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CA Intermediate · Financial Management and Strategic Management · Cost of Capital

The risk-free return is 7%, the expected market return is 13% and the equity beta of Kaveri Auto Ltd is 1.2. Using CAPM, what is the cost of equity?

The cost of equity is 14.2%. CAPM adds the risk-free rate to beta times the market risk premium. The premium is 13% minus 7%, which is 6%, and 1.2 times 6% is 7.2%. Adding the 7% risk-free rate gives 14.2%.

  1. A7.2%
  2. B14.2%Correct
  3. C15.6%
  4. D22.6%

Explanation

Ke = Rf + beta x (Rm - Rf) = 7% + 1.2 x (13% - 7%) = 7% + 7.2% = 14.2%. Giving only 7.2% omits the risk-free rate. Multiplying beta by the market return alone gives 15.6%, and applying beta to Rm instead of the premium gives 22.6%.

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