Understanding the Cost of Capital
Response to the following problem:
A friend of yours is currently the president of a large company. The two of you are having lunch one day when she asks your opinion on a decision she is trying to make about how to obtain funds for her company in order to cover several years of operating losses. She works with a good company and is confident that earnings are about to turn positive. As she talks about the decision, it is clear to you that she is leaning towards selling more stock in the company rather than issuing more debt. During the conversation, she states several times that new debt requires more interest expense, but that equity is largely "free money" in the sense the dividend payout rate is much lower than the company's interest rate. Further, the dividends paid out on the new equity will not affect earnings. You decide to explain to her the concept of Economic Value Added to help her better understand the full cost of adding more invested capital assets in the organization.
During a pause in the conversation, she asks you, "So, do you agree with me that selling more stock in the company is clearly the way to resolve our operating loss problem?" How do you respond?