Question

Explain the concept of cost of capital? Do you believe that a firm should use the same cost of capital for all of its projects? Why or why not?

Answer 1

Cost of capital means that the cost which has been incurred by the business in order to run the business and make a rate of return.

Cost of capital is a weighted average cost of various capital components that can be combination of equity capital or preference capital or debt capital and it is the rate of return that must be received by the firm on its investment projects for attracting various group of investors for investing capital in the firm and increasing the market value.

it is defined as a hurdle rate which company must be achieving in order to breakeven for various kinds of investment into projects & this is calculated after assignment of weights to different form of capital and then cost of capital is arrived and it is also to be adjusted with various risk exposures

No, Firm shouldn't use the same cost of capital because different projects will have specific factors to consider and they will have different risk exposures and they will be financed by different form of capital structure so, they are to be discounted with specific discount rate that is associated with there is specific operations and they should not be discounted with the single rate of discounting which is the firm rate of discounting.

So, the firm should not be using similar cost of capital for different projects as it would lead to bad selection of different projects.