Cost of capital

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.

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 remain.

The assumptions in the analysis about cost of equity and debtoverall and for projectshave a significant impact on the type and the value of investments that a company makes.

According to the Association of Finance Professionals report, published in 2011 on current trends in estimating and applying the cost of capital, companies use a discount rate that is usually above or below 1% of the companys true rate. Using this information and certain inputs from the Fed, Michael Jacobs and Anil Shivdasani estimated that a 1% drop in the cost of capital leads U.S. companies to increase their investment by about $150 million over three years.

Source: Michael T. Jacobs and Anil Shivdasani, Do You Know Your Cost of Capital? Harvard Business Review, http://hbr.org/2012/07/do-you-know-your-cost-of-capital/ar/1.

Based on your understanding of the concept of cost of capital, which of the following statements are valid? Check all that apply.

-Companies always use the weighted average cost of capital (WACC) as the discount rate to analyze the financial viability of projects.

-A companys estimate of cost of capital impacts its application in the analysis of new investments that, consequently, affects the value of the firm and shareholders wealth.

-Investors care about the incremental value addition that new projects are making; they are least concerned with the discount rates that the company uses.

-Companies incorporate the required rate of return in the cost of capital to compensate investors for the components risks.

Happy Lion Manufacturing Inc. has two divisions: one is very risky, and the other exhibits significantly less risk. The company uses its investors overall required rate of return to evaluate its investment projects. It is most likely that the firm will become:

-Less risky over time, and its value will decrease

-Less risky over time, and its value will increase

-Riskier over time, and its value will increase

-Riskier over time, and its value will decrease

Which of the following statements is correct?

-A company needs to adjust the cost of debt for taxes, because interest payments are tax deductible.

-A firms after-tax cost of preferred stock may be significantly less than its before-tax cost, because issuing preferred stock dividends creates a tax shelter.

-The market value of a firms debt and equity will continuously change throughout the day, but the book value of debt and equity tends to stay more stable over time. Consequently, the firm should use the book-value weight to define its optimal capital structure.