Question

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the: beta decreases. market risk premium decreases. risk-free rate decreases. either the risk-free rate or the market rate of return decreases. market rate of return decreases.

Answer 1

Answer:

Risk-free rate decreases

Explanation:

The CAPM formula for calculating cost of equity requires one to know the value of 3 pieces of information only:

1. the market rate of return,

2. the beta value

3. the risk-free rate.

Ra = Rrf + [Ba∗(Rm−Rrf)]

where:

Ra=Cost of Equity

Rrf = Risk-Free Rate

Ba = Beta

Rm=Market Rate of Return

​From the formula

Ra = Rrf + [1.2∗(Rm−Rrf)]

Ra = Rrf + 1.2Rm - 1.2Rrf

From Ra = 1.2Rm -0.2Rrf

From the expression above, it can be seen that the lower the value of Rrf (Risk-Free rate), the higher the value of Ra.