Question

Cost of Equity: CAPM Booher Book Stores has a beta of 0.6. 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 6.5%, and the return on an average stock in the market last year was 13.5%. What is the estimated cost of common equity using the CAPM? Round your answer to two decimal places.

Answer 1

Risk free Rate is generally the yield on 3 months T-Bills (and not the yield on 10year Treasury bond). Long term T bonds will also have some risk, specifically related to maturity risk premium.

By CAPM equation, expected rate of return or cost of equity can be explained by the formula below:

Expected rate of return = Risk free rate + (Beta * Market risk premium)

Expected rate of return = 3% + (0.6 * 6.5%) = 6.9%

This is the cost of equity. Hence, answer is 6.9%