Question

Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

Answer 1

Answer:

b. If a company assigns the same cost of capital to all of it's projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

Explanation:

Every project under consideration has it's own risk and rewards and likewise differ in respect to expected cash flows and associated costs. For example, in case of a lessee deciding to borrow from a bank and buying an asset would use cost of debt as his cost of capital.

Similarly, a lessor who leases assets would evaluate his leasing projects based upon his overall cost of capital owing to the fact, he may have financed those assets from multiple sources such as equity, debt or retained profits.

Thus, to reflect the true viability of undertaking a project, an appropriate cost of capital is to be applied. Since if a common cost of capital is applied to all projects, that would lead to inaccurate results and could result into bad decision making.