management

advisory
services
cost of capital
 An Overview of the Cost of
Capital
• The cost of capital acts as a link between the
firm’s long-term investment decisions and the
wealth of the owners as determined by investors
in the marketplace.
• It is the “magic number” that is used to decide
whether a proposed investment will increase or
decrease the firm’s stock price.
• Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it
invests to maintain the market value of its stock.

2
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
Answer: B

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
Answer: C
3
The Firm’s Capital Structure

4
5.The four basic sources of long-term
funds for the business firm are
(a) current liabilities, long-term debt,
common stock, and preferred stock.
(b) current liabilities, long-term debt,
common stock, and retained earnings.
(c) long-term debt, paid-in capital in
excess of par, common stock, and
retained earnings.
(d) long-term debt, common stock,
preferred stock, and retained earnings.
Answer:D 5
 Some Key Assumptions
• Business Risk—the risk to the firm of being unable to
cover operating costs—is assumed to be unchanged.
This means that the acceptance of a given project does
not affect the firm’s ability to meet operating costs.
• Financial Risk—the risk to the firm of being unable to
cover required financial obligations—is assumed to be
unchanged. This means that the projects are financed in
such a way that the firm’s ability to meet financing costs
is unchanged.
• After-tax costs are considered relevant—the cost of
capital is measured on an after-tax basis.

6
3. _________ is the risk to the firm of being
unable to cover operating costs.
(a) Total risk
(b) Business risk
(c) Financial risk
(d) Diversifiable risk
Answer: B
4. _________ is the risk to the firm of being
unable to cover financial obligations.
(a) Total risk
(b) Business risk
(c) Financial risk
(d) Diversifiable risk 7
Answer: C
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
8
why?
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.
Answer:C
9
 After Tax Weighted
TOTAL ASSETS = TOTAL CAPITAL Proportion Cost Cost
Long Term Debt 0.30 10% 3%
Preferred Stocks 0.10 15% 2%
Common Stock Equity 0.60 20% 12%
IRR 14.00% -2.50% 1.00 45% 16.50% WACC
IRR>WACC REJECT

10
DEBT IS LEAST COSTLY BECAUSE OF RISK AND RETURNS TRADE OFF AND TAX DEDUCTIBILITY OF INTEREST EXPENSE
1.
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.

11
23. Generally, the order of cost, from the
least expensive to the most expensive, for
long-term capital of a corporation is
(a) new common stock, retained earnings,
preferred stock, long-term debt.
(b) common stock, preferred stock, long-
term debt, short-term debt.
(c) preferred stock, retained earnings,
common stock, new common stock.
(d) long-term debt, preferred stock, retained
earnings, new common stock.
Answer: D
12
 After Tax Weighted
TOTAL ASSETS = TOTAL CAPITAL Proportion Cost Cost
Long Term Debt 0.60 10% 6%
Prefer ed Stocks 0.10 15% 2%
Common Stock Equity 0.30 20% 6%
IRR 14.00% 0.50% 1.00 45% 13.50%WACC
IRR>WACC ACCEPT

INCREASING DEBT AND RISKS DECREASES COST OF CAPITAL AND INCREASES RETURNS =RISK AND RETURN TRADE OFF
13
 The Weighted Average Cost of
Capital
WACC = ka = wiki + wpkp + wskr or n
• Capital Structure Weights

The weights in the above equation are intended to

represent a specific financing mix (where wi = % of
debt, wp = % of preferred, and ws= % of common).

Specifically, these weights are the target percentages

of debt and equity that will minimize the firm’s overall
cost of raising funds.
14
 The Weighted Average Cost of
Capital
WACC = ka = wiki + wpkp + wskr or n
• Capital Structure Weights

One method uses book values from the firm’s balance

sheet. For example, to estimate the weight for debt,
simply divide the book value of the firm’s long-term debt
by the book value of its total assets.

To estimate the weight for equity, simply divide the total

book value of equity by the book value of total assets.
15
 The Weighted Average Cost of
Capital
WACC = ka = wiki + wpkp + wskr or n
• Capital Structure Weights

Using the costs previously calculated along with the

market value weights, we may calculate the weighted
average cost of capital as follows:

WACC = .30(10%) + .10(15%) + .60(20%)

= 16.5%

This assumes the firm has sufficient retained earnings to

fund any anticipated investment projects.
16
2. Promo Pak 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
P20,000,000P25,000,000
(a) Calculate the weighted average cost of capital
using book value weights.
(b) Calculate the weighted average cost of capital
using market value weights.

