Question

Your company has always assumed a cost of common equity capital of about 12.0%. An intern you supervise at the firm recently gathered the information below, and you now want to run a check on that long-standing assumption.

What is your good estimate of R_e?

• the yield right now on a 5-year US Treasury note: 3.87%
• total liabilities: $13 million
• total shareholders' equity: $26 million
• company's stock beta: 1.55
• 5-year average return on the S&P 500: 11.23%
• YTM on the company's only bond issue: 4.20%

Answer 1

Answer-

Given

Risk free rate (RFR) = the yield right now on a 5-year US Treasury note = 3.87%
Market rate of return ( Rm) = 5-year average return on the S&P 500 = 11.23%
Beta = 1.55
Cost of equity (Re) = ?

As per the Capital Asset Pricing Model (CAPM)

Re = RFR + Beta x ( Rm - RFR)
Re = 3.87 % + 1.55 x ( 11.23 % - 3.87 %)
Re = 3.87 % + 1.55 x 7.36 %
Re = 3.87 % + 11.408 %
Re = 15.278 %

Therefore the good estimate of Cost of equity (Re) = 15.278 %

Note - YTM on the company's only bond issue = 4.20% ( This is Cost of debt ) and total liabilities and total shareholder's equity are not required for calculation of Cost of equity (Re).