Higgins Office Corp.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 Higgins Office Corp.earn on its investments if the value of the firm is to remain unchanged?

Question

Quizplus · Accepted Answer

The after-tax cost of debt is 8% * (1 - 0.40) = 4.8%. The weighted average cost of capital (WACC) is calculated as: (0.40 * 4.8%) + (0.10 * 12%) + (0.50 * 16%) = 11.12%.