Company B is currently financed by common stock equity. It is considering two alternative ways of financing in order to increase the return on common equity.

Table 7.28 lists the two options under consideration, along with the base case.

The company’s capitalization and EBIT remain constant at $30 million and $3 million, respectively. The composition of the capitalization changes from 100% common stock equity (base case) to a mix of common and preferred stocks (Option A) and to a mix of common stock and long-term debt (Option B).
The corporate tax rate is 40%. Dividends of preferred stocks are paid at a 5%
rate. The interest charge for the long-term debt is 4%.

a. Compute the rate of return on common stock equity for the three cases. Explain why these numbers change from one case to another.

b. Compute the rate of return on capitalization for the three cases.

c. Among the three cases indicated, which financing option is to be preferred by the company, and why?