1. Suppose you are hired by Tom the CEO of a large company to determine the firm
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Question
1. Suppose you are hired by Tom the CEO of a large company to determine the firm's cost of capital. Tom told you that his company's stock sells for $50 per share and the dividend will be about $5 per share. He argues that the cost of equity is equal to 10% (=$5/50) because it costs $5 to use stockholders' money. Is Tom statement correct and why?
2. List three MM assumptions and in a world without taxes. Are these assumptions reasonable in the real world?
3. According to MM with taxes, the value of the firm is maximized by taking on as much debt as possible. Can you find a real-world company (excluding financial institutions) with 100% or more debt financing? What are the challenges you may face when you run a company in the real world?
Explanation / Answer
1. The statement is not correct as the method of cost of equity calculation is wrong. Cost of equity is the rate of return of expected by the shareholders in return for the risk undertaken in buying the company's shares. While dividend / current share price is called Dividend yield.
we can use gordon growth model to calculate the correct cost of equity.
Share price = Dividend next year / ( cost of equity - growth rate)
2. MM assumptions are as follows:
a. There is no transaction cost.
b. It assumes perfect capital markets i.e. there is symmetry of information. No one has any material insider information.
c. Investors are rational.
In the real world, these assumptions do not hold true. In reality, every transaction is subject to a transaction cost. No capital market is perfect. Investors are not necessarily rational. They exhibit one or more type of biases in the investment decisions such as confirmation bias, status quoo bias, regret aversion bias, etc.
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