Capitalization of Income

[Kathleen Reynolds]

#2786

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Capitalizes income (such as rents, dividends, or profits from a business) in order to estimate the value of a business or other asset. It allows seven different capitalization rates to be used simultaneously so that a planner or client can develop a high-low valuation range.

Entering Data
Capitalization Rate: Enter an appropriate capitalization rate.
Adjusted Earnings: Enter the adjusted earnings from the asset, or adjusted profits from the business.

Results
The calculation results show the estimated value of a business or other asset. This value is calculated by capitalizing the business or asset’s income. To capitalize income, the calculation divides the adjusted earnings by the capitalization rate.

Results are displayed for the capitalization rate specified at the Capitalization Rate input (highlighted in blue), and for six additional rates. By displaying results for seven different capitalization rates, the calculation provides a high-to-low range of values.

To receive accurate results using the income capitalization method, you must use realistic values for your earning and capitalization rate. The following guidelines will help you to determine appropriate values:

Adjusted Earnings
Income includes rents, dividend, and profits from a business. Apply the following adjustments when calculating your income (in the case of a business, use five-year average after-tax profits):

• Increase earnings if salaries were too high; reduce earnings if salaries were too low.
• Add back bonuses paid to stockholder-employees and excessive rents paid to shareholders.
• Reduce earnings if rents paid to shareholders were less than what was reasonable in the market.
• Exclude non-recurring income or expense items.
• Make appropriate adjustments for excessive depreciation, significant changes in accounting procedures, widely fluctuating profits, or abnormally inflated (or deflated) earnings.
• Weight the average to receive a more accurate assessment of the company’s prospects if a strong upward or downward earnings trend occur.

Capitalization Rate
Remember: One correct or official capitalization rate does not exist. Different rates are used at different times.

Essentially, the capitalization rate is the rate of return you wish to receive from the asset or business. When determining what capitalization rate to use, consider the following:

• The smaller the capitalization rates, the higher the value.
• Less risky investments (such as a stable business with large capital asset bases and strong financial history) are generally assigned lower capitalization rates.
• A business that relies on the presence of only one or two key people is generally assigned a higher capitalization rate.

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