Question

Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent preferred stock, and 50 percent common equity indefinitely. The required return on each component source of capital is as follows: debt—8 percent; preferred stock—12 percent; common equity—16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must the firm earn on its investments if the value of the firm is to remain unchanged?A) 12.40 percentB) 12.00 percentC) 11.12 percentD) 10.64 percent

Answer 1

Answer:

C) 11.12 percent

Explanation:

We are asked to calculate the WACC with preferred stock

$WACC = K_e(\frac{E}{E+P+D}) + K_p(\frac{P}{E+P+D}) + K_d(1-t)(\frac{D}{E+P+D})$

Ke = cost of capital =       0.16

Equity weight 0.50

Kp = cost of preferred=         0.12

Preferred Weight 0.10

Kd = cost of debt = 0.08

Debt Weight 0.40

t = tax rate 0.40

$WACC = 0.16(0.5) + 0.12(0.1) + 0.08(1-0.4)(0.4)$

WACC 11.12000%