What formula is used for determining the value of a business using direct capitalization?

The formula for determining the value of a business using direct capitalization is based on the relationship between Net Operating Income (NOI) and the capitalization rate (cap rate).

In this context, the cap rate is a ratio that reflects the expected rate of return on an investment in the business. By dividing the Net Operating Income by the cap rate, you derive the value of the business. This formula underscores the principle that the higher the NOI or the lower the cap rate, the greater the value of the business.

This method is widely used in real estate and business valuation because it provides a straightforward way to estimate value based on the current income generated by the business. It does not require future cash flow projections, making it simpler for investors to assess the value with available data on their income and the current market cap rates.

Other options do not correctly capture the essence of direct capitalization. For instance, gross profit multiplied by cap rate does not account for operating expenses and therefore would not yield a true representation of value. Sales price multiplied by total liabilities could confuse concepts of valuation rather than directly addressing income generation. Lastly, net present value (NPV) considers projected cash flows over time, which is a different method than direct capitalization relies upon.