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# PHILIPPINE REVIEW INSTITUTE FOR ACCOUNTANCY (PRIA)

## MANAGEMENT ADVISORY SERVICES 6 Cost of Capital

OCTOBER 2018 CPALE (Batch No. 02) Aboy/Hapiz/jjaur😊jr

1. A corporation is considering a capital project for the coming year. If the firm has the following
target capital structure and costs, what should their decision be and why?

## Source of Capital Proportion After-Tax Cost

Long-term debt 0.30 10%
Preferred stock 0.10 15%
Common stock equity 0.60 20%

## a. Calculate the firm’s weighted average cost of capital.

b. The project has an internal rate of return of 14 percent. If the firm has the following target
capital structure and costs, what should their decision be and why?
c. Explain why debt cost less than preferred and common stocks.
d. Calculate the firm’s weighted average cost of capital assuming the firm has the following
target capital structure and costs, what should their decision be and why?

## Source of Capital Proportion After-Tax Cost

Long-term debt 0.60 10%
Preferred stock 0.10 15%
Common stock equity 0.30 20%

e. Differentiate the weighted average cost of capital in No.1 and No. 2, and discuss the
significance in terms of risks and returns trade-off.

2. Gordy Co. has compiled the following financial data:

## Source of Capital Book Value Market Value Cost

Long-term debt P10,000,000 P8,500,000 5.0%
Preferred stock 1,000,000 1,500,000 14.0
Common stock equity 9,000,000 15,000,000 20.0
P20,000,000 P25,000,000

(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.

3. Chubby Company can sell 15-year, P1,000 par value bonds paying annual interest at a 12%
coupon rate. Because of rising interest rates, the bonds can be sold for P1,010 each. However, P30
floatation cost per bond will be incurred. Chubby is in the 40% tax bracket.

## a. Find the net proceeds from the sale of the bonds.

b. Show the cash flows of the bonds from Chubby’s standpoint.
c. Use the approximation formula to estimate the before and after tax cost of debt.
d. Use the internal rate of return approach to compute the before and after tax cost of debt.
e. Contrast and compare the cost of debt under the approximation method and internal rate of
return approach.
f. Explain the relationship between the value of the bonds and current interest rates.
g. Use the approximation formula to estimate the before and after tax cost of debt if the bonds
can be sold for P1,030 each instead of P1,010, assuming all things being equal.
h. Use the approximation formula to estimate the before and after tax cost of debt if the bonds
can be sold for P1,050 each instead of P1,010, assuming all things being equal.
i. Contrast and explain the answers in c, g and h.

## 4. Compute the cost of the following preferred stocks.

Company Par Value(P) Selling Price(P) Floatation Annual Dividend
Cost(P)or (%) (P) or (%)
Floyd Co. 100 101 9 11%
Fudge Corp. 40 38 3.50 8%
Paul Inc. 35 37 4 P5
Cahayon Co. 30 26 5% of par P3
Villamin Inc. 20 20 2.50 9%

5 Data of the common stock of the following companies are listed below:

## Company Market Dividend Projected Underpricing Floatation

Value(P) Growth Rate Dividends Per Share (P) Cost Per
(%) Share(P)
Okoy Co. 50 8 2.25 2 1
Tabag Corp. 20 4 1 0.50 1.50
DelaCruz, Co 42.50 6 2 1 2
Cecilia Co. 19 2 2.10 1.30 1.70

a. Compute the cost of retained earnings or common stocks using the constant growth valuation
model or the Gordon model.
b. Compute the cost of new common stocks using the constant growth valuation model or the
Gordon model.
c. Why is the cost of new common stocks more costly than cost of retained earnings?.
d. Why is the cost of common stocks the same as the cost of retained earnings?.
e. Why is it necessary to under price new common stocks?.

6 JJ Co. common stock has a beta of 1.2. The risk free rate is 6% and the market return is 11%.
a. Determine the cost of common stock using the capital asset pricing model or M and M model.
b. Determine the required return the common stock should provide to investors.
c. What is the risk premium of the common stock?
d. Determine the cost of common stock using the capital asset pricing model or M and M model
assuming a beta of 1 instead of 1.2, assuming all things being equal.
e. Determine the cost of common stock using the capital asset pricing model or M and M model
assuming a beta of .90 instead of 1.2, assuming all things being equal.
f. Explain the concept of risk free rate, market return and beta.

