Practice Problem – Cost of Equity

Practice Question

Cases in Finance
Cost of Capital
Cost of Equity
True or False

The CAPM formula includes the risk-free rate, the equity beta, and the expected market return.

Answer +
TRUE
Step-by-step solutions +

Step 1: Recall the Capital Asset Pricing Model (CAPM) formula:

Cost of Equity = Risk-Free Rate + Beta × (Expected Market Return - Risk-Free Rate)

Step 2: Identify the components:

  • Risk-Free Rate (Rf): The return on a risk-free investment like government bonds.
  • Beta (β): A measure of the stock's volatility relative to the market.
  • Expected Market Return (Rm): The average return expected from the overall market.

Step 3: Confirm each component is included in the CAPM formula.

All the mentioned components — risk-free rate, beta, and expected market return — are included in the CAPM. Hence, the statement is TRUE.