Question

The cost of capital used to compute the present value of a project should be the rate that can be earned on:

Answer 1

Answer:

the questions are missing:

• a. a financial asset of comparable risk.
• b. the overall market portfolio.
• c.the sponsoring firm's return on equity.
• d. a riskless asset with a similar life span.
• e. the sponsoring firm's return on assets.

The answer is:

a. a financial asset of comparable risk.

The cost of capital (Re) represents the opportunity cost of investing in a certain project and leaving behind other alternative projects. E.g. if we can invest in two different securities, A or B, and security A has a much lower risk than project B, then the Re or discount factor for calculating the present value of project A will be lower than the discount factor used to determine the present value of project B.

A corporation that has a diversified investment portfolio, uses different costs of capital when analyzing potential investments, e.g. investing in Swiss securities is not the same as investing in Argentinean securities, since Argentina is currently facing a great recession and has recently defaulted again on its national debt (third time in 20 years).

Answer 2

The cost of capital that should be used on a project should be the return on  a financial asset of comparable risk.

Cost of capital:

• Is the rate of return that a project should bring in
• Is the opportunity cost of investing in the project in question

When a project is invested in, it means that other projects will be foregone. These projects would have been similar to the current project in terms of risk yet this current project was chose. The cost of capital should therefore reflect this opportunity cost by being the return on those projects.

In conclusion, the cost of capital is an opportunity cost.

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