Question

"cost of common stock equity: capm j&m corporation common stock has a beta, b, of 1.2. the risk-free rate is 6%, and the market return is 11%.
a. determine the risk premium on j&m common stock.
b. determine the required return that j&m common stock should provide.
c. determine j&m's cost of common stock equity using the capm."

Answer 1

a. Risk Premium on J & M common stock = Return on Market - Risk Free Rate

Risk Premium on J & M common stock = 11% - 6%

Risk Premium on J & M common stock = 5%

b. Required Return = Rf + Beta * (RM - RF)

= 6% + 1.2*5%

= 6% + 6%

= 12%

So the required rate of return is 12% which should be atleast provided by J & M common stock.

c. J & M cost of common stock equity is the same as b that equals to 12%.

Answer 2

a. Risk premium = Market rate of return - Risk free return = 11 % - 6 % = 5 %

b. Required return -

Market risk premium = Beta * Risk premium = 1.2 * 5 % = 6 %

Required return = Market risk premium + Risk free return = 6% + 6 % = 12 %

c. CAPM -

Cost of equity = Risk free return + Beta * ( Market rate of return - Risk free return)

Cost of equity = 6 % + 1.2 * ( 11 % - 6%)

Cost of equity = 12 %