: The Cost of Capital

Issue #1 When raising external funds from debt, preference shares, and ordinary shares, it is likely that the firm will incur significant transaction costs in addition to the direct interest / dividend financing costs.

Required:

a) Discuss how firms should consider these costs in their cost of capital calculations and provide your opinion as to whether the level of transaction costs attached to raising either debt or equity capital are likely to be much different. Justify your response.

b) The pecking order theory provides a clear preference by financial managers in using internal funds / retained earnings as their initial source of capital for capital budgeting projects. Is it correct to say that this is because such source of financing has a nil cost of capital as the firm is simply using its own funds?

Issue #2 Critically comment on the following statement that is fundamental to a sound understanding of the underlying principles covered in this course: "The cost of capital depends primarily on the use of the funds, not the source.

Please provide references.