Calculate the cost of equity capital using CAPM if the risk-free rate of interest is 5...
Calculate the cost of equity capital using CAPM if the risk-free rate of interest is 5 per cent, the return on the market portfolio is 12 per cent, beta is 0.8 and the franking premium is 2 per cent.
10.6%
B. 14%
C. 12.2%
D. 12%
Please help me with the calculation.
Homework Answers
Franking credits refers to a tax credit that is paid to the stockholders (while paying dividends) by bigger companies. If these affect the cost of capital, then franking premium must be added to market risk premium while calculating equity cost of capital.
CAPM formula without franking premium is:
Cost of equity=Risk free rate +Beta*(Market risk premium)
Market risk premium=Market return-Risk free rate
However, here we will have:
Cost of equity=Risk free rate +Beta*(Market risk premium + Franking
premium)
According to the given values, we have;
Risk free rate=5%
Market return=12%
Beta=0.8
Market risk premium=Market return-Risk free rate=12%-5%=7%
Adding franking premium to market risk premium, we get;
Market risk premium + Franking premium=7%+2%=9%
Cost of equity=5% + 0.8*(9%)
=5% + 7.20%
=12.2%
Note: Without franking premium the answer would have been
10.6%. Here, we have a special situation in which franking credits
are being paid to shareholders.
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