MAS.

M-1405
COST OF CAPITAL

STRAIGHT PROBLEMS:

1. Cost of capital, basic principles. Primus Corporation wishes to compute its weighted average
cost of capital to be used in evaluating capital expenditure proposals. Earnings, capital structure
and current market prices of the companys securities on December 31, 2009 are as follows:

Par Value Total Par Market Flotation Expected

Amount Price/share Costs Growth
Rate
10%, BP P1,000 P20 M P1,250 5%
15%, PS 100 5M 250 5%
OS 20 15 M 40 7% 8%
RE 10 M 8%

EBIT P20 million

Current dividend per ordinary share P3
Tax rate 40%

Required:
a. Determine the weighted average cost of capital.
b. Assume all other data to be constant, except that the capital structure of the company shall be
as follows:
Mortgage bonds, 10%, 10 years P31,000,000
Preference shares, 15%, P100 par value 5,000,000
Ordinary shares, no par, 300,000 shares outstanding 4,000,000
Retained Earnings 10,000,000
P50,000,000
Determine the new average cost of capital of COC Corp.

Solution Guide:

a. Weighted average cost of capital = ?

Sources of Funds Market Values Individual COC Financing Mix WA COC

Ratio
10% BP P25 M 5.05 % 37.04 % 1.87 %
PS Equity 12.5 M 6.32 % 18.52 % 1.17 %
OS Equity 30 M 16.71 % 44.44 % 7.43 %
Total 67.5 M 100 % 10.47%
b. Weighted average cost of capital = ?

Sources of Funds Market Values Individual COC Financing Mix WA COC

Ratio
10% BP P38,750,000 5.05 % 61.27 % 3.09 %
PS Equity 12,500,000 6.32 % 19.76 % 1.25 %
OS Equity 12,000,000 16.71 % 18.97 % 3.17 %
Total 63,250,000 100 % 7.51 %

2. Cost of capital, with sale-leaseback component. FM Diamond Company is a manufacturer of

diamond drilling, cutting, and grinding. Melanie has 1,000 of its 8% bond issue will mature next
month. To reduce the debt, P1,000,000 in cash must be raised. One proposal under consideration
is the sale and leaseback of the companys general office building. The building would be sold to
EF Junio for P1,000,000 and leased back on a 25-year lease, with annual payments of P110,168,
permitting the lessor to recover its investment and earn 10% on investment. FM will pay all
maintenance costs, property taxes, and insurance and will reacquire the building at the end of the
lease period for a nominal payment.

The current capital structure is:

Capital Pretax Pretax
Component Amount Component
Bonds (including amount to be retired next month) P 6,000,000 8.0 %
Preference stock (market value) 2,000,000 9.0 %
Ordinary Stock and retained earnings (market value) 4,000,000 12.5 %
Diamonds income tax rate is 40%

Required: Compute the weighted average cost of capital before and after the bond retirement and
the sale-leaseback transactions.

Solution Guide:

Before the bond Retirement After the Bond Retirement

Funds MV WACOC MV WACOC

BP P6 M 2.4% P5 M 2.0%
LP - - 1M 0.5%
PSE 2M 1.5% 2M 1.5%
CSE 4M 4.17% 4M 4.17%
Total 12 M 8.07% 12 M 8.17%
3. Play with your formulas. Check it out!

a. Cost of preference stock

Case 1 Case 2 Case 3
Cost of PS 12% 4% 12%
Par value P120 P80 P375 ?
Preferred dividend rate 8% 10% 8%
Flotation cost 5% 6% 5%
MPPS (net) P80 ? P200 P250
MPPS (gross) P84 ? P212 ? P263 ?

