An analyst is calculating the Cost of Equity (Ke) for an Indian pharmaceutical firm using the Capital Asset Pricing Model (CAPM). The 10-year Government of India bond yield (Risk-free Rate, Rf) is 7.0%, the expected return on the broad market index (Rm) is 13.0%, and the firm's equity Beta is 0.80. What is the Cost of Equity?

[ A ]13.00 percent per annum

[ B ]10.40 percent per annum

[ C ]11.80 percent per annum[ CORRECT ]

[ D ]17.40 percent per annum

Takeaway

Option C is correct: 11.80 percent per annum

Derivation

Under CAPM, the Cost of Equity is calculated as: Ke = Rf + Beta * (Rm - Rf), where (Rm - Rf) represents the Market Risk Premium (MRP). Given: Rf = 7.0%, Rm = 13.0%, Beta = 0.80. Market Risk Premium = 13.0% - 7.0% = 6.0%. Equity Risk Premium = 0.80 * 6.0% = 4.80%. Cost of Equity (Ke) = 7.0% + 4.80% = 11.80% per annum. This reflects the minimum required rate of return demanded by common equity shareholders for assuming the firm's systematic risk. This tests CAPM mechanics. The primary mistake is multiplying Beta directly by market return (0.80 * 13% = 10.4%) without deducting Rf.

Why the others fail

A — 13.00 percent per annum

13.00% is the broad market portfolio return (Rm) which ignores the lower systematic risk (Beta 0.80) of this defensive pharma company.

B — 10.40 percent per annum

10.40% erroneously multiplies Beta directly by market return (0.80 * 13%) without adding the baseline risk-free rate.

D — 17.40 percent per annum

17.40% results from adding market return directly to risk-free rate (7 + 13 = 20) and applying an incorrect formula.