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Dear Sir,
In BPP solution they calculate cost of equity by using Modigliani and Miller formula.
Can you show me the calculation to find cost of equity by using CAPM.The cost of equity for the similar company is 14%.
We know the risk free rate is 4.5% and that the market premium is 4%.
So we can use the normal CAPM formula ‘backwards’ to calculate the equity beta.
14% = 4.5% + Beta x 4%.
The gives an equity beta of 2.375.The gearing is 1:1 (market value of debt to market value of equity)
So we can use the asset beta formula (with equity beta as 2.375, and debt beta as zero as usual). The gives an asset beta of 1.381
If we use this in the normal CAPM formula it gives a cost of equity (with no gearing) as 4.5% + 1.381×4% = 10.02%
(Can I suggest that in future you use the search box on this website – this is a copy of an answer I gave previously to exactly the same question 🙂 )
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