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How Cost of Capital Relates to the Excess Earnings Method of Valuation

t.  a

2.   b

True or False Question

3.   True

Fill-in-the-Blank Question

4.   a. Income attributable to tangible assets

b. Income attributable to intangible assets

Note that, in the excess earnings method, the capitalization rates are estimated on the asset side of the balance sheet, while in all other methods discussed in the book, the capitaliza­tion rates are estimated on a category of liabilities and/or equity on the right-hand side of the balance sheet.

Exercises

5.   Valuation by the excess earnings method:

Net tangible assets Expected net cash flow for coming year Required rate of return on net tangible assets Return attributable to intangible assets ("excess earnings") Intangible asset value (capitalized excess earnings) Value of company by excess earnings method. 6.  Implied capitalization rate: $60,000 _ $480,000 ~

3300,000

60,000

0.08 x S300,000 = $24.000

36,000

$36,000 / 0.20 = $180.000

$4B(X(K)0

---- '----- = $333,333 ~ valise bv the capitalization of cash flow method

0.18                                 '          F

Therefore, if the 18% capitalization rate is reasonable, the company is overvalued by S 146,667 (8480,000    8333,333) using the excess earnings method.

Probable reasons for overvaluation:

a.  Net cash flow estimate could be overly optimistic. One possible reason for this would be the failure to recognize need for capital expenditures and/or additions to working capi­ tal, and merely taking R'RTTDA as net cash flow.

b.  Too low a required return for net tangible assets. "Banks usually charge
more than 8% to loan on tangible assets and will not loan 100% of tangible asset value;
therefore, the required return on tangible assets must include a cost of equity capital

component.

c.   Too low a required return on intangible assets, A 20% required return implies a five-year
payback period. Fewr buyers are willing to accept this.

Would you pay 8180,000 for (he "blue sky" in Dad's Repair Co.?

Many people apply the excess earnings mechanically with no concept of the economic

reality of the result.

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