Which condition indicates a good investment when comparing cost of capital to ROA?

• A. Cost of capital is below ROA
• B. ROA is below cost of capital
• C. ROA equals cost of capital
• D. Cost of capital is below ROA and ROA is negative

Answer: (A)

The key idea here is that you judge a project by comparing what the assets earn to what the firm must pay to finance them. Return on assets measures how much income the assets generate relative to their size, while the cost of capital is the minimum return the firm needs to satisfy its investors.

When the return on assets exceeds the cost of capital, the asset is earning more than what the firm has to pay for the financing used to acquire or operate it. That positive spread means value is being created for shareholders (economic value added is positive, and the project typically has a positive NPV under normal assumptions). That’s why the best condition is that the cost of capital is below the ROA.

If ROA were below the cost of capital, the project would be destroying value because it doesn’t cover the financing cost. If ROA equals cost of capital, you’re at a break-even point with no value creation. If ROA is negative, you’re losing money on the assets, which is not a good sign even if the financing cost is low.