costs of capital National Leasing is evaluating the cost of capital to use in it

Question

costs of capital National Leasing is evaluating the cost of capital to use in its
capital budgeting process. Over the recent past, the company has averaged a return on equity of 12%
and a return on investment of 9%. The company can currently borrow short term money for 6%

a. Which of the preceding rate is most relevant to deciding the cost of capital to use? Explain your
answer


b., Without prejudice toyour answer to part a. explain why the company might choose to use a
cost of capital of 13% to evaluate capital expenditure opportunities.

Explanation / Answer

a. return on equity of 12% is most relevant to deciding the cost of capital to use. This is because this is the maximum cost of capital the company will have without leverage. Adding debt will only decrease this further due to tax shield. b.The company might choose to use a cost of capital of 13% to evaluate capital expenditure opportunities to be more conservative and evaluate the worst case scenario.

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