Based on current market values, Shawhan Supply 's capital structure is 30% debt, 20% preferred stock, and 50% common stock. When using book values, capital structure is 25% debt, 10% preferred stock, and 65% common stock. The required return on each component is: debt,10% before tax; preferred stock, 11%; and common stock,18%. The marginal tax rate is 35%. What rate of return must Shawhan Supply earn on its investments if the value of the firm is to remain unchanged?

Question

Quizplus · Accepted Answer

Firstly, the market values need to be calculated:

Debt = 30%
Preferred stock = 20%
Common stock = 50%

Debt cost = 10%
Preferred stock cost = 11%
Common stock cost = 18%

Marginal tax rate = 35%

Cost of debt = 10% 
Cost of Debt after tax = 10%*(1-0.35) = 6.50%

Cost of preferred stock = 11%
Cost of preferred stock after tax = 11%*(1-0.35) = 7.15%

Cost of common stock = 18%
Weighted average cost of capital (WACC) = (0.30*6.50%) + (0.20*7.15%) + (0.50*18%) = 12.575%

Now, the rate of return that Shawhan Supply must earn on its investments can be calculated using the following formula:

Rate of return = WACC*(1 - marginal tax rate)
Rate of return = 12.575%*(1 - 0.35) = 8.18%

Thus, the rate of return that Shawhan Supply must earn on its investments to remain unchanged is 8.18% which is closest to option B, 13.15%. Therefore, option B is not correct.

Based on Current Market Values, Shawhan Supply 'S Capital Structure