Question

1.) Why do is the overall cost of capital used for investment decisions even when only one source of capital will be used (e.g., debt)?

2.) In computing the cost of capital, are the historical costs of existing debt and equity or the current costs as determined in the market used? Why?

3.) Why is the cost of retained earnings equal to the firm's required rate of return on its common stock (Ke)?

4.) If the company has the opportunity to earn a rate of return less than its cost of capital, but it will still generate a profit, should it make the investment? Why or why not?

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Answer 1

Solution a) The presence of one source of capital can have an impact on the riskiness of other sources of capital. This could increase the overall riskiness of the firm and would increase the overall cost of capital for the firm. Thus, it is important to consider the overall effect on the capital structure of the firm.

Solution b) In computing the cost of capital, the current costs of existing debt and equity are used as to calculate the weighted average cost of capital as it is based on marginal costs.

Solution c) Since retained earnings are also the form of equity invested by the shareholders in the company, thus, the cost of retained earnings is equal to the required rate of return on its common stock. Using retained earnings is similar to new investment made by the shareholders in the company.

Solution d) If the company is earning a rate of return less than the company's opportunity cost of capital then even if the company is making an accounting profit but it would be an economic loss. When the company's rate of return is less than the opportunity cost of capital then the Net Present Value of the project would be negative. Hence, the investment would not be accepted. Moreover, opportunity cost of capital represents the return shareholders can earn on other alternative projects. Hence, if the rate of return is less than the opportunity cost of capital, then, it would be better for shareholders to invest in other alternatives and earn a greater return.