CVA Discount Rates and Cost of Capital Flashcards

The capitalization rate in a single-period income capitalization model is calculated as:

Answer: Discount rate minus long-term sustainable growth rate

The cap rate equals the required rate of return (discount rate) minus the expected long-term growth rate of the income stream.

When valuing equity cash flows directly (rather than invested capital), the discount rate used should be:

Answer: Cost of equity only

Equity cash flows are discounted at the cost of equity because those flows belong to equity holders after all debt obligations are serviced.

A higher degree of financial leverage in a company's capital structure generally results in:

Answer: A higher cost of equity due to increased financial risk to shareholders

Greater leverage increases the volatility of equity returns and financial risk borne by shareholders, requiring a higher equity return as compensation.

In practice, the total cost of equity for a small private company using the build-up method is most likely in the range of:

Answer: 15%–25% or higher, due to size and company-specific risk premiums

Small private companies carry substantial size and company-specific risk premiums on top of ERP and the risk-free rate, typically producing total equity costs well above 15%.

The 'terminal value' in a multi-period discounted cash flow model is most sensitive to changes in:

Answer: The long-term growth rate assumption

Because the terminal value represents the present value of all cash flows beyond the forecast period, small changes in the perpetual growth rate have a disproportionately large impact.

Which of the following would cause a CVA analyst to apply a higher company-specific risk premium to the discount rate?

Answer: The subject company derives 80% of revenue from a single customer

High customer concentration is a classic company-specific risk that increases the discount rate because losing one major customer would severely impair cash flows.