Company A's historical returns for the past three years are 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. Suppose the risk-free rate of return is 4 percent and that investors expect the market to return 10 percent. What is the cost of equity capital (required rate of return of company A's common stock), computed with the CAPM?

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Quizplus · Accepted Answer

The correct answer is A because the cost of equity capital using CAPM is 8.5 percent. The formula for CAPM is:Cost of equity = Risk-free rate + Beta * (Expected market return - Risk-free rate)In this case, the risk-free rate is 4 percent, the expected market return is 10 percent, and the beta of Company A is 1.5 (calculated as the covariance of Company A's returns with the market returns divided by the variance of the market returns). Plugging these values into the formula, we get:Cost of equity = 4% + 1.5 * (10% - 4%) = 8.5%

Company A's Historical Returns for the Past Three Years Are