28, J Ross and Sons, Inc has a target capital structure that calls for 40% debt,

Question

28, J Ross and Sons, Inc has a target capital structure that calls for 40% debt, 10% preferred stock and 50% common equity. The firms current after-tax cost of debt is 6% and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share, however, the firm will only net $80 per share from the sale of the new preferred stock. Ross expects to retain 15,000 in earnings over the next year. Ross' common stock currently sellsfor $40 per share, but the firm will only next $34 per share from the sale of the new common stock The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10% per year. a. What is the Cost of Capital for Preferred Stock? b. What is the cost of capital for Common Stock?

Explanation / Answer

a) Cost of new preferred stock = Dividend / Stock Price = 10 / 80 = 12.5%

b) Using DCF, Cost of new equity = D0 x (1 + g) / P + g = 2 x (1 + 10%) / 34 + 10% = 16.47%

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