Certified Valuation Analyst Income Approach Methods 1 — Questions and Answers
Question 1: What is the capitalization of earnings method?
- Dividing a single representative earnings figure by a capitalization rate to determine value (Correct answer)
- Adding up all earnings over the company's history
- Multiplying revenue by the number of employees
- Comparing earnings to industry averages without calculation
Correct answer: Dividing a single representative earnings figure by a capitalization rate to determine value
The capitalization of earnings method converts a single, representative level of earnings (typically normalized) into value by dividing it by a capitalization rate, assuming stable, predictable earnings will continue indefinitely.
Question 2: What is a discounted cash flow (DCF) analysis?
- Projecting future cash flows and discounting them back to present value using a required rate of return (Correct answer)
- Counting the cash currently in the company's bank accounts
- Comparing the company's cash flow to competitor averages
- Calculating the total revenue over the next 5 years
Correct answer: Projecting future cash flows and discounting them back to present value using a required rate of return
DCF projects the company's expected future free cash flows over a discrete period, then discounts them to present value using a discount rate that reflects the risk of those cash flows, plus a terminal value for the period beyond the projection.
Question 3: What is the weighted average cost of capital (WACC)?
- The blended cost of a company's debt and equity financing, weighted by their proportions in the capital structure (Correct answer)
- The average salary cost for all company employees
- The total cost of goods sold divided by revenue
- The interest rate on the company's largest loan
Correct answer: The blended cost of a company's debt and equity financing, weighted by their proportions in the capital structure
WACC calculates the overall required return by weighting the cost of equity and after-tax cost of debt by their respective proportions in the company's capital structure, serving as the discount rate in DCF valuations.
Question 4: What is the build-up method for determining a discount rate?
- Adding risk premiums (risk-free rate + equity risk premium + size premium + company-specific risk) to build a total required return (Correct answer)
- Constructing a building cost estimate
- Combining multiple valuation approaches into one
- Gradually increasing the company's value each year
Correct answer: Adding risk premiums (risk-free rate + equity risk premium + size premium + company-specific risk) to build a total required return
The build-up method constructs a discount rate by starting with the risk-free rate and adding successive premiums for equity risk, size, industry, and company-specific factors to reflect the total risk of the investment.
Question 5: What is the difference between a discount rate and a capitalization rate?
- A discount rate applies to future cash flows; a capitalization rate is the discount rate minus the expected long-term growth rate (Correct answer)
- They are identical concepts
- A capitalization rate is always higher than a discount rate
- A discount rate applies to current earnings only
Correct answer: A discount rate applies to future cash flows; a capitalization rate is the discount rate minus the expected long-term growth rate
The discount rate reflects the total required return on an investment, while the capitalization rate equals the discount rate minus the expected sustainable long-term growth rate, converting a single-period income stream into value.
Question 6: Why are normalizing adjustments made to a company's financial statements in valuation?
- To present the company's economic earning capacity by removing non-recurring, non-operating, and owner-specific items (Correct answer)
- To make the financial statements look more favorable
- To comply with GAAP requirements
- To reduce the company's tax liability
Correct answer: To present the company's economic earning capacity by removing non-recurring, non-operating, and owner-specific items
Normalizing adjustments remove items that don't represent the company's ongoing economic earning capacity, such as excessive owner compensation, non-recurring expenses, related-party transactions, and non-operating assets/liabilities.
Certified Valuation Analyst Income Approach Methods 1
What is the capitalization of earnings method?