Which of the following statements is CORRECT? Select one: a. The cost of capital

Question

Which of the following statements is CORRECT?

Select one:

a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

b. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firms outstanding debt.

c. Suppose some of a publicly-traded firms stockholders are not diversified; they hold only the one firms stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firms intrinsic value.

d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firms cost of equity capital.

Explanation / Answer

Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

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