Question

Paul Altero has gone public with his Bubbakoos Buritos restaurant chain. His current capital structure is as follows: 10,000 shares of common stock at $20 per share at a cost of 14%; 3,200 shares of preferred stock at $40 per share at a cost of 11%; and 600 bonds at $980 each at a before-tax cost of 9%. If his corporate tax rate is 25%, what should be the company’s required rate of return?

Answer 1

Total amount of common stocks outstanding

=

10000*20

=

$200,000.00

Total amount of Preferred stocks outstanding

=

3200*40

=

$128,000.00

Total amount of debt outstanding

=

600*980

=

$588,000.00

After tax cost of debt ({because we get tax benefit on interest expense)

=

Cost before tax *(1-taxrate)

=

9%*(1-0.25)

=

0.0675

or 6.75%

Total capital

=

Total common stock+total prefered stock+total debt

=

$200,000+$128,000+$588,000

=

$916,000.00

Required rate of return (cost of capital)

=

(amount of common stock*cost of common stock)+(amount of preferred stock*cost of preferred stock)+(amount of debt*after tax cost of debt)]/total capital

=

[(200,000*14%)+(128,000*11%)+($588,000*6.75%)]/916,000

=

(28,000+14,080+39,690)/916,000

=

81,770/916,000

=

0.0893 or 8.93%

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