Question

Cost of Equity: CAPM  Booher Book Stores has a beta of 1.2. The yield on a 3-month T-bill is 3% and the yield on a 10-year T-bond is 7%. The market risk premium is 5.5%, and the return on an average stock in the market last year was 13%. What is the estimated cost of common equity using the CAPM? Round your answer to two decimal places.    %

Answer 1

Solution :

The Estimated Cost of equity as per Capital Asset Pricing Model ( CAPM ) is calculated using the following formula :

RE = RF + [ β * ( RM - RF ) ]

Where

RE = Cost of equity    ; RF = Risk free rate of return   ; β = Beta of the stock ;

( RM – RF ) = Market risk Premium ;

As per the information given in the question we have

RF = Yield on a 10 year T-bond = 7 %   ;   ( RM - RF ) = Market Risk Premium = 5.5 %   ;

β = 1.2   ;

Applying the above values in the formula we have

= 7 % + ( 1.2 * 5.5 % )

= 7 % + 6.60 % = 13.60 %

Thus the estimated cost of equity = 13.60 %