 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at CPA exam questions that could appear on the BEC section of the exam. Specifically, the topic will be the capital asset price and model, or CAPM. The CAPM is covered in a corporate finance course on my website, farhadlectures.com. I do have a corporate finance course. And what I do, I cover, which is in my introduction to finance course, I cover the CAPM in details. So in this session, I'm going to be looking at questions that could appear or similar that will appear on the exam. But you want to have a good understanding about the CAPM because it's a major topic in the BEC section. And if you fail the CAPM, there's a good chance you might fail the exam because the AI CPA thinks you are not qualified to pass. So the difference between my website and your review course, your review course with review CAPM would you assume when you understand CAPM? I teach you CAPM. But in this session, I will show you how you will answer these questions on the exam day. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, finance, stacks, as well as Excel tutorial. Please subscribe to my channel. If you like my lectures, like them, share them, put them in playlists. If they help you, it might help other people connect with me on Instagram. On my website, farhadlectures.com, this is where I dive into this CAPM under my introduction to finance course and have you give you more exercises. But always like to remind you, I have plenty of resources. If you are looking to add 10 to 15 points to your CPA score on my website, I'll be able to help you check out my website. If you are serious about your CPA and CPA, it's a long-term investment. Let's take a look at the first question. Which of the following method could be used to calculate the cost of common equity capital? So when we compute, remember, we have a cost of equity, we have the cost of that. So which model can we use to find out? What is our cost? How much is raising capital is costing us as a company? Because that's very important because the cost of raising money is an important factor in making a decision because when you undertake a project, you want to earn more than your cost. The cost of capital, which is the common equity is part of the cost of capital. So what can you use? Which method can you use to determine this common equity capital cost? Can you use the capital asset pricing model? And the answer is yes, you can use something called CAPM and we're gonna be looking at exercises today on how to compute CAPM. Definitely CAPM can be used to estimate your cost of equity. Once you know one is right, so you could eliminate B, you could eliminate D. Now all that you have to find out now, if discounted cash flow model is also an acceptable model for determining the cost of equity. And let me tell you, yes, discounting cash flow of what? Think about it. What do, what do, what do equity does? Equity pays dividend. So equity pays you dividend and what you do, you can factor the percentage dividend divided by the market price plus you could add some growth rate and you could use this formula and a discounted cash flow model to find out how much equity is costing you because you have to pay the investor's dividend. So that's also your cost of equity. So guess what? Both of these method can be used to estimate your cost of equity. Now why is this important? This is important for something called the WAC, the weighted average cost of capital. You have to find out which maybe we'll work another session. The cost of equity is involved in that computation but you could use either model to compute your cost of equity. Let's take a look at an example that involves actually numbers. Troy Inc. is a wholesaler and a retailer of board and computer games. Using the capital asset pricing model CAPM, how much is the required rate of return for Troy? Assuming a beta of 0.95 when the market return is 12 and the risk-free rate is 5%. Simply put here, they're asking you, compute CAPM. What is CAPM? Your cost of equity. Now how could you compute your cost of equity? There's a formula. Here you have to memorize the formula but it's more important if you understand the formula. So I'm gonna kind of, as I'm working through this exercise, I'm gonna try to explain the formula for you but you really want to understand it. So what is CAPM? Think about it. You have two options, okay? You have option one and option two. Option one is to put your money in a safe place, to put your money in the bank, okay? And let's consider this a safe place. Ensure the bank, if you put your money in the bank, it's a safe place. So if you put your money in the bank, you will earn 2% for the sake of simplicity. What does that mean? It means if you put your money in the bank, you would earn 2%. This 2% is a risk-free rate. So taking no risk whatsoever, taking no risk whatsoever, you can earn 2%. That's one. So if you want to undertake risky investment, you have to earn more than 2%. So putting your money in the bank is safe. Now if you want to take a risky option, a risky option, what could be risky option stocks? What happened is this? If the risky option, you have to make at least more than 2%. So let's assume you want to earn, you can earn 15% on this risky option. So risky option is 15%. What does that mean? It means you are earning 13% more than the risk-free, right? 15 versus 2%. So we call this the risk-premium. So you are earning 13% more. So this is the risk-premium by investing in stocks. Why? Because by investing, by putting your money in the bank in a safe place, it's risk-free investment. So this is what the risk-premium is. So what you have to do, this risk-premium is multiplied by something called the beta. For example, the beta is the volatility of the return of the stock. So let's assume the beta is one. If the beta is one, one times 13 equal to 13, it means this stock work exactly as the market. Then you would add the risk-free rate for 13 plus 2% equal to 15%. So this is your cap M. But let me show you in this exercise how you will work it. I just explained the concept, but let me show you how you would work it here. So the risk-free rate is 5%. So you could earn 5% regardless, even if this is risk-free rate, putting your money in the bank. That's a suit. Or sometime what they do is they give you the risk-free rate. They tell you the treasury bill. If you invest with the government, it's 5%. So that's the risk-free rate. Sometime they tell you it's the risk-free rate. Sometime they tell you it's the government bond. It's a risk-free rate because when you lend your money to the government, when you invest with the government, it's risk-free. Then you're gonna add to that your beta. You're gonna add to that beta, which is the beta here is giving 0.95. So the stock is less volatile than the overall market times, so this is the formula. You'll take the risk-free rate plus your beta times the risk-premium. What we called the risk-premium. What's the risk-premium? Well, the market is returning 5%. You can earn 12%. So 12 minus 5% equal to 7%. Simply put, your risk-premium is 7%. Now you wanna make sure you do the math correctly here. You don't wanna, you know, after you memorize the formula, you don't want to make sure you do any problem. You do, you run into math issues. So 0.95 times 0.07 plus 0.05 will give us a cap M of 11.65. Therefore, your cost of equity using the cap M is 11.65. Again, this problem could be given to you as a separate problem, or this could be part of something called the weighted average cost of capital, which is part of it is the cost of equity. Therefore, when this company wants to raise equity, one wants to issue equity, their cost is 11.65. Therefore, they have to invest in a project that earns more than that. That's their cost of equity. Let's take a look at this question. Pocono is issuing debt to raise capital, so not equity, and here we are dealing with that. Which of the following would be correct regarding the cost of that to Pocono? Well, one, if the market interest rate are higher than the coupon rate, Pocono's cost of capital will be reduced. So what we're saying here, if market rate, of what the market requiring is higher than the coupon rate, okay, we're saying the cost will be reduced, the cost of that will be reduced. So let's take a look at the market. If the market is requiring 10% and you're offering the coupon rate, the company's offering 8%, what does that mean? It means the company is showing a bond, offering a bond to the market, and they're telling the market, we're willing to pay 8%, we're willing to pay you 8%. The market is demanding, based on the current interest rate and market condition, it's demanding 10%. What would happen? Would the cost of that will be reduced to Pocono or would the cost of that will be higher? And the answer is the cost of that will be higher. What does that mean? It means when the company wants to issue the bond, they're gonna have to sell the bond at a discount. Discount means they're gonna get less money than what they want. Why? Because they are not competing with the market, they are paying less than the market. Therefore, the cost of that will go up, will be higher, okay? Therefore, is statement one true? Statement one is false. Therefore, if statement one is false, I can immediately take out A, I can immediately take out C. Now all what I have to know now, if a statement two is true or not true, if it's true, the answer is D. If it's not true, the answer is D. Because interest expense is tax deduction, so far so good, interest expense is tax deduction, the cost to Pocono is lower than the market rate on the debt. Is this a true statement? And the answer is yes, because the cost of, let me just erase all of this. So let's assume and let's go back to 8%. If you're offering 8%, it's gonna be less than the market yield. The market yield, let's assume the market yield is 8% as well. Your cost of capital will be lower, why? Because what's gonna happen is you're gonna take the 8% multiplied by one minus the tax rate. Why one minus the tax rate? Because the 8% that you're gonna be paying, it's gonna give you a tax deduction. So if it's 8%, and let's assume your tax rate is 30% minus 0.3, which is you have to take 8% times 0.7, and you can find out your tax, your net cost, your net cost, and net of tax, your interest cost net of tax, so 0.08 times 0.7, that's gonna be 5.6%. So your rate, your cost of capital is 5.6%. That is a true statement, B will be the correct answer. So remember, make sure you know how to compute your interest expense net of cost. So your interest expense is eight, since the tax rate is 30%, net of tax is 5.6%. Let's take a look at this question. Facebook is planning to use retained earnings to finance anticipated expenditure. The beta coefficient for Facebook is 1.2, means it's a little bit, it has more volatility than the market, overall market, which is the beta of one equal to the market. The risk-free rate is 7%, that's pretty high, right? For a risk-free rate, now the risk-free rate is practically close to zero, and the market return is estimated to be 12.4. Using the CAPM model, what is the cost of used retained earnings to finance the capital expenditure? Now, in the prior example we said, we could use this to find the cost of equity, retained earnings is part of equity. So when we say cost of common stock, cost of retained earnings, practically the same thing, they're both part of the equity, because remember under the equity section of your balance sheet, the two main components are common stock, or sometimes you have preferred stock, but usually common stock, and two is retained earnings. So those are both part of equity. So we could use CAPM to figure out our cost of retained earnings, which is also part of equity. Again, the risk-free rate, we'll start with the risk-free rate, we can earn 7% without taking any risk, plus it's gonna be beta, which is beta 1.2 times the risk-premium, the risk-premium is the return on the market, 12.4 minus the risk-free rate, 7%. So let's do the math and figure out what is our, what is our 12.4 minus 7, which is 0.05. So this is 5.4%. So let's turn everything into percentages, 0.045 times 1.2 is 6.48 plus 0.07 plus 7%. So the answer is 13.48. Therefore, your cost of using retained earnings is 13.48. Hopefully you have a better understanding about the CAPM, because the CAPM could be tested separately. The CAPM could be tested as part of weighted average cost of capital, which we'll talk about this. Maybe I will have another recording about this. As always, I would like to remind you to visit my website, because what I do on my website, I teach you the material. I don't review it with you like a review course. I teach you the concept. And this is what you need to know for the CPA exam. You will need to learn the concept. You need to learn the concept. And this is what I do in my introduction to finance course, as well as I have plenty of resources. Stay safe, study hard. You invest for your CPA once in your lifetime. Don't shortchange yourself. Good luck and study hard.