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 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.

  • 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?
 

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