J. Ross and Sons, Inc has a target capital structure that calls for 40% debt, 10

Question

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 sells for $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.

What is the Cost of Capital for Preferred Stock?

What is the cost of capital for Common Stock?

Explanation / Answer

Cost of existing preferred Stock = Preferred Dividends/ Price per preferred stock = 10/90 = 11.11%

Cost of new preferred stock = 10/80 = 12.5%

Cost of Existing common stock = D1/P0 + g

D1= D0* 1.1 = 2*1.1 = $ 2.2

Cost of Existing common stock = 2.2/40 + 10% = 5.5% + 10% =15.5%

Cost of new Common stock = 2.2/34 + 10% = 6.47% + 10% = 16.47%

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