Question

Assertion :Weighed average cost of capital should be used as a hurdle rate for accepting or rejecting a capital budgeting proposal. Reason: It is because by financing in the proportions specified and accepting the project, yielding more than the weighed average required return, the firm is able to increase the market price of its stock.

• A. Both Assertion and Reason are correct and Reason is the correct explanation for Assertion
• B. Both Assertion and Reason are correct but Reason is not the correct explanation for Assertion
• C. Assertion is correct but Reason is incorrect
• D. Both Assertion and Reason are incorrect

Answer 1

The correct option is B Both Assertion and Reason are correct but Reason is not the correct explanation for Assertion

Most companies use their weighted average cost of capital as a hurdle rate for investments. This stems from the fact that companies can buy back their own shares as an alternative to making a new investment, and would presumably earn their weighted average cost of capital as the rate of return. In this way, investing in their own earnings represents the opportunity cost of any alternative investment.

Another way of looking at weighted average cost of capital is that it’s the required rate of return that the investors demand from the company. Therefore, any project the company invests in must equal to it’s cost of capital.