Shawhan Supply plans to maintain its optimal capital structure of 30% debt, 20% preferred stock, and 50% common stock far into the future. The required return on each component is: debt-10%; preferred stock-11%; and common stock-16%. Assuming a 40% marginal tax rate, what after-tax rate of return must Shawhan Supply earn on its investments if the value of the firm is to remain unchanged? a. 10% b. 12% c. 14% d. 16%
We need to compute WACC to determine the required rate of return
= Cost of debt X weight of debt + cost of Preferred X weight + cost of equity X weight
= 10%(1-40%) X 30% + 11% X 20% +16% X 50%
= 1.8 + 2.2 + 8
= 12% Choice b
I am a qualified Chartered Accountant. Currently i am working in financial institution.