5. The cost of equity

In financial analysis, it is important to select an appropriate discount rate. A projects discount rate must be high to compensate investors for the projects risk. The return that shareholders require from the company as a compensation for their investment risk is referred to as the cost of equity.

Consider this case:

The Shoe Building Inc. is a 100% equity-financed company (no debt or preferred stock); hence, its WACC equals its cost of common equity. The Shoe Building Inc.s retained earnings will be sufficient to fund its capital budget in the foreseeable future. The company has a beta of 1.50, the risk-free rate is 5.0%, and the market return is 6.5%.

What is The Shoe Building Inc.s cost of equity?

7.25%

9.82%

23.54%

2.32%

The Shoe Building Inc. is financed exclusively using equity funding and has a cost of equity of 12.25%. It is considering the following projects for investment next year:

Project	Required Investment	Expected Rate of Return
W	$54,675	13.65%
X	$42,450	9.60%
Y	$27,575	13.10%
Z	$32,875	11.10%

Each project has average risk, and The Shoe Building Inc. accepts any project whose expected rate of return exceeds its cost of capital. How large should next years capital budget be?

$87,550

$82,250

$75,325

$124,700