- CFA Exams
- CFA Level I Exam
- Topic 4. Corporate Issuers
- Learning Module 33. Cost of Capital-Foundational Topics
- 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 calculating its weighted average cost of capital. The controller 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%

B. 11.6

C. 13.1

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 capital asset pricing model (CAPM) approach, the cost of equity (%) for the company is closest to ______.

A. 8.5

B. 11.6

C. 13.1

Correct Answer: C

The cost of equity using the CAPM = risk-free rate + Beta x market equity risk premium = 3.5 + 1.6 x (6.0) = 13.1%.

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**User Contributed Comments**
7

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

leon121 |
shouldn't it be: 3.5 + (6.0 - 3.5)*1.6 = 7.5 ? |

chris12345 |
6% is already the premium, leon121. |

GBolt93 |
(6.0-3.5)*1.6 would be if 6.0 was the market return, not the market risk premium |

Inaganti6 |
gotta read carefully....the 6% is already the risk premium....not the expected market return.....! |

khalifa92 |
equity risk premium and beta are given, you only have to decide which treasury bill to compare with. |

zriddle |
I always assumed that the risk free rate was the 3-Month T-Bill because of the risk of not being able to reinvest the earnings on the 10-year at the original rate. |

MathLoser |
Yields on default risk-free debt such as T-notes are usually used to estimate when calculating CAPM. |