ExpertEasy2 marksMultiple Choice
ACCA · Question 21 · Estimating the Cost of Capital
Section B - Case 2: NeuroLink Prosthetics
Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.
Question: Using the Capital Asset Pricing Model (CAPM), what is NeuroLink's cost of equity?
Section B - Case 2: NeuroLink Prosthetics
Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.
Question: Using the Capital Asset Pricing Model (CAPM), what is NeuroLink's cost of equity?
Answer options:
A.
7.2%
B.
11.2%
C.
16.0%
D.
12.0%
How to approach this question
Apply the CAPM formula: Ke = Risk-free rate + Beta * (Market Return - Risk-free rate). Note that the 'expected return on the market' is Rm, not the market risk premium.
Full Answer
B.11.2%✓ Correct
The Capital Asset Pricing Model (CAPM) calculates the required return on equity based on systematic risk.
Formula: Ke = Rf + β(Rm - Rf)
Where Rf = 4%, β = 1.2, Rm = 10%.
Ke = 4% + 1.2 * (10% - 4%)
Ke = 4% + 1.2 * 6%
Ke = 4% + 7.2% = 11.2%.
Common mistakes
Treating the 10% market return as the market risk premium (Rm - Rf). If the question says 'market risk premium is 10%', you don't subtract the risk-free rate. Here it says 'expected return on the market', so you must subtract it.
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