Initial equity is $250,000 and annual before-tax cash flow to equity is $75,000. What current cash dividend rate results?
Correct Answer
C) 30.0%
75000÷250000×100 = 30. Common errors: inverting the ratio (equity ÷ cash flow) gives 333.3%; misplacing the decimal (×10 instead of ×100) gives 3.0%; dividing by equity plus the cash flow gives 23.1%.
Why This Is the Correct Answer
Option C is correct because the equity dividend rate equals annual before-tax cash flow divided by equity: $75,000 ÷ $250,000 = 0.30, or 30.0%. This measures the current cash return on the equity investment.
Why the Other Options Are Wrong
Option A: 3.0%
Option A, 3.0%, is wrong because it misplaces the decimal by multiplying by 10 instead of 100: $75,000 ÷ $250,000 × 10 = 3.0. The correct result is $75,000 ÷ $250,000 × 100 = 30.0%.
Option B: 23.1%
Option B, 23.1%, is wrong because it divides by equity plus the cash flow: $75,000 ÷ ($250,000 + $75,000) × 100 = 23.1%. The denominator is the equity alone, so $75,000 ÷ $250,000 = 30.0%.
Option D: 333.3%
Option D, 333.3%, is wrong because it inverts the ratio, dividing equity by cash flow: $250,000 ÷ $75,000 × 100 = 333.3%. The correct ratio is cash flow over equity, $75,000 ÷ $250,000 = 30.0%.
Cash Over Cash Invested
Cash-on-cash means cash received on top, cash invested on the bottom.
How to use: Use this phrase to set the numerator and denominator for any equity dividend rate question.
Exam Tip
A rate above 100% for a typical investment usually means the ratio is upside down. Keep cash flow in the numerator.
Common Mistakes to Avoid
- -Dividing equity by cash flow instead of cash flow by equity
- -Adding the cash flow to the equity in the denominator
- -Confusing the equity dividend rate with the equity yield rate
Concept Deep Dive
Analysis
This question tests the equity dividend rate, also called the cash-on-cash rate or equity capitalization rate. It equals annual before-tax cash flow to equity divided by the initial equity investment. The task is to keep cash flow in the numerator and equity alone in the denominator.
Background Knowledge
The equity capitalization rate, or equity dividend rate, is annual pre-tax cash flow to equity divided by the equity investment. It is a single-year cash return measure and differs from an equity yield rate, which considers all cash flows over the holding period. It is a component used in band-of-investment overall rate calculations.
Real-World Application
An appraiser analyzing an investor's purchase of a small office building computes before-tax cash flow after debt service and divides it by the down payment. That equity dividend rate is compared with rates investors accept in the market to support a band-of-investment overall rate.
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