Under the Efficient Market Hypothesis, prices can be used to assess a firm's cost of capital.

Under the Efficient Market Hypothesis, prices can be used to assess a firm's cost of capital.

• A. True
• B. False
• C. Sometimes
• D. Not specified

Answer: (A)

Under the Efficient Market Hypothesis, prices reflect all available information about a firm's risk and expected cash flows. Because the market price of the firm’s securities embodies the return investors require for that risk, those prices can be used to infer the cost of capital. For equity, the current stock price can be translated into the cost of equity via models like CAPM or the dividend/earnings capitalization approaches, since the price already encodes expected dividends or earnings and their risk. For debt, the yield available on the firm’s bonds reflects the market’s required return given credit risk, providing the cost of debt. The overall cost of capital (WACC) can then be assembled from these market-based costs and the market values of equity and debt. In EMH, prices are the best available signal of the true cost of capital at that moment, so the statement is true.

Under the Efficient Market Hypothesis, prices reflect all available information about a firm's risk and expected cash flows. Because the market price of the firm’s securities embodies the return investors require for that risk, those prices can be used to infer the cost of capital. For equity, the current stock price can be translated into the cost of equity via models like CAPM or the dividend/earnings capitalization approaches, since the price already encodes expected dividends or earnings and their risk. For debt, the yield available on the firm’s bonds reflects the market’s required return given credit risk, providing the cost of debt. The overall cost of capital (WACC) can then be assembled from these market-based costs and the market values of equity and debt. In EMH, prices are the best available signal of the true cost of capital at that moment, so the statement is true.