Question

Cost of capital Summary In 2010 the Federal Reserve Board (the Fed) reported that nonfinancial companies in the United States had around $2 trillion in cash and short-term liquid assets. As the U.S economy was still struggling, consumer spending remained low, and companies resisted in investing in new projects that would create value for their stakeholders Based on your understanding of the concept of cost of capital, which of the following statements are valid? Check all that apply. As the economy improves, uncertainty in the markets decreases, and companies will start investing in projects. However, the challenge of analyzing and selecting projects that would generate cash flows and returns and add value to the firm would emain Companies are financed by several sources of investor-supplied capital, which are called capital components Preferred stock is not taken into account when considering the costs related to investor-supplied capital Short-term debt such as accounts payable or short-term loans are not considered capital components Companies often finance their new projects with capital that comes from retained earnings. This also constitutes investor-supplied capital The assumptions in the analvsis about

Answer 1

Question 1: Based on your understanding of....

Option 1 is true. Companies indeed deploy various sources of capital with varying cost of capital. Each of these sources is called the component if capital.

Option 2 is wrong. Preferred stock remains a frequently used source of capital by companies. And they are included (taken into account) while calculating the weighted average cost of capital for the company

Option 3 is correct: The word capital refers to funds available for long term use by the firm. Short term debts, payables etc are not considered as capital component.

Option 4 is correct: Retained earnings or internal accruals is a common source of financing used by the company. Retained earnings are money actually belonging to the shareholders. By retaining them in the business, the existing shareholders are in a way supplying this capital to the company.

Hence, please check option 1, 3 & 4 - All of them apply.

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Question 2: Happy lion Manufacturing Inc....

A project's cash flow should be discounted by the discount rate applicable to that particular project. The discount rate chosen should be commensurate with the riskiness of the cash flows. In a firm having two divisions, one of them being riskier than the other, the WACC applicable to the firm will be lower than that applicable to the riskier division and higher than that applicable to the relatively safer division. If company uses investor's overall required rate of return (say WACC), then it will end up selecting riskier projects because some of them may become acceptable or positive NPV projects because the cash flows are discounted by a lower discount rate. Similarly, the company may miss upon certain less risky projects because their cash flows will be discounted at relatively higher discount rate. Due to this distortion in selection, the company will be full of riskier project and its valuation will decrease.

Hence option (2) is correct.

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Question (3) Which of the following....

Option (1) is correct. Debt financing results in interest tax shield which is a function of tax rate. Interest originating from debt is tax deductible and hence for a debt the post tax cost is considered in cost of capital calculation. A higher tax rate will thus lower the WACC.

Option (2) is incorrect. The cost of debt is the post tax yield of the bond and not the coupon rate. It's the prevailing interest rate on the similar instrument available in the market, that is considered to be the cost of debt.

Option (3) is incorrect. Book values are values stated at cost. There may be significant variation between the market value of equity and the book value of equity. Hence book values should not be considered in the WACC calculation. Market values are recent and relevant depiction of the capital structure. Alternatively the capital structure to be used in WACC calculation should be the target capital structure.

Hence please tick / choose option (1)

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