Asked by Shayan Patel on May 21, 2024
Verified
Which statement regarding cost of capital is true?
A) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it should accept and to accept some risky projects that it should reject.
B) Because of the risk of bankruptcy, the cost of debt is always higher than the cost of equity capital.
C) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
D) Higher flotation costs tend to reduce the cost of equity capital.
Cost of Capital
The minimum return needed for a capital investment project, like constructing a new manufacturing facility, to be considered viable.
Risky Projects
Investments or projects that carry a high level of uncertainty regarding their future returns.
Safe Projects
These are investment ventures with a low risk of failure or loss, often characterized by predictable revenue streams or market demands.
- Comprehend the consequences of employing a standardized cost of capital in evaluating projects and its possible effect on a company's risk profile and inherent worth.
- Explore the consequences of distinct project risks on the capital cost and the essentiality of adjusting the WACC based on different risk categorizations.
Verified Answer
AG
Alejandro GomezMay 22, 2024
Final Answer :
A
Explanation :
Assigning the same cost of capital to all projects regardless of risk leads to misallocation of resources. Safe projects may be rejected because their returns are not deemed high enough to meet the cost of capital, while risky projects may be accepted even if their returns do not cover the higher cost of capital required to finance them. It's important for a company to differentiate between various projects based on their expected risk levels and assign an appropriate cost of capital to each one to ensure that resources are allocated efficiently.
Learning Objectives
- Comprehend the consequences of employing a standardized cost of capital in evaluating projects and its possible effect on a company's risk profile and inherent worth.
- Explore the consequences of distinct project risks on the capital cost and the essentiality of adjusting the WACC based on different risk categorizations.