Question

Assume the​ following: The​ risk-free rate is​ 2%, the expected return on the market is​ 7%,...

Assume the​ following: The​ risk-free rate is​ 2%, the expected return on the market is​ 7%, and this​ firm's stock is twice as risky as the market on average. What would be the cost of equity for this​ firm? A. ​12% B. ​20% C. ​14% D. ​8%

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Answer #1

Solution :

The Cost of equity of a firm is calculated using the following formula :

Cost of equity = RF + [ β * ( RM - RF ) ]

Where

RF = Risk free rate of return   ; β = Beta of the stock;   RM = Expected return on the market

As per the information given in the question we have

RF = 2 %   ; RM = 7 %   ;

β = twice as risky as the market on average = 2 * 1 = 2

( Beta is a measure of risk. The market Beta is = 1 )

Applying the above values in the formula we have

= 2 % + [ 2 * ( 7 % - 2 % ) ]

= 2 % + [ 2 * 5 % ]

= 2 % + 10 % = 12 %

= 12 %

Thus the cost of equity for the firm is = 12 %

Thus the solution is Option A. 12 %

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