ACCA Applied Skills · Financial Management · Estimating the cost of capital
Karo Co has an equity beta of 0.8. The expected market return is 11% and the risk-free rate is 3%. Which of the following is Karo Co's cost of equity using CAPM?
The cost of equity is 9.4%. The market risk premium is 8% (11% less 3%), so beta of 0.8 gives a premium of 6.4%, which added to the 3% risk-free rate produces 9.4%.
- A8.8%Correct
- B11.0%
- C9.4%
- D6.4%
Explanation
The market risk premium is Rm - Rf = 11% - 3% = 8%. Ke = 3% + 0.8 x 8% = 3% + 6.4% = 9.4%. The option 8.8% is wrong; check: 9.4% is correct. The 6.4% option omits the risk-free rate, and 8.8% uses 0.8 x 11%.
Did you get it right without looking?
One question tells you little. A timed set on Estimating the cost of capital shows your real accuracy, how long you take and where you lose marks.
More Estimating the cost of capital questions
- Kestrel Co has just paid a dividend of $0.40 per share. Dividends have grown at a constant 5% a year and are expected to continue to do so. …
- 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 retur…
- Zeta Co has irredeemable loan notes with a nominal value of $100 and a coupon of 8%. The notes currently trade at $80 ex-interest. The tax r…
- Vale Co has 6% convertible loan notes of $100 nominal, redeemable at par in 3 years. Comparable non-convertible debt would yield 8% pre-tax.…
- Orla Co has 6% loan notes in issue, redeemable at par ($100 nominal) in 5 years. The current market price is $95 ex-interest. The tax rate i…
- Which of the following is the main assumption of the dividend valuation model when used to estimate the cost of equity?