Test 3: Cost of Capital: answer key

Question 1 · 2 marks · Cost of Capital · medium

Scenario. Bharat Renewables Ltd. is a growing manufacturer of solar modules and energy-storage equipment. The company is planning to establish a new manufacturing facility and its finance committee is evaluating the expected return required by existing shareholders and prospective equity investors. The finance director has requested separate calculations of cost of equity and cost of retained earnings because the company intends to finance the expansion through both fresh equity and internal accruals. Existing capital structure (₹ crore): Equity share capital: ₹60 crore. Retained earnings: ₹15 crore. 12% preference share capital: ₹10 crore. 10% non-convertible debentures: ₹25 crore. Term loans carrying 10% interest: ₹15 crore. Total capital: ₹125 crore. Additional financial information: Forecast EBIT: ₹24 crore. Annual interest on debentures and term loans: ₹4 crore. Corporate income-tax rate: 30%. Existing equity beta: 1.20. Risk-free rate: 6%; expected market return: 14%. Current market price of equity shares: ₹50. Dividend paid during the previous year (D0): ₹4 per share. Expected constant dividend growth rate: 10%. Proposed new equity issue price: ₹48 per share. Flotation expenses on new equity: ₹3 per share. Current earnings per share: ₹9. Expansion proposal: Initial investment: ₹40 crore. Expected annual CFAT: ₹11 crore for 5 years. Working capital cycle: Raw-material holding 40 days, work-in-progress 15 days, receivables 45 days and creditors' credit period 30 days. Net operating cycle: 70 days. The company has sufficient taxable profits and expects dividends to grow at a constant rate. The finance committee wants to compare the Gordon growth approach with CAPM and the earnings-price approach. All market prices supplied are ex-dividend. The company intends to retain part of its earnings rather than distribute the entire profit as dividends. For the purpose of the calculations, assume that the stated dividend growth rate is sustainable throughout the relevant forecast period.

Using Gordon's Dividend Growth Model, calculate the cost of equity shares of Bharat Renewables Ltd. using the existing market price and the expected constant growth rate.

1. 18.80% (correct answer)
2. 17.50%
3. 14.40%
4. 20.00%

Answer: A — 18.80%

Explanation. D0 = ₹4 and the expected growth rate is 10%. Therefore, next year's dividend D1 = ₹4 × 1.10 = ₹4.40. The current market price is ₹50. Applying Gordon's model, Ke = D1/P0 + g = ₹4.40/₹50 + 10% = 8.80% + 10% = 18.80%. The answer must include both the dividend yield and expected growth. Ignoring growth produces an incomplete cost estimate, while using D0 directly understates the next expected dividend.

Where it goes wrong. Using the historical dividend D0 instead of the expected dividend D1, or omitting the dividend growth component.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 2 · 2 marks · Cost of Capital · hard

Bharat Renewables Ltd. plans a fresh equity issue at ₹48 per share with flotation expenses of ₹3 per share. Using Gordon's growth model, calculate the cost of newly issued equity capital.

1. 18.80%
2. 19.78% (correct answer)
3. 20.00%
4. 21.00%

Answer: B — 19.78%

Explanation. Expected dividend D1 = ₹4 × 1.10 = ₹4.40. Net proceeds from the fresh equity issue = ₹48 − ₹3 = ₹45 per share. The cost of new equity is Ke = D1/(P0 − F) + g. Substituting, Ke = ₹4.40/₹45 + 10% = 9.7778% + 10% = 19.78%. The current market price of ₹50 is relevant for existing equity and retained earnings, not for calculating the proceeds of this new issue. Ignoring flotation expenses would give a lower result.

Where it goes wrong. Using the existing market price or gross issue price instead of net proceeds after flotation expenses.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 3 · 2 marks · Cost of Capital · hard

Determine the cost of equity of Bharat Renewables Ltd. under CAPM. The company has an equity beta of 1.20, a risk-free rate of 6% and an expected market return of 14%.

1. 15.00%
2. 16.00%
3. 15.60% (correct answer)
4. 17.20%

Answer: C — 15.60%

Explanation. CAPM formula: Ke = Rf + β(Rm − Rf). Market risk premium = 14% − 6% = 8%. Risk premium for the company's equity = 1.20 × 8% = 9.60%. Therefore, Ke = 6% + 9.60% = 15.60%. Beta measures systematic risk and multiplies the market risk premium, not the entire market return. Adding 1.20 times the market return directly to the risk-free rate would significantly overstate the required return.

