Question

The president of Dronavation, Inc. has hired you to determine the firm's cost of debt and cost of equity capital. The stock is currently selling for $40 a share and the dividend per share is expected to be around $2. The company has total liabilities of $16 million and interest expense for the year of $2 million.

A.) The president makes the statement that it will cost $2 per share to use the stockholders' money, so the cost of equity is equal to 5 percent (2/40). Is this correct? How do you respond?

B.) The president says to you that if the company owes $16 million and has only $2 million in interest, the cost of debt is 12.5 percent ($2 million / $16 million). Is this conclusion correct? Explain.

C.) Based on his calculations, the president recommends the company increase its use of equity financing, because debt costs 12.5 percent, but equity only costs 5 percent. How do you respond?

Answer 1

1. Cost of equity=Expected Dividend/Price+growth rate..Here, the president is assuming the growth rate to be zero so he is incorrect..He needs to incorporate the dividend growth rate as well.

2. Two things: first he has not adjusted for tax benefits of interest. Second, he is assuming the bond price to be equal to par..Cost of debt is equal to ytm*(1-tax rate)...His calculation is correct only when tax rate is zero and bonds are issued at par.

3. The calculations are incorrect..Equity is more risky hence cost of equity should be more than debt.