Question

If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur? I) The firm will reject good low-risk projects; II) The firm will accept poor high-risk projects; III) The firm will correctly accept projects with average risk

Answer 1

I) The firm will reject good low-risk projects

II) The firm will accept poor high-risk projects

Step-by-step explanation:

Cost of Capital:

• The required return on the existing firm assets. It is based on the risk of assets.
• The risk of firm’s overall assets is equal to the weighted average risks of firm’s debt, preferred stock and common equity.
• The cost of capital of a firm equals the weighted average of the cost of debt, the cost of preferred stock, and the cost of common equity

Each project has different risk profiles, using one cost of capital for project evaluation might provide misleading results and the investor or company may end up accepting high risk projects or may reject low risk good projects.