Multiple Choice
Which of the following best explains why historical rates of return are used to estimate expected returns for investments in securities?
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7. Receivables and Investments
Introduction to Investments in Securities
Multiple Choice
Which one of the following will increase the cost of equity for a company?
A
A decrease in expected market returns
B
A reduction in the company's financial leverage
C
A decrease in the risk-free rate
D
An increase in the company's beta coefficient
Verified step by step guidance1
Understand the concept of cost of equity: The cost of equity represents the return that investors require for investing in a company's equity. It is influenced by factors such as risk-free rate, market returns, financial leverage, and the company's beta coefficient.
Review the Capital Asset Pricing Model (CAPM) formula, which is commonly used to calculate the cost of equity: \( \text{Cost of Equity} = \text{Risk-Free Rate} + \beta \times (\text{Market Return} - \text{Risk-Free Rate}) \). This formula shows how beta impacts the cost of equity.
Analyze the role of beta coefficient: Beta measures the sensitivity of a company's stock returns to market returns. A higher beta indicates higher risk, which leads to a higher cost of equity as investors demand more return for taking on additional risk.
Evaluate the impact of an increase in beta: When the company's beta coefficient increases, the \( \beta \times (\text{Market Return} - \text{Risk-Free Rate}) \) term in the CAPM formula becomes larger, directly increasing the cost of equity.
Conclude that among the options provided, an increase in the company's beta coefficient is the factor that will increase the cost of equity, as it raises the perceived risk and required return for investors.
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