Question

1. The current risk free rate of return is 3% and the expected return on the market is 8%.
   1. Calculate the cost of equity (required rate of return) for a stock with a Beta = 0.54.
   2. Calculate the cost of equity (required rate of return) for a stock with a Beta = 1.35.
   3. Create a one way data table to determine the cost of equity by varying Beta.
   4. Use your data table to generate a graph. Include a title and label the axes for the graph.
   5. What does this graph represent?

Answer 1

Using the CAPM model,

ER_i = R_f + β(ER_m - R_f)

where,

ER_i = Cost of Equity
R_f = Risk-free rate = 3%
β = Beta of the investment
ER_m = Expected return of market = 8%

(a) β = 0.54

ER_i = 3 + 0.54(8 - 3) = 5.7%

(b) β = 1.35

ER_i = 3 + 1.35(8 - 3) = 9.75%

(c)

(d)

(e) This line is called the security market line (SML)