Answer the following questions in your own words: Why do we use the overall cost

Question

Answer the following questions in your own words:

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

Ans.

a) Consistency: If each investment was judged against the specific type of financing used to implement it, investment selection decisions would be inconsistent. It is best to average the rate of the different methods (debt, stock) to find out if the combination is acceptable.. This also wouldn’t give us the full picture, because debt might be acceptable in the short term but not in the long run for the firm.

b)

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

c)The cost of equity is the maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock.’ The cost of equity capital is function of the expected return by its investors. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every year. Moreover, payment of dividend is not a legal binding. It may or may not be paid. But it does not mean that equity share capital is a cost free capital. Retained earnings dos have implications of funds for share holders of the firm.

d) The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying for debt, any cash left over that is not returned to shareholders in the form of dividends is kept in the bag on behalf of shareholders. If debt holders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.

If the only money the bag held was $50 from debt holders and $50 from shareholders, and the company invested $100 in a project, to meet expectations the project would have to return $5 a year to debt holders and $10 a year to shareholders. This would require a total return of $15 a year, or a 15% WACC.

For example:- Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company's return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

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