Which of the following statements is correct?
a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
b. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.
c. One problem with the CAPM approach in estimating the cost of equity capital is that if a firm's stockholders are, in fact, not well diversified, beta may be a poor measure of the firm's true investment risk.
d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital.
e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost of preferred stock since preferred stock is issued infrequently.
Sources of Funds:
The types of funds that are generally used by the firms overall in their sources of funds are equity, debt and preference capital. Each has its own cost of procurement and associated risks. Hence, the choice of capital selection is based on the firm's ability to bear the associated financial risks.
Answer and Explanation:
The correct answer is Option C.
This is because investors who are not well diversified will view the firm's security risk as too high because they are not holding stocks with unsystematic risks. The benefit of diversification is not available to them. Hence, beta, which indicates the non-diversifiable risk, magnifies their total risk of investing in that security.
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fromChapter 14 / Lesson 2
In this lesson, we'll be learning about financial policy and the cost of capital. A financial policy is very important to any company, and it helps to drive the decisions alongside the cost of capital.