ACCA Financial Management (F9) Certification Practice Exam

What does the cost of capital represent for a company?

1. The expense of operating capital

2. The expected return by investors on their investment

3. The total cash outflow for investments

4. The interest rate on borrowed funds

The correct answer is: The expected return by investors on their investment

The cost of capital represents the expected return by investors on their investment in a company. This concept is crucial for businesses, as it reflects the minimum return that the company must earn on its invested capital to satisfy its investors and maintain their confidence. Investors typically seek returns that compensate them for the risk they undertake when investing in a business, which includes equity holders and debt holders. When a company makes investment decisions, it uses the cost of capital as a benchmark to evaluate whether those investments will generate sufficient returns. If an investment is expected to yield returns greater than the cost of capital, it will likely increase the company's value and be considered a worthwhile endeavor. Conversely, if the returns are less than the cost of capital, the investment could diminish shareholder wealth. The other options do not accurately represent the concept of cost of capital. It is not merely an operational expense, nor is it the total cash flow out for investments, or solely the interest rate on borrowed funds. The cost of capital encompasses the overall expected return required by all capital providers, combining both cost of equity and cost of debt. This comprehensive perspective helps firms make informed decisions about financing and investment opportunities.