Chapter 4: Cost of Capital

Question 1

What are the three explanations of cost of capital?

Answer 1

1. The return one expects and requires from an investment in a company
2. Discount rate for calculating present value of future cash flows derived from assets
3. Economic cost to the company to attract and retain capital

Question 2

What is one of the primary advantages of using the Duff & Phelps Report (SBBI)?

Answer 2

Provides the appraiser with several measures of company size other than market capitalization.

(SBBI = Stocks, Bonds, Bills, and Inflation)

Question 3

How is the equity risk premium determined in the CAPM or build-up method (a.k.a. the long horizon equity risk premium)?

Answer 3

historical arithmetic average return on stocks - the historical average risk-free rate

Question 4

What is the Duff and Phelps Valuation Handbook?

Answer 4

An annual yearbook that contains historical data about returns in the capital markets since 1926 through the current year.

Question 5

What weights are applied to debt and equity in calculating the WACC under FMV?

Answer 5

Market values of debt and equity.

Question 6

What is the basis for determining the risk-free rate?

Answer 6

20-year Treasury bond yield

Question 7

What is the formula for the capitalization method?

Answer 7

calculated value = [net cash flow * (1 + growth rate)] / (capitalization rate)

capitalization rate = discount rate - long-term growth rate

Question 8

What sources can be used to determine beta?

Answer 8

• -Value Line Investment Source
• -S&P’s CompuStat
• -New York Stock Exchange
• -Yahoo Finance