Evaluate debt or equity

Hi Sir,

If we want to evaluate if the company to has choose a finance from debt or equity
as I think we have to see the cost of each to the company and we can choose the cheapest.

I could easily get the cost of loan notes by saying 8(1-.3)/100=5.6%

But if we are not giving the expected dividends to the equity.

So here how to arrive at the cost of equity by choosing another approach or doing a different ratios for example .

this problem has come in the following question # 1 of SEP/DEC 2020 Past exam :

Thanks,

This scenario relates to three requirements.

Spine Co is looking to spend $15m to expand its existing business. This expansion is expected to increase profit before interest and tax by 20%. Recent financial information relating to Spine Co can be summarised as follows:

$’000

Profit before interest and taxation

13,040

Finance charges (interest)

240

Profit before taxation

12,800

Taxation

3,840

Profit for the year (earnings)

8,960

Spine Co is not sure whether to finance the expansion with debt or with equity. If debt is chosen, the company will issue $15m of 8% loan notes at their nominal value of $100 per loan note. If equity is chosen, the company will have a 1 for 4 rights issue at a 20% discount to the current market price of $6.25 per share. Spine Co has 12 million shares in issue. The company pays corporation tax at 30%.

(a) Evaluate whether, on financial grounds, Spine Co should finance the expansion with debt or equity.