uo he use the belail Cost of capital for investment de Question: Why do we use t
ID: 2592083 • Letter: U
Question
uo he use the belail Cost of capital for investment de Question: Why do we use the overall cost of capital for investmek 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 fess than its cost of capital, but it will still generate a profit, should it make the investment? Why or why not?
Explanation / Answer
1) Cost of capital of each source is different so the investments based on each cost of capital will be different that may result in inconsistency. Also, investment decisions based on cost of capital will be commensurate with the minimum growth rate acceptable of company.
2) Current costs for computing cost of capital is most relevant as the money in the new project will be invested now.
3) Retained earnings is the amount available with the company which is not paid to shareholders as dividend. So, cost of equity is considered as cost of retained earnings.
4) No. It should not make investment as it will result in reduction in valuation of the company.
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