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.

Discuss

1. 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?

2. 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.

3. 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

ANS 1

The calculation of cost of equity in the given case is made under dividend discount model. The computation of cost of equity under this method considers dividend yield and the growth rate. The growth rate has not been considered. Hence, it seems to be incorrect.

ANS 2

The president has calculated current yield based on book value of debt.

Cost of debt is tax deductible. cost of debt is as : kd = interest (1-t)/ value of debt

but here tax rate is not considered.

secondly, the cost of debt is calculated on book value & not market value.

so it is incorrect.

ANS 3

Equity is inherently riskier than debt. so generally we observe that cost equity is higher than cost of debt.

so cost of equity can not be greater than cost of debt.

so president should consider above cases and recalculate the cost of equity & debt.

he will come to know after above recommendations that cost of equity is higher than cost of debt and will change his decision