J. Ross and Sons Inc. WACC Calculation

Weighted Average Cost of Capital (WACC) Calculation

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Question

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 will be the

WACC above the break point?

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A. B. C. D. E.

A

Preferred stock return: 10/80 = 12.5% WACC = 6%(0.40) + 12.5%(0.10) + 16.5%(0.50) = 11.90%.

To calculate the weighted average cost of capital (WACC) above the break point for J. Ross and Sons Inc., we need to determine the cost of each component of capital (debt, preferred stock, and common equity) and then weight them according to their proportions in the capital structure.

First, let's calculate the cost of debt:

Cost of Debt (rd) = After-Tax Cost of Debt = 6%

Next, let's calculate the cost of preferred stock:

Cost of Preferred Stock (rp) = Dividend / Net Proceeds from Sale = $10 / $80 = 0.125 or 12.5%

Now, let's calculate the cost of common equity using the dividend growth model. The formula for the cost of common equity (re) is:

Cost of Common Equity (re) = (Dividend / Current Stock Price) + Growth Rate of Dividends

Given: Dividend = $2 Current Stock Price = $40 Growth Rate of Dividends = 10%

Cost of Common Equity (re) = ($2 / $40) + 0.10 = 0.05 + 0.10 = 0.15 or 15%

Now that we have the cost of each component, let's calculate the weights of each component based on the target capital structure:

Weight of Debt (wd) = 40% Weight of Preferred Stock (wp) = 10% Weight of Common Equity (we) = 50%

To calculate the WACC, we multiply the cost of each component by its respective weight and sum them up:

WACC = (wd * rd) + (wp * rp) + (we * re) = (0.40 * 0.06) + (0.10 * 0.125) + (0.50 * 0.15) = 0.024 + 0.0125 + 0.075 = 0.1115 or 11.15%

Therefore, the WACC above the break point for J. Ross and Sons Inc. is 11.15%.

Among the provided answer choices, the closest option to 11.15% is option A: 11.9%.

Therefore, the correct answer is A. 11.9%.

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