Total initial equity is $100,000 and annual before-tax cash flow to equity is $8,500. What current equity dividend rate results?
Correct Answer
C) 8.5%
8500÷100000×100 = 8.5. Common errors: inverting the ratio (equity ÷ cash flow = 11.8) and mislabeling that multiple as a percentage gives 11.8%; dividing by equity plus the cash flow gives 7.8%; misplacing the decimal (×10 instead of ×100) gives 0.9%.
Why This Is the Correct Answer
Option C is correct because the equity dividend rate is before-tax cash flow ÷ equity: $8,500 ÷ $100,000 = 0.085, or 8.5%. The equity capitalization rate is annual pre-tax cash flow to equity relative to the equity invested. It measures a current cash return, not a total yield.
Why the Other Options Are Wrong
Option A: 0.9%
Option A, 0.9%, results from multiplying by 10 instead of 100: $8,500 ÷ $100,000 × 10 = 0.85, rounded to 0.9. The correct conversion is 0.085 × 100 = 8.5%.
Option B: 7.8%
Option B, 7.8%, divides by equity plus the cash flow: $8,500 ÷ ($100,000 + $8,500) × 100 = 7.8%. The denominator should be the equity alone, giving 8.5%.
Option D: 11.8%
Option D, 11.8%, inverts the ratio: $100,000 ÷ $8,500 = 11.8, which is a multiple and not a percentage. The rate is $8,500 ÷ $100,000 = 8.5%.
Cash over cash invested
The equity dividend rate is the cash you get each year divided by the cash you put in.
How to use: Use this to set up the equity dividend rate without inverting it.
Exam Tip
Keep cash flow in the numerator and equity in the denominator; a rate far above typical market levels may signal an inverted ratio.
Common Mistakes to Avoid
- -Dividing equity by cash flow
- -Adding the cash flow to 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 equity capitalization rate. It equals annual pre-tax cash flow to equity divided by the equity investment. Here $8,500 ÷ $100,000 = 0.085, or 8.5%.
Background Knowledge
The equity dividend rate expresses the relationship between one year's before-tax cash flow and the equity investment. It is used in band of investment and mortgage-equity analysis. It differs from an equity yield rate, which accounts for all cash flows including resale over the holding period.
Real-World Application
An appraiser surveys investors in small apartment buildings about the first-year cash return they expect on their down payments. She expresses each as before-tax cash flow divided by equity invested. She then uses a supported equity dividend rate in a band of investment calculation.
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