The cost of equity capital

9 important questions on The cost of equity capital

What 2 things does business risk depend on?

1. Responsiveness of the firm's revenues to the business cycle
2. Operating leverage of the firm

What is the difference between operating leverage and financial leverage?

Operating leverage refers to the firm's fixed costs of production, while financial leverage is the extent to which a firm relies on debt and thus the fixed costs of finance.

What is the corporate discount rate?

Unless all projects in the corporation are of the same risk, choosing the same discount rate for all projects is incorrect. So a project should be discounted at the reate commensurate with its own beta
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What are the market impact costs?

The price drop associated with a large sale and the price rise associated with a large purchase

Why is liquidity negatively related to expected return and cost of capital?

Investors demand a high expected return when investing in equities with high trading costs (that are less liquid), and this high expected return implies a high cost of capital.

What 2 strategies to lower trading costs are there for corporations?

1. Firms should try to bring in more uninformed investors (e.g. through stock splitting)
2. Firms should disclose more information

What is the difference between capital budgeting and performance measurement?

Capital budgeting is forward-looking to estimate future cash flows to value a project, while performance measurement is backward-looking

What is the EVA formula?

(ROA - Wacc) x Total capital. This is used to compensate the error that the percentage nature of ROA poses

What are the 2 problems with EVA?

1. EVA has little to offer for capital budgeting, because it only focuses on current earnings
2. May increase shortsightedness of managers, as they are rewarded if their current earnings are high

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