Question

Which of the following is false regarding a firm's cost of capital?

A: It is used to calculate the NPV on a firm's projects.

B: It considers the proportion of each component in a firm's capital structure.

C: It should be lower than the investor's required rate of return.

D: It is measured using current market values.

Why should stock market investors ignore diversifiable risks when calculating the required rates of return?

A: Diversifiable risk cannot be accurately quantified.

B: Beta includes a component to compensate for the diversifiable risk.

C: Diversifiable risk can be eliminated.

D: The market risk premium compensates investors for diversifiable risk.

Answer 1

Firms cost of capital is Expected return.

When the required rate of return is higher than the expected rate of return. The stock doesn't satisfy the investor and destroys his value.

Buy the stock when: expected return - required rate of return= positive.

Otherwise, don't buy.

So firms cost of capital should be ideally higher than the investor's required rate of return.

The answer is C. It should be lower than the investor's required rate of return.

2nd:

When some risk can be eliminated, then why should someone (Stock/security/portfolio/Market) compensate for it?

Diversifiable risk can be eliminated, As it can be eliminated there is no value of holding that risk.

Thus no return expected from it.

The answer is C: Diversifiable risk can be eliminated.