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Suppose Mr. Thomas, president of your company, has hired you to determine the firm's cost...

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Finance

Suppose Mr. Thomas, president of your company, has hired you to determine the firm's cost of debt and the cost of equity capital.

a) The stock is selling fir $50 per share now, and the dividend per share will probably be about $5. Mr. Thomas argues, "It will cost us $5 per share to use the shareholders' money this year, so the cost of equity is equal to 10 percent ($5/50)." What is wrong with this conclusion?

b) Based on the most recent financial statements, the company's total liabilities are $8 millions. Total interest expense for the coming year will be about $1 million. Mr. Thomas therefore reasons, "We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously 12.5% = 1 / 8." What is wrong with this conclusion?

c) Based on his analysis, Mr. Thomas is recommending that the company increase its use of equity financing because "debt costs 12.5%, but equity only costs 10%." Do you agree that the cost of equity is less than the cost of debt? What is missing in the comparison?

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