Question

1. If a company applies the same cost of capital to all projects, it would:

a) reward project with higher risk.

b) get the best possible projects carried out.

c) reward project with lower risk.

d) achieve lowest cost of capital.

2. Which of the following is the least common instrument for financing?

a) Preferred stocks.

b) Common stocks.

c) Bonds

d) All of the three are equally common.

Answer 1

1. If a company applies the same cost of capital to all projects, it would reward project with higher risk

Therefore correct answer is option a) reward project with higher risk.

The project cost of capital depends on its riskiness. In the capital budgeting process; risk-adjusted discount rate approach is used where discount rates are different for different risk categories. For example, discount rate should be higher for more risky projects and it should be lower for less risky projects. The effective cost of capital for a company is the weighted average cost of capital (WACC). It is the cost of raising capital, where the weights represent the proportion of each source of financing that is used in capital structure of the company. If firms will use a constant project cost of capital, then they will use same discount rates for all projects irrespective of its riskiness then it would reward project with higher risk which is not an appropriate strategy.

2. Which of the following is the least common instrument for financing?

The least common instrument for financing in the followings is preferred stocks.

Therefore correct answer is option a) Preferred stocks

The least common instrument for financing is preferred stocks because common stocks and debts are more popular because of the following reasons-

• For the preferred stock dividends are fixed and this characteristic is consistent with debt because debt also pays fixed rate of interest on it.
• But no tax adjustments are made when calculating the cost of preferred stock and this characteristic is consistent with equity because like dividend payments for equity stocks, the dividend payments on preferred stock are not tax deductible.
• The dividend payment on preferred stock gets preference over common stock but preferred stockholders have limited claim on the earning of the company and they do not have voting rights.