Question

I need to calculate the cost of equity financing using the CAPM model and am having a hard time figuring it out.  The capital investment is a 7 year asset.

debt 40%

interest rate 5%

tax rate 26%

equity 60%

risk free rate 6%

Rm 13%

beta 1.10

working capital 10% of next years sales

capital investment for project 1 is 1,000,000

Project 1	1	2	3	4	5	6	7	8
Revenue	780,000	799,500	819,488	839,975	860,974	882,498	904,561	927,175
Expense	585,000	599,625	614,616	629,981	645,731	661,874	678,421	695,381
Annual depreciation rate	14.29%	24.49%	17.49%	12.49%	8.93%	8.92%	8.93%	4.46%
Depreciation	142,900	244,900	174,900	124,900	89,300	89,200	89,300	0
Expense-depreciation	442,100	354,725	439,716	505,081	556,431	572,674	589,121	695,381
Cost of Debt	0.57	0.44	0.54	0.60	0.65	0.65	0.65	0.75

Answer 1

Cost of Equity financing using the CAPM Model

As per Capital Asset Pricing Model [CAPM], the Cost of Equity is computed by using the following equation

Cost of Equity = Risk-free Rate + Beta[Market Rate of Return – Risk-free Rate]

= Rf + Beta(Rm – Rf)

Here we’ve, Risk-free Rate (Rf) = 6%

Market Rate of Return (Rm) = 13%

Beta of the stock = 1.10

Therefore, the Cost of Equity = Risk-free Rate + Beta[Market Rate of Return – Risk-free Rate]

= Rf + Bet(Rm – Rf)

= 6% + 1.1(13% - 6%)

= 6% + (1.1 x 7%)

= 6% + 7.70%

= 13.70%

“Hence, the Cost of Equity financing using the CAPM Model would be 13.70%”