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ACCA Applied Skills · Financial Management · Estimating the cost of capital

Brava Co's shares have a beta of 1.4. Brava's cost of equity under CAPM is 12.2%. The risk-free rate is 3%. What is the expected return on the market portfolio?

The expected market return is 9.6%. Subtracting the 3% risk-free rate from the 12.2% cost of equity leaves 9.2%, dividing by beta of 1.4 gives a market premium of about 6.6%, and adding the risk-free rate gives roughly 9.6%.

  1. A9.6%
  2. B8.7%
  3. C10.7%Correct
  4. D6.6%

Explanation

Ke = Rf + beta(Rm - Rf), so 12.2% = 3% + 1.4 x premium. The premium = 9.2% / 1.4 = 6.571...%. That does not reconcile cleanly; recheck: 1.4 x 6.5% = 9.1%, so with Ke of 12.2% the premium is about 6.57% and Rm about 9.57%, giving 9.6%.

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