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 retained earnings?
Click on the arrows to vote for the correct answer
A. B. C. D. E.A
k(s) = $2.20/$40 + 0.10 = 15.5%.
To determine the cost of retained earnings, we need to calculate the cost of equity. The cost of equity represents the return required by the firm's shareholders or the opportunity cost of investing in the firm's common stock.
The formula to calculate the cost of equity using the dividend growth model (also known as the Gordon growth model) is as follows:
Cost of Equity = Dividend / Current Stock Price + Dividend Growth Rate
In this case, we have the following information:
Substituting the values into the formula:
Cost of Equity = $2 / $40 + 0.10 = 0.05 + 0.10 = 0.15 or 15%
Therefore, the cost of equity is 15%.
The cost of retained earnings is the same as the cost of equity since retained earnings represent the portion of earnings not paid out as dividends but reinvested back into the business. Thus, the cost of retained earnings is also 15%.
Answer: C. 10.0%