17
ASSUMING 13% IRR
After Tax Weighted
TOTAL ASSETS =TOTAL CAPITAL Book Value Proportion
Proportion Cost Cost
Long Term Debt 10,000,000 10/20 0.50 5% 2.50%
Preferred Stocks 1,000,000 1/20 0.05 14% 0.70%
Common Stock Equity
9,000,000 9/20 0.45 20% 9.00%
20,000,000 20,000,000 1.00 12.20% WACC
IRR>WACC ACCEPT
13%>12.20% (.50)(5%)+(.05)(14%)+(.45)(20%) = 12.20%
WRONG ECONOMIC DECISION (Wd)(Kd)+Wp)(kp)+(We)(Ke) = WACC

After Tax Weighted

TOTAL ASSETS =TOTAL CAPITAL Market ValueProportion
Proportion Cost Cost
Long Term Debt 8,500,000 8.5/25 0.34 5% 1.70%
Preferred Stocks 1,500,000 1.5/25 0.06 14% 0.84%
Common Stock Equity
15,000,000 15/25 0.60 20% 12.00%
25,000,000 25,000,000 1.00 14.54% WACC
IRR<WACC REJECT
13%<14.54% (.50)(34%)+(.06)(14%)+(.60)(20%) = 14.54%
CORRECT ECONOMIC DECISION (Wd)(Kd)+Wp)(kp)+(We)(Ke) = WACC 18
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. 19
Answer: A
10. Floyd Co. made the following investment decision:

Particulars Project Apple Project Mona

Required investment P60,000 P40,000
Life 15 Years 15 Years
Internal Rate of 8% 15%
Return
Source of Financing Debt Equity
Cost of Financing 7% 16%
Decision Accept Reject
Reason IRR8%>7%Cost of IRR15%<16%Cost of
financing 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 should20 be
accepted.
10b
Capital Capital After
Structure Structure Tax Weight
Source of Capital Book Value Weight Weight Costs Costs
LTD 60,000.00 6/10 0.60 7.00% 4.20%
PS - 0 0.00 0.00% 0.00%
CS 40,000.00 4/10 0.40 16.00% 6.40%
TOTAL 100,000.00 1.00 10.60% WACC

Project Apple IRR 8%<10.6%WACC Reject

21
Project Mona IRR 15%>10.6%WACC Accept
 The Basic Concept Problem 10
• Why do we need to determine a company’s overall
“weighted average cost of capital?”
• As Problem 10 clearly illustrates, using this piecemeal
approach to evaluate investment opportunities is clearly
not in the best interest of the firm’s shareholders the
company the company accepted Apple with an IRR 0f
8% and rejected Mona with an IRR of 15%.
• Over the long haul, the firm must undertake investments
that maximize firm value.
• This can only be achieved if it undertakes projects that
provide returns in excess of the firm’s overall weighted
average cost of financing (or WACC) as illustrated in
10b.
22
 Specific Sources of Capital:
The Cost of Long-Term Debt
• The pretax cost of debt is equal to the the yield-to-
maturity on the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a
number of factors including the bond’s coupon rate,
maturity date, par value, current market conditions, and
selling price.
• After obtaining the bond’s yield, a simple adjustment
must be made to account for the fact that interest is a
tax-deductible expense.
• This will have the effect of reducing the cost of debt.

23
4. 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.24
i. Contrast and explain the answers in c, g and h.
 Specific Sources of Capital:
The Cost of Long-Term Debt
• Before-Tax Cost of Debt
• The before-tax cost of debt can be
calculated by:
• Approximating the cost
• Internal Rate of Return

25
 Specific Sources of Capital:
The Cost of Long-Term Debt
(cont.)
• Before-Tax Cost of Debt
– Approximating the Cost

26
Appproximation cost of debt formula:
kd = I + P1,000-Nd/n ki = kd x (1-tax rate)
Nd + P1,000
'2

kd = before tax cost of debt

I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
27
ki - after tax cost of debt
4a
Selling price 1,010.00
Less
Floatation cost 30.00
Net proceeds, Nd 980.00

