As financial manager of Cosco Pacific Limited, you have been tasked with determining your firm’s cost of debt and cost of equity capital.

(a) The shares currently sell for HK$10.40, and the dividend per share will probably be about HK$0.05736. Your assistant argues, ‘It will cost us HK$0.05736 per share to use the shareholders’ money this year, so the cost of equity is only equal to 0.55 per cent (HK$0.05736/HK$10.40).’ What’s wrong with this conclusion?

(b) Based on the most recent financial statements, Cosco Pacific Limited’s total liabilities are HK$2.5 billion. Total interest expense for the coming year will be about HK$58 million. Your assistant therefore reasons, ‘We owe HK$2.5 billion, and we will pay HK$58 million interest. Therefore, our cost of debt is obviously HK$58 million/HK$2.5 billion = 2.32 per cent.’ What’s wrong with this conclusion?

(c) Based on his own analysis, your assistant is recommending that the company increase its use of equity financing because ‘debt costs 2.32 per cent, but equity only costs 0.55 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?