Stuck on something, and needed some help in answering this question:
You have a company with 20x P/E, a pre-tax cost of interest of 10%, and a tax rate of 50%. What is more expensive - stock or debt?
How would you answer this? Thought process would be appreciated!
Anything helps.
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Stock from a cost of capital perspective is always more expensive. Think about the WACC calculation.
http://people.stern.nyu.edu/adamodar/pdfiles/country/levvalue.pdf Here is a good link that explains it better than I can.
I’m pretty sure the way they want you to answer the question in this case is that they are the same. The fact that they mentioned P/E makes it seem like they want you to infer that cost of equity is implied by the reciprocal of P/E - 1/20, or 5%. And after-tax cost of debt is also 5%, so they are equal.
Exactly this, and I'm pretty sure I know which firm this question was from lol
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