(a) What is the cost of capital? What role does it play in making long term investment decisions? Why is the use of the firm's weighted average cost rather than the specific cost of a project recommended?

(b) Don Trader Ltd (DTL) is contemplating a new project, at a cost of $4 million and is estimated to have an internal rate of return (IRR) of 13.25%. Given the information below, should DTL undertake this new project?

i. The company's marginal tax rate is 30%.

ii. DTL just paid an ordinary share dividend of $0.185 and this dividend is expected to grow at a constant rate of 3% per year. The share price is currently $1.25. New shares can be sold at this price subject to issue costs of 15% of market value.

iii. DTL can issue new 12% preference shares, with a par value of $2.00. Issue costs would be $0.20 per share.

iv. DTL would issue new debt that has a $100 par (face) value with a coupon rate of 10%pa, paid semi-annually. The new issue would have issue costs of 3.5% of the estimated market value of $105. The debt would mature in 8 years.

v. There is $350,000 available in retained earnings.

vi. The optimal capital structure is Debt: 40% Preference shares: 10% Ordinary equity: 50%