4b
t0 t1 t2 … t15
980.00 (120.00) (120.00) … (120.00)
28
(1,000.00)
4c
Appproximation cost of debt formula:
kd = I + P1,000-Nd/n ki = kd x (1-tax rate)
Nd + P1,000
'2

kd = before tax cost of debt

I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
ki - after tax cost of debt

kd= P120 + P1,000 - P980/15 years ,= P120 + 1.3333333 0.122556

P980 + P1,000 990 12.26%
'2

ki= 12.26% x 1-.40 = 0.073533 29

7.35%
 Specific Sources of Capital:
The Cost of Long-Term Debt

Find the after-tax cost of debt for Duchess

assuming it has a 40% tax rate:

ki = 12.26% (1-.40) = 7.35%

This suggests that the after-tax cost of raising
debt capital is 7.35%.
30
4g
kd= P120 + P1,000 - P1,000/15 years ,= P120 + 0 0.12
P1,000 + P1,000 1000 12.00%
'2

ki= 12.00% x 1-.40 = 0.072

7.20%
4h
kd= P120 + P1,000 - P1020/15 years ,= P120 + -1.333333 0.117492
P1020 + P1,000 1010 11.75%
'2

ki= 11.75% x 1-.40 = 0.070495

31
7.05%
  n
I   M 
Bo   
t  n
 t 1 (1  k)   (1  k) 

 $120  $1,000
15
$980  
t  15 
 t1 (1k)   (1k)  32
 t0 t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12 t13 t14 t15
B0 980.00 (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00)

(120)/1.IRR
(120)/1.IRR/1.IRR
x 1/1.IRR3
x 1/1.IRR4
x 1/1.IRR5
x 1/1.IRR6
x 1/1.IRR7
x 1/1.IRR8
x 1/1.IRR9
x 1/1.IRR10
x 1/1.IRR11
x 1/1.IRR12
x 1/1.IRR13
x 1/1.IRR14
x 1/1.IRR15

1/1.IRR15x (1,000.00)
PVFCF (980.00) IF THE 16 FUTURE CASHFLOWS BE ADDED IT MUST BE EQUAL TO B0 WHICH IS 980.00 33
NPV - THIS BECOMES 0 IF THE SUM OF THE 16 FUTURE CASHFLOWS IS EQUAL TO B0 WHICH IS 980.00
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

(120)/1.IRR
(120)/1.IRR/1.IRR
3
x 1/1.IRR

15
x 1/1.IRR

15
1/1.IRR x (1,000.00)
PVFCF (980.00) IF THE 16 FUTURE CASHFLOWS BE ADDED IT MUST BE EQUAL TO B0 WHICH IS 980.00
NPV - THIS BECOMES 0 IF THE SUM OF THE 16 FUTURE CASHFLOWS IS EQUAL TO B0 WHICH IS 980.00 34
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

(120)/1.12
(120)/1.12/1.12
3
x 1/1.12

15
x 1/1.12

15
1/1.12 x (1,000.00)
PVFCF (1,000.32) THE 16 FUTURE CASHFLOWS IS NOT EQUAL TO B0 WHICH IS 980.00
35
NPV (20.32) SINCE THIS IS NOT 0 12% IS NOT THE INTERNAL RATE OF RETURN
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

12% (817.32) 6.811 X

(183.00) 0.183 X (1,000.00)
(1,000.32)
(20.32) 36
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

(120)/1.13
(120)/1.13/1.13
3
x 1/1.13

15
x 1/1.13

15
1/1.13 x (1,000.00)
PVFCF (935.44) THE 16 FUTURE CASHFLOWS IS NOT EQUAL TO B0 WHICH IS 980.00
37
NPV 44.56 SINCE THIS IS NOT 0 13% IS NOT THE INTERNAL RATE OF RETURN
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

13% (775.44) 6.462 X

(160.00) 0.160 X (1,000.00)
(935.44)
44.56 38
 t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

12% (817.32) 6.811 X

(183.00) 0.183 X (1,000.00)
(1,000.32)
(20.32)

t0 t1 t2 t3 … t15
B0 980.00 (120.00) (120.00) (120.00) (120.00)

13% (775.44) 6.462 X

(160.00) 0.160 X (1,000.00)
(935.44) 39
44.56
 12% ? 13%
1,000.32 980.00 935.44

100% OR 1 64.88 1,000.32 - 935.44 STEP2

20.32 1,000.32 - 980.00 STEP3

20.32/64.88= 1-.31 20.32/64.88 STEP4

0.31 0.69

40
4e
12.26% and 12.31% after tax is 7.35% and 7.39% for approximation and IRR respectively, dif erence is
negligible.

