Question

A company's overall cost of capital is a. equal to its cost debt. b. a weighted average of the costs of capital for the collection of individual projects that the company is working on. c. best measured by the cost of capital of the riskiest projects that the company is working on. d. none of the above

Answer 1

The cost of capital of a company refers to the total cost (interest) of raising additional capital. The cost of capital depends on the capital structure, i.e. how much debt and equity the company's balance sheet contains.

a. Cost of capital depends on both the cost of debt and equity, hence this option is wrong

c. If a company simply takes the cost of capital of riskiest projects, it could end up raising the cost of capital. In this case, even a very small but risky project will overpower the riskless high cash inflow project. Hence, simply taking cost of capital of riskiest projects is not a good idea.

b. If all projects are considered, this will make better sense to overall cost of capital. So both low risk and risky projects with weighted average costs can contribute to a cost of capital that will reflect a more fair condition of the company. Hence, the overall cost of capital is weighted average of cost of capital for the collection of individual projects.

Answer B