Eddy Blaire M.

Policarpio BSA 2-2A

Financial Management
Problem exercises

Cost of Capital
Problem 1
DRW, Inc. is preparing to issue Preferred stock. The preferred stock will have a P100 par value and will
pay P8 per year in dividends. DRW’s marginal tax rate is 34%. Flotation costs for the new issue will be
P2.38 per share. The issue price is expected to be P96.50 per share. Based on this information, DRW’s
cost of preferred stock is nearest:
a. 5.3% b. 8.5% c. 5.6% d. 8.0%
Solution:
P8 / (P96.50 – P2.38) = 8.5%

Problem 2
Ames Co. is preparing to issue new common stock. Ames stock is currently selling in the market for P50.
Very recently, the stock paid a dividend of P2 per share. Dividends are expected to grow at 10% per year
through the foreseeable future. Flotation costs on the new issue will be P3 per share. Ames marginal tax
rate is 34%. Assume the new stock can be sold to investors at the current price of the existing shares.
I. Based on the information given above, Ames cost of retained earnings is nearest to:
a. 4.4% b. 4.7% c. 14.0% d. 14.4%
Solution:
[(P2x110%) / P50] + 10% = 14.4%

II. Based on the information given above, Ames cost of new common stock is nearest to:
a. 8.33% b. 14.40% c. 14.68% d. 14.25%
Solution:
[(P2x110%) / (P50 – P3] + 10% = 14.68%

Problem 3
Using the CAPM, the required rate of return for a firm with a beta of 1.25 when the market return is 14
percent and the risk free rate is 6 percent.
a. 14.0 percent b. 6.0 percent c. 7.5 percent d. 16.0 percent
Solution:
6% + 1.25 x (14% - 6%) = .16 or 16%

Problem 4
The AAA Corporation made available the following data as required:
Total interest payments on bond payable 60,000
Preferred stock dividends 20,000
Common stock dividends 24,000
Annual growth in common stock dividend 2%
Market values of:
Bonds payable 400,000
Common stock 300,000
Preferred stock 200,000
Retained earnings 100,000
Company tax rate 30%
 Stockholders’ marginal tax rate 70%
Required: calculate the following: (cost of debt, cost of preferred stock, cost of common stock, cost of
retained earnings and cost of capital.)

Solutions:
a. Cost of debt
Cost of debt = Interest Expense (1 – Tax rate)
= 60,000 (1 – 0.30)
= 60,000 (.07)
= 42,000
b. Cost of preferred stock
Cost of preferred stock = Dividend Price / Stock Price + Growth rate
=20,000 / 200,000 + 0
= .10 or 10%
c. Cost of common stock = 24,000/300,000 + 2%
= .08 + 2%
= 10%

d. Cost of retained earnings = (DI / NP) + g

= 2/102 + 2%
= .0196 + 2%
= .0396 or 3.96%

Problem 5
COC co. reported the ff. pre-tax cost of securities and optimal capital mix.
Cost of security Optimal capital mix
Bonds payable, 10% 6% 50%
Preferred equity 10% 30%
Ordinary share 14% 10%
Retained earnings 13% 10%
The company available P4,000,000 retained earnings for capital investment. The company’s tax rate is
30%.
Required:
1. The weighted average cost of capital under present condition.
2. The weighted average cost of capital if the company finances a P20M project.
3. The weighted average cost of capital if the company finances a P30M project.

Use this as guide in your answers

Sources of funds Amount of funds Cost of security Optimal capital WACOC
mix

Total
*pasensya sir wala jud ko kabalo unsaon ni hehe (insert sad emoticon)
Capital budgeting
Problem 1
Ralph com. Is considering buying a new machine which will require an initial outlay of P15,000. The
company estimates that over the next four years this machine would save P6,000 per year in cash
operating expenses. At the end of four years, the machine will have no salvage value. The company’s
cost of capital is 14%.
I. The net present value of the investment is
a. P(12,632) b. P17,484 c. P2,484 d. P3,612
Solution:
Present value of cash inflow (6,000 x 2.914) P17,484
Less: Net Investment 15,000
Net Present value of Investment 2,484

II. The machine’s IRR is closest to

a. 14% b. 16% c. 18% d. 22%

Problem 2
Allo Foundation, a tax-exempt organization, invested P200,000 in a five year project at the beginning of
19x5. Allo estimates that the annual cash savings will amount to P65,000. The P200,000 asset will be
depreciated over five years on a straight line method. On this type of investment, Allo’s desired rate of
return is 12%.
I. What is the net present value of this project?
a. P34,325 b. P36,400 c. P90,000 d. P125,000
Solution:
Years Amount 12% factor Present Value
Initial Investment Now P(200,000) 1.000 (200,000)
Annual savings 1-5 65,000 3.605 234,325
Net present value 34,325

*243,325/65,000= 3.605
*65,000 x 3.605 = 243,325

II. Allo’s Internal rate of return is

a. Less than 12% b. less than 14% but more than 12% c. less than 16% but more than 14%
d. more than 16%
Solution:
P65,000 x PV factor = 200,00 x 1.0 (PV of an annuity of 1 of 5 periods)
P65,000(PV factor) = 200,000
Then divide by 65,000: P200,000 / 65,000 =3.08, it indicates that a PV factor of 3.08 would
relate to an interest rate of more than 16%
 III. What is the payback period?
a. 5 years b. 4 years c. 3.08 years d. 2.4 years

Formula:
Payback period = Initial Investment or Original Cost of the Asset / Cash Inflows
Solution:
200,000/65,000=3.08
*200,000 divided by 65,000 is equal to 3.08