CHAPTER 7

DISCOUNT RATES IN VALUATION

LEARNING OBJECTIVES
1.
2.
3.
4.

Why different valuation models use different discount rates.

The capital asset pricing model and how it relates to discount rates.
How to estimate the discount rate for each model.
How to alter the analysis of discount rates for private companies.

TRUE/FALSE QUESTIONS
1.

Different valuation models rely on different components of the firms cash flows because the components of
cash flow belong to different capital suppliers.
(moderate, L.O. 1, Section 1, true)

2.

Unlevered cost of equity is the discount rate used in the adjusted present value model.
(moderate, L.O. 1, Section 1, true)

3.

Like other sources of capital, common equity has a promised rate of return.
(easy, L.O. 1, Section 1, false)

4.

The degree to which a stocks returns are correlated with market movements is known as systematic risk.
(moderate, L.O. 2, Section 1, true)

5.

Beta is the variable which measures a stocks correlation with the market.
(moderate, L.O. 2, Section 1, true)

6.

Diversification eliminates systematic risk.

(easy, L.O. 2, Section 1, false)

7.

The systematic risk of a portfolio is the total of the individual systematic risks of each stock in the
portfolio.
(difficult, L.O. 2, Section 1, false)

8.

The volatility of an individual stock has significant effect on the volatility of a well-diversified portfolio.
(moderate, L.O. 2, Section 1, false)

9.

When a firms economic balance sheet has only core operations, debt, and common equity, the weightedaverage cost of capital is the average of the after-tax cost of debt and cost of equity.
(difficult, L.O. 3, Section 2, true)

10.

Under the concept of negative debt, a firm that holds equal amounts of debt and nonoperating securities is
viewed as not being leveraged at all.
(difficult, L.O. 3, Section 2, true)

11.

Under the weighted-average cost of capital, the weights of all components must equal.
(moderate, L.O. 3, Section 2, true)

12.

Under the weighted-average cost of capital, the discount rate for core operations is the weighted-average of
the demanded return on all economic balance sheet items other than core operations.
(difficult, L.O. 3, Section 2, true)

13.

Analysts cannot infer the value of the unlevered beta from either the levered beta or the firms capital

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structure since no theoretical relationship among these elements exist.

(moderate, L.O. 3, Section 2, false)
14.

The beta for a private company is identical to the beta for a publicly held company as long as the two are
of similar sizes in the same industry.
(moderate, L.O. 4, Section 4, false)

15.

Precision is a statistical measure of the unlevered cost of capital, and it is equal to the reciprocal of the
variance.
(moderate, L.O. 4, Section 4, false)

MULTIPLE CHOICE QUESTIONS

16.

The valuation models that use the weighted-average cost of capital as a discount rate are the:
a. free cash flow and the adjusted present value models
b. residual income and flows to equity models
c. dividend discount and adjusted present value models
d. free cash flow and residual income models
(moderate, L.O. 1, Section 1, d)

17.

The valuation models that use the cost of common equity as a discount rate are the:
a. dividend discount and flows to equity models
b. dividend discount and free cash flow models
c. free cash flows and flows to equity models
d. free cash flows and dividend discount models
(moderate, L.O. 1, Section 1, a)

18.

Using the capital asset pricing model (CAPM), the variable known as the risk-free interest rate best
approximates the interest rate on the:
a. 30-year Treasury bond
b. average 5-year bank certificate of deposit
c. average systematic risk computed for the general domestic bond market over the last 30 months
d. prime interest rate as established by the Federal Reserve Bank
(moderate, L.O. 2, Section 1, a)

19.

In the capital asset pricing model formula, the additional expected return above the risk-free rate that an
investor requires to hold an average-price stock is known as:
a. historical equity premium earned
b. equity risk premium
c. beta
d. risk-free rate of interest
(moderate, L.O. 2, Section 1, b)

20.

Regarding beta in the capital asset pricing model, it is true that __________ can be eliminated through
diversification, however __________ cannot be eliminated in the same way.
a. systematic risk; unsystematic risk
b. systematic risk; equity risk premium
c. unsystematic risk; systematic risk
d. unsystematic risk; equity risk premium
(moderate, L.O. 2, Section 1, c)

21.

Beta represents the firms sensitivity to market performance when using CAPM. If a firm has a beta that is
greater than 1 on a particular day, then we can conclude that the firms expected return:
a. is greater than market movement in both directions on that day
b. is less than market movement in both directions on that day
c. is whatever the markets return was on that day

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d. It is impossible for a firm to have a beta greater than 1.

(moderate, L.O. 2, Section 1, a)
22.

