CAPM Formula
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CPA Auditing and Attestation (AUD) › CAPM Formula
The overall cost of capital is the:
Rate of return on assets that covers the costs associated with the funds employed
Maximum rate of return on assets
Minimum rate a firm must earn on high risk projects
Cost of the firm's equity capital at which the market value of the firm will remain unchanged
Explanation
Firms must at least earn a rate of return on investments equal to their cost of capital, otherwise the investments are losing money and decreasing value.
ABC company is determining how to finance some long term debt projects. ABC has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the creditworthiness of the company. Which of the following would best meet ABC's financing requirements?
Bonds
Common stock
Short term debt
Long term debt
Explanation
Common stock does not require payment, does not mature, and decreases the debt to equity ratio as there is no debt incurred.
Using the capital asset pricing model, the required rate of return for a firm with a beta of 1.25 when the market return is 14% and the risk-free rate is 6% is:
14%
17.50%
16%
7.50%
Explanation
Cost of retained earnings=6% + 1.25 (14% - 6%) = 16%
The cost of debt most frequently is measured as:
Actual interest rate minus tax savings
Actual interest rate adjusted for inflation
Actual interest rate
Actual interest rate plus a risk premium
Explanation
Actual interest rates minus tax savings is the most frequently used measure for cost of debt.
The benefits of debt financing over equity financing are likely to be highest in which of the following situations?
Low marginal tax rates and many noninterest tax benefits
Low marginal tax rates and few noninterest tax benefits
High marginal tax rates and many noninterest tax benefits
High marginal tax rates and few noninterest tax benefits
Explanation
The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high and if there are few noninterest tax benefits.
Of the following, which would not impact the CAPM formula in determining a firm's cost of retained earnings?
Treasury yield
Risk-free rate
Beta
Net income
Explanation
Treasury yield is the same as the risk-free rate, which would be included in CAPM as well as beta. Net income is not.