Question

What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent?

Answer 1

Risk free rate of return is \(2.9 \%\). Market return is \(11.4 \%\). The beta of the firm is \(1.2\).

Compute the cost of equity using the CAPM.

The formula is as follows:

Cost of equity \(=R f+\beta(R m-R f)\)

Here the risk-free rate of return is \(R f\), The market rate of return is \(R m\), The beta of the firm is \(\beta\).

Substitute \(1.2\) for \(\beta, 2.9 \%\) for \(R f\) and \(11.4 \%\) for \(R m\).

$$ \begin{aligned} \text { Cost of equity } &=R f+\beta(R m-R f) \\ &=2.9 \%+1.2(11.4 \%-2.9 \%) \\ &=2.9 \%+1.2(8.5 \%) \\ &=13.1 \% \end{aligned} $$

Therefore, the cost of equity is \(13.1 \%\)