Question

1 - Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm's debt and equity? Assume that you are an outsider to the firm

2 - Your friend has recently told you that the federal government effectively subsidizes the use of debt financing (vs. equity financing) for corporations. Do you agree with that statement? Explain.

3 - Your boss just finished computing your firm's weighted average cost of capital. He is relieved because he says that he can now use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate that statement.

please answer/ explain the following questions

Answer 1

1). As an outsider, finding the return on debt and equity is much easier than finding the return on assets for a firm. This is so because information about cash flows pertaining to all assets of the firm will not be available to outsiders. However, as far as financing of the firm is concerned, the market will have an estimate about the cash flows from financing (ie, debt and equity).

2). The interest paid on debt is tax deductible. In that sense, the government does subsidize debt financing as this tax shield lowers the effective cost of debt as compared to financing from equity.

3). The firm's weighted average cost of capital (WACC) can be used as the cost of capital for projects of the firm only if they have the same risk as the firm. If the projects are more or less risky than the firm, then WACC will have to be suitably adjusted otherwise, one may end up overvaluing or undervaluing the projects.