Practice Problem – Cost of Equity and Beta

Practice Question

Cases in Finance
Cost of Capital
Cost of Equity
Short Answer

What happens to the cost of equity when the firm's beta increases?

Answer +
C
Explanation +

An increase in a firm's beta indicates it is more volatile relative to the overall market. According to the Capital Asset Pricing Model (CAPM), the cost of equity increases with beta because investors demand a higher return for taking on more risk. Specifically, CAPM is calculated as:

Cost of Equity = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate).

So, as beta increases, the second term becomes larger, which increases the overall cost of equity.