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