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Up5
This is on the CFAI practice question place. I was wondering if anyone else felt slighted at this question and its explanation?
Can I get some feedback on how the actual test is going to be? With the below example, it is no wonder why the pass rate is so low.
Below is all the info from the question, copy and pasted, if you think it is missing information, so do I.Mock question example:
A company that wants to determine its cost of equity gathers the following information:
Rate of return on 3-month Treasury bills 3.0%
Rate of return on 10-year Treasury bonds 3.5%
Market risk premium 6.0%
The company’s equity beta 1.6
Dividend growth rate 8.0%
Corporate tax rate 35%Using the capital asset pricing model (CAPM) approach, the cost of equity (%) for the company is closest to:
A. 13.1%.
B. 7.5%.
C. 12.6%.Answer – A. 13.1%
Explanation
CAPM: Cost of equity = Risk free rate + Beta × Market risk premium = 3.5% + 1.6 × (6.0%) = 13.1%
The 10-year risk free rate is appropriate based on the long-term duration of the cash flows from the
project.2014 CFA Level I
“Cost of Capital,” by Yves Courtois, Gene C. Lai, and Pamela Peterson Drake
Section 3.3.1
/Mock question exampleSo what gives?
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Up5
the question provides you with all of the information you need to solve it. CAPM = RFR + B(RM-RFR). (RM-RFR) is also known as the market risk premium, so you can calculate the cost of equity using CAPM as they have above. does that help? if not i can try to better explain it. i cant provide a perspective on what the actual exam will be like since im taking it for the first time in about two weeks (trying not to panic) RFR= risk free rate; RM= market risk
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Up5
So for @simply_complex2‌ and @jmsatchwell‌, what do you use as the risk free rate? and how would we know that it gives us the closest CAPM answer?
@WesMantooth‌, brilliant. Thank you.
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Up4
Thats rough, no info given about a project. Disconcerting that it comes from CFAI.
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Up4
I’ve found mock questions from CFAI and any 3rd party providers to be vague and slightly unfair. My experience on the actual exams for L1&2 was that all the questions were very clear in what they were asking and I never felt as though I was missing information. If there is one thing the CFAI does really well, it is picking exam questions that are tough, fair, and unambiguous.
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Up4
Thank you @jmsatchwell, you forced me to dig through the curriculum ;-).
I found where this problem was referencing, page 49 of Volume 4. Section 3.3.1. It looks over CAPM and mentions “If we are evaluating a project with an estimated useful life of 10 years, we may want to use the rate on the 10-Year Treasury bond”.Also I found on page 251 of the 2014 Level 1 Volume 1 CFA curriculum book where it is defining risk rates: The footnotes suggest the 90 day US T-Bill as the best proxy of the Risk Free Rate.
In addition, one could show that a shorter timeline has less default risk, and with no other indications or wording in the test question about the length of the “project”, the 90 day T-Bill would have (albeit perhaps slightly) less risk than the 10 year T-Bond and is a better choice for the RFR.I suppose this exercise was simply a “heads up”. Once in a while questions ARE vague, unfair, or even simply wrong. 😉
(Not as often as I first thought they were! I’ve had to prove myself wrong too many times. haha!)On to more questions!
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Up4
Guess Im a little fuzzy on my L1 material, I used the 30 day Rf rate when I plugged in CAPM.
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Up2
The question did not refer to a long-term project, so I can see where one would use the three month t-bill as the risk-free rate. Tricky.
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Up2
Great question.
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Up1
I agree its just a basic CAPM equation. No need to over think it.
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Up1
The US 10 year is commonly used as a risk free rate due to it being backed by the US gov and having a longer duration that should be mentioned in your readings. If you plug it in to the CAPM equation you get 13.1 since that’s an option for your multiple choice and your inputs are correct you’ve got the answer.
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