Where it goes wrong. Applying beta to the entire market return instead of applying it only to the market risk premium.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 4 · 2 marks · Cost of Capital · medium

Using the Earnings Price Approach, calculate the cost of equity of Bharat Renewables Ltd. based on its current EPS of ₹9 and market price of ₹60 per share.

1. 12.00%
2. 18.00%
3. 20.00%
4. 15.00% (correct answer)

Answer: D — 15.00%

Explanation. Under the Earnings Price Approach, Ke = EPS/P, where EPS is current earnings per share and P is the market price per share. Therefore, Ke = ₹9/₹60 × 100 = 15%. This approach assumes that earnings per share remain constant. It does not use the dividend payout ratio or expected dividend growth, unlike Gordon's model. The numerator should be earnings per share rather than dividend per share; using dividends would produce a different valuation-based yield.

Where it goes wrong. Substituting dividend per share for earnings per share or confusing the Earnings Price Approach with the Dividend Price Approach.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 5 · 2 marks · Cost of Capital · medium

Scenario. Aditya Automotive Ltd. manufactures precision automotive components and electric-vehicle powertrain assemblies. The company is considering an expansion of its production capacity and has requested an independent assessment of the opportunity cost of equity and retained earnings. Management has observed that the expected return of shareholders depends on dividend expectations, market risk and the price at which shares are traded. Existing capital structure (₹ crore): Equity share capital: ₹90 crore. Retained earnings: ₹20 crore. 12% preference share capital: ₹15 crore. 10% debentures: ₹40 crore. Term loans carrying 9% interest: ₹20 crore. Total capital: ₹185 crore. Additional financial information: Forecast EBIT: ₹30 crore. Annual interest on existing borrowings: ₹5.80 crore. Corporate income-tax rate: 25%. Equity beta: 1.40. Risk-free rate: 5.5%; market return: 13.5%. Current market price of equity share: ₹90. Dividend paid during the previous year (D0): ₹6 per share. Expected dividend growth rate: 8%. Current EPS: ₹18. An investor acquired the company's equity shares for ₹950 per share. The investor received an annual dividend of ₹80 per share for each of the subsequent three years and sold the share for ₹1,000 at the end of year three. For interpolation, use the following factors: At 9%: PVAF (3 years) = 2.531 and PVF (3 years) = 0.772. At 11%: PVAF (3 years) = 2.444 and PVF (3 years) = 0.731. Expansion proposal: Initial investment: ₹35 crore. Expected annual CFAT: ₹10 crore for 6 years. Working capital cycle: Raw-material holding 50 days, work-in-progress 20 days, receivables 40 days and creditors' credit period 35 days. Net operating cycle: 75 days. The company proposes to finance the expansion partly through retained earnings. The management requires the analyst to distinguish the historical realised return from the prospective return under CAPM and Gordon's model. For two additional investor-side adjustment questions, the personal tax and brokerage percentages expressly supplied in those questions must be used as stipulated. No company-level tax deduction is available for dividends or returns distributed to equity shareholders.

Calculate the cost of retained earnings of Aditya Automotive Ltd. under Gordon's Growth Model. Use the existing market price of ₹90, D0 of ₹6 and expected growth of 8%.

1. 15.20% (correct answer)
2. 14.67%
3. 16.00%
4. 8.64%

Answer: A — 15.20%

Explanation. The next expected dividend is D1 = D0(1 + g) = ₹6 × 1.08 = ₹6.48. Cost of retained earnings under Gordon's model is Kr = D1/P0 + g. Therefore, Kr = ₹6.48/₹90 + 8% = 7.20% + 8% = 15.20%. The current market price is used because retained earnings represent funds belonging to existing shareholders. Fresh equity issue flotation expenses must not be deducted when using the standard ICAI retained earnings approach.

Where it goes wrong. Deducting new equity flotation expenses from the market price when calculating the standard cost of retained earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 6 · 2 marks · Cost of Capital · hard

An investor purchased an equity share of Aditya Automotive Ltd. for ₹950 and received dividends of ₹80 annually for three years. The share was sold for ₹1,000 at the end of year three. Using the supplied present value factors and linear interpolation, estimate the realised yield (cost of equity).

