Suppose a firm estimates its cost of capital for the coming year to be 10%.
What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects?
Cost of Capital:
The question deals with a firm's cost of capital, which is simply the return required to make a capital budgeting project worth pursuing. While it's expressed as a single rate of return, cost of capital generally reflects a firm's weighted average cost of capital (WACC) for all of its sources of funding (debt, preferred stock, and common stock).
The explanation above relates to a firm's internal use of the cost of capital measure. From a capital markets perspective, the cost of capital is used by investors to assess whether an investment's return is worth its risk.
Answer and Explanation:
If a firm estimates its cost of capital for the coming year to be 10%, it would be reasonable to assume the following costs of capital for average-risk, high-risk, and low-risk projects:
Low-risk = 6%
Average-risk = 10%
High-risk = 14%
Lower risk projects generally reflect a lower cost of capital than the firm's average, while higher risk projects reflect a higher cost of capital.
Become a member and unlock all Study Answers
Try it risk-free for 30 daysTry it risk-free
Ask a question
Our experts can answer your tough homework and study questions.Ask a question Ask a question
Learn more about this topic:
from Finance 101: Principles of FinanceChapter 14 / Lesson 1