Final answer:
The cost of capital in capital budgeting is influenced by the cost of acquiring funds, which includes interest rates, opportunity costs, and risk premiums. Option C
Step-by-step explanation:
The cost of capital used in capital budgeting is primarily a function of the cost of acquiring the funds that will be invested. This encompasses any interest rates associated with borrowing as well as the opportunity costs of using company funds instead of investing them elsewhere.
In capital budgeting, it is essential to select an interest rate that reflects both the return of other financial investment opportunities and an additional risk premium if the investment is deemed risky.
For example, if a firm can borrow at an interest rate of 9%, but it also has the potential to earn a return of 5% on social investments, the firm will effectively be operating at a 4% return. This determination of the cost of capital directly affects investment spending; lower interest rates generally stimulate spending while higher rates tend to reduce it.
In summary, the cost of capital considers factors beyond just the rate of interest, including the opportunity cost and a risk premium for particularly perilous investments. This comprehensive measure guides businesses in deciding how much to invest in capital projects. Option C