. The price of the dividend divided by the price c. The market price per share divided by the book value per share d. The net income less preferred stock dividends divided by the number of common shares outstanding

D is Correct—This is the definition of earnings per share (EPS)