You are to assume that a firm’s cost of capital is 10%. Using this information, what are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk projects. Based on your knowledge about this subject, I should have an estimated cost of capital for each of these 3 projects.
You are wasting your time here, and ours. This question has been answered twice
Then point me in the right direction and I will gladly quit "wasting" your time. Please.
This is a poorly written question.
It states that a firm's cost of capital is 10%. That is, it pays 10% for borrowing money.
Why, then, does the question asks for "reasonable costs of capital" depending upon the risk involved?
As a borrower, the firm may be willing to pay a higher cost for a low risk investment, such as a mortgage on a building in a thriving market. But, if gambling upon a risky project, the firm's directors may not be willing to borrow money unless at a low cost.
Please check with your instructor about this question. Also check your text materials, remembering that the question states, "Based on your knowledge about this subject . . .
I refer you to: http://www.jiskha.com/display.cgi?id=1201901472
10%, 10% and 10% is my answer.
Regardless of the risk of a project, that is the actual market interest rate for that company, according your statement of the problem. It is the prospective reasonableness (risk/reward) of the PROJECT, not the "reasonable" interest rate (capital cost), that needs to be be evaluated.
To determine the reasonable costs of capital for each project, we need to consider the risk associated with each project. Generally, higher-risk projects require a higher cost of capital, while lower-risk projects require a lower cost of capital.
1. Average-risk projects: As the baseline, average-risk projects are typically evaluated at the firm's overall cost of capital of 10%. This is because they carry a moderate level of risk comparable to the firm's overall risk profile.
2. High-risk projects: High-risk projects have a greater chance of failure or generating lower-than-expected returns. To adjust for this increased risk, the cost of capital for high-risk projects is generally higher than the firm's overall cost of capital. A reasonable estimate for high-risk projects could be 12-15% or even higher, depending on the specific risk characteristics of the project.
3. Low-risk projects: Conversely, low-risk projects have a higher chance of success or generating higher-than-expected returns. Therefore, the cost of capital for low-risk projects is generally lower than the firm's overall cost of capital. A reasonable estimate for low-risk projects could be around 8-9% or even lower, depending on the specific risk profile of the project.
It's important to note that these estimates are subjective and can vary depending on the industry, market conditions, and specific project details. It is recommended to consult with financial professionals or conduct a thorough risk assessment to obtain more accurate cost of capital estimates for each project.