b. Cost of ordinary stock and retained earnings

Case 1 Case 2 Case 3
Cost of OSE 11.6% ? 22% 21% ?
Cost of RE 11.4% ? 21.2% ? 20%
Flotation costs 5% 7% 8%
Current dividend P10.00 P20.56 ? P25
Expected dividend P10.80 ? P22 27.25
Expected yield rate 3.6% ? 12.0% 10.99% ?
Expected growth rate 8% 10% 9% ?
MPPS (net) P300 P193 ? P228 ?
MPPS (gross) P316 ? P197% ? P248 ?
c. Capital Asset Pricing Model
Case 1 Case 2 Case 3
Risk-free rate 6% 7.6% ? 7%
Beta Coefficient 1.4 1.2 1.5 ?
Risk Market rate 15% 19.6% ? 19% ?
Risk Premium 9% ? 12% 12%
Cost of OS Equity 18.6% ? 22% 25%

4. Operating and Financial leverages. Verbatim Corporation reports the following financial data
at the end of 2009:

CM (250,000 x P40) P10 M

Fixed costs and expenses, excluding interest charges 2M
10% Bonds payable 20 M
12%, Preference shares, P500 par, 20,000 shares outstanding 10 M
Ordinary shares, P100 par, 100,000 shares outstanding 10 M
Tax rate 40%

Required: Solve the following:

a. Degree of operating leverage, degree of financial leverage, and degree of total leverage.
b. Assuming sales are expected to increase by 25% in 2011, what is the expected change in:
1. EBIT 2. PAOS 3. EPS
c. Assuming that there were no preference shares outstanding in 2009, what would have been
the:
1. DOL, DFL, and DTL?
2. Percentage change in DFL and DTL if there were no preferred shares as compared to when
there were preferred shares issued by the company?

Solution Guide:

a. DOL = CM/EBIT= P10M/P8M = 1.25

DFL = EBIT/ (EBIT interest expense PDBT)
= P8M/ (P8M P2M P2M) = 2.0
DTL = DOL x DFL = 1.25 x 2 = 2.5
Or:
DTL = CM/ (EBIT - interest expense PDBT)

Analysis:

Before After %
CM P 10 M P 12.5 M 25 %
(FxCE) 2M 2M
EBIT 8M 10.5 M 31.25 %
(Interest expense) 2M 2M
PBT 6M 8.5 M
(Income tax) 2.4 M 3.4 M
PAT 3.6 M 5.1 M
(Preference Div.) 1.2 M 1.2 M
PAOS 2.4 M 3.9 M 52.5 %
Shares outstanding 100,000 100,000
EPS P 24 P 39 62.5 %

b.
1 % EBIT = % Sales x DOL 25% x 1.25 = 31.25%
% EBIT = % CM x DOL 31.25%
2 % PAOS = % EBIT x DFL 31.25% x 2 = 62.5%
3 % EPS = % EBIT x DFL 62.5%

C1 w/ PS w/o PS %
DOL 1.25 1.25 -
DFL 2 1.33 -33.33%
DTL 2.5 1.67 -33.33%
5. The Financial Breakpoints. Efemela Corporation provided you the following synopsis of its
financing data:

Funds Optimal capital structure Cost of funds

Debt 30% ?
Preference equity 50% 10%
Ordinary equity 20%
Ordinary shares 16%
Retained earnings 15%

Retained earnings for reinvestment P 20 M

The after-tax cost of debt are as follows:
P 1- P 45 M 6%
P45,000,001 and above 7.5%

Required:
a. Break points of retained earnings and additional debt.
b. Determine the weighted average cost of capital:
b1. within the retained earnings break point.
b2. within the additional debt break point.
b3. after the additional debt break point.

Solution Guide:

a. RE breakpoint P20 M/ 20% P100 M

Additional debt breakpoint P45 M/ 30% P150 M

b1. WACOC within the RE breakpoint:

(At P100M total equity, the debt component is P30M (ie, P100M x 30%), therefore the cost
of debt to be used is 6%)

Amount Mix COC WACOC

Debt P30 M 30% 6% 1.8%
PSE 50 M 50% 10% 5
RE 20 M 20% 15% 3
P100 M 9.8%

b2. WACOC within the additional debt breakpoint:

