Lecture 8 - Risk and Cost of Capital

Question 1

Maximizing Shareholder Wealth and Opportunity
Cost

Answer 1

• Corporate objective: maximize shareholders’ wealth
• This entails achieving a return on invested capital that is greater than
  shareholders could obtain elsewhere with an equivalent-risk class
• They could opt to invest elsewhere with comparable risk, potentially yielding higher returns
• If alternative investments offer superior returns for the same risk level, it
  implies a loss of shareholder wealth by the management team

Question 2

Cost of Capital

Answer 2

• The company’s cost of capital is the opportunity cost of capital for an
  investment in all the firm’s assets and is the correct discount rate for its
  average-risk projects
• The cost of capital refers to the rate of return a company must offer
  investors to entice them to invest in and retain a security
• This rate is established based on the returns provided by other securities of similar risk levels

Question 3

Importance of accurate cost of capital in investment assessment

Answer 3

• It is important to use the correct cost of capital as a discount rate when assessing investment opportunities
• Overestimation of the cost of capital may lead to unnecessary constraints on investments, as potentially viable projects might be
  erroneously rejected
• Underestimation of the cost of capital could result in the undertaking of
  value-destructive investment ventures as projects may be mistakenly
  accepted