Rising interest rates impact on cost of equity?
Hi all--
If interest rates rise, how does this affect your WACC? Obviously, cost of debt increases, but what about cost of equity? The risk free rate in CAPM increases, but wouldn't an interest rate increase also decrease the expected market return, leading to a decreased cost of equity?
The below site says the expected market return would increase, which seems counter intuitive.
https://corporatefinanceinstitute.com/resources/k…
Easier way to look at it would be - in a rising rate environment, equity investors would be requiring a greater rate of return to incentivize risk-taking. This is because alternatively, they can already earn higher yields through less risky fixed income instruments. Cost of equity hence increases.
Breaking it down using CAPM is tricky because you have no visibility on the extent of change for each of the variables within the CAPM formula.
Understood, and it makes sense. What is confusing is that even if we use a historical benchmark for the expected rate of return (only variable that changes is Rf), this can give a lower cost of equity if the beta is >1.
Scenario 1: 2+1.2(10-2)=11.6 Scenario 2: 3+1.2(10-3)=11.4
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