In terms of Cost of Equity, which company should have a higher rate?

• A. The company with a larger market cap
• B. The company with a smaller market cap
• C. Both companies should have the same Cost of Equity
• D. A company with negative earnings should have a higher Cost of Equity

Answer: (B)

The Cost of Equity reflects the return that investors expect for holding a company's equity and is influenced by the perceived risk of that investment. A smaller market cap often indicates that a company is perceived as riskier compared to larger companies. This is due to several factors: smaller firms are usually less established, may have less access to capital, and are more vulnerable to market fluctuations or economic downturns. Consequently, investors require a higher return to compensate for this increased risk, resulting in a higher Cost of Equity for the company with a smaller market cap.

In addition, a company with negative earnings typically indicates financial difficulty or instability, which can also drive up its Cost of Equity as investors perceive a higher risk associated with that investment. However, the question specifically asks about market capitalization, making the size of the company the primary factor in determining the Cost of Equity. Thus, the company with a smaller market cap is considered to have a higher Cost of Equity due to the associated risks.