You are comptroller for your company. The CEO is a savvy individual with great instincts for the business. She strongly favors an investment that is only marginally acceptable at best. She has asked...

1. Last year your company financed its investments by selling shares of common stock. This year the plan is to use debt. The after tax cost of debt is 5%, the cost of equity is 12% and the weighted average cost of capital is 9.5%. The first investment for this year is an expansion project. What cost of capital will you use and why?
Cost of capital plays vital role in project evaluation; basic purpose behind undertaking any project is to earn desired profit. Projects are evaluated to estimate whether a project is able to provide the desired rate of return to the investors or not. While evaluating project a rate of return is required to evaluate it, the best rate that should be considered to evaluate any project is its weighted average cost of capital i.e. WACC.
It is very important to understand the concept of cost of capital in order to determine the proper WACC, if any mistake occurs while determining the WACC then it will lead to a wrong decision of whether to accept or reject a particular project.
In the present case cost of capital that would be used to evaluate the first investment (expansion project) for this year would weighted average cost of capital (WACC). The reason why we choose the WACC as the cost of capital to evaluate the investment for this year is that, WACC can also be termed as average cost of capital or minimum cost of capital that the company should earn in order to pay the minimum required return on the capital employed.
2. The weighted average cost of capital can consist of debt, preferred stock and equity. Which of these sources is the most expensive and the least expensive and why?
There are various components of cost of capital which are as follows:-
· Cost of debt,
· Cost of equity,
· Cost of retained earnings,
· Cost of preferred share capital.
All of the above components together constitute the WACC. Weighted average cost of capital is determined by adding the weighted cost of equity, weighted cost of debt, weighted cost of preference stock and weighted cost of retained earnings. Among all the components of the cost of capital the most expensive source is the equity, the reason why the equity is most expensive source of finance is that the expectations of equity stock holder is very high as compared to any other stakeholder reason being that they bear the maximum risk among all the stakeholders, therefore there expectation is also very high which in turn lead to high cost of equity.
Whereas the least expensive source of finance is the debt, reason being they are given the first preference while distributing the interest payments, also they are paid prior to equity and...