Question

based on the knowledge that our minimum average cost of capital is a d/e of 1.00, for each new dollar of assets should be financed with _______ cents of debt and _____ cents of equity.

Answer 1

Each new dollar of assets should be financed with 50 cents of debt and 50 cents of equity due to a minimum average cost of capital with a D/E ratio of 1.00.

Step-by-step explanation:

Based on the knowledge that our minimum average cost of capital is a debt-to-equity (D/E) ratio of 1.00, for each new dollar of assets that should be financed, 50 cents of debt and 50 cents of equity should be utilized. This is because a D/E ratio of 1.00 implies an equal amount of debt and equity financing.

When making investment decisions, a firm assesses its cost of capital, which includes both the cost of debt and the cost of equity. The interest rate given, which is 9%, represents the cost of financial capital. However, if a firm can capture external benefits such as a 5% return to society, its effective rate of return on investments would be reduced to 4%, modifying how much the firm is willing to invest.

For instance, in the scenario provided, the firm's investment decision changes from investing $102 million to $183 million because of its ability to internalize the societal benefits, thus changing its demand for capital.