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More About This Textbook
Overview
"I would recommend Cost of Capital and the companion Cost of Capital Workbook as excellent tools for passing the various professional exams that lead to valuation accreditations and designations."
James R. Hitchner, Phillips Hitchner Group, Inc., Atlanta, Georgia
"As a discussion leader for the AICPA ABV exam review course, this set of questions is perfect for people to use for practice for that exam and others (ASA and NACVA from my experience), for that matter. The mix of formats, including exercises, is great."
Ronald L. Seigneur, Seigneur & Company, PC, CPAs, Lakewood, Colorado
"The exercises are particularly good."
Stephen J. Bravo, Apogee Business Valuations, Framingham, Massachusetts
Cost of capital estimation has long been recognized as one of the most critical elements in business valuation, capital budgeting, feasibility studies, and corporate finance decisionsit is also, however, one of the most difficult procedures to perform and assess. The Cost of Capital Workbook will help financial officers of small, midsize, and even multibillion dollar companies estimate required rates of return and tackle the myriad issues associated with cost of capital. It will also help business valuation professionals of all levels to gain a greater understanding of cost of capital concepts and procedures.
Using handson exercises designed to implement procedures described in Cost of Capital, Second Edition, the Cost of Capital Workbook provides a deeper understanding of cost of capital problems by offering a practical experience in applying solutions. The Workbook includes multiple choice, true or false, and fillintheblank questions as well as:
* Exercises estimating cost of capital by the buildup model and the Capital Asset Pricing Model
* Exercises using Ibbotson Associates' Stocks, Bonds, Bills, and Inflation Valuation Edition Yearbook
* Applications using discounted cash flow (DCF) methods, based on forecasted earnings and cash flows
* Examples covering valuing a business by both equity and invested capital procedures, making project selections, and utilityrate determinations
* Numerous exercises using Ibbotson data from the Cost of Capital Workbook
Business appraisers, corporate finance officers, CPAs, and attorneys will find the Cost of Capital Workbook an indispensable guide to the effective estimation and application of cost of capital.
Product Details
Meet the Author
ALINA V. NICULITA is the managing editor of Shannon Pratt's Business Valuation Update (r). She earned her bachelor of economics in banking and financing from the Academy of Economic Studies in Bucharest, Romania, and her master's in business administration in finance from the Joseph M. Katz Graduate School of Business at the University of Pittsburgh.
Read an Excerpt
Cost of Capital Workbook
By Shannon P. Pratt
John Wiley & Sons
ISBN: 0471228966Chapter One
Defining Cost of CapitalThis chapter presents a variety of concepts about the nature of cost of capital and how measured.
MULTIPLE CHOICE QUESTIONS
1. Cost of capital usually is expressed:
a. In percentage terms, as a percentage of the face value of the investment.
b. In percentage terms, as a percentage of the amount invested.
c. In dollar terms, in real dollars.
d. In dollar terms, in nominal dollars.
2. The components of a company's capital structure include:
a. Accounts payable, longterm debt, and preferred stock.
b. Accounts payable, preferred stock, and common stock.
c. Accounts payable, longterm debt, and common stock.
d. Longterm debt, preferred stock, and common stock.
3. Cost of capital for an acquisition or a project is a function of:
a. The company's marginal overall cost of capital.
b. The company's average overall cost of capital.
c. The company's marginal cost of equity capital.
d. The investment (the use to which the capital is put).
4. Which of the following items are referred to as the "time value of money"?
a. The expected "real" rate of return, expected inflation, and risk.
b. The expected "real" rate of return and expected inflation but not risk.
c. Expected inflation and risk but not the expected "real" rate of return.
d. The expected "real" rate ofreturn and risk but not expected inflation.
5. Which of the following is a correct statement?
a. Cost of capital is based on market value and usually is stated in real terms.
b. Cost of capital is based on book value and usually is stated in real terms.
c. Cost of capital is based on market value and usually is stated in nominal terms.
d. Cost of capital is based on book value and usually is stated in nominal terms.
