Initial equity is $200,000 and annual before-tax cash flow to equity is $24,000. What current equity dividend rate results?
Correct Answer
B) 12.0%
24000÷200000×100 = 12. Common errors: inverting the ratio (equity ÷ cash flow) gives 833.3%; misplacing the decimal (×1,000 instead of ×100) gives 120.0%; dividing by equity plus the cash flow gives 10.7%.
Why This Is the Correct Answer
Option B is correct because the equity dividend rate is before-tax cash flow divided by initial equity: $24,000 ÷ $200,000 = 0.12. Multiplied by 100, that is 12.0%.
Why the Other Options Are Wrong
Option A: 10.7%
Option A, 10.7%, comes from dividing by equity plus the cash flow: $24,000 ÷ ($200,000 + $24,000) × 100 = 10.7%. The denominator is the equity alone, so the rate is $24,000 ÷ $200,000 = 12.0%.
Option C: 120.0%
Option C, 120.0%, comes from misplacing the decimal: $24,000 ÷ $200,000 × 1,000 = 120. The correct conversion is 0.12 × 100 = 12.0%.
Option D: 833.3%
Option D, 833.3%, comes from inverting the ratio: $200,000 ÷ $24,000 × 100 = 833.3. The rate puts cash flow on top, giving $24,000 ÷ $200,000 = 12.0%.
Cash over cash invested
The equity dividend rate is the cash the investor receives this year divided by the cash the investor put in. It is a one-year income ratio, not a total return.
How to use: Use this to set up any equity dividend or cash-on-cash rate question.
Exam Tip
Keep the equity dividend rate distinct from the equity yield rate; the dividend rate looks only at current annual cash flow relative to equity.
Common Mistakes to Avoid
- -Dividing equity by cash flow
- -Using NOI instead of before-tax cash flow to equity
- -Confusing the equity dividend rate with the equity yield rate
Concept Deep Dive
Analysis
This question tests calculation of the equity dividend rate, also called the cash-on-cash rate. It is annual before-tax cash flow to equity divided by the initial equity investment. Distractors come from inverting the ratio, misplacing the decimal, or using the wrong denominator.
Background Knowledge
The equity capitalization or dividend rate is annual pre-tax cash flow to equity divided by the equity investment. Before-tax cash flow is NOI less debt service. This rate is used in the band of investment and differs from an equity yield rate, which accounts for the full holding period.
Real-World Application
An investor puts $200,000 of equity into a small apartment building, and after debt service the property throws off $24,000 a year. An appraiser comparing investor returns notes the 12% equity dividend rate when building a band of investment.
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