Question

A firm's cost of equity (in the WACC calculation) can be calculated as:

a) The firm's ROE (Net income divided book equity)
b) The firm's required return on equity from the CAPM
c) Both (a) and (b) above
d) None of the above

Answer 1

The correct way to calculate a firm's cost of equity for the WACC is by using the required return on equity from the CAPM, not by using the firm's ROE.

Step-by-step explanation:

The firm's cost of equity in the Weighted Average Cost of Capital (WACC) calculation can be determined by option (b): The firm's required return on equity from the Capital Asset Pricing Model (CAPM). The CAPM is a model that calculates the expected return on equity based on the risk-free rate, the expected market return, and the stock's beta, which measures its volatility relative to the market. Option (a) is incorrect because the Return on Equity (ROE), which is net income divided by book equity, represents the return a company generates on its shareholders' equity and is not used in the WACC calculation for cost of equity. The correct answer to the question is option (b).