Why is the cost of equity important for a firm?

The cost of equity is crucial for a firm because it represents the return required by investors to hold the company's stock. This return is essential for businesses to attract and retain investors, as it reflects the compensation required for the risk they take by investing in the company's equity rather than other investments with similar risk profiles. A higher cost of equity implies higher expected returns, which can influence the firm's capital structure and investment decisions.

Understanding the cost of equity helps managers make informed financial decisions, such as determining the viability of projects, assessing the appropriate mix of debt and equity financing, and ultimately ensuring that the firm meets its financial obligations to shareholders. It serves as a pivotal metric in valuation models, often used to calculate the company's overall cost of capital and to evaluate whether investment opportunities meet or exceed this required return.