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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Using the Capital Asset Pricing Model, Kaveri Textiles Ltd has an equity beta of 1.2. The risk-free return is 7% per annum and the expected return on the market portfolio is 12% per annum. What is the company's cost of equity?

The cost of equity is 13%. CAPM adds the risk-free rate of 7% to beta multiplied by the market risk premium of 5% (12% minus 7%), giving 7% plus 6%. Using the full market return instead of the premium would wrongly give 14.4%.

  1. A12.0%
  2. B13.0%Correct
  3. C14.4%
  4. D8.4%
  5. 6.0%

Explanation

CAPM: Ke = Rf + beta x (Rm - Rf) = 7% + 1.2 x 5% = 13%. Choosing 14.4% multiplies beta by the market return (1.2 x 12%) and ignores the risk-free rate. 12% is just the market return, and 6% is 1.2 x 5% without adding Rf.

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