Question

A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should undertake any investment that earns a return of at least 8% because such investments will enable the firm to pay debtholders what they desire, and any earnings above 8% will go to stockholders. If a firm decides to make investments based on this logic it will ________.

undertake investments that it should decline

decline to make investments that it should undertake

maximize its stock price

make only those investment decisions that increase shareholder value

none of these

Answer 1

ANSWER:

Correct answer is:

undertake investments that it should decline

Explanation:

Given:

Given that:

A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%).

The WACC of the firm will be higher than 8% and lower than 14% depending on weightages of debt and equity. If firm takes undertake any investment that earns a return of at least 8%, there is a possibility that the firm takes some projects that has rate of return less than WACC.

As such statement A is correct.

If there are possbilities of accepting projects that have rate of returns less than WACC, then it will have negative impact on shareholder value.

As such statement C, D and E are incorrect.