Certified Valuation Analyst CVA Valuation Approaches and Methodologies 2 — Questions and Answers
Question 1: Under the income approach, the capitalization of earnings method is most appropriate when a company's future earnings are expected to:
- Grow at a stable, constant rate (Correct answer)
- Fluctuate widely year to year
- Decline to zero within five years
- Be entirely reinvested with no distributions
Correct answer: Grow at a stable, constant rate
Capitalization of earnings assumes a single, stable growth rate, making it suitable for companies with steady, predictable earnings.
Question 2: The capitalization rate used in the income approach is best described as:
- The discount rate minus the long-term growth rate (Correct answer)
- The discount rate plus the growth rate
- The risk-free rate alone
- The company's tax rate
Correct answer: The discount rate minus the long-term growth rate
The capitalization rate equals the discount rate less the expected long-term sustainable growth rate.
Question 3: In the discounted cash flow method, the terminal value typically represents:
- The bulk of total enterprise value for a going concern (Correct answer)
- Only the final year's cash flow
- The liquidation proceeds of fixed assets
- The historical book value of equity
Correct answer: The bulk of total enterprise value for a going concern
Terminal value usually accounts for a large portion of total value because it captures all cash flows beyond the explicit forecast period.
Question 4: Which adjustment is commonly made to normalize earnings before applying an income approach?
- Removing above-market owner compensation (Correct answer)
- Adding back all depreciation permanently
- Eliminating all interest expense regardless of debt
- Ignoring non-recurring lawsuit settlements
Correct answer: Removing above-market owner compensation
Normalizing adjustments remove excess owner compensation to reflect a fair-market wage and true earning capacity.
Question 5: The Gordon Growth Model is used in the income approach primarily to:
- Calculate the terminal value of perpetual cash flows (Correct answer)
- Determine the company's beta
- Estimate working capital needs
- Allocate purchase price among assets
Correct answer: Calculate the terminal value of perpetual cash flows
The Gordon Growth Model capitalizes a perpetual stream of cash flows growing at a constant rate to compute terminal value.
Question 6: When projecting cash flows, an analyst should ensure the growth rate used in perpetuity does not exceed:
- The long-term growth rate of the overall economy (Correct answer)
- The company's most recent single-year growth
- The discount rate plus inflation
- The industry's gross margin
Correct answer: The long-term growth rate of the overall economy
A perpetual growth rate above long-term economic growth is unrealistic because the company would eventually outgrow the economy.
Question 7: A key limitation of the income approach is that it:
- Relies heavily on the reliability of future projections (Correct answer)
- Cannot be used for profitable companies
- Ignores the time value of money
- Requires identical guideline public companies
Correct answer: Relies heavily on the reliability of future projections
The income approach is only as reliable as the assumptions and forecasts that drive the projected cash flows.
Certified Valuation Analyst CVA Valuation Approaches and Methodologies 2
Under the income approach, the capitalization of earnings method is most appropriate when a company's future earnings are expected to: