Question

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision? Answer a. Amount of debt used to finance the projectb. Use, or lack thereof, of preferred stock to finance the projectc. Mix of funds used to finance the projectd. Risk level of the projecte. Length of the project's life

Answer 1

Answer:

c. Mix of funds used to finance the project.

Explanation:

Most of the time businesses don't have the required funds to invest in projects especially capital intensive projects. So businesses raise long term finance from various sources, for example, from capital markets through issuance of shares/stocks and from debt sources through raising long term loans and debt instruments like bonds.

Now each source of finance has a different cost to the business depending upon the likely risks associated with each source of finance and nature of business itself. Therefore, businesses strive to assign such a cost of capital that primarily recovers the cost of finance and generate surplus wealth for the business. So the decision of what cost of capital should be assigned to a project primarily depends upon the the mix of funds used.

Secondly, risk level of the project might somehow effect the required rate of return expected by shareholders and/or debt providers but may not be the primary consideration in this decision.