Amount Mix COC WACOC

Debt P45 M 30% 6% 1.8%
PSE 75 M 50% 10% 5
Ord shares ? 10 M 7% 16% 1.12
RE 20 M 13% 15% 1.95
P150 M 9.87%
b3. WACOC after the additional debt breakpoint:

Mix COC WACOC

Debt 30% 7.5% 2.25%
PSE 50% 10% 5
OSE 20% 16% 3.2
10.45%

MULTIPLE CHOICE QUESTIONS

1. The minimum return that a project must earn for a company in order to leave the value of the
company unchanged is the
A. Current borrowing rate C. Capitalization rate
B. Discount rate D. Cost of capital

2. The theory underlying the cost of capital is primarily concerned with the cost of
A. Long-term funds and old funds
B. Short-term funds and new funds
C. Long-term funds and new funds
D. Short-term funds and old funds

3. Which of these statements are pertinent to cost of capital?

1. It is the return that investors demand for a given level of risk.
2. It may be employed as a benchmark for the evaluation of performance.
3. For investment decisions, it must be based on the current or prospective cost of the
various capital components rather than on their historical costs.
4. It may also be used in acquisition analysis, liquidation studies and source of financing
decisions.
5. It may differ from the hurdle rate used to reflect the alternative risk attributed to a
specific project, decision, or business unit.

A. All five statements. C. Statements 1, 2, 3 and 4 only

B. Statements1, 2 and 3 only D. Statements 1, 2, 4 and 5 only

4. If K is the cost of debt and t is the marginal tax rate, the after-tax cost of debt, ki, is best
represented by the formula
A. ki = k/t C. ki = k(t)
B. ki = k/(1-t) D. ki = k(1-t)

5. In general, it is more expensive for a company to finance with equity capital than with debt
capital because
A. Long-term bonds have a maturity date and must therefore be repaid in the future
B. Investors are exposed to greater risk with equity capital
C. Equity capital is in greater demand than debt capital
D. Dividends fluctuate to a greater extent than interest rates
6. A financial manager usually prefers to issue preferred stock rather than debt because
A. Payments to preferred stockholders are not considered fixed payments.
B. The cost of fixed debt is less expensive since it is tax deductible even if a sinking fund is
required to retire the debt.
C. The preferred dividend is often cumulative, whereas interest payments are not.
D. In a legal sense, preferred stock is equity; therefore, dividend payments are not legal
obligations. (cma)

7. A firm must select from among several methods of financing arrangements when meeting its
capital requirements. To acquire additional growth capital while attempting to maximize earnings
per share, a firm should normally
A. Attempt to increase both debt and equity in equal proportions, which preserves a stable
capital structure and maintains investor confidence
B. Select debt over equity initially, even though increased debt is accompanied by
interest costs and a degree of risk.
C. Select equity over debt initially, which minimizes risk and avoids interest costs.
D. Discontinue dividends and use current cash flow, which avoids the cost and risk of
increased debt and the dilution of EPS through increased equity.

8. When calculating the cost of capital, the cost assigned to retained earnings should be
A. Zero
B. Lower than the cost of external common equity
C. Equal to the cost of external common equity
D. Higher than the cost of external common equity

9. Which of the following is directly applied in determining the value of a stock when using the
dividends growth model?
A. The firms capital structure
B. The firms cash flows
C. The firms liquidity
D. The investors required rate of return on the firms stock

10. The difference between the required rate of return on a given risky investment and that on a
riskless investment with the same expected return is the
A. Risk premium C. Standard deviation
B. Coefficient of variation D. Beta coefficient

11. Maylar Corporation has sold $ 50 million of $ 1,000 par value, 12% coupon bonds. The
bonds were sold at a discount and the corporation received $985 per bond. If the corporation tax
rate is 40%, the after-tax cost of these bonds for the first year (rounded to the nearest hundredth
percent) is
A. 7.31% C. 12.00%
B. 4.87% D. 7.09% (cma)

