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Questions and Answers
How do general economic conditions influence the risk-free rate of return?
How do general economic conditions influence the risk-free rate of return?
What happens to the cost of capital when investors increase their required rate of return due to higher risk?
What happens to the cost of capital when investors increase their required rate of return due to higher risk?
Why do investors require a higher rate of return when inflation is expected to deteriorate the purchasing power of money?
Why do investors require a higher rate of return when inflation is expected to deteriorate the purchasing power of money?
What is the impact of issuing more debt on the cost of debt?
What is the impact of issuing more debt on the cost of debt?
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How does increasing the payout ratio affect the marginal cost of capital schedule?
How does increasing the payout ratio affect the marginal cost of capital schedule?
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What is the common consequence of trying to place a large issue in the market without reducing the price of the security?
What is the common consequence of trying to place a large issue in the market without reducing the price of the security?
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How does granting large sums without evidence of management's capability impact suppliers of capital?
How does granting large sums without evidence of management's capability impact suppliers of capital?
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How does the investor's required rate of return change in response to a security being readily marketable and having a reasonably stable price?
How does the investor's required rate of return change in response to a security being readily marketable and having a reasonably stable price?
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How do business risk and financial risk affect the investor's required rate of return?
How do business risk and financial risk affect the investor's required rate of return?
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How does the level of financing required by the firm impact the weighted cost of capital?
How does the level of financing required by the firm impact the weighted cost of capital?
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Study Notes
Economic Influence on Risk-Free Rate
- General economic conditions stabilize or destabilize the risk-free rate, which reflects the yield on government securities unaffected by default risk.
- Economic growth can lead to higher demand for investment which may increase the risk-free rate, while recessionary conditions tend to lower it.
Cost of Capital and Required Rate of Return
- When investors raise their required rate of return due to perceived higher risk, the overall cost of capital increases.
- A higher cost of capital affects corporate investments, potentially slowing growth as projects become less attractive.
Higher Rate of Return and Inflation
- Investors demand a higher rate of return during expected inflation to compensate for the loss of purchasing power over time.
- The required return aligns with the risk of inflation eroding real returns, leading to adjustments in investment strategies.
Impact of Issuing More Debt
- Issuing additional debt can increase the cost of debt due to elevated perceived default risk and potential impact on credit ratings.
- Higher debt levels may lead to a rise in interest rates demanded by lenders.
Payout Ratio and Marginal Cost of Capital
- Increasing the payout ratio generally reduces retained earnings, leading to a higher reliance on external financing.
- This shift affects the marginal cost of capital, as external funding is often more costly than retained earnings.
Large Issues and Market Pricing
- Attempting to issue a large quantity of securities without price adjustments can saturate the market, leading to decreased demand and a potential drop in price.
- Poor market reception can negatively impact the firm's financial health and future capital-raising activities.
Management Capability and Capital Suppliers
- Granting funds without evidence of management capability undermines investor confidence and can make capital suppliers hesitant.
- This lack of trust may lead to stricter financing terms or outright refusal to provide capital.
Marketability and Investor’s Required Return
- A security that is readily marketable and maintains stable prices may have a lower required rate of return due to reduced liquidity risk.
- Investors seek reliable returns in exchange for the perceived risks associated with the marketability of their investments.
Business and Financial Risk
- Business risk (operational performance) and financial risk (debt levels) together influence the investor's required rate of return.
- Increased risks can elevate required returns as investors seek compensation for additional uncertainty.
Financing Requirements and Weighted Cost of Capital
- The level of financing a firm needs influences the weighted average cost of capital (WACC); higher financing demands can lead to increased costs.
- Adjustments in capital structure impact WACC, thus affecting investment decisions and firm valuation.
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Description
Test your knowledge on how general economic conditions impact the demand for and supply of capital, as well as the level of expected inflation. This quiz covers topics such as risk-free rate of return and its reflection on economic variables.
