Question

What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent?

Answer 1

13.1$ is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent.

The cost of equity of a firm represents the compensation that the market demands in exchange for the asset ownership and bearing its risk. The traditional formula which comprises the cost of equity is the dividend capitalization model as well as the capital asset pricing model (CAPM).

Using the CAPM model or capital asset pricing model which determines the cost of equity financing would be equated as

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)

Here, the risk-free rate determines the minimum rate of return, to which the excess return is added.

Beta is referred to as the standard CAPM measure of systematic risk and has the tendency for the return of a security to move parallel with the whole return of the stock market.

In the CAPM model, the market return of an asset is the risk-free rate plus the premium which is multiplied by the beta of the asset.

So, here risk-free rate return RF=2.9

The expected market rate of return RM=11.4

Beta (β) =1.2

According to the CAPM model,

Cost of equity Re =RF+ β(RM-RF)

=2.9+1.2(11.4-2.9)

=2.9+10.2

=13.1

Therefore 13.1$ is the cost of equity.

Learn to know more about the estimation of the cost of equity by the CAPM model at,

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