Which of the following is an assumption in applying the capital asset pricing model (CAPM) to estimate the cost of equity capital?
A) The investors are well diversified.
B) The firm's dividends and earnings grow at a constant rate far into the future.
C) The cost of equity and the cost of debt of a firm are always equal.
D) The cost of retained earnings is lower than the cost of preferred stock due to the tax savings on earnings retained.
E) The investors always prefer to receive lower return on retained earnings than regular dividend payments.

Question

Quizplus · Accepted Answer

CAPM assumes that investors are well diversified, which means that they have invested in a portfolio of assets rather than in a single asset. This assumption is necessary because the model is based on the idea that investors are only compensated for the systematic risk they bear, which cannot be diversified away. If investors were not well diversified, they would also require compensation for unsystematic risk, which would not be accounted for by the CAPM.

Which of the Following Is an Assumption in Applying the Capital