Question

#1: Capital Budgeting Related

a) If the projects being selected by a company have a higher degree of risk than current existing projects do, what will happen to the cost of capital over time? If projects being selected have less risk than current projects do, what will happen to the cost of capital over time?

b) How might a change in the long-term interest rate (a change upward or a change downward) affect the marginal cost of equity capital and the overall marginal cost of capital?    

Answer 1

a) There is a general rule of finance that says, higher the risk higher the reward. The same could be applied in the given case. Since business is prone to a number of risks during its operation, the stakeholders always consider the risk in their return expectation. For Example, Banks and Financial Institutions charge a premium for riskier projects and gives a discount on less risky projects.

Thus, we can say that a riskier project will push the cost of capital to a higher level in comparison with the current level. As investors, whether Debt or Equity, will demand higher returns for their increased risk.

Vice-versa, the COC will drop if the risk taken by the company is lower than the current level.

b) In simple terms, the marginal cost of funds refers to the cost of additional funds the business requires. The marginal cost of equity and the marginal cost of capital are directly related to long-term interest rates. Since an increase in the long-term interest rate would increase the Risk-free rate, which in turn increases the cost of equity. Also, an equity investor demands a premium over debt investor, therefore increasing the interest rate further would increase the equity investor's expectation. Similarly, the cost of capital of business will also go up, as the cost of equity has gone up and debt cost is obviously to go up with an increase in long-term interest rates. Vice-versa with a fall in long-term interest rates.