Question

Can anyone explain why:

The cost of equity is cheap when:

1. The management believes that the share price is overvalued, i.e. raise equity now before the share price is corrected downwards?

and

2. The market believed the shares are undervavlued?

Pls explained seperately, or you can give a simple examples.

Answer 1

1) Cost of equity according to dividend capitalisation method is Re=D1/P0 +g

there is opposite relationship between Current market price of share and cost of equity . If the management believes that the share price is overvalued it means the current market price of shares is high hence due to inverse relationship the cost of equity would be low .

2) Since the market believes that shares are undervalued, then investors purchase shares in larger quantities and this raises the price of the share in the market and hence again with higher share price cost of equity will be cheap.