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?

Answer 1

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8*(1-0.4)

'= 4.8%

Weight of equity = E/A

Weight of equity =

W(E)=0.5

Weight of debt = D/A

Weight of debt = 0.4

W(D)=0.4

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.4 - 0.5

W(PE)=0.1

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.8*0.4+16*0.5+12*0.1

WACC% = 11.12