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Cap Rate Principles

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NEVADA DEPARTMENT OF TAXATION Capitalization Rate Study Principles of Development Calendar Year 2012 For the 2014-2015 Secured & 2013-2014 Unsecured Tax Year Valuation In the Department’s capitalization rate study, four capitalization criteria are considered: 1.) 2.) 3.) 4.) The estimate of the equity cost of capital must comport with common sense. The company’s equity risk premium should be reasonably stable over short periods of time. The estimate of the cost of equity should apply for the long term. The estimation procedure must be sufficiently straightforward so that it can be easily understood, applied, and even adjusted by educated practitioners.

“The duration of the cost of equity should approximately match the duration of the dividend stream.” “Estimating the Cost of Equity Capital” (Bradford Cornell, John I. Hirshleifer, and Elizabeth P. James, Contemporary Finance Digest, Vol. 1, Number 1, Autumn, 1997). “With the respect to the oldest and most established model, the capital asset pricing model (CAPM), the academic consensus, to the extent that there is one, is that it does not work. Furthermore, there is no widely accepted alternative that does. (Cornell, p. 7) The Department’s capitalization rate model uses comparables, and: 1.) It provides development of “pure plays*”. 2.) It uses comparables to reduce measurement error, however, there is a trade-off between the reduced measurement error that averaging makes possible and the potent bias that it introduces. “There is no unambiguous way to identify comparability.” 3.) Because of the impact of diversification, averaging reduces the short-term variation in the estimated cost of equity. From the standpoint of regulatory agencies, which must set policies based on estimates of the cost of capital, this increased stability is a major benefit.” (Cornell, p. 9). “The fact that the target company is not a “pure…...

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