Suppose a firm estimates its cost of capital for the coming year to be 10%. What might be...

Question:

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.


Learn more about this topic:

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Required Return vs. Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 1
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