Cost of Capital: Understanding its Significance in Financial Analysis

The True Importance of Cost of Capital

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Question

Which of the following statements about the cost of capital is TRUE?

Answers

A. New common equity used to finance projects is usually dilutive.

B. The component cost of retained earnings equals the required rate of return on new stock.

C. Using the marginal cost of capital (MCC) is superior to the weighted average cost of capital (WACC) because the MCC assumes different risks across projects.

D. A firm can shift its retained earnings breakpoint by changing the dividend policy.

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Explanations

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A. B. C. D.

The firm can shift the break point of the MCC schedule by changing its payout ratio through the dividend policy. Remember that the dividend payout ratio is in the numerator of the calculation that dictates the breakpoint between lower cost internally generated equity (retained earnings) and higher cost externally generated equity (common stock).

The other choices are false. New common equity is not by definition dilutive. However, if the firm does not earn the cost of new common equity on the portion of the investment that is financed with the new issue, the firm's earnings per share will fall. The MCC is the cost of the last dollar raised by the company and assumes constant risk across projects. The component cost of retained earnings equals the required rate of return on existing stock.

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