FINANCIAL MANAGEMENT 2

Weighted Average Cost

of Capital and Company
Valuation
Individual Exercise
1. T/F: Since the money is readily available, the
cost of retained earnings is usually a lot cheaper
than the cost of debt financing.
2. T/F: If investors become more risk averse, the
probable effects are as follows: increase in cost
of debt, decrease in cost of equity, and increase
in WACC.
3. T/F: A value-maximizing firm will determine its
optimal capital structure (which is defined as the
mix of debt, preferred, and common equity that
causes its stock price to be maximized), use it
as a target, and then raise new capital in a
manner designed to keep the actual capital
structure on target over time.
4. T/F: Failing to adjust the WACC for differences in
risk would lead the firm to accept too many risky
projects and reject too many safe ones.
5. What will be the effect of using book value of debt
in WACC decisions if interest rates have
decreased substantially since a firm's long-term
bonds were issued?
A) There will be no effect on WACC decisions.
B) The debt-to-value ratio will be overstated.
C) The debt-to-value ratio will be understated.
D) None of the above.
Note: Value = MV of debt + MV of equity
6. For a company that pays no corporate taxes, its
WACC will be equal to:
A) the total value of its assets.
B) the expected return on it assets.
C) the expected return on its debt.
D) the expected return on its equity.
7. Which of the following statements is most
correct?
A) Theoretically, the weights should be based on
market values, but if a firms book value weights
are reasonably close to its market value weights,
book value weights can be used as a proxy for
market value weights.
B) In general, the WACC should include the types
of capital used to pay for long-term assets, and these
are typically short-term and long-term debt, preferred
stock (if used), and common stock.
C) The relevant WACC component costs are todays
historical costs rather than marginal costs.
D) Since preferred dividends are tax deductible to the
issuer, there is a need for a tax adjustment.
8. Which of the following will increase the WACC?
A) Decrease in interest rates
B) Increase in corporate taxes
C) Decrease in dividend and capital gains taxes
D) Decrease in stock prices
9. What is the WACC for a firm with 60% debt and
40% equity that pays 12% on its debt, 20% on its
equity, and has a 35% tax rate?

10. How much will a firm need in cash flow before
tax and interest to satisfy debtholders and
equityholders if: the tax rate is 35%, there is P10
million in common stock requiring a 10% return, and
P8 million in bonds requiring an 6% return?


11. Information on the Balance Sheet of Heaven Corp are
as follows:
Total Assets = P6,000 Pref. Stock = P 300
CL = P 500 Com. Stock = P1,800
LT Liabilities = P1,500 RE = P1,900

Other information are as follows:
EPSo = P18 g = 10%
Plowback ratio = 0.60 After-tax cost of debt = 11%
Stock Price = P50 Tax rate = 40%
Flotation cost = 9% rp = 13%

What is the companys WACC if new common stock
(external equity) is used?

12. If the market risk premium is 7%, the risk free
rate is 5%, and the beta is 1.5, what is the cost of
common equity from retained earnings using the
CAPM method?

13. In relation to no.11 and 12, what is the cost of
new common stock based on CAPM? (Hint: Find the
difference between Rs and Re, as determined by
the DCF method and add that differential to the
CAPM value for Rs.)




14. The current price of the firms 12% coupon,
semi-annual payment, non-callable bonds with 5
years remaining to maturity is P1,162. Its face value
is P1,000. If the tax rate is 40%, what is the cost of
debt?





15. The companys stock currently sells for P50.00
per share. It is expected to pay a dividend of P4.00
next year, its growth rate is a constant 9.0%, and the
company will incur a flotation cost of 8.0% of the
market value if it sells new common stock. The
firm's tax is 35%. What is the firm's cost of retained
earnings?




ANSWERS:
1. F 9. 12.68%
2. F 10. P2.02M
3. T 11. 22.14%
4. T 12. 15.50%
5. C 13. 17.07%
6. B 14. 4.8%
7. A 15. 17%
8. D