Series 79 practice questionmediumWACC and Cost of Capital
According to the Capital Asset Pricing Model (CAPM), the cost of equity is calculated as:
- ARisk-free rate + beta x (market risk premium)✓ Correct answer
- BRisk-free rate + market return
- CBeta x market return
- DRisk-free rate / beta
Explanation
Why A — Risk-free rate + beta x (market risk premium)
The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta x (Expected Market Return - Risk-Free Rate), where (Expected Market Return - Risk-Free Rate) is the equity risk premium (or market risk premium). Beta measures the stock's systematic risk relative to the market. A beta greater than 1.0 indicates the stock is more volatile than the market, requiring a higher expected return to compensate investors for the additional risk.
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