Cost of Capital

In accounting terms, we define the cost of capital as a company’s minimum estimation of returns that is essential for justifying the execution of a capital budgeting venture, such as installing a brand-new piece of capital equipment in the plant.

Investors are well acquainted with this term. Business analysts and consultants also deal with the cost of capital expenses. Despite this, it has always been a simple concept that determines whether a projected commercial decision is eligible to meet the minimum gain compared to its cost. Investors generally use this metric to determine an investment’s prospect with respect to its risks and expenses.

An alternative yet equivalent metric is considered for many brands that implement an amalgamation of equity and debt to financially stabilize their business growth. This has been identified as WACC or weighted average statistic of cost of capital. It measures the net returns that a company secures after successful business transactions. The underlying condition continues to be the same, i.e., the bar must justify the monetary expenses of any capital project.

The fundamental purpose of determining the cost of capital is to ensure the exact hurdle rate of a particular project or venture. The frontline managers must be informed well in advance by the directors about the minimum returns that are expected to be generated unless the project becomes a loss for the company. Exceeding this benchmark will garner a return on investment for the company which is the final desired output.

The end goal of the majority of the companies is to outgrow their present scope of operations. To achieve this, the directors and executives may consider many possible options such as growing an existing manufacturing unit, purchasing a similar production house either entirely or parts of it, and constructing a new factory that is supposedly equipped with better pieces of machinery and has even better manpower supply, etc. Before choosing any of the above-mentioned ways, the companies hire accountants to evaluate the exact cost of capital involved in all of the ventures. This procedure provides us with information regarding many crucial queries such as the estimated period required by a project to recover its initial costs and how efficient it is to generate a stable wholesome income for the company in the future. All of these data are forecasted information based on years of expertise in the accounting field. Although these are just mere estimates still it is essential for a corporate body to abide by any of the set methodologies before concluding its business growth plan.

Cost of Capital MCQs

1. How do we evaluate the committed dividend on preference shares that needs to be furnished by the company?

   1. By calculating the value of Kp which is possible through division of the selling price for each preference share. Here, the constant dividend per share acts as the divisor.
   2. Dividing the price for each preference share and then calculating the risk premium.
   3. Evaluating the value of Kp and then adding the economic growth rate.
   4. None of these

Answer. Option (A)

 2. Why do we always see that the price of share capital in equity is always more than the overall debt amount?

1. 1. This is because equity stakes are not readily sellable in the open market.
   2. Equity shares are not meant for providing a constant dividend rate.
   3. Debts are relatively safer than equity stakes.
   4.  There is a generalized opinion that equity offers lower face value compared to that debenture on the majority of occasions.

Answer. Option (C)

 3. What is meant by the cost of capital of a company?

1. 1.  It is the equity shares of the company that will provide variable rates of dividend over a set period.
   2. It is a metric that is inversely proportional to the overall pile of debts.
   3. It is the return on investment recorded against each fixed asset owned by the company.
   4. Cost of capital of a company is a stat that represents the internal return rates.

Answer. Option (C)

 4. Choose the factor(s) that can be internally controlled by a company to govern the cost of capital incurred over its assets.

1. 1. Capital structure targets
   2. Periodic debt service charges
   3. Policies designed specifically for investors
   4. None of the above options.

Answer. Option (D)

 5. Can you point out the statistic that is needless while calculating the price of cashable preference shares?

1. 1. Costs incurred by the firm while issuing new stocks, also referred to as the floatation costs.
   2. EPS or earnings generated in the form of profit dividend per share.
   3. Cost deduction or discount
   4. Past risk premium amount.

Answer. Option (B)

 6. How to describe marginal cost?

1. 1. Marginal cost can be described as the extra cost incurred due to the upbringing of an additional capital unit.
   2. Marginal cost is the extra capital re-allocations that are sanctioned by the firm for securing funds for successful operations.
   3. Weighted average cost that is intended to improve the financial stability of a brand.
   4. All of the above.

Answer. Option (A)

 7. Please identify which of the below-mentioned premium(s) is/are responsible for the gap between the present yield or output of treasury bonds & the estimated ROI on common stock.

1. 1. Expected premium – of the subtracted value obtained through dividend ratio and the difference cited in the long-run growth rate that is assessed for growth portfolios.
   2. Past risk premium – it is obtained by subtracting an investor’s return estimates upon an equity investment from the risk-free return rates.
   3. Current risk premium
   4. Both options (B) and (C).

Answer. Option (C)

 8. When we hear the term ‘cost of capital’ we reflect this opinion – “Minimum forecasted return on investment that has to be earned”. Choose the correct option that justifies this statement.

1. 1. The statement is false.
   2. It is applicable in some exceptional cases.
   3. It is a universally accepted truth in the field of accountancy.
   4. The statement does not make any sense to the readers.

Answer. Option (C)

 9. Which of the following statements is not applicable in relation to ‘cost of capital’?

1. 1. Rates of interest are determined successfully when we know the ‘cost of capital.
   2. Cost of capital forecasts the dividend rates of each investor.
   3. Cut-off rates can be chalked out by the top-level managers.
   4. Cost of capital is helpful to some extent in extending the money lending permissions that are required to own capital.

Answer. Option (C)

 10. In regards to the cost of capital, please figure out the incorrect proposition from the list given below.

1. 1. The retained profit margin does not include any of the company’s expenditures.
   2. Composite cost is defined as the additional value obtained by summing the price of equity and overall debts.
   3. As per traditional accounting theory, the cost of capital always gets related to the debt-equity mix.
   4. none.

Answer. Option (D)

 11. Can you point out the metric which is not required at the time of evaluation of the cost of equity in equity capital?

1. 1. Equity market capitalization – this is an aggregate value that expresses the entire valuation of the equity market.
   2. Dividend growth rate – an annualized percentage value that expresses the margin by which a stock’s dividend grows or reduces over a certain time.
   3. CAPM is also referred to as the pricing model for capital assets. This is the strategic risk factor between stocks and returns expected per asset.
   4. External yield surface

Answer. Option (D)

 12.What do we understand by the abbreviation “RADR”?

1. 1. RADR is described as the total price of capital and risk premium.
   2. It is an indicator that directs the executives to accept a growth project if IRR comes out to be greater compared to the value of RADR.
   3. This indicator allows project execution if the net present value at RADR appears to be negative.
   4. None of the options are right.

Answer. Option (A)

 13. A company expects a minimum return rate upon the successful launch of a venture. This is essential to satisfy the interests of active investors. What is this minimum return on investment called in accountancy terms?

1. 1. Equity
   2. Average cost generated through the borrowing of assets
   3. Weighted Average Capital Cost
   4. Net ratio of profit

Answer. Option (C)

These are a few MCQs that have been discussed with the intention of answering a few frequently asked questions related to the cost of capital. Learning them by heart will help examinees score brilliantly in their exams.