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 ?