4f
The value of bonds and interest rate have an inverse relationship.
41
 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%
Louie Corp. 40 38 3.50 8%
Paul Inc. 35 37 4 P5
Cahayon Co. 30 26 5% of par P3
Vil amin Inc. 20 20 2.50 9%
42
 Specific Sources of Capital:
The Cost of Preferred Stock

KP = DP/Np OR KP = DP/Po-FC
Kp=Cost of Preferred Stock Dp= Dividends of
Preferred Stock Po=Price or Market Value of
Preferred Stock FC= Floatation Costs

KP = DP/Np = P100X11%/P101-P9 =
P11/P92 = 11.96% 43
kp  Dp  Np=
Preferred Calculation
Stock
Floyd kp 11.00  92.00 = 11.96%
Louie kp 3.20  34.50 = 9.28%
Paul kp 5.00  33.00 = 15.15%
Cahayon kp 3.00  24.50 = 12.24%
Villamin kp 1.80  17.50 = 10.29%
44
 5. Data of the common stock of the following companies are listed
below:

Company Market Dividend Projected Underpricing Floatation

Value(P) Growth Dividends Per Share Cost Per
Rate (% ) (P) Share(P)
Ofel Co. 50 8 2.25 2 1
Tabag 20 4 1 0.50 1.50
Corp.
DelaCruz, 42.50 6 2 1 2
Co
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 underprice new common stocks?.
45
 Specific Sources of Capital:
The Cost of Common Stock
• There are two forms of common stock financing:
retained earnings and new issues of common stock.
• In addition, there are two different ways to estimate the
cost of common equity: any form of the dividend
valuation model, and the capital asset pricing
model (CAPM).
• The dividend valuation models are based on the premise
that the value of a share of stock is based on the present
value of all future dividends.

46
 The Cost of Common Stock
• Using the constant growth model, we have:

kS = (D1/P0) + g

• We can also estimate the cost of common equity

using the CAPM:

kE = rF + b(kM - RF).

47
 The Cost of Common Stock
• The CAPM differs from dividend valuation
models in that it explicitly considers the firm’s
risk as reflected in beta.
• On the other hand, the dividend valuation model
does not explicitly consider risk.
• Dividend valuation models use the market price
(P0) as a reflection of the expected risk-return
preference of investors in the marketplace.

48
 The Cost of Common Stock
• Although both are theoretically equivalent,
dividend valuation models are often preferred
because the data required are more
readily available.
• The two methods also differ in that the dividend
valuation models (unlike the CAPM) can easily
be adjusted for flotation costs when estimating
the cost of new equity.
• This will be demonstrated in the examples
that follow.

49
 The Cost of Common Stock
• Cost of Retained Earnings (kE)
– Constant Dividend Growth Model

ks = D1/P0 + g
Ks = Cost of Retained Earnings or
Common Stock; D1= Dividends as
forecasted or expected; Po= Price or
Market Value of Common Stocks; g=
Growth Rate.

kS = (P2.25/P50.00) + .08 = 12.5%. 50

 t-1 t0 t1
Past Present Future
2012 2013 2014

P-1 P0 P1
Price 2012 Price 2013 Price 2014

D-1 D0 D1
Dividends Dividends Dividends
2012 2013 2014

Paid for Paid for

2013 2013
Investment Investment
51
P-1 P0
 The Cost of Common Stock
• Cost of New Equity (kn)
– Constant Dividend Growth Model
kn = D1/Nn + g or
Kn = D1/Po-FC-U + g
Kn= Cost of New Common Stock; D1= Dividends as
forecasted or expected; Nn= Net Proceeds (Price or
Market Value of Common Stock – Floatation Cost –
Underpricing); g=Growth Rate?

kn = [P2.25/(P50.00 – P1.00-P2.00) + .08= 12.79%

52
Firm Calculation
Ofel kr = (P2.25  P50.00) + 8% = 12.50%
kn = (P2.25  P47.00) + 8% = 12.79%
Tabag kr = (P1.00  P20.00) + 4% = 9.00%
kn = (P1.00  P18.00) + 4% = 9.56%
Dela Cruz kr = (P2.00  P42.50) + 6% = 10.71%
kn = (P2.00  P39.50) + 6% = 11.06%
Cecilia kr = (P2.10  P19.00) + 2% = 13.05%
kn = (P2.10  P16.00) + 2% = 15.13%

53
6c
Because of floatation costs and underpricing
6d
Retained earnings rightful y belongs to common stockholders.
6e
Signalling theory - investors takes issuance of equity as a sign of companies poor prospects.
54
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.
Answer: C

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.
Answer: A 55
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.
Answer: D
56
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. 57
f. Explain the concept of risk free rate, market return and beta.
 (The Cost of Common Stock)
• Cost of Retained Earnings (kE)
– Security Market Line Approach

ks = RF + b(kM - RF).