7. Chubbylite Company’s common stock is currently selling for P57.50. The firm expects to pay a
P3.40 dividends at the end of 2007. After underpricing and floatation cost, Chubby expects to net
P52 per share on new issuance of common stocks. Dividends paid for the last 5 years are as
follows:

## Year 2002 2003 2004 2005 2006

Dividends 2.12 2.30 2.60 2.92 3.10

## a. Compute for the dividend growth rate.

b. Determine the net proceeds on the common stocks.
c. Compute the cost of retained earnings using the constant growth valuation model or the
Gordon model.
d. Compute the cost of new common stocks using the constant growth valuation model or the
Gordon model.

8. Chubbylito Inc., reported earnings available to common stockholders of P4,200,000 last year.
From these earnings dividends were paid for P1.26 per share on its 1,000,000 common
outstanding shares. The company has a 40% debt ratio, 10% preferred stock and 50% common
stocks in its capital structure. It is in the 40% tax bracket.
a. If the market value of the company’s common stock is P40 and dividends are expected to
grow at a rate of 6% per year, what is the company’s cost of financing with retained earnings.
b. If the underpricing and floatation costs on new shares of common stocks amounts to P7 per
share, what is the company’s cost of nnew common stock financing?
c. If the company can issue P2 dividend preferred stock for a market price of P25 per share with
floatation costs of P3 per share. What is the cost of preferred stock financing?
d. The company can issue P1,000 par value, 10% coupon, 5-year bonds that can be sold for
P1,200 each. Floatation costs would amount to P25 per bond. What is the approximate cost of
debt?.
e. What is the maximum investment that the company can make before issuing new common
stocks?.
f. What is the weighted average cost of capital for projects at a cost at or below the amount
computed in e?
g. What is the weighted average cost of capital for projects at a cost higher the amount computed
in e?

## Particulars Project Apple Project Mona

Required investment P60,000 P40,000
Life 15 Years 15 Years
Internal Rate of Return 8% 15%
Source of Financing Debt Equity
Cost of Financing 7% 16%
Decision Accept Reject
Reason IRR8%>7%Cost of financing IRR15%<16%Cost of financing

a. Explain why the decision to accept project apple and reject project mona might not have been
to the best interest of the stockholders.
b. Compute weighted average cost of capital and determine which project should be rejected and
which should be accepted.
Multiple Choice

1. The _________ is the rate of return a firm must earn on its investments in projects in order to
maintain the market value of its stock.
(a) net present value
(b) cost of capital
(c) internal rate of return
(d) gross profit margin

2. The _________ is the rate of return required by the market suppliers of capital in order to attract
their funds to the firm.
(a) yield to maturity
(b) internal rate of return
(c) cost of capital
(d) gross profit margin

3. _________ is the risk to the firm of being unable to cover operating costs.
(a) Total risk
(c) Financial risk
(d) Diversifiable risk
4. _________ is the risk to the firm of being unable to cover financial obligations.
(a) Total risk
(c) Financial risk
(d) Diversifiable risk

5. The four basic sources of long­term funds for the business firm are
(a) current liabilities, long­term debt, common stock, and preferred stock.
(b) current liabilities, long­term debt, common stock, and retained earnings.
(c) long­term debt, paid­in capital in excess of par, common stock, and retained earnings.
(d) long­term debt, common stock, preferred stock, and retained earnings.

6. The specific cost of each source of long­term financing is based on _________ and _________
costs.
(a) before­tax; historical
(b) after­tax; historical
(c) before­tax; book value
(d) after­tax; current
7. A corporation has concluded that its financial risk premium is too high. In order to decrease this, the
firm can
(a) increase the proportion of long­term debt to decrease the cost of capital.
(b) increase short­term debt to decrease the cost of capital.
(c) decrease the proportion of common stock equity to decrease financial risk.
(d) increase the proportion of common stock equity to decrease financial risk.

8. A tax adjustment must be made in determining the cost of _________.
(a) long­term debt
(b) common stock
(c) preferred stock
(d) retained earnings

9. The before­tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. The
after­tax cost of debt is
(a) 4.8 percent.
(b) 6.0 percent.
(c) 7.2 percent.
(d) 12 percent.

