Question

All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2. An increase in the risk-free rate. A reduction in the firm's beta. An increase in the dividend amount. O A reduction in the dividend amount. A reduction in the market rate of return.

Answer 1

SOLUTION:-

Security market line formula or equation :

Cost of equity or required rate of return = Risk free rate of return + (Beta * (Market rate of return - risk free rate of return))

All others constant, if dividend is reduced or increased, it will have effect on market price per share as per dividend growth model. It will not effect cost of equity as per security market line approach.

As per Security Market line, if Risk free rate or Beta or Market rate of return increases, it will lead to increase in cost of equity.

Given the option, appropriate option is increase in the Risk - free rate will make increase in cost of equity.

Answer: An increase in the risk -free rate.

All others are wrong.