A company that wants to determine its cost of equity gathers the following information:
Rate of return on 3-month Treasury bills
Rate of return on 10-year Treasury bonds
Market risk premium
The company’s equity beta
Dividend growth rate
Corporate tax rate
Using the capital asset pricing model (CAPM) approach, the cost of equity (%) for the company is closest to:
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 ?