CFA Level 1 Question of the Week – Corporate Finance

Question

When financing a new project by raising capital, in which of the following situations will a company most likely increase the value of its firm?

 	A. The value of the firm will increase when the return from the project is
positive.
 	B. The value of the firm will increase only when the weighted average cost
of capital (WACC) is greater than the return on the project.
 	C. The value of the firm will increase only when the return on the project
is greater than the weighted average cost of capital (WACC).

Matt_AnalystPrep · Answer

The correct answer is C.The WACC is considered as an opportunity cost for the firm. Therefore, a company can create value by producing returns that are greater than the cost of capital (WACC).Options B and C are incorrect because taking on projects whose returns are below the WACC will decrease the value of the firm. For example, a one-year project that would return 1% when the cost of capital is 10% would decrease the value of the firm.