medium · Principles of Finance cost-of-capital-structure
An analyst is comparing the cost of equity for two firms. Firm A has a bond yield of 5% and Firm B has a bond yield of 8%.
Using the bond-yield-plus-risk-premium method with a constant 4% premium, which firm has the higher cost of equity and why?
- Firm B, because its higher cost of debt signals higher overall financial and business risk.
- Firm B, because higher bond yields indicate that the company is more likely to pay high dividends.
- Firm A, because investors demand more return to compensate for the lower interest payments.
- They both have the same cost of equity because the 4% premium is the same.
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