Question

Cost of Equity: CAPM

Booher Book Stores has a beta of 0.7. 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 7.5%, and the return on an average stock in the market last year was 14%. What is the estimated cost of common equity using the CAPM? Round your answer to two decimal places.

Answer 1

Here 14% market return last year is irrelevant because it is just one observation.

Here Risk free rate of return is used in CAPM model is should be matched with the maturity of the investment being examined.Since stocks are considered as a long term investment, so we can use long term risk free rate in cost of equity.

Here Rf = 7%

Beta = 0.7, Market risk premium = 7.5%

Cost of equity under CAPM approch = Rf + Beta * Market risk premium

= 0.07 + 0.7 * 0.075 = 0.1225

Cost of equity under CAPM approch = 12.25%