Chartered Financial Analyst Level 2

Explanation

Higher earnings predictability (Option B) most likely results in a lower cost of capital because:

• Reduced risk perception: When earnings are predictable, investors perceive lower business risk, leading to lower required returns
• Lower equity risk premium: Predictable earnings reduce the uncertainty premium that investors demand
• Better debt capacity: Lenders are more willing to provide capital at lower interest rates when cash flows are stable and predictable
• Lower beta: Companies with predictable earnings typically have lower systematic risk (beta), which directly reduces cost of equity

Why not the other options:

• Higher operating leverage (Option A): Increases business risk because fixed costs amplify earnings volatility, leading to higher cost of capital
• Higher revenue concentration (Option C): Increases risk due to dependency on few customers or markets, making earnings more vulnerable to specific risks

In summary, earnings predictability reduces overall business risk, which is rewarded by capital markets through lower required returns on both debt and equity.