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Question is
A share in ms Co has an equity beta of 1.3 debt beta of 0.1 gearing of 20% market premium of 8% and risk free is 3%What is the cost of equity.
The answer uses the capital asset pricing model
3% + (1.3 × 8) = 13.4%
But as per formula I deducted 3 from the 8 (market premium less risk free) can’t understand why this was not done in the answer. I make the coat of equity 9.5%
Also from the question how do I talk my way through the question go know which formula to use. The gearing and debt beta throw me out a little.
Thank you for your time
1. If the question had said that the market return was 8% then you would have been correct. However the question said that the market premium is 8% – the premium is the excess of the market return over the risk free rate (and so the market return is actually 11%)
2. It is the equity beta that measures the risk of the share, and therefore the equity beta that determines the shareholders required rate of return, which is the cost of equity.
I do suggest that you watch my free lectures on CAPM, because I cover both these points in the lectures. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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