10. A firm has issued 10 percent preferred stock, which sold for P100 per share par value. The cost of
issuing and selling the stock was P2 per share. The firm’s marginal tax rate is 40 percent. The cost
of the preferred stock is
(a) 3.9 percent.
(b) 6.1 percent.
(c) 9.8 percent.
(d) 10.2 percent.

11. If a corporation has an average tax rate of 40 percent, the approximate, annual, after­tax cost of debt
for a 15­year, 12 percent, P1,000 par value bond, selling at P950 is
(a) 10 percent.
(b) 10.6 percent.
(c) 7.6 percent.
(d) 6.0 percent.

12. If a corporation has an average tax rate of 40 percent, the approximate annual, after­tax cost of debt
for a 10­year, 8 percent, P1,000 par value bond selling at P1,150 is
(a) 3.6 percent.
(b) 4.8 percent.
(c) 6 percent.
(d) 8 percent.

13. Debt is generally the least expensive source of capital. This is primarily due to
(a) fixed interest payments.
(b) its position in the priority of claims on assets and earnings in the event of liquidation.
(c) the tax deductibility of interest payments.
(d) the secured nature of a debt obligation.

14. The cost of common stock equity may be estimated by using the
(a) yield curve.
(b) net present value method.
(c) Gordon model.
(d) DuPont analysis.

15. The cost of common stock equity may be estimated by using the
(a) yield curve.
(b) capital asset pricing model.
(c) internal rate of return.
(d) DuPont analysis.

16. The cost of retained earnings is
(a) zero.
(b) equal to the cost of a new issue of common stock.
(c) equal to the cost of common stock equity.
(d) irrelevant to the investment/financing decision.

17. The cost of new common stock financing is higher than the cost of retained earnings due to
(a) flotation costs and underpricing.
(b) flotation costs and overpricing.
(c) flotation costs and commission costs.
(d) commission costs and overpricing.

18. A firm has common stock with a market price of P25 per share and an expected dividend of P2 per
share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the
firm’s common stock equity is
(a) 5 percent.
(b) 8 percent.
(c) 10 percent.
(d) 13 percent.

19. A firm has a beta of 1.2. The market return equals 14 percent and the risk­free rate of return equals
6 percent. The estimated cost of common stock equity is
(a) 6 percent.
(b) 7.2 percent.
(c) 14 percent.
(d) 15.6 percent.

20. Firms underprice new issues of common stock for the following reason(s).
(a) When the market is in equilibrium, additional demand for shares can be achieved only at a
lower price.
(b) When additional shares are issued, each share’s percent of ownership in the firm is diluted,
thereby justifying a lower share value.
(c) Many investors view the issuance of additional shares as a signal that management is using
common stock equity financing because it believes that the shares are currently overpriced.
(d) All of the above.

21. A firm has common stock with a market price of P55 per share and an expected dividend of P2.81
per share at the end of the coming year. The dividends paid on the outstanding stock over the past
five years are as follows:

Year Dividend
1 P2.00
2 2.14
3 2.29
4 2.45
5 2.62
The cost of the firm’s common stock equity is
(a) 4.1 percent.
(b) 5.1 percent.
(c) 12.1 percent.
(d) 15.4 percent.

22. Given that the cost of common stock is 18 percent, dividends are P1.50 per share, and the price of
the stock is P12.50 per share, what is the annual growth rate of dividends?
(a) 4 percent.
(b) 5 percent.
(c) 6 percent.
(d) 8 percent.

23. Generally, the order of cost, from the least expensive to the most expensive, for long­term capital of
a corporation is
(a) new common stock, retained earnings, preferred stock, long­term debt.
(b) common stock, preferred stock, long­term debt, short­term debt.
(c) preferred stock, retained earnings, common stock, new common stock.
(d) long­term debt, preferred stock, retained earnings, new common stock.

