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. A. a reduction in the dividend amount B. an increase in the dividend amount C. a reduction in the market rate of return D. a reduction in the firm's beta E. a reduction in the risk-free rate Question 3

E. a reduction in the risk-free rate

Explanation:

The Security Market Line approach uses the Capital Asset Pricing Model to calculate the Cost of Equity.

CAPM formula is depicted as follows,

Ce = rF + b(rM - rF)

Where,

Ce is Cost of equity,

rF is Risk free rate of return,

b is Beta,

rM is the market rate of return

(rM - rF) is the market premium

Looking at this formula, one can deduce that if the risk free rate were to reduce, the beta would be multiplying a higher Market Premium because the reduction from the market rate return by the Risk free rate would be lesser.

For example.

Assuming rF is originally 4% and b is 2 and market return is 10%.

The cost of equity would be,

= 4% + 2 ( 10% - 4% )

= 4% + 2 ( 6%)

= 16%

Now assuming that the risk free rate dropped to 3%. The cost of equity will become,

= 3% + 2 (10% - 3% )

= 3% + 2 (7%)

= 17%.

Notice that the Cost of capital increased to 17% when the risk free rate dropped to 3%.

This means that option E is correct.

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