CFA Practice Question

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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 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%.

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.
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