ABV Discount Rates & Capital Structure Flashcards
6 cards from real ABV practice questions. Tap to flip, then mark Knew It or Still Learning — missed cards come back until you master them.
Read the first 6 ABV Discount Rates & Capital Structure flashcards as text
What is the difference between levered beta (equity beta) and unlevered beta (asset beta)?
Answer: Levered beta reflects financial risk from debt in addition to business risk; unlevered beta reflects only business (operating) risk
Unlevering removes the effect of the company's debt financing, isolating the underlying business risk that can be compared across firms with different capital structures.
What is the Hamada equation used for in business valuation?
Answer: Converting an unlevered (asset) beta to a levered (equity) beta given a target capital structure
The Hamada equation re-levers the unlevered beta by incorporating the tax shield of debt: βL = βU × [1 + (1–t)(D/E)].
What is the 'size premium' in business valuation, and why is it added to the cost of equity?
Answer: An additional return demanded by investors for bearing the higher risk associated with smaller, less liquid companies
Empirical research (Fama-French, Duff & Phelps) shows small-cap stocks have historically earned returns above what CAPM predicts, supporting a size premium add-on.
When the subject company's capital structure differs from the guideline public companies used to derive beta, what adjustment is required?
Answer: Unlever guideline company betas, then re-lever to the subject company's capital structure
To apply guideline betas to a subject company, practitioners unlever each guideline beta to remove its specific capital structure effect, then re-lever using the subject's target D/E ratio.
What is the Gordon Growth Model (GGM) formula, and how does it relate to the capitalization rate used in the income approach?
Answer: Value = CF / (Ke – g); cap rate equals Ke minus the sustainable growth rate g
The GGM values a perpetually growing cash flow stream; the capitalization rate (cap rate) is cost of equity minus the expected long-run growth rate.
How does the presence of a controlling interest versus a minority interest affect the discount rate applied in a business valuation?
Answer: The discount rate itself is generally not changed; instead, premiums or discounts are applied to the concluded value to reflect the level of ownership
Standard practice is to value the enterprise or equity on a control basis using a market-derived discount rate, then apply a minority interest discount (or control premium) separately.