There are a couple BPP MCQs that are answered using E(r)=R+B(E(r )-R), however without the second R and I'm confused at to why. Example:
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 answer then proceeds to state the formula and write it as 3% + (1.3 x 8%) = 13.4%
Why is it 1.3 x 8% and not 1.3 x (8%-3%)?
Thank you.
Ask the Tutor ACCA FM
Capital Asset Pricing Model
I think I understand now. E(rm) is the return from the market and Rf is the risk-free rate. The market premum is E(rm)-Rf. Which in this example is 8%. (and the return from the market would be 11%). I hadn't realised there were three elements at play.
5y ago#2That is correct - the market premium is the difference between the market return and the risk free rate (and I do stress this in my free lectures on CAPM).
Sign into reply to this topic.