A common approach to estimating beta is to go back in time five years and analyze a firms data. This time
period usually provides sufficient daily intervals to obtain a reasonably narrow level of confidence. What
factor can cause a company to change substantially and thus inhibit estimating beta during this five-year
time period?
a. an acquisition
b. a divestiture
c. recapitalization
d. All of the above answers can cause a substantial change over a five-year period.
(easy, L.O. 2, Section 1, d)

23.

The cost of equity can be expressed as ke = rf + m when using the CAPM. In the formula, m represents:
a. the cost of equity
b. the risk free interest rate
c. the equity risk premium
d. systematic risk
(difficult, L.O. 2, Section 1, c)

24.

A fact that is critically important to an investor who holds a diversified portfolio is:
a. systematic risk can be eliminated by holding a diversified portfolio
b. unsystematic risk can be eliminated by holding a diversified portfolio
c. all risk can be eliminated by holding a diversified portfolio
d. the risk factors for diversified portfolios are approximately the same as risk factors for nondiversified
portfolios
(moderate, L.O. 2, Section 1, b)

25.

To understand what beta means we must formalize the distinction between correlation with the market and
volatility. Rt = Rmt + Et is the formula that expresses this relationship. The variable Rmt stands for the:
a. market return on date t
b. firms return on date t
c. additional volatility unrelated to the market
d. measure of correlation with the market
(difficult, L.O. 2, Section 1, a)

26.

In a situation in which a firms economic balance sheet consists of only core operations, debt, and common
equity, the weighted-average cost of capital (WACC) is defined as the weighted average of the after-tax cost
of debt and cost of equity. The weightings in this case are based on __________, not __________.
a. historical costs; fair market values
b. the proportion of debt to equity; debt to total capital
c. appraisals and industry guidelines; historical costs
d. fair values of debt and equity; book values of debt and equity
(difficult, L.O. 3, Section 2, d)

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27.

A characteristic of the WACC is that:

a. it is the discount rate used for the adjusted present value model
b. the only capital supplier considered in the WACC are debtholders
c. it is the discount rate used in the flows to equity valuation model
d. it blends the costs of equity and other sources of financing
(moderate, L.O. 3, Section 2, d)

28.

In a situation in which a firms economic balance sheet consists of only core operations, debt, and common
equity, the combined risk of __________ and of __________ must equal the risk of __________.
a. the firms debt; the firms equity; the firms core operations
b. the firms core operations; the firms equity; the marketplace
c. the firms core operations; its nonoperating assets; the firms total debt
d. the firms investors; the marketplace; the firms diversified portfolio
(difficult, L.O. 3, Section 2, a)

29.

In the WACC model, the effect of the firm holding other assets such as Treasury Bonds:
a. does not affect the nature of the firms equity
b. does affect the nature of its core operations
c. does not affect the nature of its core operations
d. does affect the nature of the firms debt
(moderate, L.O. 3, Section 2, c)

30.

Using the WACC model, Treasury Bonds that the firm holds is treated as a nonoperating asset. The
Treasury Bonds in this situation would be treated in the WACC model as:
a. positive debt
b. negative debt
c. a hedge against an inflationary spiral
d. a hedge against the discount rate applied to the firms core operations
(moderate, L.O. 3, Section 2, b)

31.

To estimate the firms unlevered cost of equity, the analyst must first find the unlevered beta. Formulas are
employed to convert levered betas to unlevered betas. There are different formulas used to perform this
task, because the relationship between levered and unlevered betas depends on:
a. the pattern of the free cash flow stream
b. whether the debt will remain as a fixed dollar amount, a fixed percentage of capital, or follow some
other pattern
c. the beta on the firms debt
d. All of the answers are correct.
(moderate, L.O. 3, Section 3, d)

32.

The adjusted present value model uses the unlevered cost of equity as:
a. a way to compute the levered betas required for the formula
b. a way to estimate the unlevered beta directly from stock returns
c. its discount rate
d. None of the above answers are correct.
(easy, L.O. 3, Section 3, c)

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33.

Estimating a discount rate for privately held companies adds complications not faced with public
companies. The degree of accuracy of the various estimated betas identified by the analyst is commonly
known as:
a. direct beta estimation
b. the standard average beta formula
c. precision
d. beta appraisal
(moderate, L.O. 4, Section 4, c)

34.

An analyst must adjust the beta estimates of comparable private companies for the difference in their
capital structures. The analyst can approach this task by:
a. choosing a firm with a comparable capital structure similar to the one being valued, if possible
b. choosing an estimated average beta based on public firm industry standards
c. estimating the cost of capital for the comparable firm.
d. Answers a and c are both correct.
(moderate, L.O. 4, Section 4, d)

35.

