In: Finance

Cost of capital

Suppose Tom O’Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm’s cost of debt and cost of equity capital. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It will cost us $5 per share to use the stockholders’ money this year, so the cost of equity is equal to 10 percent (5$5/$50).” What’s wrong with this conclusion?


Expert Solution

The cost of equity is the capital cost when equity share capital is raised using capital. Equity cost is determined using capital asset pricing model and dividend cash flows model. Under CAPM, the cost of capital is computed by the following formula

RS=RF +β {RM-RF} where RS is the expected return on stock, RF is the risk free rate, β is Beta, RM is the market portfolio return and the cost of equity under dividend discounted model is Rs={dividend/price}+ growth rate.

The conclusion made by Tom is not valid

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