12. Acme Corporation is selling $25 million of cumulative, non-participating preferred stock.
The issue will have a par value of $65 per share with a dividend rate of 6%. The issue will be
sold to investors for $68 per share, and issuance costs will be $4 per share. The cost of preferred
stock to Acme is
A. 5.42% C. 6.00%
B. 5.74% D. 6.09%

13. Cute, Inc. paid cash dividends to its common shareholders over the past 12 months of P2.20
per share. The current market value of the common stocks id P40 per share, and investors are
anticipating the common dividends to grow at a rate of 6% annually. The cost to issue new
common stocks will be 5% of the market value. The cost of a new common stock issue will be
A. 11.50% C. 11.83%
B. 11.79% D. 12.14%

14. Yolanda, Inc. is planning to use retained earnings to finance anticipated capital expenditures.
The beta coefficient for Yolandas stock is 1.15, the market rate is 12.5% and the risk-free rate is
8.50%. If a new issue of common stock were used in this model, the flotation costs would be 7%.
By using the capital asset pricing model (CAPM) equation [R = RF + (RM RF)], the cost of
using retained earnings to finance the capital expenditures is
A. 12.50% C. 13.78%
B. 14.38% D. 13.10%

15. By using the dividend growth model, estimate the cost of equity capital for a firm with a
stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an
expected growth rate of 10%.
A. 21.1% C. 11.0%
B. 12.2% D. 20.0%

Questions 16 through 18 are based on the following information.

Manila Telecom is considering a project for the coming year that will cost P50 million. Manila
plans to use the following combination of debt and equity to finance the investment
Issue P15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and
flotation costs of 2% of par
Use of P35 million of funds generated from earnings
The equity market is expected to earn 12%, Philippine Treasury Bonds are currently
yielding 5%. The beta coefficient for Manila is estimated to be .60. Manila is subject to
an effective corporate income tax rate of 40%.

16. The before-tax cost of Manilas planned debt financing, net of flotation costs, in the first year
is
A. 11.60% C. 10.00%
B. 8.08% D. 7.92%

17. Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine the
weighted-average cost of capital
A. 10.50% C. 9.50%
B. 8.50% D. 6.30%
18. The capital asset pricing model (CAPM) computes the expected return on a security by
adding the risk-free rate of return to the incremental yield of the expected market return, which is
adjusted by the companys beta. Compute Manilas expected rate of return.
A. 9.20% C. 7.20%
B. 12.20% D. 12.00%

Questions 19 through 22 are based on the following information.

D, Inc., which is interested in measuring its overall cost of capital, has gathered the following
data. Under the terms described below, the company can sell unlimited amounts of all
instruments.

D can raise cash by selling P1, 000, 8%, 20-year bonds with annual interest payments. In
selling the issue, an average premium of P30 per bond would be received, and the firm
must pay flotation costs of P30 per bond.
D can sell 8% preferred stock at P105 per share. The cost of issuing and selling the
preferred stock is expected to be P5 per share.
Ds common stock is currently selling for P100 per share. The firm expects to pay cash
dividends of P7 per share next year, and the dividends are expected to remain constant.
The stock will have to be underpriced by P3 per share, and flotation costs are expected to
amount to P5 per share.
D expects to have available P100, 000 of retained earnings in the coming year; once these
retained earnings are exhausted, the firm will use new common stock as the form of
common stock equity financing.
Ds preferred capital structure is
o Long-term debt 30%
o Preferred stock 20%
o Common stock 50%
The applicable tax rate is 40%.

19. The cost of funds from the sale of common stock for D, Inc. is
A. 7.0% C. 7.4%
B. 7.6% D. 8.1%

20. The cost of funds from retained earnings for D, Inc. is

A. 7.0% C. 7.4%
B. 7.6% D. 8.1%

21. If D Inc., needs a total of P200, 000, the firms weighted-average cost of capital would be
A. 19.8% C. 6.5%
B. 4.8% D. 6.8%

22. If D Inc., needs a total of P1, 000, 000, the firms weighted-average cost of capital would be
A. 6.8% C. 6.5%
B. 4.8% D. 27.4%
Questions 23 through 25 are based on the following information:
R Inc. operates a chain of restaurants located in the Southeast. The company has steadily grown
to its present size of 48 restaurants. The board of directors recently approved a large-scale
remodeling of the restaurant, and the Co. is now considering two financing alternatives.
The first alternative would consists of
- Bonds that would have 9% coupon rate and would net P19.2 million after flotation
costs
- Preferred stock with a stated rate of 6% that would yield P4.8 million after a 4%
flotation cost
- Common stock that would yield P24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would have an
11% coupon rate and would net P48 million after flotation costs.

