CFA Practice Question

There are 233 practice questions for this study session.

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 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%.

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.
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