Question

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.

Short answer

Cost of capital represents the minimum required rate of return that a project or investmentmust generate to cover the expenses of the project or investment.

Step-by-step solution

Definition of Capital structure

Capital structure can be defined as the proportion of the debt and equity elements present in the capital of the business entity. The business entity uses the debt-to-equity ratio to determine the risk associated with capital borrowings.

Comparison of cost of capital and rate of return

An investment whose rate of return is lower than the cost of capital must not be accepted because in such case the return from the investment will not be able to cover the cost of financing. This will negatively affect the business operations and the overall wealth of the shareholders will reduce.