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

Dorne Co has a cost of equity of 10% calculated using CAPM. Its beta is 0.75 and the market risk premium is 6%. What risk-free rate of return was used?

The risk-free rate is 5.5%. The beta-adjusted risk premium is 0.75 multiplied by 6%, which is 4.5%. Subtracting this from the 10% cost of equity leaves the risk-free rate of 5.5%.

  1. A5.5%Correct
  2. B4.5%
  3. C6.0%
  4. D10.0%

Explanation

Ke = Rf + beta x premium, so 10% = Rf + 0.75 x 6% = Rf + 4.5%. Therefore Rf = 5.5%. The 4.5% option confuses the beta-adjusted premium with the risk-free rate.

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