Question

Which is true for a firm’s overall cost of equity:

Select one:

a.  It is generally less than a leveraged firm’s WACC

b. Ii is unaffected by changes in the market risk premium

c.  It is generally less than the firm’s after-tax cost of debt

d. It is dependent on growth rate and risk level of the firm

Answer 1

Answer: Option D (It is dependent on growth rate and risk level of the firm)

Cost of equity can be determined by below 2 ways:

1. Dividend Capitalization Model

2. Capital Asset Pricing Model (CAPM)

1. As per Dividend Capitalization Model:

Cost of Equity= [Dividend per share (for next year) / Current Market Price of share] + Growth rate

Change in growth rate leads to change in cost of equity.

Example 1:- Growth rate is 5%

Dividend- $5, Current Market price of share- $100, Growth rate- 5%

Cost of equity= [5/100]+ 0.05 = 0.10 or 10%

Example 2:- Growth rate is 10%

Dividend- $5, Current Market price of share- $100, Growth rate- 10%

Cost of equity= [5/100]+ 0.10 = 0.15 or 15%

As we can see from the above examples, change in growth rate leads to change in cost of equity.

2. As per CAPM:

Cost of Equity = Risk free rate of return + Beta * (Market rate of return - Risk free rate of return)

Risk level of firm is generally denoted by Beta of the firm. Cost of equity is dependent on Beta as slight change in Beta leads to change in cost of equity.

Example 1:- Beta- 1

Risk free rate of return- 5%, Market rate of return- 10%, Beta =1

Cost of Equity = 5% + 1 * (10% - 5%) = 10%

Example 2:- Beta- 1.5

Risk free rate of return- 5%, Market rate of return- 10%, Beta =1.5

Cost of Equity = 5% + 1.5 * (10% - 5%) = 12.5%

As we can see from the above examples, Cost of Equity is dependent on Risk level of firm (Beta).