1. 9.00%
2. 10.02% (correct answer)
3. 11.00%
4. 12.00%

Answer: B — 10.02%

Explanation. At 9%, PV of dividends = ₹80 × 2.531 = ₹202.48 and PV of sale proceeds = ₹1,000 × 0.772 = ₹772. Total PV = ₹974.48; NPV = +₹24.48. At 11%, PV = ₹80 × 2.444 + ₹1,000 × 0.731 = ₹926.52; NPV = −₹23.48. IRR = 9% + [24.48/(24.48 + 23.48)] × 2% = 10.02%. The purchase price is the initial investment, not an additional inflow.

Where it goes wrong. Ignoring the share sale proceeds or forgetting that the initial purchase price must be equated with discounted dividends and sale proceeds.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 7 · 2 marks · Cost of Capital · hard

Calculate the prospective cost of equity for Aditya Automotive Ltd. using CAPM. Beta is 1.40, risk-free return is 5.5% and market return is 13.5%.

1. 15.50%
2. 14.70%
3. 18.00%
4. 16.70% (correct answer)

Answer: D — 16.70%

Explanation. Market risk premium = Rm − Rf = 13.5% − 5.5% = 8%. Applying CAPM, Ke = Rf + β(Rm − Rf) = 5.5% + 1.40 × 8% = 5.5% + 11.2% = 16.70%. The risk premium is adjusted for systematic risk through beta. A beta of 1.40 indicates that the equity has greater systematic risk than the market portfolio. Using beta against the risk-free rate alone would omit the market risk premium.

Where it goes wrong. Using the wrong market risk premium or applying beta to the risk-free return rather than the excess market return.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 8 · 2 marks · Cost of Capital · hard

For this question, apply the separately stipulated investor-side adjustment formula Kr = Ke × (1 − tp) × (1 − b), where tp is personal tax rate and b is brokerage rate. Using Aditya Automotive Ltd.'s CAPM cost of equity, calculate the adjusted cost of retained earnings if personal tax is 20% and brokerage is 5%.

1. 13.36%
2. 15.03%
3. 12.69% (correct answer)
4. 10.20%

Answer: C — 12.69%

Explanation. First calculate Ke under CAPM: 5.5% + 1.40 × (13.5% − 5.5%) = 16.70%. Apply the stipulated adjustment: Kr = Ke × (1 − tp) × (1 − b). Thus Kr = 16.70% × (1 − 0.20) × (1 − 0.05) = 16.70% × 0.80 × 0.95 = 12.692%, approximately 12.69%. The percentages must be converted into decimal multipliers before multiplication. Applying only one adjustment would overstate the adjusted cost.

Where it goes wrong. Applying only personal tax or brokerage instead of multiplying by both adjustment factors.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 9 · 2 marks · Cost of Capital · medium

Scenario. A listed company expects to pay a constant annual dividend of ₹7.50 per equity share indefinitely. The current ex-dividend market price is ₹60. Determine the cost of equity under the Dividend Price Approach.

A listed company expects to pay a constant annual dividend of ₹7.50 per equity share indefinitely. The current ex-dividend market price is ₹60. Determine the cost of equity under the Dividend Price Approach.

1. 12.50% (correct answer)
2. 10.00%
3. 15.00%
4. 8.00%

Answer: A — 12.50%

Explanation. The Dividend Price Approach assumes that the dividend per share remains constant indefinitely. Cost of equity = Expected annual dividend/Current ex-dividend market price. Therefore, Ke = ₹7.50/₹60 × 100 = 12.50%. No separate growth rate is added because the problem expressly assumes a constant dividend. The dividend is already the expected annual payment, so using an additional growth adjustment would introduce a factor not applicable to this approach.

Where it goes wrong. Adding a growth rate despite the assumption of constant dividends or using face value instead of the current market price.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 10 · 2 marks · Cost of Capital · hard

Scenario. An enterprise paid a dividend of ₹5 per share during the previous year. Dividends are expected to grow at 12% annually. If the current market price is ₹70, determine the cost of equity under Gordon's Growth Model.

