Common Errors in Estimation and Use of Cost of Capital
This chapter reviews some of the concepts discussed throughout the book that are most :omrnonly misunderstood or misapplied.
t. Which of (he following is a correct statement?
a. The discount rate is equal to tlie capitalization rate.
b. The discount rate is the reciprocal of the capitalization rate.
c. The discount rate is equal to the capitalization rate minus the rate of growth in perpetuity.
d. The discount rate is equal to the capitalization rate plus the rate of growth in perpetuity.
2. The proper discount rate to use when evaluating a potential acquisition by the disc cash flow (DCK) method is:
a. The acquiring company's overall cost of capital.
h. The acquiring company's cost of equity.
c. The acquiring company's "hurdle rate."
d. A rate that reflects the risk of the potential acquisition.
3. Which of the following is the most correct statement.?
a. Historical returns should be capitalized because they are factual and not speculative.
b. Historical returns should be extrapolated into the future to be discounted or capitalizi.
c. Historical returns should be used only for guidance about what is reasonable to expectin the future.
d. Historical returns should be ignored when forecasting the future.
4. Which of the following is/are the most correct statement(s) about Risk Management Association's (formerly Robert Morris Associates) Annual Statement Studies1.
a. The industry returns that they compile are a good indication of the cost of capital for that industry.
b. The industry returns that they compile should not be used as a source for cost of capital because they are historical and may not represent expectations about the future.
c. The industry returns that they compile should not be used as a source for cost of capital because they arc based on book values rather than on market values.
d. Both (b) and (c) are correct.
5. Which of the following is a correct statement1.'
a. Tn the United States, it is most common to state the discount rate in nominal terms, that is, not including inflation.
b. Tn the United States, it is most common to state trie discount rate in nominal terms, that is, including inflation.
c. Tn the United States, it is most common to state the discount rate in real terms, that is, not including inflation.
d. Tn the United States, it is most common to state the discount rate in real terms, that is, including inflation.
6. [fan acquiring company were to useiLs own cost of capital for valuation by the DC F method rather than the target cost of capital for the potential acquiree, the result would most likely be what standard of value?
a. Fair market value.
b. Fair value.
c. Investment value.
d. intrinsic value.
7. IT an acquiring company were to include the benefit of its synergies with the target company in the cash flow projections for valuation of the target, the result would most likely be what standard of value?
a. Fair market value.
b. Fair value.
c. Investment value.
d. intrinsic value.
8. Using Ibbotson's data, the equity risk premium should be selected to match which of the following maturities of U.S. government obligations?
a. 30 days, 5 years, or 30 years.
b. 1 year, 5 years, or 30 years.
c. 30 days, 10 years, or 20 years.
d. 30 days, 5 years, or 20 years.
9. Which of the following is a correct statement about the size premium?
a. The Ibbotson data sped fy the boundaries of the company size, as measured by the market value of common equity, and the boundaries vary from year to year.
b. The Ibbotson data specify the boundaries of company size, as measured by company revenues, and the boundaries vary from year t.o year.
c. The Ibbotson data sped fy the boundaries of the company size, as measured by the market value of common equity, and the boundaries are constant from year to year.
d. The JbboLson data specify the boundaries of company size, as measured by company revenues, and the boundaries are constant from year to year.
Decrease in the market value of an acquiring company's stock following an acquisition is a common phenomenon.
If a company foresees supergrowth in the short term, then a discounting model would be more appropriate than a capitalization model
12. The excess earnings method has capitalization rates for two categories of capital, while the weighted average cost of capital (WACO) is not limited in its categories of capital.
13. In estimating the terminal value for a company that is expected to grow beyond the terminal year, capital expenditures should beestimated to be equal to depreciation in the terminal year.
14. For the purpose of valuation, a company's capital structure should be the weighted average of the book values of the respective capital structure components.
15. Within CAPM, a portion of the company-specific risk premium is captured in the size premium.
Cost of capital plays a critical role in a variety of court cases in most venues, including both federal and slate courts. This chapter explores the treatment of cost of capital in various court settings (see also about capital management).
MULTIPLE CHOICE QUESTIONS
1. Which of the following state's courts have been the national trendsetter in shareholder disputes?
a. New York
b. New Jersey
c. Delaware
d. Pennsylvania
2. Which of the following is a correct statement about the valuation methods/approaches most favored by the Delaware Court of Chancery?
a. The discounted cash flow (DCF) method is most favored, but the market approach and asset approach also are sometimes accepted-fa. The market approach is most favored, but the DCF method and the asset approach also are sometimes accepted.
c. The DCF method and the market approach have roughly equal acceptance, but the asset approach is sometimes accepted.
d. The DCF method, the market approach, and the asset approach ail are equally accepted.
3. Which of the following is the best statement about the approaches favored by the U.S. Tax Court?
a. The market approach tends to be most favored, but the income approach has been gaining favor in recent years.
b. The market approach tends to be most favored, and its margin of favor over the income approach has tended to increase in recent years.
e income approach tends to be most favored, but the market approach has been gaining favor in recent years.
e income approach tends to be most favored, and its margin of favor over the market approach has tended to increase in recent years.
The U.S. Tax Court has consistently rejected the addition of a small stock premium in the estimation of a discount rate.
The U.S. Tax Court has yet to address the choice of beta in developing the cost of equity capital estimate.
Interest rates awarded on receivables in the bankruptcy courts have tended to be at the creditor's cost of capital.
Bankruptcy courts have not accepted the DCF method for valuation of a company on the basis that projected cash flows for a company in bankruptcy are too speculative to be reliable.
m utility rate-settings, it is recognized virtually universally that one of the costs the service provider is entitled to recover is the cost of its capital.
In rate-setting where i t. has jurisdiction, the Federal Communications Commission typically relies on classic DCF methodoloav.
Taxicab lease rates have been set based on the cost of company's weighted average cost of
Cost of capital is getting increasing attention in family lawr courts.
Cost of capital is not a relevant concept in damages cases.
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Common Errors in Estimation and Use of Cost of Capital