If a business buyer estimates that a 20 percent return is reasonable for an existing business expected to produce a profit of $27,000, its capitalized value would be

To calculate the capitalized value of a business based on a desired return and expected profit, you need to use the following formula:

Capitalized Value = Expected Profit / Desired Rate of Return

In this case, the expected profit is $27,000 and the desired rate of return is 20%. To convert the percentage into a decimal for the calculation, you divide the percentage by 100. So, 20% becomes 0.20 in decimal form.

Now, plug the numbers into the formula:

Capitalized Value = $27,000 / 0.20 Capitalized Value = $135,000

Therefore, the capitalized value of the business, with a desired return of 20% and an expected profit of $27,000, would be $135,000.

Extra: The concept we used here is called capitalization of earnings, which is a method of determining the value of an investment based on the expected return. In the context of a business, it means assessing the worth of a business by looking at its ability to generate profit in the future. The capitalized value gives an investor an idea of what the business is worth based on the future benefits it is likely to bring, in this case, represented by the profits.

The rate of return is the percentage of the investment amount that an investor expects to get back as profit. The higher the desired rate of return, the lower the capitalized value, because the investor wants to make more money back in a shorter amount of time. Conversely, a lower desired rate of return would mean a higher capitalized value, because the investor is willing to accept a smaller return over a longer period.

This method of valuation is commonly used when looking to buy or sell a business, invest in stock, real estate investments, and in other financial scenarios where understanding the future profitability and the value of an investment is important. It is particularly useful for evaluating businesses with a stable and predictable profit stream. However, it is important to note that this method doesn't take into account potential changes in profit over time or any other factors that might affect the business's future performance.