Corporate Finance, Module 18: Weighted Average Cost of Capital

Illustrative Test Questions

(The attached PDF file has better formatting.)

Question 18.1: WACC

Which of the following statements about weighted average cost of capital (WACC) is true?

A.    The WACC provides a good evaluation measure for a capital budgeting project that is safer than other projects of the firm.
B.    One purpose of the WACC is to adjust the cost of equity by the appropriate tax rate.
C.    The WACC provides the correct discount rate only for projects with business risks similar to those of the existing assets of the firm.
D.    The WACC provides the correct discount rate only for projects whose capital needs are provided by the same percentage of debt as the other projects of the firm.
E.    If a company issues additional debt, the increased leverage causes the WACC to rise.

Answer 18.1:

Statement A: The applies only to projects that are similar to the firm.

Statement B: The cost of debt capital (not equity capital) is adjusted by the tax rate.

Statement C: The WACC is the firm’s cost of capital; it applies only to projects that are similar in risk to the existing activities of the firm.

Statement D: The actual borrowing for each project is not relevant. Only the risk of the project is relevant, or the optimal debt-equity ratio for the project.

Statement E: If the value of the tax shield is greater than the increased cost of bankruptcy, the increased leverage causes the WACC to decline.