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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.
Required:
Question a. 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 10 percent ($5/50)." What's wrong with this conclusion?
Question b. 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= 12.5%." What's wrong with this conclusion?)
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