6. Which of the following terms are often (properly) interchangeable?
a. Cost of capital, discount rate, and required rate of return.
b. Cost of capital and discount rate but not required rate of return.
c. Cost of capital and required rate of return but not discount rate.
d. Required rate of return and discount rate but not cost of capital.
7. Which of the following is used as a divisor to convert a single element of return to an estimate of present value?
a. Cost of capital.
b. Discount rate.
c. Capitalization rate.
d. Required rate of return.
TRUE OR FALSE QUESTIONS
8. Cost of capital is market driven. True False
9. Cost of capital is based on historical returns. True False
10. The discount rate is the link that equates expected future returns for the life of the investment with the present value of the investment at a given date. True False
Chapter Two
Introduction to Cost of Capital Applications: Valuation and Project SelectionThis chapter discusses using the cost of capital as the discount rate in valuation and project selection. It gives the present value formula and an example of applying it to estimate the value of a bond. It discusses briefly the relationship between a discount rate and a capitalization rate.
MULTIPLE CHOICE QUESTIONS
1. For valuation and capital investment project selection, what is the measure of economic income on which most analysts today prefer to focus?
a. Net cash flow.
b. Net income.
c. EBIT.
d. EBITDA.
2. If a company's overall cost of capital is 10%, and a project the company is considering is riskier than the average of the company's overall risk, the rate at which the expected returns from the project should be discounted would be:
a. Less than 10%.
b. 10%.
c. More than 10%.
d. The rate that the proposed project manager recommends.
3. The discount rate represents:
a. The reciprocal of the price/net cash flow ratio.
b. The total expected rate of return.
c. The current yield on the investment.
d. The reciprocal of the capitalization rate.
TRUE OR FALSE QUESTIONS
4. The procedure for using cost of capital to evaluate an acquisition is basically similar to the procedure used for project selection. True False
5. Cost of capital is used to convert expected future returns to present value. True False
FILLINTHEBLANK QUESTIONS
6. Net cash flow is also referred to as:
__________________________________________________
7. A yield rate used to convert a single payment or measure of economic income into a present value is called:
__________________________________________________
EXERCISES
Given the following:
Face value of bond: $1,000 Interest rate on face value: 7% Bond pays interest once a year, at end of year. Bond matures, from valuation date: 4 years Market yield on bonds of comparable risk and other characteristics as of valuation date: 10%
8. Compute the value of this bond at the valuation date.
9. What is the company's embedded cost of capital for this bond?
10. What is the company's market cost of capital for debt such as this?
Chapter Three
Net Cash Flow: The Preferred Measure of ReturnThis chapter defines net cash flow, both to equity and to invested capital, and explains why it is considered the preferred measure of return for valuation and capital budgeting. It also states that the estimates of net cash flow should be probabilityweighted expected values and shows how to calculate them.
MULTIPLE CHOICE QUESTIONS
1. Which of the following must be subtracted from EBITDA to compute net cash flow to invested capital?
a. Depreciation, interest (taxaffected), capital expenditures, and additions to working capital.
b. Depreciation, capital expenditures, and addition to working capital but not interest. c. Capital expenditures, additions to working capital, and interest (taxaffected) but not depreciation.
d. Capital expenditures and additions to working capital, but neither depreciation nor interest.
2. The net cash flows that theoretically should be discounted in future periods are:
a. The most likely outcomes.
b. Amounts based on extrapolation of historical net cash flows.
c. The probabilityweighted expected values.
d. The most conservative estimates of net cash flows.
TRUE OR FALSE QUESTIONS
3. In a symmetrical distribution of possible outcomes, the cash flow most likely to occur is the expected value of the probability distribution. True False
4. Net cash flow is the amount of money available to be distributed without disrupting the projected ongoing operations of the enterprise. True False
5. Net cash flow is the economic income measure for which we have the best historical data available for estimating cost of equity capital. True False
EXERCISES
Use the following balance sheet and income statement for questions 6 and 7.
