Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because:
A) as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will not decrease.
B) returns below the cost of capital will cover all the fixed costs associated with the capital and provide excess returns to the firm's stockholders.
C) it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets.
D) it is an indication of the return the firm is expecting to earn in future from all of its expansion plans.
E) the weighted average cost of capital remains unchanged if the components costs of capital changes.

Question

Quizplus · Accepted Answer

The weighted average cost of capital is used as the firm's required rate of return because it represents the minimum rate of return that the firm must earn on its investments to maintain its current value. As long as the firm earns a return greater than the cost of capital, the value of the firm will not decrease. Therefore, A is the best choice. B is incorrect because returns below the cost of capital will not cover all fixed costs and will not provide excess returns to the firm's stockholders. C is incorrect because the weighted average cost of capital is not necessarily comparable to the average of all the interest rates on debt currently prevailing in the financial markets. D is incorrect because the weighted average cost of capital is not necessarily an indication of the return the firm is expecting to earn in the future from all of its expansion plans. E is incorrect because the weighted average cost of capital will change if the component costs of capital change.

Under Normal Circumstances, the Weighted Average Cost of Capital Is