Opinion ID: 2604259
Heading Depth: 1
Heading Rank: 11

Heading: Identifying the Appropriate Capitalization Rate

Text: Put in its simplest terms, the capitalization rate is the percentage (or rate) of return that a prospective investor would expect to receive on his or her investment from the income stream in any particular year. Of course, there is more than one way to invest in a company, and each form of investment carries its own expectations as to a rate of return. For example, one who invests in long-term debt of a company probably would expect a different rate of return than would another investor who purchased common or preferred stock in the same company. The holders of the common and preferred stock might themselves have different expectations. These different forms of investment are called bands of investment. Experts from both sides in this case attempted to identify the particular bands of investment applicable to UP and to assign an appropriate capitalization rate to each. The parties agree that the process involves four steps. First, the percentage of the company's capital structure in each particular band of investment must be determined. Then, the rate of return expected by investors for each band of investment must be identified. Next, the rate of return expected for each band of investment must be multiplied by that band of investment's share of the company's capital structure, in order to weight the rate of return for that band vis-à-vis the entire capital structure. Finally, the various weighted percentages must be added together to produce a weighted average rate of return for the company as a whole. This weighted average rate of return then becomes the capitalization rate, the k, in the equation (or, as we have now identified it for the purposes of this case,, where a equals adjustment for Account 510 income and d equals adjustment for deferred income taxes). The parties agreed on the general approach to be taken in identifying a capitalization rate, but disagreed on the result, as the following discussion demonstrates.