An enterprise paid a dividend of ₹5 per share during the previous year. Dividends are expected to grow at 12% annually. If the current market price is ₹70, determine the cost of equity under Gordon's Growth Model.

1. 17.00%
2. 20.00% (correct answer)
3. 18.00%
4. 21.00%

Answer: B — 20.00%

Explanation. D0 = ₹5 and g = 12%. First calculate next year's dividend: D1 = ₹5 × 1.12 = ₹5.60. The Gordon formula is Ke = D1/P0 + g. Substituting, Ke = ₹5.60/₹70 + 12% = 8% + 12% = 20%. The common error is to divide D0 by the current market price without first incorporating the expected growth. That would produce an understated dividend yield and an incorrect cost of equity.

Where it goes wrong. Using D0 instead of D1 in Gordon's model and thereby understating the expected dividend yield.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 11 · 2 marks · Cost of Capital · medium

Scenario. A company reports current earnings per share of ₹18. Its equity shares are quoted at ₹120 each. Using the Earnings Price Approach, calculate the cost of equity.

A company reports current earnings per share of ₹18. Its equity shares are quoted at ₹120 each. Using the Earnings Price Approach, calculate the cost of equity.

1. 12.00%
2. 18.00%
3. 15.00% (correct answer)
4. 20.00%

Answer: C — 15.00%

Explanation. The Earnings Price Approach relates earnings per share to the market price of the equity share. Ke = EPS/P = ₹18/₹120 × 100 = 15%. The approach assumes that earnings per share remain constant indefinitely. It does not require an adjustment for dividend growth or the dividend payout ratio. Option b incorrectly treats EPS as a percentage of face value rather than market price, while option a understates the earning yield.

Where it goes wrong. Using the face value of the share instead of its market price in the earnings-price calculation.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 12 · 2 marks · Cost of Capital · hard

Scenario. The risk-free rate is 7.5%, the market portfolio is expected to return 13.5%, and the company's equity beta is 1.50. Calculate the cost of equity under CAPM.

The risk-free rate is 7.5%, the market portfolio is expected to return 13.5%, and the company's equity beta is 1.50. Calculate the cost of equity under CAPM.

1. 13.50%
2. 15.00%
3. 18.00%
4. 16.50% (correct answer)

Answer: D — 16.50%

Explanation. Market risk premium = 13.5% − 7.5% = 6%. Risk premium on the company's equity = 1.50 × 6% = 9%. Therefore, Ke = 7.5% + 9% = 16.50%. The company's required return consists of the risk-free rate plus the risk-adjusted premium. A frequent error is to calculate beta times the entire market return, rather than beta times the difference between market return and risk-free return.

Where it goes wrong. Multiplying beta by the market return rather than by the market risk premium.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 13 · 2 marks · Cost of Capital · hard

Scenario. An equity security has a required return of 17.5%. The risk-free rate is 6.5% and the market risk premium is 5.5%. Determine the security's beta coefficient under CAPM.

An equity security has a required return of 17.5%. The risk-free rate is 6.5% and the market risk premium is 5.5%. Determine the security's beta coefficient under CAPM.

1. 2.00 (correct answer)
2. 1.80
3. 1.50
4. 2.20

Answer: A — 2.00

Explanation. CAPM gives Ke = Rf + β(Market Risk Premium). Substituting the figures, 17.5% = 6.5% + β × 5.5%. Hence, β = (17.5% − 6.5%)/5.5% = 11%/5.5% = 2.00. This represents a systematic risk level twice that of the market portfolio under the model. Subtracting the risk-free rate is necessary before dividing by the market risk premium. Dividing the required return directly by the premium would give an incorrect beta.

Where it goes wrong. Failing to subtract the risk-free rate before solving for beta.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 14 · 2 marks · Cost of Capital · medium

Scenario. A company has paid a dividend of ₹4.80 per share. The dividend is expected to grow at a constant rate of 5%. The current market price is ₹60. Calculate the cost of retained earnings using Gordon's Growth Model.

A company has paid a dividend of ₹4.80 per share. The dividend is expected to grow at a constant rate of 5%. The current market price is ₹60. Calculate the cost of retained earnings using Gordon's Growth Model.

