Eaton electronic company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity). assume: rf = 6 % km = 9 % β = 1.8 d1 = $ .90 p0 = $ 19 g = 5 % a. compute ki (required rate of return on common equity based on the capital asset pricing model).
Ki = 0.063 or 6.30%
The CAPM or Capital asset pricing model is an approach to calculate the required rate of return of a stock. The required rate of return or cost of equity is the minimum return required by the investors o invest in a stock based on the systematic risk of the stock. The formula to calculate the required rate of return of a stock using the CAPM is,
Ki = Rf + β * (Km - Rf)
Where,Rf is the risk free rateβ is the beta of the stockKm is the expected return on the market
Ki = 0.03 + 1.1 * (0.06 - 0.03)
Ki = 0.063 or 6.3%