CFA Level II Exam · Cost of Capital: Advanced Topics

Cost of Preferred Stock and Common Equity Using CAPM

Updated 7 October 2026 · Fact-checked

Cost of preferred stock is the fixed dividend divided by price: rp = Dp ÷ P. Cost of common equity is the return shareholders require. Estimate it with CAPM (Rf + β × ERP), the dividend discount model (D1 ÷ P0 + g), or bond yield plus risk premium. Read the vignette to pick the right inputs.

Understand Cost of Preferred Stock and Common Equity (CAPM)

Every source of capital has a cost: the return its investors demand. For equity, there is no contractual payment, so you must estimate the required return. Level II tests whether you can pick the right estimation method and the right inputs from a vignette.

Preferred stock pays a fixed dividend and usually has no maturity. It is a perpetuity, so its cost is the dividend divided by the current price. Preferred dividends are not tax deductible, so there is no tax adjustment. Floatation costs, if given, reduce the net proceeds and raise the cost.

Common equity is riskier than debt and preferred stock, so it costs more. The CAPM says required return equals the risk-free rate plus beta times the equity risk premium. Beta measures exposure to market risk only. The risk-free rate should match the horizon of the cash flows, usually a long-term government bond yield.

The dividend discount model (DDM) turns the Gordon growth formula around. If the price equals D1 ÷ (r − g), then r = D1 ÷ P0 + g. It works for stable dividend payers. It is very sensitive to the growth estimate. You can estimate g as the retention rate times ROE.

The bond yield plus risk premium approach adds a judgmental premium (often 3% to 5%) to the company's own long-term bond yield. It is useful when beta is hard to estimate, such as for private or thinly traded firms. It is less rigorous because the premium is subjective.

Key formulas to remember

Cost of preferred stock: rp = Dp ÷ P; Dp is the annual fixed dividend; P is the current price. No tax adjustment. If floatation cost applies, use P × (1 − f).
CAPM cost of equity: re = Rf + β × (E(Rm) − Rf); (E(Rm) − Rf) is the equity risk premium. Use the risk-free rate that matches the cash flow horizon.
Dividend discount model cost of equity: re = D1 ÷ P0 + g; D1 = D0 × (1 + g). Assumes constant growth forever.
Sustainable growth: g = b × ROE; b is the earnings retention rate = 1 − payout ratio.
Bond yield plus risk premium: re = YTM of company's long-term debt + risk premium; The risk premium is a judgment, commonly a few percentage points.

How to solve Cost of Preferred Stock and Common Equity (CAPM) questions

Use this sequence for any question on the cost of preferred or common equity in an item set.

1Identify the security: preferred (fixed dividend, perpetuity) or common equity.
2Identify the method the question asks for, or the one the data supports: CAPM needs beta and a premium; DDM needs dividend, price and growth; bond yield plus premium needs a bond yield.
3Pull the inputs from the vignette or exhibit. Check whether a dividend is D0 or D1 and whether a premium is the market return or the excess return.
4Adjust for growth if the dividend given is D0: D1 = D0 × (1 + g).
5Apply the formula and keep returns in decimals until the end.
6Do not tax-adjust equity or preferred costs.
7Sanity check: cost of equity should exceed the cost of the firm's debt and the cost of its preferred stock.
8If asked to compare methods, comment on input sensitivity and suitability.

Quickest way: Match the formula to the data

When to use it: Use when time is short and the exhibit lists several inputs, some irrelevant.

Scan the exhibit for the keywords: beta, risk premium, dividend, price, growth, bond yield.
Beta present: CAPM. Dividend, price and growth present: DDM. Bond yield and premium present: bond yield plus premium.
Preferred: just divide the dividend by price.
Write the formula, substitute, and compute once.
Check that the cost of equity exceeds the firm's cost of debt and cost of preferred stock.

