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James Co have determined that the asset beta for the new machine is 1.2. The gearing ratio of James (debt to equity) is 0.2. The tax rate of 30%, the risk free rate is 5%, and the market premium is 8%.
What is the project specific cost of equity?
Answer given: 15.94%
Using the asset beta formula the equity beta = 1.368
MY confusion is with the formula given in the answer:
Project specific cost of equity = 5% + (1.368 x 8%) = 15.94%
Shouldn’t it be: 5% + 1.368 (8% – 5%) = 9.1%
Please advise?
The market premium is the excess of the market return over the risk free rate.
(`Since the premium is 8%, the market return is 13% 🙂 )
I do mention this in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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