CFA Level ICorporate IssuersMedium
A financial analyst is estimating the cost of equity for Delta Corp using the Capital Asset Pricing Model. The risk-free rate is 3%, Delta's equity beta is 1.2, and the expected return on the market portfolio is 9%. What is Delta's estimated cost of equity?
- A11.4%
- B9.0%
- C10.2%
- D7.2%
Show answer & explanationAnswer & explanation
Correct answer: C. 10.2%
CAPM: re = Rf + β(Rm − Rf) = 3% + 1.2 × (9% − 3%) = 3% + 7.2% = 10.2%.
Why the other options are wrong
- A. Results from incorrectly adding the full market return to the risk premium.
- B. This is the market return, not Delta's required return.
- D. This is only the risk premium component, missing the risk-free rate.
CAPM Cost of Equity
The required return on equity based on the risk-free rate plus a risk premium proportional to systematic risk (beta).
- re = Rf + β(Rm − Rf)
- Beta measures sensitivity to market movements
- Higher beta implies higher required equity return
Memory trick: Risk-Free plus Beta times Market Premium equals required Return