Certified Valuation Analyst CVA Discount Rates and Cost of Capital 1 — Questions and Answers
Question 1: In the build-up method for estimating cost of equity, which component is added to the risk-free rate to account for the size of the subject company?
- Small company risk premium (Correct answer)
- Equity risk premium
- Industry risk premium
- Company-specific risk premium
Correct answer: Small company risk premium
The small company risk premium (size premium) compensates investors for the additional risk of investing in smaller companies relative to large-cap stocks.
Question 2: The Weighted Average Cost of Capital (WACC) is used in business valuation primarily when:
- Valuing invested capital using a debt-free net cash flow stream (Correct answer)
- Applying the direct capitalization of equity cash flows
- Using the guideline public company method
- Calculating the asset-based approach
Correct answer: Valuing invested capital using a debt-free net cash flow stream
WACC discounts invested capital (debt-free) cash flows and is appropriate when the capital structure includes both debt and equity.
Question 3: Which risk-free rate is most commonly used in U.S. business valuations as the base for the build-up method?
- Yield on 20-year U.S. Treasury bonds (Correct answer)
- Federal funds rate
- 3-month U.S. Treasury bill yield
- Prime lending rate
Correct answer: Yield on 20-year U.S. Treasury bonds
The 20-year U.S. Treasury bond yield is the standard risk-free rate proxy in U.S. valuations because it matches long-term investment horizons.
Question 4: Beta in the Capital Asset Pricing Model (CAPM) measures:
- Systematic (market) risk of an investment relative to the overall market (Correct answer)
- Total risk including both systematic and unsystematic components
- The company's financial leverage ratio
- The volatility of a company's earnings over time
Correct answer: Systematic (market) risk of an investment relative to the overall market
Beta measures systematic risk — how much a security's returns move in relation to overall market movements — and cannot be diversified away.
Question 5: When using Duff & Phelps size premium data, which decile has the highest size premium?
- Decile 10 (smallest companies) (Correct answer)
- Decile 1 (largest companies)
- Decile 5 (mid-market)
- Decile 8 (small-cap)
Correct answer: Decile 10 (smallest companies)
The smallest companies (Decile 10) carry the highest size premium because they are the most illiquid and risky relative to large-cap benchmarks.
Question 6: The company-specific risk premium (CSRP) in the build-up method is intended to capture:
- Risks unique to the subject company not already reflected in other premium components (Correct answer)
- Macroeconomic risk affecting all businesses equally
- The liquidity of the company's stock in public markets
- Regulatory risk applicable to the entire industry
Correct answer: Risks unique to the subject company not already reflected in other premium components
CSRP reflects idiosyncratic risks such as customer concentration, management depth, or reliance on key personnel that are specific to the subject company.
Certified Valuation Analyst CVA Discount Rates and Cost of Capital 1
In the build-up method for estimating cost of equity, which component is added to the risk-free rate to account for the size of the subject company?