Certified Valuation Analyst CVA Discount Rates and Cost of Capital 2 — Questions and Answers
Question 1: To convert a levered beta to an unlevered beta (asset beta), the analyst uses the:
- Hamada equation (Correct answer)
- Gordon Growth Model
- Fisher equation
- Black-Scholes formula
Correct answer: Hamada equation
The Hamada equation strips out the effect of financial leverage to derive the unlevered (asset) beta, which can then be re-levered for the subject company's capital structure.
Question 2: In the WACC formula, the cost of debt is adjusted by multiplying by (1 - tax rate) because:
- Interest expense is tax-deductible, reducing the effective cost of debt financing (Correct answer)
- Debt is always less risky than equity
- The IRS requires this adjustment for all valuations
- It eliminates double-counting of equity risk
Correct answer: Interest expense is tax-deductible, reducing the effective cost of debt financing
The after-tax cost of debt reflects the tax shield on interest payments, which reduces the true cost of debt capital to the company.
Question 3: The equity risk premium (ERP) used in CAPM and the build-up method represents:
- The excess return investors expect above the risk-free rate for investing in equities (Correct answer)
- The return on a diversified portfolio of government bonds
- The company's cost of equity minus its cost of debt
- The historical average return of the S&P 500
Correct answer: The excess return investors expect above the risk-free rate for investing in equities
The ERP compensates equity investors for bearing market risk beyond the guaranteed return of risk-free Treasury securities.
Question 4: When a subject company has no publicly traded stock, an analyst estimates beta by:
- Using unlevered betas of comparable publicly traded companies, then re-levering for the subject's capital structure (Correct answer)
- Using the industry average price-to-earnings ratio as a proxy
- Assuming beta equals 1.0 for all private companies
- Applying the historical earnings growth rate of the subject company
Correct answer: Using unlevered betas of comparable publicly traded companies, then re-levering for the subject's capital structure
Private companies lack market price data, so analysts use guideline public company betas, strip leverage, and re-apply the subject's own capital structure.
Question 5: An increase in the subject company's long-term sustainable growth rate (g) in the Gordon Growth Model will:
- Decrease the capitalization rate and increase value (Correct answer)
- Increase the capitalization rate and decrease value
- Have no effect on the capitalization rate
- Increase both the capitalization rate and value
Correct answer: Decrease the capitalization rate and increase value
Since the cap rate equals (discount rate − growth rate), a higher growth rate reduces the cap rate, which increases the capitalized value of the cash flow.
Question 6: Which data source is most commonly cited by CVA analysts for equity risk premium and size premium inputs in the U.S.?
- Duff & Phelps Valuation Handbook (CRSP data) (Correct answer)
- Federal Reserve Statistical Release H.15
- Bloomberg consensus analyst estimates
- NACVA's quarterly valuation tables
Correct answer: Duff & Phelps Valuation Handbook (CRSP data)
The Duff & Phelps Valuation Handbook, based on CRSP historical data, is the primary industry reference for ERP and size premium inputs in U.S. valuations.
Certified Valuation Analyst CVA Discount Rates and Cost of Capital 2
To convert a levered beta to an unlevered beta (asset beta), the analyst uses the: