CFA Practice Question

There are 233 practice questions for this study session.

CFA Practice Question

Which of the following statements is true?

A. If a firm is entirely financed with equity, the cost of capital cannot be calculated.
B. The cost of capital of an investment project must reflect the average cost of the various sources of long-term funds used by the firm.
C. The cost of capital of an investment project must reflect the average cost of the various sources of long-term funds used by the project.
D. The cost of capital of an investment project must reflect the average cost of the various sources of long-term debt used by the firm.
Correct Answer: B

The firm has to be viewed as a going concern. Its financing decisions affect the future cost of capital. Therefore, the right measure of cost of capital is the weighted average of the various types of funds the firm normally uses.

User Contributed Comments 18

User Comment
vincenthuang I thought C is the better answer because the hurdle rate reflect the risk of this project.
tony1973 It has to use the firm's average cost of capital, not the project's.
rockeR why? what if the investment project is not carbon copy of the business??
Plz Explain me why answer c is wrong answer.
melissatt I think (B) is the correct answer because, for example, the company uses all debt financing available for project X. This means that in the future, if a new project Y, is extremely profitable, the company may not be able to go ahead with it because project X has already taken up all the debt financing the firm can have. So, the financing decisions of any one project, be it identical or unique projects, would affect the firm's cost of capital as a whole.
kulla Even I think C is the correct answer. What if the project has drastically different risks as compared to that of the firm, then one would have to use the project WACC and not the company WACC.
FAR57 I think B is the right answer because various funds are pooled and new projects are financed from the same pool ie same WACC.
thedeuce i think b is correct because the projects wacc might be lower then the firms wacc and might lead to the wrong decision
mtcfa My head is spinning from what I thought was an easy question. I originally thought B, but according to the book and notes
JP09 WACC used the firm's cost of capital. You have to look at it from a long term perspective.

If Project A generates funds by using new bonds (lowest WACC) it will may look like a very attractive project. However by issuing bonds this time when the nexy project becomes available you may not be able to issue bonds and therefor pass on even better project than the 1st on because of the new higher WACC. If you use the firm's WACC for all projects you eliminate this problem and ensure that you are comparing projects fairly.
sarath Good Explanation...
smillis So then when, if ever, do you use the project risk return?
Nightsurfer When you evaluate a project's NPV you use a risk-adjusted discount factor. Thus, in the initial screening (ranking of IRRs and NPVs) you filter out the good from the bad as well as address discrepencies between NPV and IRR conclusions.
missmalik I thought its B. But A was confusing me. It a company is financing based on equity. There is no need to calculate the cost. Later I realized its one of the sourses of financing which we use to calculate WACC. And I sellect B as my answer.
NavdeepS I think C is the right answer, because the firm's WACC is an average for all projects and doesnt reflect the actual risk of a project. WACC should be revised upwards or downwrds as per the project risk.
kutta2102 The question is asking for what should be 'reflected' in cost of capital for an investment project. Imagine yourself to be in the shoes of the management trying to prepare an IOS - at the planning stage, you only know the firm's target capital structure. There's really no way to assign specific type of financing to a specific investment project. In fact, the only rate with which the NPV can be calculated, for apples to apples comparison, is the WACC. Therefore, it's logical that B is the only correct answer.
abhinavkapoor if a company is completely financed with equity, how do we determine the cost of capital. Can somebody please explain?
johntan1979 B - don't think too much. Simple question.
elmagico10 Please check answer of question 18 from reading 36. You have to use D/E from the project. That means that C is correct?
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