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The importance of knowing a firm's cost of capital Summary Cost of capital In 2010 the Federal Reserve Board Based on your understanding of the concept of cost of capital, which of the following statements are valid? Check all that (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 apply. economy was still struggling, consumer Short-term debt such as accounts payable or short-term loans are not considered capital components Companies often finance their new prajects with capital spending remained low, and companies resisted in investing in new projects that would create value for their stakeholders. that comes from retained eamings. This also constitutes investor-supplied capital. Preferred stock is not taken into account when 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 considering the costs related to investor-supplied capital. Companies are financed by several sources of investor-supplied capital, which are called capital components. and add value to the firm would remain. The assumetions in the analvsis about Purple Lemon is considering investing in a project whose risk is greater than the firmm's current risk level based on any method for assessing risk. Which of the following should management do when evaluating this project? O To take the higher risk level Into account, they will need to use a discount rate that is greater than the cost of capital to evaluate the project O They should always reject the protect, because it will increase the firms risk level O To take the higher risk level into account, they will need to increase the IRR of the project would generate cash flows and returns and add value to the firm would components. remain. The assumotions in the analvsis about Purple Lemon is considering investing in a project whose risk is greater than the firm's current risk level based on any method for assessing risk. Which of the following should management do when evaluating this project? O To take the higher risk level into account, they will need to use a discount rate that is greater than the cost of capital to evaluate the project. O They should always reject the project, because it will increase the firm's risk level. To take the higher risk level into account, they will need to increase the IRR of the project. To take the higher risk level into account, they will need to increase the NPV of the project. Which of the following statements is correct? O A firm's after-tax cost of preferred stock may be significantly less than its before-tax cost, because issuing preferred stock dividends creates a tax shelter O A company needs to adjust the cost of debt for taxes,, because interest payments are tax deductible. O The market value of a firm's 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. yewN30.0 00-5Aol gh ee Cee ng n ee Orade it Now Save & Continue

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