Certified Valuation Analyst Income Approach Methods 3 — Questions and Answers
Question 1: The Capital Asset Pricing Model (CAPM) is used in the income approach to estimate:
- The cost of equity capital (Correct answer)
- The terminal growth rate
- Working capital needs
- The company's net asset value
Correct answer: The cost of equity capital
CAPM estimates the required return on equity using the risk-free rate, beta, and equity risk premium.
Question 2: In CAPM, beta measures:
- A company's systematic risk relative to the market (Correct answer)
- The risk-free rate of return
- The company's dividend yield
- Total company-specific risk only
Correct answer: A company's systematic risk relative to the market
Beta quantifies how sensitive a security's returns are to overall market movements (systematic risk).
Question 3: The build-up method differs from CAPM primarily because it:
- Does not rely on a beta coefficient (Correct answer)
- Ignores the risk-free rate
- Uses only the equity risk premium
- Cannot include a size premium
Correct answer: Does not rely on a beta coefficient
The build-up method sums risk premiums without using a beta, making it common for closely held companies.
Question 4: A size premium is typically added to the discount rate because:
- Smaller companies generally carry higher risk than large public firms (Correct answer)
- Small companies always grow faster
- Large companies have higher returns
- It reduces the cost of equity
Correct answer: Smaller companies generally carry higher risk than large public firms
Empirical data shows smaller firms exhibit higher returns and risk, justifying an added size premium.
Question 5: The company-specific risk premium accounts for:
- Unsystematic risks unique to the subject company (Correct answer)
- General market risk
- The risk-free rate
- Inflation expectations
Correct answer: Unsystematic risks unique to the subject company
This premium reflects firm-specific factors such as customer concentration or key-person dependence not captured elsewhere.
Question 6: The Weighted Average Cost of Capital (WACC) is the appropriate discount rate when valuing:
- Invested capital (debt plus equity) cash flows (Correct answer)
- Only equity cash flows
- Personal goodwill
- Liquidation proceeds
Correct answer: Invested capital (debt plus equity) cash flows
WACC blends the cost of debt and equity and is used to discount cash flows available to all capital providers.
Question 7: When converting an after-tax discount rate to value pre-tax cash flows, an analyst must:
- Ensure the rate and cash flow basis are consistent (Correct answer)
- Always use a higher growth rate
- Ignore taxes entirely
- Apply a control premium
Correct answer: Ensure the rate and cash flow basis are consistent
Consistency between the cash flow basis and discount rate (both after-tax or both pre-tax) is essential to avoid error.
Certified Valuation Analyst Income Approach Methods 3
The Capital Asset Pricing Model (CAPM) is used in the income approach to estimate: