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What do you understand by capitalization of earnings How is the value of a firm ascertained with the help of its earnings Explain with an example?
'Capitalization Of Earnings'
A method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flows. The capitalization of earnings estimate is done by taking the entity's future earnings and dividing them by the capitalization rate (cap rate). This will take into account the risk that earnings will stop or be lower than the estimate.
Where:
d = discount rate
g = growth rate
This is an income-valuation approach that determines the value of a business by looking at the current benefit of realizing a cash flow now, rather than in the future. The capitalization of earnings is particularly useful when the future earnings can be predicted easily and accurately.
For example, if a company had a business that made $1.2 million last year and that was expected to grow at a 4% rate (plus a 3.25% inflation rate), the annual rate of return needed by a purchaser given the level of risk would be 26%. Expected value using the capitalization of earnings method would be $6.4 million, calculated as:
-$1,200,000/ (0.26 - (.04+.0325))
-$1,200,000/0.1875
-$6.4 million
What else can I help you with?
Explain why retained earnings have an associated opportunity cost?
Retained earnings have an opportunity cost associated with them because they can be invested to earn more rather than keeping them idle. For example reatined earnings can be invested in a savings account in a bank and earn interest but if this is not done the are loosing some extra income and so if they are invested somewhere else, the bank rate will be the opportunity that has been lost. Opportunity cost is the real cost of choosing one thing and not another.
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