I am hired to determine a widget company’s cost of debt and the cost of equity c
ID: 2709005 • Letter: I
Question
I am hired to determine a widget company’s cost of debt and the cost of equity capital. The stock currently sales for $25 per share and the dividend will be $5. The president of the company argues that it will cost the company $5 per share to use the stockholders money this year therefore the cost of equity is equal to 20%. Furthermore, the president believes that the cost of debt is 25%. This is based upon the most recent financial statements which show the company has total liabilities of $10 million and will face total interest expenses for the year of $2.5 million. The president argues that the company should increase its use of equity financing because debt costs 25% while equity only costs 20% and thus equity is cheaper. Is the president’s analysis of the cost of equity, debt, and decision to increase the use of equity financing over debt financing accurate?
Explanation / Answer
Current Share Price = $ 25
Dividend = $ 5
According to the president of the company cost of equity = $5/$25 = 0.2
This argument is not correct as
The price of a share is generally an estimation of the company’s dividends and growth reflected in in growth rate in future. To arrive at this figure we need to know the dividend payment trend and growth rate of the earnings and dividends over a period to arrive at a better estimate of the rate of return to the shareholders. Even in the case where the growth of dividends and earnings is constant over time, we need to know whether the dividend paid over recent past periods is same as $5 mentioned and expected to continue with the same pay out in coming future. Then only the rate of return of 20% mentioned by the president of the company would be correct.
With regards to cost of debt, there are two issues with the way it was calculated by the president.
Example – say the debt at the beginning of the year was 15 Million and the company paid off 5 Million around 6 months back. Then the average debt over the year would be (15+10)/2 = 12.5 Million and cost of debt would be 20% instead of that stated.
Based on the above, the assumptions of the President are not correct in both calculations and needs to be corrected.
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