Certified Valuation Analyst Income Approach Methods 2 — Questions and Answers
Question 1: Under the capitalization of earnings method, the capitalization rate is derived by:
- Subtracting the long-term growth rate from the discount rate (Correct answer)
- Adding the growth rate to the discount rate
- Multiplying the discount rate by the tax rate
- Dividing net income by total assets
Correct answer: Subtracting the long-term growth rate from the discount rate
The cap rate equals the discount rate minus the expected long-term sustainable growth rate.
Question 2: The discounted cash flow (DCF) method is most appropriate when:
- Future cash flows are expected to vary significantly year to year (Correct answer)
- The company has perfectly stable, unchanging earnings
- No financial projections are available
- The company is being liquidated
Correct answer: Future cash flows are expected to vary significantly year to year
DCF suits businesses with uneven or changing projected cash flows because it discounts each period individually.
Question 3: In a DCF analysis, the terminal value represents:
- The value of cash flows beyond the explicit forecast period (Correct answer)
- The company's current book value
- The first year of projected earnings
- The total liabilities at exit
Correct answer: The value of cash flows beyond the explicit forecast period
Terminal value captures all cash flows occurring after the discrete projection period.
Question 4: Which normalization adjustment is commonly applied to owner compensation in the income approach?
- Adjusting above-market owner salary to a market rate (Correct answer)
- Removing all employee wages
- Doubling the owner's bonus
- Eliminating cost of goods sold
Correct answer: Adjusting above-market owner salary to a market rate
Excess owner compensation is normalized to a reasonable market-rate salary to reflect true earning capacity.
Question 5: The Gordon Growth Model is used in valuation primarily to calculate:
- A terminal value assuming constant perpetual growth (Correct answer)
- Working capital requirements
- Depreciation schedules
- The company's marginal tax rate
Correct answer: A terminal value assuming constant perpetual growth
The Gordon Growth Model estimates terminal value as a perpetuity growing at a constant rate.
Question 6: When applying a mid-year convention in a DCF, the analyst assumes cash flows are received:
- Evenly throughout the year rather than at year-end (Correct answer)
- Only at the very end of each year
- All at the beginning of year one
- Exclusively in the terminal year
Correct answer: Evenly throughout the year rather than at year-end
The mid-year convention discounts cash flows as if received at mid-period, reflecting continuous receipt.
Question 7: A higher discount rate applied to the same projected cash flows will result in:
- A lower present value and lower indicated value (Correct answer)
- A higher present value
- No change in value
- An increase in terminal value
Correct answer: A lower present value and lower indicated value
Increasing the discount rate reduces the present value of future cash flows, lowering the indicated value.
Certified Valuation Analyst Income Approach Methods 2
Under the capitalization of earnings method, the capitalization rate is derived by: