Question

If a firm pays an annual dividend of $2 and the firm’s stock has a beta of 1.5, which one of the following will increase a firm’s cost of equity (assume security market line approach to calculate the cost of equity).

1. a reduction in the dividend amount.
2. an increase in the dividend amount.
3. a reduction in the market rate of return.
4. an increase in the firm's beta.
5. a reduction in the firm's beta.

Answer 1

Ans 4. an increase in the firm's beta.

An increase in the firm's beta will increase the cost of equity.

Cost of Equity=	Risk free Return + (Market Return - Risk free return)* Beta
Cost of Equity=	5% + (9% - 5%) * 1.5
Cost of Equity=	11.00%

When Beta increased from 1.5 to 2.0 the cost of equity increased from 11.00% to 13.00%.

Cost of Equity=	Risk free Return + (Market Return - Risk free return)* Beta
Cost of Equity=	5% + (9% - 5%) * 2.0
Cost of Equity=	13.00%