CA Intermediate · Financial Management and Strategic Management · Cost of Capital
Under the CAPM, the risk-free rate is 7%, expected market return is 13% and a company's equity beta is 1.5. What is the cost of equity?
The cost of equity is 16%. CAPM states cost of equity equals risk-free rate plus beta times the market risk premium. The premium is 13% minus 7%, which is 6%; multiplied by beta of 1.5 gives 9%, and adding 7% gives 16%.
- A16%Correct
- B13%
- C20%
- D14.5%
Explanation
Ke = Rf + beta x (Rm - Rf) = 7 + 1.5 x (13 - 7) = 7 + 9 = 16%. Option 20% wrongly applies beta to the market return (1.5 x 13 = 19.5) plus other errors; 14.5% adds 1.5 to... the wrong figure instead of multiplying the premium by beta.
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