Ross and Sons Inc. Cost of Newly Issued Common Stock

Cost of Newly Issued Common Stock

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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. What is the firm's cost of newly issued common stock?

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A. B. C. D. E.

A

Cost of new common equity:

k(e) = ($2.20/$34) + 0.10 = 0.1647 = 16.5%.

To determine the cost of newly issued common stock, we need to calculate the cost of equity. The cost of equity represents the return required by the investors to hold the company's stock. One common method to calculate the cost of equity is the dividend discount model (DDM), which takes into account the expected dividends and the growth rate.

Given information:

  • Target capital structure: 40% debt, 10% preferred stock, and 50% common equity.
  • Current after-tax cost of debt: 6%.
  • Preferred stock: Selling price = $90, dividend = $10, net proceeds = $80.
  • Retained earnings: $15,000.
  • Common stock: Current selling price = $40, net proceeds = $34.
  • Common stock dividend: $2 per share.
  • Expected dividend growth rate: 10% per year.

Let's break down the calculation step by step:

  1. Calculate the cost of debt: The cost of debt is given as 6%.

  2. Calculate the cost of preferred stock: The cost of preferred stock can be calculated using the formula: Cost of preferred stock = Dividend / Net proceeds Cost of preferred stock = $10 / $80 = 0.125 or 12.5%

  3. Calculate the cost of equity (common stock): The cost of equity can be calculated using the DDM formula: Cost of equity = Dividend / Current stock price + Dividend growth rate Dividend = Expected dividend * Retained earnings Dividend = $2 * $15,000 = $30,000

Cost of equity = $30,000 / $40 + 10% = $30,000 / $40 + 0.10 = $750 + 0.10 = 0.1875 or 18.75%

However, we need to account for the net proceeds from the sale of new common stock. The cost of equity should be adjusted for the flotation cost. The flotation cost is the cost incurred in the process of issuing new securities. In this case, the net proceeds from the sale of new common stock are $34.

Adjusted cost of equity = Cost of equity / (1 - Flotation cost) Flotation cost = (Current stock price - Net proceeds) / Current stock price Flotation cost = ($40 - $34) / $40 = $6 / $40 = 0.15 or 15%

Adjusted cost of equity = 0.1875 / (1 - 0.15) = 0.1875 / 0.85 = 0.22 or 22%

  1. Weighted Average Cost of Capital (WACC): The weighted average cost of capital is calculated by taking a weighted average of the costs of the different sources of financing, based on their target capital structure.

WACC = (Weight of debt * Cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common equity * Cost of equity)

Weight of debt = 40% Weight of preferred stock = 10% Weight of common equity = 50%

WACC = (0.4 * 0.06) + (0.1 * 0.125) + (0.5 * 0.22) WACC = 0.024 + 0.0125 + 0.11 = 0.1465 or 14.65%

Therefore, the firm's cost of newly issued common stock is approximately 14.65%.

The closest option to this value is option E: 15.5%.

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