Alice Stewart, who is the CFO of Meyers Foods, is teaching an upper-level course

Question

Alice Stewart, who is the CFO of Meyers Foods, is teaching an upper-level course in corporate finance at the University of Phoenix. One of the assignments Alice gave her class was to compute the component costs of capital for Meyers Foods. Meyers Foods uses debt and common stock (no preferred stock) to finance its investments. Students in the class did not reach the same conclusions about the relationships among the components coststhat is, the after-tax cost of debt, rdT, the cost of retained earnings (i.e., internal equity), rs, and the cost of new, or external, equity, re. Which of the following relationships should be correct for Meyers Foods?

a. rdT < rs < re

b. rs < rdT < re

c. re < rdT < rs

d. re < rs < rdT

e. None of the above is a correct relationship.

Explanation / Answer

b. rs < rdT < re

Companies should finance in below order:

1) RE

2) Debt

3) Equity

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