Problem:
Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm's cost of debt and cost of equity capital.
The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, "It will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 1 0 percent (5 $5/50)." What's wrong with this conclusion?
Based on the most recent financial statements, Bedlam Products' total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, "We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million 5 1 2.5 percent." What's wrong with this conclusion?
Based on his own analysis, Tom is recommending that the company increase its use of equity financing because, "debt costs 12.5 percent, but equity only costs 10 percent; thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt? Please explain in detail and also provide step by step solution.