The Cost of Capital is the minimum rate of return the firm must generate on proj

Question

The Cost of Capital is the minimum rate of return the firm must generate on projects in order to be able to serve its investors – both lenders and owners – with a sufficient return on their investments to justify the risks they take by making them. But there are two significant problems: 1) it is a moving target because as market forces change the values of the firm’s stock and bonds, the investors’ required returns change, and 2) different projects carry different risks, and changes in risk should dictate fluctuating required returns.

Describe what measures you would take if you were the firm’s CFO to ensure that the costs of capital used over time to evaluate the firm’s projects accurately reflect the changing returns investors are likely to seek.

Explanation / Answer

I would use a weighted average cost of capital which would be closer to the expected future cost of capital instead of just using the cost of capital at the current time. I would also be conservative in my assumptions when discounting the cash flows of projects.

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