Factors Affecting the Cost of Equity Capital

D

The cost of equity capital represents the expected return that investors require in order to invest in a company's stock. The cost of equity is considered a critical input in various financial calculations, including the weighted average cost of capital (WACC), which is the average cost of all the capital that a company raises to fund its operations.

Now, let's look at the given answer choices:

A. The minimum rate that a firm should earn on the equity-financed part of an investment:

This statement is essentially describing the cost of equity capital, and it is a correct definition. Therefore, option A is not the correct answer.

B. A return on the equity-financed portion of an investment that, at worst, leaves the market price of the stock unchanged:

This definition of the cost of equity is also correct. It implies that the cost of equity is the minimum return that investors require to invest in a company's stock, and if the company can achieve this return, the market price of its stock will remain unchanged. Thus, option B is not the correct answer.

C. By far the most difficult component cost to estimate:

This statement is true. Estimating the cost of equity capital involves making assumptions about future market conditions, the company's future performance, and the investors' expectations, which can be very difficult to predict. Therefore, option C is not the correct answer.

D. Generally lower than the before-tax cost of debt:

This statement is incorrect. The cost of equity capital is typically higher than the cost of debt because equity investors require a higher return to compensate for the higher risk they are taking on. Therefore, option D is the correct answer.

In summary, the cost of equity capital is the return that investors require to invest in a company's stock. It is difficult to estimate and is generally higher than the cost of debt. Therefore, the correct answer is D.