United Corporation's common stock has a beta of 1.9. The risk-free rate is 6.2 percent and the expected return on the market is 12 percent. What is the firm's cost of equity?

Solution :

Cost of equity as per Capital Asset Pricing Model is calculated using the following formula :

R_E = R_F + [ β * ( R_M - R_F )]

Where

R_E = Cost of equity   ;   R_F = Risk free rate of return   ; β = Beta of the stock ; R_M = Expected Return on the Market   ;

As per the information given in the question we have

R_F = 6.2 %   ; R_M = 12 %   ; β = 1.9   ;

Applying the above values in the formula we have the cost of equity as

= 6.2 % + [ 1.9 * ( 12 % - 6.2 % ) ]

= 6.2 % + [ 1.9 * 5.8 % ]

= 6.2 % + 11.02 % = 17.22 %

Thus the firm’s cost of equity = 17.22 %