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ACCA Applied Skills · Financial Management · Estimating the cost of capital

Zeta Co has an equity beta of 1.2. The risk-free rate of return is 4% and the market risk premium (Rm - Rf) is 6%. Using the capital asset pricing model, what is Zeta Co's cost of equity?

The cost of equity is 11.2%. Under CAPM it equals the risk-free rate of 4% plus beta of 1.2 multiplied by the 6% market risk premium, which gives 7.2%, so the total required return is 11.2%.

  1. A7.2%
  2. B11.2%Correct
  3. C10.0%
  4. D13.2%

Explanation

Ke = Rf + beta x (Rm - Rf) = 4% + 1.2 x 6% = 4% + 7.2% = 11.2%. The 7.2% option is only the risk premium component and omits the risk-free rate. The 13.2% option wrongly adds 6% to the beta-adjusted premium.

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