IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy
A company's equity beta is 1.2, the risk-free rate is 6% and the expected market return is 12%. Using CAPM, what is the cost of equity?
Under CAPM the cost of equity is the risk-free rate plus beta times the market risk premium. That is 6% plus 1.2 times 6%, which equals 13.2%.
- A12.0%
- B13.2%Correct
- C14.4%
- D7.2%
- 18.0%
Explanation
Cost of equity = 6% + 1.2 x (12% - 6%) = 6% + 7.2% = 13.2%. Option 14.4% wrongly adds beta times the full market return minus nothing else; 7.2% omits the risk-free rate.
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