1. 12.50%
2. 13.40% (correct answer)
3. 10.00%
4. 15.00%

Answer: B — 13.40%

Explanation. The last dividend is D0 = ₹4.80. Expected dividend D1 = ₹4.80 × 1.05 = ₹5.04. Under the retained earnings growth approach, Kr = D1/P0 + g = ₹5.04/₹60 + 5% = 8.40% + 5% = 13.40%. The market price is used without deducting flotation expenses because the funds are internally generated. The dividend growth rate must be added to the expected dividend yield to obtain the full opportunity cost.

Where it goes wrong. Deducting flotation costs from retained earnings or omitting the dividend growth rate.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 15 · 2 marks · Cost of Capital · hard

Scenario. For this question, apply the separately stipulated investor-side adjustment formula Kr = Ke × (1 − tp) × (1 − b). A company's CAPM cost of equity is 15.40%, personal tax rate is 25% and brokerage rate is 4%. Calculate the adjusted cost of retained earnings.

For this question, apply the separately stipulated investor-side adjustment formula Kr = Ke × (1 − tp) × (1 − b). A company's CAPM cost of equity is 15.40%, personal tax rate is 25% and brokerage rate is 4%. Calculate the adjusted cost of retained earnings.

1. 11.55%
2. 12.32%
3. 11.09% (correct answer)
4. 10.78%

Answer: C — 11.09%

Explanation. Given Ke = 15.40%, tp = 25% and b = 4%. Applying the stipulated formula, Kr = 15.40% × (1 − 0.25) × (1 − 0.04). Thus Kr = 15.40% × 0.75 × 0.96 = 15.40% × 0.72 = 11.088%, approximately 11.09%. Option a applies only the personal tax adjustment. Option b incorrectly uses 20% brokerage adjustment. Both specified adjustments must be applied multiplicatively.

Where it goes wrong. Using an incorrect brokerage percentage or applying the tax and brokerage adjustments additively rather than multiplicatively.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 16 · 2 marks · Cost of Capital · hard

Scenario. A company's last dividend was ₹8 per share. Dividends are expected to grow at 5% annually, and the current market price is ₹100. For this question, apply the adjustment Kr = Ke × (1 − tp) × (1 − b), where tp is personal tax and b is brokerage. If personal tax is 20% and brokerage is 5%, calculate the adjusted cost of retained earnings.

A company's last dividend was ₹8 per share. Dividends are expected to grow at 5% annually, and the current market price is ₹100. For this question, apply the adjustment Kr = Ke × (1 − tp) × (1 − b), where tp is personal tax and b is brokerage. If personal tax is 20% and brokerage is 5%, calculate the adjusted cost of retained earnings.

1. 13.40%
2. 10.72%
3. 11.50%
4. 10.18% (correct answer)

Answer: D — 10.18%

Explanation. First, D1 = D0(1 + g) = ₹8 × 1.05 = ₹8.40. Cost under Gordon's model is Ke = ₹8.40/₹100 + 5% = 13.40%. The stipulated adjustment gives Kr = 13.40% × 0.80 × 0.95 = 13.40% × 0.76 = 10.184%, or 10.18%. Applying tax alone gives 10.72%, while ignoring brokerage overstates the adjusted cost. Both adjustments must be applied to the calculated return.

Where it goes wrong. Applying the personal tax adjustment but forgetting to make the additional brokerage adjustment.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 17 · 2 marks · Cost of Capital · hard

Scenario. A company has a current market price of ₹50 per share and a last dividend of ₹5 per share. Dividends are expected to grow at 10%. New equity shares can be issued at ₹48 per share with flotation cost of ₹2. By how many percentage points is the cost of newly issued equity higher than the standard cost of retained earnings?

A company has a current market price of ₹50 per share and a last dividend of ₹5 per share. Dividends are expected to grow at 10%. New equity shares can be issued at ₹48 per share with flotation cost of ₹2. By how many percentage points is the cost of newly issued equity higher than the standard cost of retained earnings?

