The correct answer is: C. Both A and B
The cost of debt, $kd$, is the interest rate that a firm pays on its outstanding debt. The cost of equity, $kc$, is the rate of return that investors require on their investment in the firm’s equity.
In the case of a partially debt-financed firm, the cost of capital, $k0$, is the weighted average of the cost of debt and the cost of equity. This is because the firm’s debt and equity holders both have a claim on the firm’s cash flows, and the firm must pay a return to both groups of investors in order to attract their capital.
The cost of capital is a key concept in financial management, as it is used to evaluate investment projects and to determine the firm’s optimal capital structure.
Here is a brief explanation of each option:
- Option A: The cost of debt, $kd$, is the interest rate that a firm pays on its outstanding debt. The interest rate on debt is typically lower than the cost of equity, $kc$, because debt is a senior claim on the firm’s cash flows. This means that debt holders are paid first before equity holders, and they have a legal claim on the firm’s assets if the firm defaults on its debt.
- Option B: The cost of equity, $kc$, is the rate of return that investors require on their investment in the firm’s equity. The cost of equity is typically higher than the cost of debt, $kd$, because equity is a riskier investment than debt. This is because equity holders are the last to be paid in the event of a liquidation, and they have no legal claim on the firm’s assets.
- Option C: Both A and B. The cost of capital, $k0$, is the weighted average of the cost of debt and the cost of equity. This is because the firm’s debt and equity holders both have a claim on the firm’s cash flows, and the firm must pay a return to both groups of investors in order to attract their capital.
- Option D: None of the above. The cost of capital is not equal to the cost of debt or the cost of equity. It is the weighted average of the cost of debt and the cost of equity.