Which of the following statements is correct?
A)The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
B)The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.
C)One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are, in fact, not well diversified, beta might be a poor measure of the firm's true investment risk.
D)The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital.
E)The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost of preferred stock which is issued infrequently.

Question

Quizplus · Accepted Answer

The statement that one problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are not well diversified, beta might be a poor measure of the firm's true investment risk is correct. The other statements are incorrect. The cost of capital used to evaluate a project should be the weighted average cost of all types of financing used to fund that project (option A is incorrect). The cost of debt used to calculate the weighted average cost of capital is based on the current market value of the firm's outstanding debt or the cost of new debt, not an average (option B is incorrect). The bond-yield-plus-risk-premium approach may be one method of estimating the cost of equity capital, but it is not necessarily the most sophisticated or objective (option D is incorrect). The cost of equity capital is often more difficult to measure than the cost of debt or preferred stock, which may have fixed rates or dividends (option E is incorrect).

Which of the Following Statements Is Correct