Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt,

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 percent

B) 12.00 percent

C) 11.12 percent

D) 10.64 percent

Explanation / Answer

Hi,

Please find the detailed answer as follows:

After Tax Rate of Return = Weight of Debt*After Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity = =0.4*8*(1-0.4)+0.1*12+0.5*16 = 11.12%

Option C (11.12%) is the correct answer.

Thanks.

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