Ks=Cost of Retained Earnings; RF=Risk Free Rate =nth

T-bill rate Or Govt. Bond rate; Km = Average Market
Return; b = beta a measure of stock price volatility:

ks = 6.0% + 1.2 (11.0%-6.0%) = 12.0%.

58
ks = RF + [b  (km - RF)]
ks = 6% + 1.2  (11% - 6%)
ks = 6% + 6%
ks = 12%
(c) Risk premium = 6%
(b) Rate of return = 12%
(a) After-tax cost of common equity using the CAPM = 12% 59
ks = RF + [b  (km - RF)]
ks = 6% + 1  (11%- 6%)
ks = 6% + 5%
ks = 11% 60
ks = RF + [b  (km - RF)]
ks = 6% + .90  (11% - 6%)
ks = 6% + 4.5%
ks = 10.5% 61
7f
Risk fre rate is the rate from t-bil s or govt. bonds, market return is the return paid by the market which
is higher than the risk fre rate and beta is a measure of volatil ty of the stock price which is measure of
risk. 62
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.
Answer: C
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. 63
Answer: B
7.Chubby 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
64
valuation model or the Gordon model.
A. USING FUTURE VALUE TABLE ANSWER IS 10% USING EXCEL ANSWER IS 9.97%
D2006 3.10 = 1.462 FACTOR
D2002 2.12
USING THE TABLE OF FUTURE VALUES FOR 4 PERIODS 1.462
IS NEAREST TO 1.464 WITH A RATE OF 10%

B.
Nn P52 Given in the problem 65
66
GEOMETRIC GROWTH RATE
YEARS 1 2 3 4 5 = 5 YEARS
PERIODS 1 2 3 4 = 4 PERIODS
FUTURE
t1
2002 2003 2004 2005 2006 2007
2.12 2.30 2.60 2.92 3.10 3.40
GROWTH P 0.18 0.30 0.32 0.18 D1=P3.40
GROWTH% 8% 13% 12% 6%

9.97% 2.12 X 1.462 = 3.0994 FACTOR RATE

2.12 X1.0997 X1.0997 X1.0997 X1.0997 3.1005 1.462 9.97%

10% 2.12 X 1.464 = 3.1037 FACTOR RATE

67
2.12 X1.10 X1.10 X1.10 X1.10 3.1039 1.464 10.00%
C.
Kr D1 +g P3.40 + .10 15.91%
P0 P57.50

D.
Kn D1 +g P3.40 + .10 16.54%
Nn P52.00 68
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.
Answer: C
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. 69
Answer: B
8. Aristorenas 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? 70
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 for71
projects at a cost higher the amount computed in e?
Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income or Earnings Before Interest and Taxes
Interest Expense
Earnings Before Tax
Tax
Earnings After Tax or Accounting Net Income Dividends (Common Stockholders)
Preferred Dividends 1.26 x 1,000,00 common shares 1,260,000
Earnings Available to Common Stockholders 4,200,000
Retained Earnings (Corporation)
4,200,000 - 1,260,000 2,940,000
72
 Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 0.40 0.00%
Fixed Assets Preferred Stock 0.10 0.00%
Retained Earnings2,940,000.00 0.50 0.00%
TOTAL ASSETS TOTAL 5,880,000.00 1.00 0.00% WACC
2,940,000/50% 73
 Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,352,000 0.40 0.00%
Fixed Assets Preferred Stock 588,000 0.10 0.00%
Retained Earnings 2,940,000 0.50 0.00%
TOTAL ASSETS 5,880,000 TOTAL 5,880,000 1.00 0.00% WACC
74
a. Cost of Retained Earnings
Kr D1 +g P1.26 (1+.06) + .06 9.35%
P0 P40.00
OR
D0(1+g) +g
P0

