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Problem set – Cost of Capital
Problem 1: The following are annual returns on the stock market (as measured by a broad
market index) and on short-term U.S. Treasury obligations for five consecutive years.
a. Compute the short-term arithmetic mean equity risk premium over the five years of data
given.
b. Compute the short-term geometric mean risk premium over the five years of data given.
c. Use the build-up method to calculate the cost of equity capital for Company XYZ using the
following known variables:
Problem 2: The following are known:
Risk-free rate as of the valuation date (Rf ): 6%
Beta for security XYZ (B): 1.5
Equity risk premium for the market as a whole (RPm): 8%
a. Compute the equity risk premium for security XYZ.
b. Compute the expected return (cost of capital) for security XYZ based on CAPM.
c. The expected return in excess of the risk-free rate for security ABC is 12% and the
