Total initial equity is $100,000, and annual before-tax cash flow to that equity is $8,000. What current equity dividend rate results?
Correct Answer
B) 8.0%
8000÷100000×100 = 8. Common errors: inverting the ratio (equity ÷ cash flow) gives 1250.0%; misplacing the decimal (×1,000 instead of ×100) gives 80.0%; dividing by equity plus the cash flow gives 7.4%.
Why This Is the Correct Answer
Option B is correct because $8,000 / $100,000 = 0.08, or 8.0%. That is the current return on the equity invested.
Why the Other Options Are Wrong
Option A: 7.4%
Option A, 7.4%, is $8,000 / ($100,000 + $8,000) x 100, which wrongly adds the cash flow to the equity. The divisor is equity alone: $8,000 / $100,000 = 8.0%.
Option C: 80.0%
Option C, 80.0%, is $8,000 / $100,000 x 1,000, which misplaces the decimal. Converting to a percentage uses x 100, giving 8.0%.
Option D: 1250.0%
Option D, 1250.0%, inverts the ratio: $100,000 / $8,000 x 100. The rate is cash flow divided by equity, $8,000 / $100,000 = 8.0%.
Cash over cash invested
The equity dividend rate is the cash you receive this year over the cash you put in.
How to use: Use this to set up the fraction for equity dividend or cash-on-cash rates.
Exam Tip
Put income on top and the investment on the bottom; answers above 100% for a dividend rate usually mean the fraction was inverted.
Common Mistakes to Avoid
- -Dividing equity by cash flow
- -Misplacing the decimal when converting to a percentage
- -Adding cash flow to the equity base
Concept Deep Dive
Analysis
This question tests the equity dividend rate, which relates annual before-tax cash flow to the equity investment. Divide cash flow by equity and express it as a percentage.
Background Knowledge
The equity capitalization or dividend rate is annual pre-tax cash flow to equity divided by the equity investment. It measures the current cash return to the equity position after debt service.
Real-World Application
An appraiser surveys investors in local apartment buildings and finds they expect cash flow after debt service of about 8% of their down payment. She uses that equity dividend rate in a band-of-investment analysis.
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