11-7 Why is the cost of retained earnings the equivalent of the firms own required rate of return on common stock (Ke)? Because stockholders can earn a return at least equal to their present investment. For this reason, the firm s rate of return(Ke) serves as a means of approximating the opportunities for alternate investments 11-8. Why is the cost of issuing new common stock(Kn) higher than the cost of retained earnings(Ke)? In issuing new common we must earn a slightly higher return than the normal cost of common in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher l1-9 How are the weights determined to arrive at the optimal weighted average cost The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights l1-10 Explain the trad itional, U-shaped approach to the cost of capital The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped l1-11 It has often been said that if the company can,'t earn a rate of return greater than the cost of capital it should not make investments. Explain If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm,s operations and will lower the overall wealth of the shareholder Clearly, it is undesirable to invest in a project yield ing 8 percent if the financing cost is 10 percent CopyrightC 2005 by The McGray-Hill Companies, Inc.Copyright © 2005 by The McGraw-Hill Companies, Inc. S-380 11-7. Why is the cost of retained earnings the equivalent of the firm's own required rate of return on common stock (Ke)? Because stockholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return (Ke) serves as a means of approximating the opportunities for alternate investments. 11-8. Why is the cost of issuing new common stock (Kn) higher than the cost of retained earnings (Ke)? In issuing new common stock, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher. 11-9. How are the weights determined to arrive at the optimal weighted average cost of capital? The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights. 11-10. Explain the traditional, U-shaped approach to the cost of capital. The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped. 11-11. It has often been said that if the company can't earn a rate of return greater than the cost of capital it should not make investments. Explain. If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm's operations and will lower the overall wealth of the shareholders. Clearly, it is undesirable to invest in a project yielding 8 percent if the financing cost is 10 percent