Question

If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the:

A.		difference between the return on the market and the risk-free rate.
B.		beta times the market risk premium.
C.		market rate of return.
D.		beta times the risk-free rate.
E.		return on the stock minus the risk-free rate.

Answer 1

Solution:

As per the Capital Asset Pricing Model (CAPM) Cost of equity capital is calculated using the following formula :

R_E = R_F + [ β * ( R_M - R_F ) ]

Where

R_E = Cost of equity capital ; R_F = Risk free rate of return   ; β = Beta   ;   R_M = Expected return on the market

Here ( R_M - R_F ) is the difference between the Expected return on the market and the Risk free rate of return. This is also known as the market risk premium.

Thus the expected excess market return is equal to difference between the return on the market and the risk-free rate.

Thus the solution is Option A. difference between the return on the market and the risk-free rate