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    helpme 83's Avatar
    helpme 83 Posts: 2, Reputation: 1
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    #1

    Apr 11, 2007, 08:39 AM
    Cost of capital
    I have a couple questions on my finance homework that I need help with -

    1. 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?


    2. It has often said that if the company can't earn a rate of return greater than the cost of capital it should not make investments. Explain?

    I have searched the internet as well as my book can't find then anywhere.
    goldenbutterfly's Avatar
    goldenbutterfly Posts: 63, Reputation: 8
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    #2

    Apr 12, 2007, 05:32 AM
    1. Cost of debt is cheaper that cost of preferred stock because you do not put any of your own money in debt.

    If, let's say, you loan $5M to buy a piece of property and pay 10% in interest and earn $50000 a month renting it out. Each month, you get a net of interest of $8,333. With $0 investment, your rate of return is practically infinity compared to only 10% from preferred stocks investment.

    2. If you can get a rate of return higher than your cost of capital, do not proceed with the project unless you foresee far higher returns in the future.

    If you loan the money to start a project that asks for 10% interest annually but you only earn 8% from the project, there is no point in pushing through with it.
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