The correct answer is D. All of the above.
Depreciation-generated funds do have a cost, because they are a tax shield that reduces the amount of taxes a company pays. This means that the after-tax cost of debt is lower than the pre-tax cost of debt.
Cost of capital is not low if a project is heavily debt-financed. This is because the risk of a project increases with the amount of debt financing. This means that the cost of equity will also increase, which will increase the overall cost of capital.
Cost of equity is not equal to the dividend rate. This is because the dividend rate is only one component of the cost of equity. The other components are the risk-free rate, the market risk premium, and the company’s beta.
Here is a more detailed explanation of each option:
- Option A: Depreciation-generated funds have no cost.
This is a common misconception because depreciation is a non-cash expense. However, depreciation does have a cost, because it is a tax shield that reduces the amount of taxes a company pays. This means that the after-tax cost of debt is lower than the pre-tax cost of debt.
For example, let’s say a company has a debt of $100 million and a tax rate of 21%. The pre-tax cost of debt is 5%. This means that the company pays $5 million in interest each year. However, because of depreciation, the company’s tax bill is reduced by $2.1 million. This means that the after-tax cost of debt is only 3.4%.
- Option B: Cost of capital is low if a project is heavily debt-financed.
This is also a common misconception. Cost of capital is not low if a project is heavily debt-financed. This is because the risk of a project increases with the amount of debt financing. This means that the cost of equity will also increase, which will increase the overall cost of capital.
For example, let’s say a company has a project that costs $100 million. The company has a debt-to-equity ratio of 1:1. This means that the company will finance the project with $50 million in debt and $50 million in equity.
The cost of debt is 5% and the cost of equity is 10%. This means that the company’s overall cost of capital is 7.5%.
However, if the company had a debt-to-equity ratio of 2:1, the company would finance the project with $75 million in debt and $25 million in equity. The cost of debt would still be 5%, but the cost of equity would be 15%. This means that the company’s overall cost of capital would be 10.5%.
- Option C: Cost of equity is equal to the dividend rate.
This is also a common misconception. Cost of equity is not equal to the dividend rate. This is because the dividend rate is only one component of the cost of equity. The other components are the risk-free rate, the market risk premium, and the company’s beta.
The risk-free rate is the rate of return on a risk-free investment, such as a Treasury bill. The market risk premium is the additional return that investors demand for investing in risky assets, such as stocks. The company’s beta is a measure of the company’s volatility relative to the market.
The cost of equity is calculated using the following formula:
Cost of equity = risk-free rate + market risk premium * beta
For example, let’s say a company has a risk-free rate of 2%, a market risk premium of 5%, and a beta of 1.2. This means that the company’s cost of equity is 8.4%.
In conclusion, all of the options are common misconceptions about cost of capital. Depreciation-generated funds do have a cost, cost of capital is not low if a project is heavily debt-financed, and cost of equity is not equal to the dividend rate.