Question

The common stock of Contemporary Interiors has a beta of 1.13 and a standard deviation of 21.4 percent. The market rate of return is 12.7 percent and the risk-free rate is 4.1 percent. What is the cost of equity for this firm

Answer 1

Cost of equity =13.82%

Step-by-step explanation:

The capital asset pricing model is a risk-based model. Here, the return on equity is dependent on the level of reaction of the the equity to changes in the return on a market portfolio. These changes are captured as systematic risk. The magnitude by which a stock is affected by systematic risk is measured by beta.

Under CAPM, Ke= Rf + β(Rm-Rf)

Rf-risk-free rate (treasury bill rate) - 4.1

β= Beta-1.13

Rm= Return on market- 12.7

Ke= 4.1% + 1.13× (12.7- 4.1 )%

Ke =13.82%