Cost of Equity Calculation using Capital Asset Pricing Model | CFA® Level 1 Exam Prep

Calculate Cost of Equity for Proposed Common Stock Issue | CFA® Level 1 Exam Prep

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Question

Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, and the company's combined federal/ state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be 13.5%. Shares of Intelligent

Semiconductor have a historical beta of 1.6. What is the cost of equity for this proposed common stock issue using the Capital Asset Pricing Model?

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Explanation

The cost of issuing common stock can be calculated using several methods, including the Bond-Yield- Plus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. The latter is illustrated in this example. To calculate the cost of common equity using the CAPM, use the following formula: {cost of common equity = [risk free rate of return + beta(expected return on the market - risk free rate of return)}. Incorporating the appropriate figures into this example will yield a cost of common equity at 18.24%.

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