Question

If we assign discount rates to individual projects according to the risk level of each project, it Multiple Choice may cause the company's overall weighted average cost of capital to either increase or decrease over time will prevent the company's overall cost of capital from changing over time will cause the company's overall cost of capital to decrease over time decreases the value of the company over time negates the company's goal of creating the most value for its shareholders

Answer 1

1. If we assign different discount rates to different projects according to their risk level, then if the company takes more risky projects, its WACC will increase otherwise it will decrease. This is because WACC is the weighted average cost and hence it may either increase or decrease with time. (option 1)

2. We should assign the discount rate to a project based on the riskiness of the cashflows from that project and not the riskiness of the firm or overall WACC . We should do so on the basis of risks associated with the use of funds associated with the project. (Option 5)

3. WACC depends on the riskiness of the cashflows undertaken by the project. The weights assigned to the preferred stock will increase with increase in its market value. The WACC will decrease with an increase in tax rates.Weight of equity depends on market value of shares. The preferred stock is generally costlier than debt and hence if debt is used in place of preferred stock the WACC will most likely decrease. (option 1)

4.The after tax cost of debt may be less than the YTM of company's outstanding bonds .The preferred stock is generally costlier than debt .Cost of equity can also be estimated by other models. WACC may also change because of change in costs of equity and debt . Cost of equity is unaffected by the tax rate and hence is the correct option (Option 3)