Chartered Financial Analyst (CFA) Practice Exam Level 2

Which of the following factors is considered a top-down factor in determining the cost of capital?

1. Company Size

2. Debt Levels

3. Inflation Expectations

4. Profitability

The correct answer is: Inflation Expectations

Cost of capital is influenced by various factors that can be categorized into bottom-up and top-down approaches. A top-down factor is one that affects the entire economy or broader market conditions rather than focusing solely on individual firm characteristics. Inflation expectations are a key top-down factor because they influence the overall risk-free rate and the required returns by investors across various sectors. When inflation expectations rise, investors anticipate higher costs and adjust their required return rates accordingly, which in turn increases the cost of capital for firms as they must offer higher returns to attract investment to compensate for the eroding purchasing power of money over time. In contrast, company size, debt levels, and profitability are generally considered bottom-up factors. Company size may influence investor perceptions of risk and market dominance, but it does not inherently pertain to macroeconomic conditions. Debt levels provide insights into a specific firm's financial leverage but do not reflect aggregate market movements. Profitability is focused on how well a firm performs independently and does not encompass broader economic variables impacting capital costs. Thus, inflation expectations clearly emerge as the dominant top-down factor when analyzing the cost of capital.