Valuation and the Cost of Capital - Required Returns on Equity

8 important questions on Valuation and the Cost of Capital - Required Returns on Equity

How do you calculate Re?

Re = Rf + β [Rm - Rf)

What is β? Where does it depend on?

Beta is the sensitivity of returns on stock to overall market returns. It depends on:
  1. The business risk of the firm
  2. The financial risk of the firm (leverage)

What is the difference called between β [Rm - Rf]?

The market risk premium. For example, a market risk premium is 5%; so we expect the annual return on stocks to be 5% higher than the returns on bonds.
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What is a defensive investment?

A stock that tends to move less strongly with overall market conditions; therefore, lower betas.

How to increase equity?

  1. Don't pay dividends.
  2. Ask stockholders to increase its capital, because if the company would increase its stocks, the value goes down.

What are three characteristics of preferred stockholders?

  • They earn a certain percentage.
  • They have certain requirements.
  • They get paid first.

What is an advantage and a disadvantage of being a common stockholder?

An advantage is that they may receive a higher return. A disadvantage may be that they don't receive a return at all.

How will an increase in financial leverage affect a company's cost of equity capital? How will it affect a company's equity beta?

Increasing financial leverage increases the risk of equity investors; therefore the Re will increase. The company's beta will go up as well.

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