Question

J. ross and sons inc. j. ross and sons inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. the firm's current after-tax cost of debt is 6 percent, 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 net only $80 per share from the sale of 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 net only $34 per share from the sale of 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 percent per year. refer to j. ross and sons inc. what is the firm's cost of newly issued common stock?
a. 15.5%
b. 16.5%
c. 10.0%
d. 12.5%
e. 18.0%

Answer 1

Cost of new common equity is found by using Dividend (D0), growth rate (g) and Price of the newly issued stock (P0).

where, D0 = $2 per share

P0 = $34

g = 10%

Cost of new common equity = {D0*(1+g)}/P0 + g

Cost of new common equity = [$2*(1+0.1)]/34 + 0.1

= (2.2)/34 + 0.1

= 16.47% or 16.5%

Therefore the correct answer is 16.50% (b)