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.

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

• Short-term debt such as accounts payable or short-term loans are not considered capital components.
• 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.
• Companies often finance their new projects with capital that comes from retained earnings. This also constitutes investor-supplied capital.

Purple Lemon Fruit Company 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 increase
• Less risky over time, and its value will decrease
• Riskier over time, and its value will increase
• Riskier over time, and its value will decrease

Which of the following statements is correct?

• When all other factors are held constant, a higher tax rate will lower a firms weighted average cost of capital only if the firm uses debt financing.
• 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.
• If a firm wants to lower its cost of debt, it can simply issue debt with a lower coupon rate.