1. When talking about cost of capital, it is said that required return is the sa

Question

1. When talking about cost of capital, it is said that required return is the same than cost of capital. How's that (one is return and the other one is cost)?
2. If a company's D/E equity ratio is 1/2, what are the corresponding weights for Debt and Equity?
3. Dividends....would you prefer your stocks to pay dividends or would you rather earnings are reinvested into the company? Why?
4. Why are taxes are applied to cost of debt (to get after-tax cost of debt) but taxes are not applied to cost of equity?

Explanation / Answer

1)Required rate of return and Cost of Capital are same.

It is Return for Capital Providers (i.e COmmon Stock HOlders, Prefrered StockHolders , Debt Holders) and it is Cost for the Company.

..

2)If Company's D/E ratio = 1/2

Weight for Debt = 1/(1+2)

= 33.33%

Weight of Equity = 2/(1+2)

= 66.67%

..

..

3)Its depends upon Return on Investment(ROI) and Required rate of retrurn(Re)

IF , ROI > Re = No Dividend

IF, ROI = Re = indifferenr

IF, ROI < RE = Dividend

..

..

4)Becuase interest on Debt is a tax deductible expense whereas Dividend paid to Common Stockholders are an Appropriation of Profits and not an expenditure.

So , taxes are applied to cost of debt (to get after-tax cost of debt) but taxes are not applied to cost of equity.

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