Question

A risk analyst gives Oracle Corp., the enterprise software and database management firm, a CAPM (Capital Asset Pricing Model) equity beta of 1.20. The risk-free rate is 4%. Required: Prepare a table with the cost of capital (cost of equity) that you would calculate for the equity with the following estimates of the market risk premium. (12 points) 4.5% 6.0 % 6.5% 7.0 %

Answer 1

Solution:

As per the CAPM the cost of capital ( cost of equity ) is calculated using the formula:

Cost of capital = Risk free rate + ( Beta * Market Risk premium )

Using the above formula we can calculate the Cost of capital ( Cost of equity ) for various estimates of Market Risk premiums as follows:

Table showing calculation of Cost of Equity Capital for various estimates of Market Risk Premium:

Sl.No.	Risk Free Rate	Beta	Market Risk Premium	Beta * Market Risk Premium	Cost of Capital = Risk Free Rate + (Beta * Market Risk Premium)
	(a)	(b)	(c )	(d) = (b) * (c )	(e) = (a) + (d)
1	4 %	1.20	4.5 %	5.40 %	9.40 %
2	4 %	1.20	6.0 %	7.20 %	11.20 %
3	4 %	1.20	6.5 %	7.80 %	11.80 %
4	4 %	1.20	7.0 %	8.40 %	12.40 %

Also find the attached screenshot of the excel sheet containing the detailed calculation for the solution.