prashantsahni

A firm’s cost of equity capital is least accurately described as the:

A) minimum rate of return investors require to invest in the firm’s equity securities.

B) ratio of the firm’s net income to its average book value.

C) expected total return on the firm’s equity shares in equilibrium.

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The ratio of the firm’s net income to its average book value is the firm’s return on equity, which can be greater than, equal to, or less than the firm’s cost of equity. Cost of equity for a firm can be defined as the expected equilibrium total return in the market on its equity shares, or as minimum rate of return that investors require as compensation for the risk of the firm’s equity securities.

prashantsahni

Which of the following changes would most likely cause a firm’s return on equity to increase?

A) Net income increases by 5% and average book value of equity increases by 10%.

B) Net income increases by 5% and average book value of equity increases by 5%.

C) Net income decreases by 5% and average book value of equity decreases by 10%.

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Return on equity is net income divided by average book value of equity. If the book value of equity decreases relatively more than net income decreases, return on equity will increase. This illustrates that an increase in ROE is not necessarily positive for the firm. An analyst must examine the reasons for changes in ROE.

prashantsahni

When analyzing an industry characterized by increasing book values of equity, return on equity for a period is most appropriately calculated based on:

A) beginning book value.

B) ending book value.

C) average book value.

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When book values are not stable, analysts should calculate ROE based on the average book value for the period. When book values are more stable, beginning book value is appropriate.