How Cost of Capital Relates

Unlike (lie methods previously presented for deriving capitalization rates for a class of in­vestment (liability or equity), the excess earnings method derives capitalization rates applicable to the asset side of the balance sheet.

I. What was the origin of the excess earnings method (i.e., to what use was it put initially)?

a. Payments by the U.S. government to compensate brewers and distillers for their economic loss of goodwill as a result of Prohibition.

b. Payments by (he U.S. government to subsidize small businesses during the Depression.

c. Calculations of taxes on capital gains when the capital gains tax first went into effect (see also about safe investments).

d. Calculation of taxes on capital gains starting in 1968.

I. What is the number of the Revenue Ruling that addresses the excess earnings method?

a. 59-60.

b. 68-609.

c. 77-287.

d. 83-120.

3. The weighted average of the two capitalization rates used in the excess earnings method should be approximately equal to the capitalization rate for the entire company derived through other methods such as the build-up method or CAPM.

4. The excess earnings method requires two capitalization rates. What are tliese two rates ap­plied to?

Given the following pro forma information about Dad's Repair Co.: et tangible assets 8300,000

Expected net cash How for coming year 60,000

Required rate of return on tangible assets 8%

5. Required rate of return on intangible assets (excess earnings) 20% air Company bv the excess earnings method.

6. Compute the implied blended capitalization rate on the tangible and intangible excess earnings method.

7. Given an estimated capitalization rate of 18% by the build-up method, is the company over-or undervalued by the excess earnings method? By how much?

8. What are the probable reasons for this undervaluation or overvaluation?

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