Should cost of equity be higher for a $5 billion or $500 million market cap company?

Should cost of equity be higher for a $5 billion or $500 million market cap company?

• A. It should be higher for the $5 billion company
• B. It should be higher for the $500 million company
• C. It should be the same for both
• D. It should be lower for the $500 million company

Answer: (B)

Cost of equity rises with risk. Investors demand a higher return to own shares in riskier companies, so smaller firms typically have a higher cost of equity than larger firms. In the CAPM framework, ke = risk-free rate plus beta times the equity risk premium. Smaller companies often exhibit higher betas because they have less diversified earnings, more volatile cash flows, tighter access to capital, and greater distress risk. All else equal, that higher beta means a higher ke for the $500 million market‑cap company than for the $5 billion one. Empirically, small-cap stocks also tend to offer higher expected returns to compensate for this additional risk.

Cost of equity rises with risk. Investors demand a higher return to own shares in riskier companies, so smaller firms typically have a higher cost of equity than larger firms. In the CAPM framework, ke = risk-free rate plus beta times the equity risk premium. Smaller companies often exhibit higher betas because they have less diversified earnings, more volatile cash flows, tighter access to capital, and greater distress risk. All else equal, that higher beta means a higher ke for the $500 million market‑cap company than for the $5 billion one. Empirically, small-cap stocks also tend to offer higher expected returns to compensate for this additional risk.