Most companies operate a number of different businesses. Each of these businesses faces different risks and
therefore suitable discount rates will vary among divisions, product lines, or subsidiaries based on the risk
profile of the particular business. To determine the cost of capital, an analyst should:
a. use a single discount rate for the entire firm
b. estimate the beta separately for each division, and then obtain a weighted average of all divisions to
compute the firms cost of capital
c. consult industry standards for publicly held firms in a similar industry
d. None of the above answers are correct.
(moderate, L.O. 4, Section 4, b)

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ESSAYS
36.

Briefly explain the capital asset pricing model as a model that relates risk and return. What does beta
represent in this model?
Suggested solution:
The capital asset pricing model (CAPM) is a formal model that relates risk and return. This model makes
an assumption that investors do not like to take risks (that is, they are risk adverse), but if the reward for
taking a risk by holding riskier stocks or riskier portfolios is sufficient, investors will take the risk to
potentially gain a higher expected rate of return.
One assumption the CAPM makes is that stocks whose returns are highly correlated with the rest of the
stock market are considered to produce more risk in an investor portfolio than a stock whose risk is not as
highly correlated with the stock market. This means that a stock that is highly correlated with the market
will be expected to produce a higher rate of return. The opposite holds true for stocks that are not highly
correlated to the market, because it is not expected that such stocks will produce a higher rate of return.
When a portfolio is well diversified, the volatility of an individual highly volatile stock (one that is not
correlated with the market) will have almost no effect on the portfolio itself.
The degree to which stock returns are correlated with the movement of the markets is known as systematic
risk, or beta. Beta (the symbol is used to denote beta) represents systematic risk in the CAPM. A beta of
1 on a given day equals whatever the markets return is for that day. A beta greater than 1 on a given day
means that the firms expected return is greater than the movements of the markets, either positive or
negative on that day. A beta that is less than 1 on a given day means that the firms expected return is worse
than market movements on that day.
(moderate, L.O. 2, Section 1)

37.

Discuss the relationship among core operations, debt, and equity of a firm when the weighted-average cost
of capital model is used for valuation purposes.
Suggested solution:
When working with the weighted-average cost of capital model (WACC), analysts want to know the
appropriate expected return for the cash flows to be discounted for core operations. The expected return is
dependent on the core operations risk factor. The analyst may not be able to clearly determine the level of
risk associated with the firms core operations, so an assumption must be made in this case. Since the firms
combined debt and equity must equal its core operations (so that an economic balance sheet will balance),
we can conclude that the combined risk of the firms debt and equity must also equal the risk of its core
operations. This assumption can be restated as, the weighted average of the required returns on the debt
and the common equity must be equal to the required return on the core operations.
There is an important reason for this assumption. The risk associated with the firms core operations
depends entirely on the characteristics of those operations. Depending on the valuation model used, an
analyst can divide risk among debtholders and equityholders in a number of ways. How debt and equity
risk is divided is irrelevant to the total risk of the firms assets. Therefore, the appropriate expected return
on the firms assets can be inferred by determining the returns demanded on the combined claims (that is,
debtholder and equityholder claims) against the firms assets.
(moderate, L.O. 3, Section 2)

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38.

Identify and comment on some of the issues an analyst faces when evaluating private companies.
Suggested solution:
It is more difficult to estimate a discount rate for privately held firms since an analyst cannot observe
security returns for a privately held company, and therefore cannot estimate a beta with a regression. Also,
a private firm may be a subsidiary of another firm, or be comprised of several subsidiaries, any of which
may have different capital structures.
Companies in the same industry may share similar operating risks, but they may have different capital
structures. Since capital structures affect betas, it may not be possible to compare companies in the same
industry. One possible solution is to adjust the betas for the differences in capital structures. An analyst can
algebraically adjust the beta of one firm to more closely match the capital structure of another firm, with
the goal of generating a beta that is comparable for the firms. Although this method is inexact, it has some
value. Unfortunately, there is no perfect solution in this situation.
An analyst can also adjust for a situation where a firm is a subsidiary of another firm, or is itself comprised
of several subsidiaries by estimating a beta for each subsidiary and then taking the weighted average of the
betas to generate a firm-wide beta. This method is preferable to merely taking a single discount rate for a
firm that has divisions or subsidiaries, since this approach may overstate the value of high-risk divisions or
subsidiaries and understate the value of lower-risk divisions or subsidiaries.
(moderate, L.O. 4, Section 4)

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