Chapter 10 Selected Answers
Chapter 10: Analysis and Valuation of Privately Held Companies
Answers to End of Chapter Discussion Questions
10.1 What is the capitalization rate and how does it relate to the discount rate?
Answer: The terms discount rate and capitalization rate are often used interchangeably. Whenever the growth rate of a firm’s cash flows is projected to vary over time, the term discount rate generally refers to the factor used to convert the projected cash flows to present values. In contrast, if the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely, the discount rate employed by practitioners is often referred as the capitalization rate.
10.2 What are the common ways of estimating the capitalization rate?
Answer: Capitalization rates may be estimated by using the Capital Asset Pricing Model, cost of capital, price-to-earnings ratios, accounting based returns such as the return on equity, and the build-up method.
10.3 What is the marketability discount and what are common ways of estimating this discount?
Answer: The risk associated with an illiquid market for the specific stock is often referred to as the marketability or liquidity discount. Liquidity is the ease with which an investor can sell their stock without a serious loss of value. An investor in a small company may find it difficult to sell quickly their shares because of limited interest in the company. Consequently, the investor may find it necessary to sell their shares at a significant discount from what they paid for the shares.
10.4 Give examples of private company costs that might be understated and explain why.
Answer: Examples may include employee training and the cost of complying with government regulation such as OSHA and the EPA. Small, privately owned firms tend to under-spend in these areas since they do not contribute directly to current profitability.
10.5 How can an analyst determine if the target firm’s costs and revenues are
Answers to End of Chapter Discussion Questions
10.1 What is the capitalization rate and how does it relate to the discount rate?
Answer: The terms discount rate and capitalization rate are often used interchangeably. Whenever the growth rate of a firm’s cash flows is projected to vary over time, the term discount rate generally refers to the factor used to convert the projected cash flows to present values. In contrast, if the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely, the discount rate employed by practitioners is often referred as the capitalization rate.
10.2 What are the common ways of estimating the capitalization rate?
Answer: Capitalization rates may be estimated by using the Capital Asset Pricing Model, cost of capital, price-to-earnings ratios, accounting based returns such as the return on equity, and the build-up method.
10.3 What is the marketability discount and what are common ways of estimating this discount?
Answer: The risk associated with an illiquid market for the specific stock is often referred to as the marketability or liquidity discount. Liquidity is the ease with which an investor can sell their stock without a serious loss of value. An investor in a small company may find it difficult to sell quickly their shares because of limited interest in the company. Consequently, the investor may find it necessary to sell their shares at a significant discount from what they paid for the shares.
10.4 Give examples of private company costs that might be understated and explain why.
Answer: Examples may include employee training and the cost of complying with government regulation such as OSHA and the EPA. Small, privately owned firms tend to under-spend in these areas since they do not contribute directly to current profitability.
10.5 How can an analyst determine if the target firm’s costs and revenues are