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CMA Final · Strategic Performance Management and Business Valuation · Fundamentals of Business Valuation

A valuer estimates a private firm's cost of equity using the CAPM with a risk-free rate of 7%, equity beta of 1.2 and market return of 13%. Which cost of equity results?

The cost of equity is 14.2%. Under CAPM it equals the risk-free rate of 7% plus beta of 1.2 times the market risk premium of 6% (13% minus 7%), which is 7% plus 7.2%.

  1. A14.2%Correct
  2. B15.6%
  3. C13.0%
  4. D7.2%

Explanation

Cost of equity = 7% + 1.2 x (13% - 7%) = 7% + 7.2% = 14.2%. Using 1.2 x 13% gives 15.6%, a mistake of applying beta to market return rather than the premium. 7.2% is only the risk premium component.

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