I am hired to determine a widget company’s cost of debt and the cost of equity c
ID: 2712859 • 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? Defend your answer.
Explanation / Answer
Presidents analysis is not correct as he is just looking after the interest expense but he is ignoring the point that the interest expense is tax deductible and cost of equity has no tax benefits . President is just overviewing the pretax cost of the debt but the actual decision or comaprison can be made by taking into consideration the post tax cost of debt
Pre tax cost of debt = 25%
Tax Rate = 30%
Post Tax cost of debt = Pre tax cost of debt ( 1- Tax Rate)
= 25 ( 1-0.30) i.e 17.5% which is better than cost of equity
Hence the decision should be to go with debt financing over equity financing
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