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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

Using the CAPM approach, a company has a risk-free rate of 7%, a market return of 13% and an equity beta of 1.2. The cost of retained earnings is:

The cost of retained earnings under CAPM is 14.2%. The market risk premium is 13% minus 7%, which is 6%. Multiplying by beta of 1.2 gives 7.2%, and adding the 7% risk-free rate gives 14.2%.

  1. A14.2%Correct
  2. B15.6%
  3. C7.2%
  4. D13%

Explanation

Ke = Rf + beta x (Rm - Rf) = 7 + 1.2 x 6 = 7 + 7.2 = 14.2%. The 15.6% option applies beta to the market return (1.2 x 13) and is wrong. The 7.2% option omits the risk-free rate.

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