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:

Sunny Co. is a 100% equity-financed company (no debt or preferred stock); hence, its WACC equals its cost of common equity. Sunny Co.s retained earnings will be sufficient to fund its capital budget in the foreseeable future. The company has a beta of 1.80, the risk-free rate is 6.0%, and the market return is 7.8%.

What is Sunny Co.s cost of equity?

A. 9.24%

B. 3.32%

C. 14.12%

D. 33.88%

Sunny Co. is financed exclusively using equity funding and has a cost of equity of 13.05%. It is considering the following projects for investment next year:

Project	Required Investment	Expected Rate of Return
W	$5,250	10.60%
X	$6,375	13.65%
Y	$4,575	14.10%
Z	$3,675	13.10%

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

A. $14,625

B. $15,300

C. $13,500

D. $9,825