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?

Answer 1

a) Overall cost of Capital is used even when only one source is used because the capital structure might change in the future during an investment whereas the practice of using only one cost of the particular thing might not change. To avoid any confusions , overall cost of capital is used.

b) Market values of debt and equity provide the best estimate of costs of debt and equity rather than historic costs. This is because to fund new projects, current costs based on market have to be used to source funds and thereby to determine the appropriate cost of capital.

c) Retained earnings are basically the income of equityholders whch they chose not to take out of the business. So , it is simply the same money as if newly invested by equityholders. Thus , the required rate of return on the Retained earnings should also be the same as  required rate of return on its common stock (Ke)

d) No, even if an investment is profitable, if it generates a return less than the cost of capital, doing the investment will return negative NPV and cause a loss to the business. It is better in such circumstances to return the amounts to respective stakeholders, prepaying the loan, giving out money in the form of dividends etc. However, if these options are not available, the company should invest in the best possible project.