In March 2010, Hertz Pain Relievers bought a massage machine that provided a return of 8 percent. It was financed by debt costing 7 percent. In August, Mr. Hertz came up with a heating compound that would have a return of 14 percent. The chief financial officer, Mr. Smith, told him it was impractical because it would require the issuance of common stock at a cost of 16 percent to finance the purchase. Is the company following a logical approach to using its cost of capital?

An organization's cost of capital alludes to the cost that it should pay to raise new capital funds, while its cost of equity measures the returns estimated by investors who are part of the organization's ownership structure.

Assume financing a conveyor system having an 9% return with 7% debt and also evaluating a new product having an 12% return but financed with 13% common stock. The project with the higher return would be rejected and the project with the lower return would be accepted if projects and financing are matched in this way.

Actually, if debt and stock are sold in equivalent proportions, the average cost of financing would be 10%(1/2 debt at 7% and 1/2 stock at 13%). With a 10% average cost of capital, we would now reject the 9% conveyor system and accept the 12% new product. This would be a reliable and rational decision.