Common mistakes in Cost of Preferred Stock and Common Equity (CAPM)

Using the market return as the equity risk premium in CAPM.
The exhibit lists E(Rm) and the term 'premium' is confused with it.
Fix: Subtract the risk-free rate from the market return first, or use the formula Rf + β(Rm − Rf).
Using D0 instead of D1 in the DDM.
The vignette gives the most recent dividend.
Fix: Always compute D1 = D0 × (1 + g) before dividing by price.
Applying a tax shield to preferred or equity.
Mixing up the after-tax cost of debt step in WACC.
Fix: Only debt interest is deductible. Preferred dividends and equity returns are not tax-adjusted.
Using total share price growth or ROE as g.
Confusing growth in dividends with other growth measures.
Fix: Use the dividend growth rate given, or b × ROE.
Treating the bond yield plus premium as precise.
The method looks mechanical.
Fix: Remember the premium is a subjective estimate, so the method is a rough cross-check.

Worked examples

Example 1

Vignette: Lakeshore Industries has a beta of 1.20. The 10-year government bond yields 3.5%. The expected market return is 8.5%. Lakeshore also has preferred stock paying an annual dividend of 4.80 per share, trading at 60.00. Q1: What is the CAPM cost of equity? Q2: What is the cost of preferred stock?

Show the solution

Equity risk premium = 8.5% − 3.5% = 5.0%.
CAPM: re = 3.5% + 1.20 × 5.0% = 3.5% + 6.0% = 9.5%.
Preferred: rp = 4.80 ÷ 60.00 = 0.08 = 8.0%.
Check: preferred cost 8.0% is below equity cost 9.5%, as expected.

Answer: Q1: 9.5%. Q2: 8.0%.

Example 2

Vignette: Norvik Ltd just paid a dividend of 2.00 per share. Its stock trades at 40.00. Its payout ratio is 40% and ROE is 15%. Its long-term bonds yield 6.0%, and the analyst uses a 4.0% risk premium. Q1: What is the sustainable growth rate? Q2: What is the DDM cost of equity? Q3: What is the bond yield plus risk premium cost of equity?

Show the solution

Retention b = 1 − 0.40 = 0.60.
g = 0.60 × 15% = 9.0%.
D1 = 2.00 × 1.09 = 2.18.
DDM: re = 2.18 ÷ 40.00 + 0.09 = 0.0545 + 0.09 = 14.45%.
Bond yield plus premium: 6.0% + 4.0% = 10.0%.
Check: both estimates exceed the 6.0% bond yield, as expected for equity.

Answer: Q1: 9.0%. Q2: 14.45%. Q3: 10.0%. The two estimates differ widely. The gap reflects both the DDM's sensitivity to the high growth assumption and the subjectivity of the risk premium in the bond yield plus premium method.

Exam tips

Underline whether the dividend given is D0 or D1 before you calculate.
If the exhibit gives the market return, convert to a premium by subtracting Rf.
Questions often ask which method suits a firm: DDM for stable dividend payers, bond yield plus premium when beta is unreliable, CAPM when beta is available.
Expect a conceptual question on why equity costs more than preferred and debt, tied to risk and priority of claims.
Watch for floatation costs on preferred stock; use net proceeds if given.

Cost of Preferred Stock and Common Equity (CAPM) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Preferred Stock and Common Equity (CAPM): frequently asked questions

How do you calculate cost of equity using CAPM?

Add the risk-free rate to beta times the equity risk premium. The premium is the expected market return minus the risk-free rate. For example, 3.5% + 1.2 × 5.0% = 9.5%.

What is the difference between the cost of preferred stock and common equity?

Preferred stock pays a fixed dividend, so its cost is dividend divided by price. Common equity has no fixed payment, so you must estimate its required return with a model such as CAPM or DDM. Common equity is riskier, so its cost is usually higher.

When should I use the DDM instead of CAPM?

Use the DDM when the firm pays stable, growing dividends and you have a reliable growth estimate. Use CAPM when you have a good beta and a risk premium. The DDM is very sensitive to the growth input.

What is the bond yield plus risk premium approach?

You add a subjective premium to the yield on the company's long-term debt to estimate its cost of equity. It is helpful when beta is hard to estimate. Its weakness is that the premium is a judgment.