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?

Shawhan Supply intends to keep its capital structure optimal of 30% debt and 20% preferred stocks, with 50% common shares, for many years. The required return on each component is: debt–10%; preferred stock–11%; and common stock–18%. Shawhan Supply needs to achieve a return rate after taxes that is equal to the tax losses in order for its value to stay the same.

To determine this after-tax rate of return we will need to first calculate what Shawhan’s pre-tax rate of return must be based on their current capital structure and required returns on each component. To do this we can use the weighted average cost of capital (WACC) formula which takes into account all sources of financing: WACC = (E/V) x Re + (D/V) x Rd x (1 – Tc). Here, E is equity and D is debt. V represents the total value. Re is the required return for Equity. Rd is a required return for Debt. Tc is tax rate.

Using our values in our equation above, WACC = {(0.5 x 0.18)+(0.3 x 0.10)}x(1 – 0.40); WACC = 12%. It means Shawhan must earn an annual rate of return of 12% before taxes in order to maintain the current value of their business.

We can also calculate the after-tax profit margin that Shawhan must achieve to be able to maintain its profitability by using this equation: After Tax Rate = Before Tax Rate/[1-(Tax Rate)]. The following is the result: Tax rate = 12 % [1 – 40%] = 20%. Shawhan Supply, based on these assumptions, must achieve a rate after tax or a return of equal to 20 % if it so desires.