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 per 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's common stock currently sells for $40 per share. 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 common stock, rs?
A) 10.0%
B) 12.5%
C) 15.5%
D) 16.5%
E) 18.0%

Question

Quizplus · Accepted Answer

The cost of common stock, rs, is calculated using the constant growth model:rs = (D1 / P0) + gwhere:D1 = expected dividend in one yearP0 = current stock priceg = constant growth rateIn this case, D1 = $2 * (1 + 0.10) = $2.20, P0 = $40, and g = 0.10. Therefore, rs = ($2.20 / $40) + 0.10 = 0.155 or 15.5%.

J Ross and Sons Inc