Old Stable Consulting Co. Balance Sheet as of 12/31/XX
Assets
Current Assets $1,000,000 Furniture, fixtures, & equipment (net of depreciation) 500,000
Total Assets $1,500,000
Liabilities and Equity
Accounts payable 200,000 Current portion of longterm debt 100,000
Total current liabilities $300,000 Longterm debt 400,000 Stockholders' equity 800,000 Total liabilities and equity $1,500,000
Old Stable Consulting Co. Income Statement for Year Ending 12/31/XX
Revenue $9,000,000 Cost of direct labor 3,600,000
Gross margin 5,400,000 General & administrative expenses: Depreciation $100,000 Other G&A 3,700,000 3,800,000
Operating profit $1,600,000 Interest expense 50,000
Pretax income $1,550,000 Corporate income taxes (federal and state) 620,000
Net income $930,000
Assume the following:
Target working capital: 8% of last year's revenue Expected capital expenditures: $120,000
6. Compute the net cash flow to equity.
7. Compute the net cash flow to invested capital.
8. Given the following distribution of possible outcomes (unrelated to questions 6 and 7), compute the expected value (probabilityweighted value):
$100 10% 0 20% +$100 40% +$150 20% +$200 10%
9. What is the most likely outcome of the above distribution?
Chapter Four
Discounting versus CapitalizingChapter 2 briefly introduced the present value formula, which is at the heart of the discounting method, while this chapter presents the capitalization method. The reason the discounting method was presented first, even though the capitalization method is simpler, is that the capitalization method is merely a shortcut version of the discounting method. The student should have a firm understanding of the discounting method to intelligently determine whether results produced by the capitalization method are within a reasonable range of value.
This chapter presents the functional relationship between discounting and capitalizing and a formula for converting a discount rate to a capitalization rate if certain assumptions are met. It also introduces the Gordon Growth Model. It shows how discounting and capitalization models can be combined by using a capitalization model for the "terminal value" in a discounting model.
Finally, the chapter introduces the "midyear convention," which assumes that cash flows are realized more or less evenly throughout the year rather than at the end of the year.
MULTIPLE CHOICE QUESTIONS
1. Which of the following statements is true about the discount rate?
a. It is the reciprocal of the capitalization rate.
b. It represents the total compound rate of return that an investor in that class of investment expects to achieve over the life of the investment.
c. It represents the current yield.
d. Both (b) and (c) are true.
2. Which of the following statements is true about the relationship between discount and capitalization rates?
a. The discount rate equals the capitalization rate only for an investment whose returns are growing at a constant rate over time.
b. The discount rate and the capitalization rate are terms that are properly used interchangeably. c. The discount rate equals the capitalization rate only when the expected returns in each period are equal in perpetuity.
d. The discount rate never equals the capitalization rate.
3. Which of the following is a correct statement?
a. In discounting, changes in expected returns are reflected in the numerator, while in capitalizing, changes in expected returns after the first year are reflected in the denominator.
b. In discounting, changes in expected returns are reflected in the denominator, while in capitalizing, changes in expected returns after the first year are reflected in the numerator.
c. In both discounting and capitalizing, changes in expected returns after the first year are reflected in the numerator.
d. In both discounting and capitalizing, changes in expected returns after the first year are reflected in the denominator.
4. If the expected rate of growth is constant in perpetuity, which of the following is a correct statement about the relationship between the discounting and capitalizing models? a. The discounting model would be expected to produce a higher value than the capitalizing model.
b. The discounting model would be expected to produce the same value as the capitalizing model.
c. The discounting model would be expected to produce a lower value than the capitalizing model.
d. Not enough information is provided to determine what the relationship would be.
