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A company that wants to determine its cost of equity gathers the following information:

Rate of return on 3-month Treasury bills

3.0%

Rate of return on 10-year Treasury bonds

3.5%

Market risk premium

6.0%

The company’s equity beta

1.6

Dividend growth rate

8.0%

Corporate tax rate

35%

Using the capital asset pricing model (CAPM) approach, the cost of equity (%) for the company is closest to:

13.1%.

7.5%.

12.6%.

 

Incorrect.

CAPM: Cost of equity = Risk free rate + Beta × Market risk premium = 3.5% + 1.6 × (6.0%) = 13.1%

The 10-year risk free rate is appropriate based on the long-term duration of the cash flows from the project.

How do we decide which risk free to use ?

"indispensable down the final stretch and had a HUGE impact on my studies." - Christopher, USA

10 year tbond should be the appropriate risk free. We can’t use 3 months tbill because the period is too short 

Shorter term T-Bill is going to give less risk than a longer term T-Bill. If given two options, use the shorter, more liquid version for the “risk-free” rate. 

Don't forget to carry the one.

PreDRaR66 wrote:
Shorter term T-Bill is going to give less risk than a longer term T-Bill. If given two options, use the shorter, more liquid version for the “risk-free” rate.

With all due respect, this is bad advice.

The maturity of the risk-free rate should closely match the expected term of the investment.  The explanation given in the original post is correct.

Simplify the complicated side; don't complify the simplicated side.

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@ S2000magician could you explain how we can tell the expected term of the investment? I couldn’t quite tell from the question itself.  Thanks