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Hi sir,
There is a question in the BPP Kit that I am confused of.
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?The solution given in the answer sheet is:
E(ri) = Rf + ? (E(Rm) – Rf) = 3% + (1.3 x 8%) = 13.4%I do not understand why is the the risk-free rate of 3% excluded in the last half of the CAPM formula. I thought it should be 3% + 1.3 (8% – 3%) = 9.5%?
Thank you for your assistance in advance 🙂
What you are wanting to do would be correct if 8% was the market return.
However the questions says that the market premium is 8% which means that the market is giving 8% more than risk free (i.e. the market return is 11%).
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