1. 0.96 percentage point (correct answer)
2. 1.50 percentage points
3. 2.00 percentage points
4. 0.50 percentage point

Answer: A — 0.96 percentage point

Explanation. D1 = ₹5 × 1.10 = ₹5.50. Standard Kr = ₹5.50/₹50 + 10% = 21.00%. Net proceeds from new equity = ₹48 − ₹2 = ₹46. Therefore Ke = ₹5.50/₹46 + 10% = 21.9565%, approximately 21.96%. Difference = 21.96% − 21.00% = 0.96 percentage point. Flotation cost increases the cost of fresh equity but does not reduce the market price used for standard retained earnings.

Where it goes wrong. Deducting flotation cost from the retained earnings denominator or failing to deduct it from new equity proceeds.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 18 · 2 marks · Cost of Capital · hard

Scenario. A company's dividend has grown from ₹10 per share four years ago to ₹14.641 currently. Assuming constant annual growth, determine the growth rate and cost of equity under Gordon's model if the current market price is ₹100.

A company's dividend has grown from ₹10 per share four years ago to ₹14.641 currently. Assuming constant annual growth, determine the growth rate and cost of equity under Gordon's model if the current market price is ₹100.

1. 8%; 24.00%
2. 10%; 26.11% (correct answer)
3. 12%; 28.00%
4. 10%; 24.64%

Answer: B — 10%; 26.11%

Explanation. Using the compound growth formula, D0 = Dn(1 + g)^n. Thus, 14.641/10 = (1 + g)^4 = 1.4641. Since 1.10^4 = 1.4641, the annual growth rate is 10%. Next dividend D1 = ₹14.641 × 1.10 = ₹16.1051. Ke = D1/P0 + g = 16.1051/100 + 10% = 26.1051%, approximately 26.11%. Using the historical dividend instead of the next expected dividend would understate the cost.

Where it goes wrong. Using the total four-year growth percentage as the annual growth rate or failing to annualise growth through the fourth root.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 19 · 2 marks · Cost of Capital · hard

Scenario. An investor holds a share for two years. At the beginning of each year, its market price is ₹100. During the first year, a dividend of ₹10 is received and the ending price is ₹100. During the second year, a dividend of ₹20 is received and the ending price is ₹100. Calculate the realised yield using the geometric mean method.

An investor holds a share for two years. At the beginning of each year, its market price is ₹100. During the first year, a dividend of ₹10 is received and the ending price is ₹100. During the second year, a dividend of ₹20 is received and the ending price is ₹100. Calculate the realised yield using the geometric mean method.

1. 10.00%
2. 15.00%
3. 14.89% (correct answer)
4. 16.00%

Answer: C — 14.89%

Explanation. Year 1 gross return factor = (Dividend + Closing Price)/Opening Price = (₹10 + ₹100)/₹100 = 1.10. Year 2 gross return factor = (₹20 + ₹100)/₹100 = 1.20. Geometric mean realised yield = [(1.10 × 1.20)^(1/2)] − 1 = √1.32 − 1 = 1.148913 − 1 = 14.89%. An arithmetic average of 10% and 20% gives 15%, but realised yield over multiple periods requires compounding through the geometric mean.

Where it goes wrong. Using the arithmetic average of annual returns instead of the geometric mean of compounded annual returns.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 20 · 2 marks · Cost of Capital · hard

Scenario. A company has an equity beta of 1.50, a risk-free return of 6% and a market risk premium of 8%. A proposed equity-funded project is expected to earn 17.50%. Using CAPM, determine the cost of equity and the appropriate investment decision.

A company has an equity beta of 1.50, a risk-free return of 6% and a market risk premium of 8%. A proposed equity-funded project is expected to earn 17.50%. Using CAPM, determine the cost of equity and the appropriate investment decision.

1. 16.00%; Accept the project
2. 17.50%; Accept the project
3. 20.00%; Reject the project
4. 18.00%; Reject the project (correct answer)

Answer: D — 18.00%; Reject the project

Explanation. CAPM cost of equity = Rf + β × Market Risk Premium = 6% + 1.50 × 8% = 6% + 12% = 18%. The project is entirely equity-funded, so the relevant required return is the cost of equity. Its expected return of 17.50% is below the required 18%. Therefore, the project should be rejected on this criterion. Accepting it merely because the expected return is positive would ignore the opportunity cost and risk borne by equity shareholders.

Where it goes wrong. Accepting a project because its expected return is positive without comparing it against the risk-adjusted cost of equity.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital