How can a firm reduce cost of equity?

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Expert Solution

A company's cost of equity can be calculated by CAPM capital asset pricing model. CAPM is a model through which assets required rate of return is calculated.

Equation of CAPM -

R = R_f + (R_m - R_f) / Beta

Here R_f = risk free rate

(R_m - R_f ) * Beta = Risk Premium the security or asset offers

Beta= it is the measure of volatility of Stock's systematic risk (non diversifiable risk) in comparison of the unsystematic risk diversifiable risk) of the market.

The expected return on the share of a company depends on its Beta, the higher the beta the higher the expected return.

If the company is able to offer low Beta than the cost of equity can be reduced as high beta require high risk premium and vice versa.

The beta of a firm depends on a number of factors. One of the factor is financial leverage. High financial leverage cause higher beta. A firm can manage its capital structure lower its beta.

All other factors like risk free rate , market return are external factors which are uncontrollable. Thus a firm can manage its Beta to adjust its cost of equity as beta is specific to a firm.

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