J. Ross and Sons Inc. has a target capital structure that calls for 40 percent d

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 aftertax 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 weighted average cost of capital (WACC)?

Explanation / Answer

Calculation of Weighted Average cost of Capital (WACC):

WACC = (Cost of Debt * weight of Debt) +(Cost of Pref. Stock * weight of Pref. Stock)+ (Cost of Equity * weight of Equity)

Cost of Debt = 6%

Cost of Pref. Stock = Dividend Per share / Net proceed per share

=10 /80 = 0.125 = 12.50%

Cost of Equity = (Expected Dividend / Price ) + Growth rate

= ((2*110%) / 40 ) +10%

= (2.2 /40) +0.10

= 0.055 +0.10

= 0.155

= 15.50%

Weight of Debt = 40%

Weight of Pref. Stock = 10%

Weight of Equity = 50%

Hence,

WACC = (6% *40%) + (12.50%*10%) + (15.50% *50%)

= 0.114

= 11.40%

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