24. When discussing weighing schemes for calculating the weighted average cost of capital, the
preferences can be stated as
(a) market value weights are preferred over book value weights and target weights are preferred
over historic weights.
(b) book value weights are preferred over market value weights and target weights are preferred
over historic weights.
(c) book value weights are preferred over market value weights and historic weights are preferred
over target weights.
(d) market value weights are preferred over book value weights and historic weights are preferred
over target weights.
25. A firm has common stock with a market price of P100 per share and an expected dividend of P5.61
per share at the end of the coming year. A new issue of stock is expected to be sold for P98, with P2
per share representing the underpricing necessary in the competitive capital market. Flotation costs
are expected to total P1 per share. The dividends paid on the outstanding stock over the past five
years are as follows:

Year Dividend
1 P4.00
2 4.28
3 4.58
4 4.90
5 5.24
The cost of this new issue of common stock is
(a) 5.8 percent.
(b) 7.7 percent.
(c) 10.8 percent.
(d) 12.8 percent.

26. A firm has determined its cost of each source of capital and optimal capital structure, which is
composed of the following sources and target market value proportions:

Target Market
Source of Capital Proportions After­Tax Cost
Long­term debt    40%      6%
Preferred stock 10 11
Common stock equity 50 15

The weighted average cost of capital is
(a) 6 percent.
(b) 10.7 percent.
(c) 11 percent.
(d) 15 percent.

27. A firm has determined its cost of each source of capital and optimal capital structure, which is
composed of the following sources and target market value proportions:

Target Market After­Tax
Source of Capital Proportions Cost
Long­term debt 45%      5%
Preferred stock 10 14
Common stock equity 45 22

If the firm were to shift toward a more leveraged capital structure (i.e., a greater percentage of debt
in the capital structure), the weighted average cost of capital would
(a) increase.
(b) remain unchanged.
(c) decrease.
(d) not be able to be determined.

28. As the volume of financing increases, the costs of the various types of financing will _________,
_________ the firm’s weighted average cost of capital.
(a) increase, lowering
(b) increase, raising
(c) decrease, lowering
(d) decrease, raising

A firm has determined its optimal capital structure which is composed of the following sources and target
market value proportions.

Table 11.1
Target Market
Source of Capital Proportions
Long­term debt    20%
Preferred stock 10
Common stock equity 70
Debt: The firm can sell a 12­year, P1,000 par value, 7 percent bond for P960. A flotation cost of
2 percent of the face value would be required in addition to the discount of P40.
Preferred Stock: The firm has determined it can issue preferred stock at P75 per share par value.
The stock will pay a P10 annual dividend. The cost of issuing and selling the stock is P3 per share.
Common Stock: A firm’s common stock is currently selling for P18 per share. The dividend
expected to be paid at the end of the coming year is P1.74. Its dividend payments have been growing
at a constant rate for the last four years. Four years ago, the dividend was P1.50. It is expected that
to sell, a new common stock issue must be underpriced P1 per share in floatation costs.
Additionally, the firm’s marginal tax rate is 40 percent.

29. The firm’s before­tax cost of debt is (See Table 11.1.)
(a) 7.7 percent.
(b) 10.6 percent.
(c) 11.2 percent.
(d) 12.7 percent.

30. The firm’s after­tax cost of debt is (See Table 11.1.)
(a) 3.25 percent.
(b) 4.6 percent.
(c) 8 percent.
(d) 8.13 percent.

31. The firm’s cost of preferred stock is (See Table 11.1.)
(a) 7.2 percent.
(b) 8.3 percent.
(c) 13.3 percent.
(d) 13.9 percent.

32. The firm’s cost of a new issue of common stock is (See Table 11.1.)
(a) 7 percent.
(b) 9.08 percent.
(c) 13.2 percent.
(d) 14.4 percent.

33. The firm’s cost of retained earnings is (See Table 11.1.)
(a) 10.2 percent.
(b) 13.9 percent.
(c) 12.4 percent.
(d) 13.6 percent.

34. The weighted average cost of capital up to the point when retained earnings are exhausted is (See
Table 11.1.)
(a) 7.5 percent.
(b) 8.65 percent.
(c) 10.4 percent.
(d) 11.0 percent.

35. The weighted average cost of capital after all retained earnings are exhausted is (See Table 11.1.)
(a) 13.6 percent.
(b) 11.0 percent.
(c) 11.55 percent.
(d) 10.4 percent.

A firm has determined its optimal structure which is composed of the following sources and target market
value proportions.

