Multiple Choice
Which term refers to the earning potential of money over time?
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10. Time Value of Money
Time Value of Money Equations
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Which of the following best completes the statement: 'The cost of _____ can be observed because it is the interest rate the firm must pay on new loans.'?
A
retained earnings
B
debt
C
preferred stock
D
equity
Verified step by step guidance1
Understand the concept of 'cost of capital': In financial accounting, the cost of capital refers to the cost a company incurs to finance its operations, typically through debt, equity, or other financial instruments.
Focus on the term 'interest rate': The problem mentions the interest rate, which is specifically associated with borrowing money through debt. Interest is the cost paid to lenders for using their funds.
Eliminate irrelevant options: Retained earnings, preferred stock, and equity do not involve an interest rate. Retained earnings are internal funds, preferred stock involves dividends, and equity involves returns to shareholders.
Identify the correct option: Debt is the only financing method listed that incurs an interest rate, which is observable and represents the cost of borrowing.
Conclude that the correct completion of the statement is 'debt,' as it directly relates to the interest rate the firm must pay on new loans.
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