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.

PLEASE Discuss the following with explanations.

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?

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.

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). The $2 cost per share captures only the dividend yield of the shareholder return but not the capital gains return so this is not correct.

2). Again, the $2 million interest captures only the current yield of the debt, not the yield to maturity. Additionally, the $16 million amount is based on book value, not market value which would accurately capture the debt amount.

3). Equity is usually riskier than debt so normally, debt is considered to be safer. Also, the interest component of debt is tax deductible so the after-tax cost of debt works out to be cheaper than the cost of equity.