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Dear John,
Would you be able to help me with the below question?
I would be grateful if you could show workings and reasoning behind them.
A share in MS Co has an equity beta of 1.3. MS Co’s debt beta is 0.1. It has a gearing ratio of 20% (debt:equity). The market premium is 8% and the risk free rate is 3%. MS Co pays 30% corporation tax.
What is the cost of equity for MS Co?
It is the equity beta (1.3) that determines the cost of equity.
Therefore, using the formula on the formula sheet:
cost of equity = 3% + (1.3 x 8%) = 13.4%
(I am puzzled because presumably you found this in the BPP Revision Kit, and the Kit does have the answer and explanation!)
The free lectures on CAPM will help you understand the reasoning.
Sir i understand that in asset capital pricing model the E(ri) is used to calculate the cost of equity or the shareholders required rate of return
But If we use the above formula
E(ri) = Rf -B(E(rm)-Rf)
Dont we get
3% +1.3(8%-3%)
Answer at the back shows
3%+(1.3×8%)
Why?E(rm) is the return on the market.
E(rm) – Rf is the market premium (the excess of the market return over the risk free rate).
This question gives the market premium and so my previous answer is correct.
I do make this point in my free lectures on CAPM because it is easy to misread a question in the exam.
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