HiFli Corp. plans to maintain its optimal capital structure of 50 percent debt,

Question

HiFli Corp. plans to maintain its optimal capital structure of 50 percent debt, 10 percent preferred stock, and 40 percent common stock and retained earnings far into the future. The required rate of return on each component is; debt: 9.5 per cent; preferred stock: 12 per cent, common stock and retained earnings: 14.5 per cent. Assuming a 40 percent marginal tax rate, what is the minimum after-tax rate of return that Action must earn on its investments?

9.85%

6.93 %

9.31 %

8.70 %

You are considering purchasing a truck for your firm. The truck will cost $95,000, plus $5,000 for a plow. Use of the truck is expected to increase the firm's revenues by $95,000 per year and increase the costs by $25,000 per year before depreciation. The truck will be depreciated using 5 year straight-line depreciation. Your firm's marginal tax rate is 40%.
What is the operating cash flow in Year 1?

$32,800

$43,000

$46,600

$50,000

9.85%

6.93 %

9.31 %

8.70 %

Explanation / Answer

1. Required Rate of Return = (Weight of Debt * cost of debt net of tax) + (weight of Preferred Stock * Cost of Pref. Stock) + (Weight of Common Stock * Cost of Common Stock)

Note: Required rate of return is also known as cost of capital.

= 0.50 (0.095 * 0.6) + (0.10 * 0.12) ( 0.40 * 0.145)

= 9.85 % which is minimum after-tax rate of return.

2. Operating cash flows = Net Income + Depreciation

Net Income = 95,000 - 25,000- 20,000 = 50,000

Net Income After Tax = 50,000 (1-0.40) = $ 30,000

Depreciation = 100,000/5 = 20,000 Per annum

Operating Cash flows for year 1 = 30,000 + 20,000 = 50,000

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.