Pony Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on 10-year U.S. Treasury bonds is 5%, and the return on the S & P 500 index is 12%. What is the cost of Pony's common equity?

Question

Quizplus · Accepted Answer

Pony's cost of common equity (R_e) can be calculated using the Capital Asset Pricing Model (CAPM) formula:

R_e = R_f + (β × (R_m - R_f))

Where:
R_f = Risk-free rate = 5%
β = Beta = 1.5
R_m = Return on the market = 12%

R_e = 5% + (1.5 × (12% - 5%))
R_e = 5% + (1.5 × 7%)
R_e = 5% + 10.5%
R_e = 15.5%

Therefore, the cost of Pony's common equity is 15.5%, which is closest to option B, 15.5%.

Pony Corporation Is Undertaking a Capital Budgeting Analysis