The market risk premium is 7.5 percent, the market rate of return is 15.6 percent and the beta of an…
Under CAPM, Ke = Rf + β (Rm − Rf). The market risk premium (Rm − Rf) is 7.5% and the market return Rm is 15.6%, so the risk-free rate is Rf = 15.6 − 7.5 = 8.1%. Ke = 8.1 +…
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The market risk premium is 7.5 percent, the market rate of return is 15.6 percent and the beta of an equity share is 1.33. Using CAPM, what is the required rate of return (cost of equity) on the equity share, in percent?
Answer and explanation
Correct answer C
Under CAPM, Ke = Rf + β (Rm − Rf). The market risk premium (Rm − Rf) is 7.5% and the market return Rm is 15.6%, so the risk-free rate is Rf = 15.6 − 7.5 = 8.1%. Ke = 8.1 + 1.33 × 7.5 = 8.1 + 9.975 = 18.075, or about 18.08%.
The other options are wrong. 15.6% is the market return, which would be the answer only if beta were 1. 8.1% is the risk-free rate alone. 23.7% (15.6 + 8.1) adds the market return to the risk-free rate, which has no basis in CAPM.
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