Question

Question: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)? (LO11-1)

Short answer

Answer

The overall cost of capital is used for investment decisions as debt is a much riskier option of raising funds.

Step-by-step solution

Definition of investment

Investment is a process of setting aside money in the form of assets to earn periodic income or to accumulate fund for future.

Reason why the cost of debt is less than the cost of preferred stock.

The business uses the overall cost of capital for investment decisions even though investment is usually financed by low-cost debt because it might appear very acceptable at first look. But, on the other hand, the use of debt could increase the risk to the firm. So, each project must be measured against the overall cost of funds to the firm.