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. The weighted average cost of capital (WACC) is considered the overall rate expected to generate required returns for investors, but companies do not use it while discounting project cash flows. The company's weighted average cost of capital (WACC) incorporates the required rates of return that investors expect as a compensation for the risk. Companies have free cash flow that is available for distribution, and investors expect to earn a certain required rate of return if it is invested. The required rate of return for long-term debt capital funding is incorporated separately in project analysis, because it is not included in the weighted average cost of capital (WACC). Warm Duck Brewing 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: O Less risky over time, and its value will decrease Riskier over time, and its value will increase O Riskier over time, and its value will decrease O Less risky over time, and its value will increase Which of the following statements is correct? O A company needs to adjust the cost of debt for taxes, because interest payments are tax deductible. The cost of raising funds from retained earnings is usually a lot cheaper than the cost of debt financing, because the firm already possesses the funds in retained earnings. If a firm wants to lower its cost of debt, it can simply issue debt with a lower coupon rate. Based on your understanding of the concept of cost of capital, which of the following statements are valid? Check all that apply. The weighted average cost of capital (WACC) is considered the overall rate expected to generate required returns for investors, but companies do not use it while discounting project cash flows. The company's weighted average cost of capital (WACC) incorporates the required rates of return that investors expect as a compensation for the risk. Companies have free cash flow that is available for distribution, and investors expect to earn a certain required rate of return if it is invested. The required rate of return for long-term debt capital funding is incorporated separately in project analysis, because it is not included in the weighted average cost of capital (WACC). Warm Duck Brewing 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: O Less risky over time, and its value will decrease Riskier over time, and its value will increase O Riskier over time, and its value will decrease O Less risky over time, and its value will increase Which of the following statements is correct? O A company needs to adjust the cost of debt for taxes, because interest payments are tax deductible. The cost of raising funds from retained earnings is usually a lot cheaper than the cost of debt financing, because the firm already possesses the funds in retained earnings. If a firm wants to lower its cost of debt, it can simply issue debt with a lower coupon rate
