Question

1. The Weighted Average Cost of Capital (WACC) is

a.  the rate at which a company’s future cash flows need to be discounted

b. to arrive at a present value for the business.

c. all of the above reflect the WACC

d. the value of a company equals the present value of its future cash flows

2.  Flotation Cost is

a. the cost for servicing equity capital

b. the cost for using debt capital

c. the cost for using retained earnings

d. the cost for raising the new capital

Answer 1

1. Weighted average cost of capital is the weighted average of the cost of the constituents of capital which can be devt, equity and preferred equity. The ratio in which they are present in the total capital forms the weight. It is the rate used for discounting future cash flow of the firm to give the present value and is used in capital budgeting to decide which project to invest in.

WACC =( %debt)*(Cost of debt)*(1-tax) + (%equity)*(Cost of equity) + (% prederred equity)*(Cost of preferred equity).

where, %debt = Total debt/Total capital and

Total Capital = Total ddebt+Total equity + Total preferred equity.

Similarly, % equity = Total equity/Total Capital

and % preferred equity = Total preferred equity/Total Capital

a. It is not the answer. It is correct that it is used to discount future cash flows if WACC is assumedd to remain the same in the future. But other options are also true.

b. It is not the answer. Yes, the discounting process yields the present value of the firm. But other options are also true.

c. Correct. Every option is correct about WACC. This is the answer thus.

d. It is not the answer. WACC when discounts the future cash flows it gives the present value of firm's business which is the present value of future cash flows as well. But other options are also true.

Thus, the answer is c.

2. Flotation costs is that cost which is incurred by the firm when it raises new miney through new debt or new equity.

a. Incorrect. Cost associated with raising new equity is the flotation cost.

b. Incorrect. Interest is the cost of using debt. Flotation cost is associated with issuing new securities.

c. Incorrect. Flotation costs is that cost which is incurred by the firm when it raises new miney through new debt or new equity.

d. Correct. The cost associated with raising new capital is flotation cost. It reflects legal, accounting, audit and other such related fees.

Thus, option d is correct.