8. Cost of capital [LO 14.5] Suppose Tom O’Bedlam, president of Bedlam Products Limited, has hired you to determine the firm’s cost of debt and cost of equity capital.

1. The shares currently sell for $50 each and the dividend per share will probably be about $5. Tom argues, ‘It will cost us $5 per share to use the shareholders’ money this year, so the cost of equity is equal to 10 per cent (= $5/50).’ What is wrong with this conclusion?

2. Based on the most recent financial statements, Bedlam Products’

total liabilities are $8 million. Total finance cost 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 = 0.125 or 12.5 per cent.’

What is wrong with this conclusion?

3. Based on his own analysis, Tom is recommending that the company increase its use of equity financing because ‘Debt costs 12.5 per cent, but equity costs only 10 per cent; 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?