Chapter 11 Discussion Questions 11-1 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)? Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm l1-2 How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10? The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation 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? 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 11-4 Why is the cost of debt less than the cost of preferred stock if both securities are d to yield 10 percent in the market? Even though debt and preferred stock may be both priced to yield 10 percent in the market the cost of debt is less because the interest on debt is a tax deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate) l1-5 What are the two sources of equity(ownership) capital for the firm? The two sources of equity capital are retained earnings and ommon stock 11-6. Explain why retained Retained earnings belong to the existing common stockholders. If the funds paid out instead of reinvested, the stockholders could earn a return on them Thus, we say retaining funds for reinvestment carries an opportunity cost iby The McGraw-Hill CoCopyright © 2005 by The McGraw-Hill Companies, Inc. S-379 Chapter 11 Discussion Questions 11-1. 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)? Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm. 11-2. How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10? The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation. 11-3. 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? 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. 11-4. Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a tax￾deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate). 11-5. What are the two sources of equity (ownership) capital for the firm? The two sources of equity capital are retained earnings and new common stock. 11-6. Explain why retained earnings have an opportunity cost associated? Retained earnings belong to the existing common stockholders. If the funds are paid out instead of reinvested, the stockholders could earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost