Certified Valuation Analyst (CVA) Practice Exam

As risk increases, what happens to the cost of capital?

1. It increases

2. It decreases

3. It remains unchanged

4. It fluctuates significantly

The correct answer is: It increases

The relationship between risk and the cost of capital is fundamental in finance. As risk increases, investors typically require a higher return on their investment to compensate for that additional risk. This higher required return leads to an increase in the cost of capital. When a company is perceived as riskier—perhaps due to market volatility, operational challenges, or a higher likelihood of default—investors identify this as a reason to seek a greater return. Essentially, they are looking for a risk premium that reflects the uncertainties associated with their investment. Therefore, the cost of capital rises in response to these increased risks, which can impact both equity and debt financing. This principle underpins various financial models, including the Capital Asset Pricing Model (CAPM), where the expected return on equity increases with the beta coefficient, which measures a stock's volatility relative to the market. The implication for companies is significant: those with higher perceived risks may find it more expensive to finance their operations or growth initiatives, affecting overall financial strategy and investment decisions.