7.2 – Discussion: Cost of Capital

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7.2 – Discussion: Cost of Capital

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Consider:

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:
• 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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