Multiple choice Question regarding Cost of Capital. Please explain your choice o
ID: 2806096 • Letter: M
Question
Multiple choice Question regarding Cost of Capital. Please explain your choice of answer.
5. a)
The cost of capital is used as a discount rate because:
A )it is an indication of how much the firm is earning overall.
B ) as long as the cost of capital is earned, the common stock value of the firm will be maintained.
C) it is comparable to the prevailing market interest rates.
D) returns below the cost of capital will cover all fixed costs associated with capital and provide an excess return to shareholders.
5. b) The overall weighted average cost of capital is used instead of costs for specific sources of funds because:
The overall weighted average cost of capital is used instead of costs for specific sources of funds because:
A) use of the cost for specific sources of capital would make investment decisions consistent.
B) it is the minimum point for the firms cost of capital given the current equity mix.
C) investments funded by low cost debt would have a disadvantage over other investments.
D) a project with the lowest return would always be accepted under the specific cost criteria.
Explanation / Answer
5 (a)
Cost of capital is the expected cost of the capital as interest and dividend. It is the earnings that to be paid by the company to the shareholders for their investment. Similarly, the same cost of capital is used as a discount rate because this rate is comparable with the market rate of interest.
Hence, the correct answer is option C, that is comparable to the prevailing market interest rates.
5(b)
A firm generally uses weighted average cost of capital instead of a specific cost of capital to calculate the total cost of the investment. The reason is the weighted average cost of capital is the actual total cost of the firm. Hence, the firm can understand minimum cost by using the weighted average cost of capital and it would be missing by using a speciic cost of funds.
Hence, the correct answer is option B, that is it is the minimum point for the firms cost of capital given the current equity mix.
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