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.

Discuss

1. 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?

2. 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.

3. 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?