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    Cost of Capital: After tax cost of debt

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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 before?tax cost of debt is 10 percent, and it can sell as much debt as it wishes at this rate. The firm tax rate is 40 percent. 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.

    a. What is the firm's after-tax cost of debt?

    b. What is the firm's cost of newly issued preferred stock, rps?

    c. What is the firm's cost of common stock, rs?

    d. What is the firm's weighted average cost of capital (WACC)?

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    Solution Preview

    a. What is the firm's after-tax cost of debt?

    The after tax cost of debt is before tax cost X (1-tax rate)
    The before tax cost is 10% and tax rate is 40%. The after tax cost of debt is 10% X (1-40%) = 6%.

    b. What is the firm's cost of newly issued preferred stock, rps?

    The preferred stock is ...

    Solution Summary

    The solution explains the calculation of components cost of capital and the WACC for J. Ross and Sons

    $2.49

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