Rs current capital structure, which is considered optimal, consists of 40% long-term debt, 10%
preferred stock, and 50% common stock. The current market value of the common stock is P30
per share, and the common stock dividend during the past 12 months was P3 per share. Investors
are expecting the growth rate of dividends to equal the historical rate of 6%. R is subject to an
effective income tax rate of 40%.

23. The after-tax cost of the common stock proposed in Rs first financing alternative would be
A. 16.00% C. 16.60%
B. 16.53% D. 17.16%

24. Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal cost of
capital for Rs first financing alternative consisting of bonds, preferred, and common stock
would be
A. 5.4% C. 10.285%
B. 6.25% D. 11.700%

25. The after tax weighted marginal cost of capital for Rs second financing alternative consisting
solely of bonds would be
A. 5.13% C. 6.27%
B. 5.40% D. 6.60%

26. A firm seeking to optimize its capital budget has calculated its marginal cost of capital and
projected rates of return on several potential projects. The optimal capital budget is determined
by
A. Calculating the point at which marginal cost of capital meets the projected rate of
return assuming that the most profitable projects are accepted first.
B. Calculating the point at which average marginal cost meets average projected rate of
return, assuming the largest projects are accepted first.
C. Accepting all potential projects with projected rates of return exceeding the lowest
marginal cost of capital
D. Accepting all potential projects with projected rates of return lower than the highest
marginal cost of capital.
Questions 27 to 29 are based on the following information.
X Co. currently sells 400, 000 bottles of perfume each year. Each bottle costs P.84 to produce &
sells for P1.00. Fixed costs are P28, 000 per year. The firm has annual interest expense of P6,
000, preferred stock dividends of P2, 000 per year, & a 40% tax rate.

27. The degree of operating leverage for X Co. is

A. 2.4 C. 2.13
B. 1.78 D. 1.2

28. The degree of financial leverage for X Co. is

A. 2.4 C. 1.35
B. 1.78 D. 1.2

29. If X Co. did not have preferred stock, the degree of total leverage would
A. Decrease in proportion to a decrease in financial leverage.
B. Increase in proportion to a decrease in financial leverage.
C. Remain the same.
D. Decrease but not be proportional to the decrease in financial leverage.

30. A higher degree of operating leverage compared with the industry average implies that the
firm
A. Has higher variable costs
B. Has profits that are more sensitive to changes in sales volume
C. Is more profitable
D. Is less risky

31. A firms optimal capital structure

A. Minimizes the firms tax liability.
B. Maximizes the firms degree of financial leverage.
C. Minimizes the firms risk.
D. Maximizes the price of the firms stock.

32. A Co. has made the decision to finance next years capital projects through debt rather than
additional equity. The benchmark cost of capital for these projects should be
A. The before-tax cost of new debt financing
B. The cost of equity financing.
C. The after-tax cost of new-debt financing.
D. The weighted-average cost of capital.

33. Which of the following is least likely to encourage a company to use more debt in its capital
structure?
A. An increase in the corporate tax.
B. An increase in the personal tax.
C. A decrease in the companys degree of operating leverage.
D. Statements a and c are correct.
34. Which of the following statements is most correct?
A. Firms whose sales are very sensitive to changes in the business cycle are more likely to
rely on debt financing.
B. Firms with large tax loss carry forwards are more likely to rely on debt financing.
C. Firms with a high operating leverage are more likely to rely on debt financing.
D. Statements a and c are correct.