Why do we use the overall cost of capital for investment decisions even when onl

Question

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

In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why?

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

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?

Explanation / Answer

Solution.

1. Because an investment financed by low-cost debt might be acceptable at first priority, the more use of debt may increase the overall firm risk and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm.

2. In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs.

3. Because stockholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return (K e ) serves as a means of approximating the opportunities for alternate investments.

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