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20 March, 18:57

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the: beta decreases. market risk premium decreases. risk-free rate decreases. either the risk-free rate or the market rate of return decreases. market rate of return decreases.

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  1. 20 March, 22:30
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    Risk-free rate decreases

    Explanation:

    The CAPM formula for calculating cost of equity requires one to know the value of 3 pieces of information only:

    1. the market rate of return,

    2. the beta value

    3. the risk-free rate.

    Ra = Rrf + [Ba∗ (Rm-Rrf) ]

    where:

    Ra=Cost of Equity

    Rrf = Risk-Free Rate

    Ba = Beta

    Rm=Market Rate of Return

    From the formula

    Ra = Rrf + [1.2∗ (Rm-Rrf) ]

    Ra = Rrf + 1.2Rm - 1.2Rrf

    From Ra = 1.2Rm - 0.2Rrf

    From the expression above, it can be seen that the lower the value of Rrf (Risk-Free rate), the higher the value of Ra.
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