Anthony Steel's Cost of Equity Financing

Cost of Equity Financing

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Question

The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent, and the market risk premium is 6 percent. This year's addition to retained earnings is $3,000,000. The company's capital budget is $4,000,000 and its target capital structure is 50 percent debt and 50 percent equity. What is the company's cost of equity financing?

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Explanation

Anthony Steel will use retained earnings to fund the equity portion of its capital budget. We can see this because the retained earnings break point is

$3,000,000/0.5 = $6,000,000, which is greater than the capital budget.

The cost of equity from the CAPM (Capital Asset Pricing Model) is: k(s) = krf) + (k(m) - k(rf))b(i) = 5% + (6%)1.2 = 12.2%.

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