Question

Explain why the use of debt by a firm necessitates an estimate of the cost of equity and the cost of debt and why the beta of a company is a function of a number of factors; identify the most important three factors (either based on your opinion, the text, or other research) in priority order (Highest to lowest priority) from your perspective. Explain your rationale for prioritization.

Answer 1

Use of debt by the firm will generate need for the estimation of the cost of equity as well as the cost of that because it will be helpful in calculation of the weighted average cost of capital and it will be helpful in the company for finding out optimum capital mix, which will help the company in order to generate a rate of return which will be higher than the overall cost of capital.

beta of a company is a function of number of factors because beta is the systematic risk and it is related to the overall fluctuation in the market.

Three factors for fluctuation of Beta could be interest rates, inflation and political event .

I will be prioritising interest rate as the primary factor because change in the interest rates in the economy is highly important for a functioning of the organisation and then I will be assigning inflation because inflation will change the disposable income pattern of the consumers in an economy, and then I will select political event management which should be properly analysed because this will have a higher impact on the share value and beta.