Table 11.2
Target Market
Source of Capital Proportions
Long­term debt    60%
Common stock equity 40
Debt: The firm can sell a 15­year, P1,000 par value, 8 percent bond for P1,050. A flotation cost of
2 percent of the face value would be required in addition to the premium of P50.
Common Stock: A firm’s common stock is currently selling for P75 per share. The dividend
expected to be paid at the end of the coming year is P5. Its dividend payments have been growing at
a constant rate for the last five years. Five years ago, the dividend was P3.10. It is expected that to
sell, a new common stock issue must be underpriced P2 per share and the firm must pay P1 per
share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent.

36. The firm’s before­tax cost of debt is (See Table 11.2.)
(a) 7.7 percent.
(b) 10.6 percent.
(c) 11.2 percent.
(d) 12.7 percent.

37. The firm’s after­tax cost of debt is (See Table 11.2.)
(a) 4.6 percent.
(b) 6 percent.
(c) 7 percent.
(d) 7.7 percent.

38. The firm’s cost of a new issue of common stock is (See Table 11.2.)
(a) 10.2 percent.
(b) 14.3 percent.
(c) 16.7 percent.
(d) 17.0 percent.

39. The firm’s cost of retained earnings is (See Table 11.2.)
(a) 10.2 percent.
(b) 14.3 percent.
(c) 16.7 percent.
(d) 17.0 percent.

40. The weighted average cost of capital up to the point when retained earnings are exhausted is (See
Table 11.2.)
(a) 6.8 percent.
(b) 7.7 percent.
(c) 9.44 percent.
(d) 11.29 percent.

41. Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of
capital is (See Table 11.2.)
(a) 9.6 percent.
(b) 10.9 percent.
(c) 11.6 percent.
(d) 12.1 percent.

Table 11.3
Balance Sheet
General Talc Mines
December 31, 2003
Assets
Current Assets
Cash P25,000
Accounts Receivable 120,000
Inventories 300,000
Total Current Assets P445,000
Net Fixed Assets P500,000
Total Assets P945,000

Liabilities and Stockholders’ Equity
Current Liabilities
Accounts Payable P80,000
Notes Payable 350,000
Accruals 50,000
Total Current Liabilities P480,000
Long­Term Debts(150 bonds issued at P1,000 par) 150,000
Total Liabilities P630,000
Stockholders’ Equity Common Stock (7,200 shares outstanding) P180,000
Retained Earnings 135,000
Total Stockholders’ Equity P315,000
Total Liabilities and Stockholders’ Equity P945,000

42.

Source of Capital After­Tax Cost
Long­term debt      8%
Common stock equity 19

Given this after­tax cost of each source of capital, the weighted average cost of capital using book
weights for General Talc Mines is (See Table 11.3.)
(a) 11.6 percent.
(b) 15.5 percent.
(c) 16.6 percent.
(d) 17.5 percent.

43. General Talc Mines has compiled the following data regarding the market value and cost of the
specific sources of capital.

Source of Capital After­Tax Cost
Long­term debt      8%
Common stock equity 19
Market price per share of common stock P50
Market value of long­term debt P980 per bond
The weighted average cost of capital using market value weights is (See Table 11.3.)
(a) 11.7 percent.
(b) 13.5 percent.
(c) 15.8 percent.
(d) 17.5 percent.

44. A corporation expects to have earnings available to common shareholders (net profits minus
preferred dividends) of P1,000,000 in the coming year. The firm plans to pay 40 percent of earnings
available in cash dividends. If the firm has a target capital structure of 40 percent long­term debt, 10
percent preferred stock, and 50 percent common stock equity, what capital budget could the firm
support without issuing new common stock?
(a) P2,000,000.
(b) P 600,000.
(c) P1,200,000.
(d) P800,000.

45. A firm has determined its cost of each source of capital and optimal capital structure which is
composed of the following sources and target market value proportions.

Target Market
Source of Capital Proportions After­Tax Cost
Long­term Debt     35%       9%
Preferred Stock 10 14
Common Stock Equity 55 20

The firm is considering an investment opportunity, which has an internal rate of return of 10 percent.
The project
(a) should not be considered because its internal rate of return is less than the cost of long­term
debt.
(b) should be considered because its internal rate of return is greater than the cost of debt.
(c) should not be considered because its internal rate of return is less than the weighted average cost
of capital.
(d) should be considered because its internal rate of return is greater than the weighted average cost
of capital.