XYZ Inc. wants to determine the cost of equity that can be used in the calculation of the WACC. The CFA has gathered the following information: Rate of return on the 3-month T-Bill: 3.0% Rate of return on the 10-year T-Bond: 3.5% Market equity risk premium: 6.0% XYZ’s estimated beta: 1.6 XYZ’s before-tax cost of debt: 8.0% Risk premium of equity over debt 4.0% Using the CAPM approach and the bond yield plus risk premium approach, respectively, the cost of equity for XYZ is closest to: CAPM Bond yield plus risk premium A. 12.6% 12% B. 12.6% 14% C. 13.1% 12% D. 13.1% 14% I chose A! K = .03 + 1.6(.06) = 12.6% BYP = 8 + 4 = 12% The correct answer was C: K = .035 + 1.6(.06) = 13.1% BYP = 8 + 4 = 12% Why would you use the 10-year T-Bond as the Risk-Free Rate? Also, can someone explain why we use 8% and 4% in the second portion? Why would we care about the 4% risk premium of equity over debt, when we’re dealing with the bond yield?!?!? Thank you!
Hmmm, good one. I went with A, too, then realized where I goofed. I think maybe b/c the firm is supposed to be thought of as a “going concern” and the 3 mth t Bill is too short in duration.
The question has an violation of Standard VII (B) reference to CFA designation.
pepp Wrote: ------------------------------------------------------- > The question has an violation of Standard VII (B) > reference to CFA designation. NICE DUDE! HOLY SMOKES, YOU MUST BE ON RED BULL
Bond yield approach: Rce=Rd+Rerp= 8 + 4= 12% Because the Risk premium of equity over debt represent the premium at which shares should sell over its long-term debty yield, also in the CAPM we take the 10-year T-Bond This is what I think is the reason
also in the CAPM > we take the 10-year T-Bond > > This is what I think is the reason I think maybe b/c the firm is supposed to be thought of as a “going concern” and the 3 mth t Bill is too short in duration.
daj224 Wrote: ------------------------------------------------------- > also in the CAPM > > we take the 10-year T-Bond > > > > This is what I think is the reason > > > I think maybe b/c the firm is supposed to be > thought of as a “going concern” and the 3 mth t > Bill is too short in duration. Well, but we dont know nothing about it…anyway I hope not for the firm 
Good one, I would have used the 3mth too.
I worked on the buy side last summer and a top analyst said we use longer term risk free b/c of the nature of the firm being expected to be around at least 10 years, something like that. This must be what he meant. So, this question is tricky b/c it tries to get you to do a quick and dirty CAPM instead of really dig out the undercurrents nasty
We’ve always used the 10-yr treasury as the risk free for CAPM at my job.
nirjraina Wrote: ------------------------------------------------------- > We’ve always used the 10-yr treasury as the risk > free for CAPM at my job. Hi nirj, in which sector do you work?
T-bill rate is to short and you will probably have reinvestment risk if you use it in CAPM, b/c you need WACC in order to discount something (it will always be something maturing in more than a year from now). Here, where I work, we match cash flow projections and risk-free rate maturity (for exp. five year cash flow and YTM for a five year default free, discount bond). Milos
strangedays Wrote: ------------------------------------------------------- > Bond yield approach: > > Rce=Rd+Rerp= 8 + 4= 12% > > Because the Risk premium of equity over debt > represent the premium at which shares should sell > over its long-term debty yield, also in the CAPM > we take the 10-year T-Bond > > This is what I think is the reason So I think what I said its correct
Milos On the other hand, the shorter maturity - less liquidity risk. 3.5% - 3%=0.5%. 0.5% might be a risk premium. Thus, 3% is closer to the theoretical RFR.