Question

a) Describe the impact of gearing (i.e. debt) on the cost of capital. b) Behavioural finance posits that investors possess behavioural biases. Discuss the importance of behavioural biases and then list and explain any four behavioural biases.

Answer 1

Debt financing is biggest issue corporate face nowadays as high debt or high leverage restricts Organisations ability to raise capital and high debt increases the cost of capital as lenders charge premium interest rates owing to risk of getting default.

Behavioural finance also is big factor as what psychological association investors have on firm is taken as given by lenders and accordingly capital is raised either at discounted or premium rates.

Behavioural biases form important factor in investment as it can favour any one sector or stock consistently and can thus help grow market capitalisation tremendously.

Some types of biases includes confirmation bias, Familiarity bias, self attribution bias, trend chasing bias.

Here investors are either favouring stock or chasing what other investors chase or simply preffering on first impressions or maybe due to self enhancement which gives them an upper edge.