The president of Dronavation, Inc. has hired you to determine the firm\'s cost o
ID: 2819688 • Letter: T
Question
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?
Explanation / Answer
Cost of equity
Cost of equity = (Dividend per share/ current market price per share)+growth%
Hence in the given case, Cost of equity = ($2/$40)+0 = 0.05 say 5%
The president’s calculation is correct
Cost of debt
Cost of debt = Interest cost/ Debt
= $2million/ $16million = 0.125 say 12.5%
The president’s calculation is correct
The president says that equity financing is to be opted because it is cheaper than debt financing. But we cannot fully agree with the decision of the president. Even though using of a cheaper source of finance is better to the entity, equity financing causes dilution of ownership of the business. Equity financing affects the ownership and control of the entity. Hence car should be taken while going for equity financing. Hence the entity shall choose an optimum finance policy which will be a mix of equity and debt financing.
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