Treasury bills currently have a return of 2.5% and the market risk premium is 7%. If a firm has a beta of 1, what is its cost of equity? What is the expected return according to the Capital Asset Pricing Model? (Here, the cost of equity and the CAPM expected return are, as is pretty much always the case, equal.) 7% 9.5% 12% 5% O 4.5%
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
![**Capital Asset Pricing Model (CAPM) Question:**
Treasury bills currently have a return of 2.5% and the market risk premium is 7%. If a firm has a beta of 1, what is its cost of equity? What is the expected return according to the Capital Asset Pricing Model (CAPM)? (Here, the cost of equity and the CAPM expected return are, as is pretty much always the case, equal.)
1. ○ 7%
2. ○ 9.5%
3. ○ 12%
4. ○ 5%
5. ○ 4.5%
**Explanation:**
The question requires using the Capital Asset Pricing Model (CAPM) to determine the expected return or cost of equity. The formula for CAPM is:
\[ \text{Expected Return} = \text{Risk-Free Rate} + \beta \times (\text{Market Risk Premium}) \]
Here:
- Risk-Free Rate (Treasury bills return) = 2.5%
- Market Risk Premium = 7%
- Beta = 1
Substitute the values into the formula:
\[ \text{Expected Return} = 2.5\% + 1 \times 7\% = 9.5\% \]
Thus, the correct answer is option 2: 9.5%.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F537cca7c-787a-475d-9aba-926e9a602de3%2F561ac36c-f148-4ead-9f76-18883cf222bb%2Fgl2qo9_processed.jpeg&w=3840&q=75)
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