- CFA Exams
- CFA Level I Exam
- Study Session 10. Corporate Finance (1)
- Reading 33. Cost of Capital
- Subject 3. Cost of Common Equity

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**CFA Practice Question**

A company wants to determine the cost of equity to use in the calculation of its weighted average cost of capital. The CFO has gathered the following information:

Rate of return on 10-year Treasury bonds: 3.5%

Market equity risk premium: 6.0%

The company's estimated beta: 1.6

The company's after-tax cost of debt: 8.0%

Risk premium of equity over debt: 4.0%

Corporate tax rate: 35%

Rate of return on 3-month Treasury bills: 3.0%

Rate of return on 10-year Treasury bonds: 3.5%

Market equity risk premium: 6.0%

The company's estimated beta: 1.6

The company's after-tax cost of debt: 8.0%

Risk premium of equity over debt: 4.0%

Corporate tax rate: 35%

Using the bond-yield-plus-risk-premium approach, the cost of equity (%) for the company is closest to ______.

A. 12.3

B. 16.3

C. 18.3

**Explanation:**The cost of equity using the bond-yield-plus-risk-premium approach is determined by the before-tax cost of debt plus the risk premium of equity over debt. The before-tax cost of debt is the after-tax cost of debt divided by (1- tax rate). 8.0/(1 - 0.35) = 12.3%

Adding the risk premium results in a cost of equity of 12.3% + 4% = 16.3%.

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**User Contributed Comments**
3

User |
Comment |
---|---|

navarro |
Can someone please explain? I suck at this. |

nascfa |
Navarro, the bond-yield-plus-risk-premium approach is a method used to determine the value of an asset (usually of a publicly traded equity). The formula is the sum of the before tax cost of debt and a risk premium of equity over debt. Therefore you calculate before tax cost of debt 12.3% + 4% risk premium = 16.3% |

khalifa92 |
people dont use analsytnotes as your primary source of knowledge its only a secondary. |