5. Which of the following is a correct statement about the midyear convention versus the yearend convention?
a. The midyear convention always produces a higher value than the yearend convention.
b. The yearend convention always produces a higher value than the midyear convention.
c. The midyear and yearend conventions produce the same value only when the cash flows are the same in every year.
d. Sometimes the midyear convention produces a higher value and sometimes the yearend convention produces a higher value, depending on the pattern of the cash flows.
TRUE OR FALSE QUESTIONS
6. In the discounting model, the terminal value is discounted for n + 1 periods. True False
7. In the discounting model, the longer the discrete projection period, the greater the impact of the terminal value on the total present value. True False
8. When the midyear convention is used in the discounting model for the discrete cash flows, it is appropriate to use it for the terminal value as well. True False
FILLINTHEBLANK QUESTIONS
9. The procedure by which the latest year's actual return is increased by a constant rate of growth and the result is divided by a capitalization rate is called:
__________________________________________________
10. The capitalization value of expected cash flows after the discrete projection period is called: __________________________________________________
EXERCISES
11.
Continues...
Table of Contents
Preface.
Acknowledgments.
Notation System Used in This Book.
Basic Formulas.
Section One: Questions.
Part I: Cost of Capital Basics.
1. Defining Cost of Capital.
2. Introduction to Cost of Capital Applications: Valuation and Project Selection.
3. Net Cash Flow: The Preferred Measure of Return.
4. Discounting versus Capitalizing.
5. Relationship between Risk and the Cost of Capital.
6. Cost Components of a Company's Capital Structure.
7. Weighted Average Cost of Capital.
Part II: Estimating the Cost of Equity Capital.
8. Buildup Models.
9. Capital Asset Pricing Model.
10. Proper Use of Betas.
11. Size Effect.
12. Discounted Cash Flow Method of Estimating Cost of Capital.
13. Using Ibbotson Associates Cost of Capital Data.
14. Arbitrage Pricing Model.
Part III: Other Topics Related to Cost of Capital.
15. Minority versus Control Implications of Cost of Capital Data.
16. Handling the Discount for Lack of Marketability.
17. How Cost of Capital Relates to the Excess Earnings Method of Valuation.
18. Common Errors in Estimation and Use of Cost of Capital.
19. Cost of Capital in the Courts.
20. Cost of Capital in Ad Valorem Taxation.
21. Capital Budgeting and Feasibility Studies.
22. Central Role of Cost of Capital in Economic Value Added.
Appendix: Data Resources.
Section Two: Answers.
Part I: Cost of Capital Basics.
1. Defining Cost of Capital.
2. Introduction to Cost of Capital Applications: Valuation and Project Selection.
3. Net Cash Flow: The Preferred Measure of Return.
4. Discounting versus Capitalizing.
5. Relationship between Risk and the Cost of Capital.
6. Cost Components of a Company's Capital Structure.
7. Weighted Average Cost of Capital.
Part II: Estimating the Cost of Equity Capital.
8. Buildup Models.
9. Capital Asset Pricing Model.
10. Proper Use of Betas.
11. Size Effect.
12. Discounted Cash Flow Method of Estimating Cost of Capital.
13. Using Ibbotson Associates Cost of Capital Data.
14. Arbitrage Pricing Model.
Part III: Other Topics Related to Cost of Capital.
15. Minority versus Control Implications of Cost of Capital Data.
16. Handling the Discount for Lack of Marketability.
17. How Cost of Capital Relates to the Excess Earnings Method of Valuation.
18. Common Errors in Estimation and Use of Cost of Capital.
19. Cost of Capital in the Courts.
20. Cost of Capital in Ad Valorem Taxation.
21. Capital Budgeting and Feasibility Studies.
22. Central Role of Cost of Capital in Economic Value Added.
Appendix: Data Resources.
International Glossary of Business Valuation Terms.
CPE Selfstudy Examination.
Index.