Which component contributes to cost of equity, especially for volatile companies like tech firms?

The cost of equity refers to the return a company must offer investors to compensate them for the risk of holding its equity. For volatile companies such as tech firms, the market return plays a critical role in determining this cost.

In the context of the Capital Asset Pricing Model (CAPM), which is often used to calculate the cost of equity, the expected return on equity is influenced by the risk-free rate plus a premium for the risk of investing in the market. The market return captures the overall expected return of the equity market, including the compensation investors require for taking on additional risk over the risk-free rate.

Given that tech firms are typically characterized by higher volatility and thus higher risk, their cost of equity is more sensitive to changes in market returns. A higher market return increases the expected returns that investors seek, thereby increasing the cost of equity for these companies.

In contrast, components like the risk-free rate have their influence but do not capture the systematic risks associated specifically with equities in the market. The leverage ratio relates to the debt level of a firm and does not directly impact the equity cost for volatile firms. Market capitalization reflects a company's size but does not directly calculate cost of equity in a DCF analysis.

Overall, the market return is the