When you are calculating the cost of equity using the CAPM formula, should you be using the T-Bill rate or the 10 year Treasury Bond rate as the risk free rate? The answer used the 10 year Treasury Bond rate however Schweser states that most analysts use Treasury Bill rate…
“In general, the selection of the appropriate risk-free rate should be guided by the duration of projected cash flows.” CFAI Curriculum V4 pg92.
hmm, the question doesn’t mention anything about cashflows though… Sorbonne Systems Incorporated wants to determine the cost of equity that can be used in the calculation of the weighted average cost of capital. The CFO has gathered the following information: 3 month Treasury Bills 3% 10 year Treasury Bonds 3.5% Market equity risk premium 6% Beta 1.6 A. 12.6% B. 13.1%
A using TBill rate
The answer is actually B. Can someone please explain why?
i believe there was a mention about the company’s cost of debt (part of the bond yield +premium sub question).based on that perhaps we should assume that it was a long term bond?. difficult to imagine 3 month debt
No, it was because you were talking about an equity (long duration asset), rather than a short duration asset (TBill). I think JDV had something to say about this: http://www.analystforum.com/phorums/read.php?11,627600,632975#msg-632975