D0 (1+g) D1
1.26 1+.06 1.34

b. Cost of New Common Stocks

Kn D1 +g P1.26 (1+.06) + .10 10.06%
Nn P40.00 - P7.00
OR
D0(1+g) +g
Nn 75
c. Cost of Preferred Stocks
Kp Dp P2.00 9.09%
Np P25.00 - P3.00

d. Cost of Debt
kd= P100 + P1,000 - P1,175/5 years 65 0.05977
P1,175 + P1,000 1087.5 5.98%
'2

ki= 5.98% x 1-.40 = 0.03586207

3.59%
76
 Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,352,000 0.40 3.59% 1.44%
Fixed Assets Prefer ed Stock 588,000 0.10 9.09% 0.91%
Retained Earnings 2,940,000 0.50 9.35% 4.68%
TOTAL ASSETS 5,880,000 TOTAL 5,880,000 1.00 7.02% WACC
2,940,000/50% 77
e.
BREAKPOINTCOMMON EQUITY Amount of Funds Available at a given cost
Target Capital Structure Weight for source

BPCOMMON EQUITY A F COMMON EQUITY

W COMMON EQUITY

BPCOMMON EQUITY P4,200,000 - (P1.26 x 1,000,000 common shares)

50%

BPCOMMON EQUITY P2,940,000 5,880,000.00

0.5

Liabilities Capital After

And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 0.10 9.09% 0.91%
Retained Earnings 2,940,000.00 0.50 9.35% 4.68%
TOTAL ASSETS 5,880,000.00 TOTAL 5,880,000.00 1.00 7.02% 78
WACC
2,940,000/50%
f. WACC with projects of cumulative costs of P5,880,000
WACC = (WdxKd) (1-T) + ( WpxKp ) + (WeKe)
WACC = (.40x5.98%) (1-.40) + ( .10x9.09% ) + (.50x9.35%)
WACC = (.02392%) (60%) + ( 0.909%) + (4.675%)
WACC = (1.435%) + ( 0.909%) + (4.675%)
WACC = 7.02%

Liabilities Capital After

And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,352,000.00 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 588,000.00 0.10 9.09% 0.91%
Retained Earnings 2,940,000.00 0.50 9.35% 4.68%
TOTAL ASSETS 5,880,000.00 TOTAL 5,880,000.00 1.00 7.02% WACC
79
2,940,000/50%
f. WACC with projects of cumulative costs above P5,880,000
WACC = (WdxKd) (1-T) + ( WpxKp ) + (WeKe)
WACC = (.40x5.98%) (1-.40) + ( .10x9.09% ) + (.50x10.06%)
WACC = (.02392%) (60%) + ( 0.909%) + (5.03%)
WACC = (1.435%) + ( 0.909%) + 5.03%)
WACC = 7.375%

Liabilities Capital After

And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,400,000.00 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 600,000.00 0.10 9.09% 0.91%
Retained Earnings2,940,000.00
New Common Stock 60,000.00 0.50 10.06% 5.03%
TOTAL ASSETS 6,000,000.00 TOTAL 6,000,000.00 0.50 7.375% WACC

Required Common Equity(6,000,00 X 50%) 3,000,000

Retained Earnings 2,940,000 80
Required New Common Stocks 60,000
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
Answer: B
81
11. A firm has determined its optimal capital structure, which is composed
of the following sources and target market value proportions:

Source of Capital Target Market Proportions

Long-term debt 30%
Preferred stock 5
Common stock equity 65
Debt: The firm can sell a 20-year, P1,000 par value, 9 percent bond for
P980. A flotation cost of 2 percent of the face value would be required in
addition to the discount of P20.
Preferred Stock: The firm has determined it can issue preferred stock at
P65 per share par value. The stock will pay an P8.00 annual dividend. The
cost of issuing and selling the stock is P3 per share.
Common Stock: The firm’s common stock is currently selling for P40 per
share. The dividend expected to be paid at the end of the coming year is
P5.07. Its dividend payments have been growing at a constant rate for the
last five years. Five years ago, the dividend was P3.45. It is expected that
to sell, a new common stock issue must be underpriced at P1 per share
and the firm must pay P1 per share in flotation costs. Additionally, the
firm’s marginal tax rate is 40 percent.
Calculate the firm’s weighted average cost of capital assuming the firm 82
has exhausted all retained earnings.
11. Answer:
ki = 5.6%
kp = 12.9%
kn = 21.34%
ka = (0.3)(5.6) + (0.05)(12.9)
+ (0.65)(21.34) = 16.20%

83
North Sea Oil has compiled the following data relative to current costs of its basic sources
of external capital—long-term debt, preferred stock, and common stock equity—for variant
ranges of financing.
Table 11.4
Source of Capital Cost Range of Total New Financing
Long-term debt 7% P0–P2,000,000
8 P2,000,001–P3,000,000
10 P3,000,001 and above
Preferred stock 19% P0–P 960,000
21 P960,001 and above
Common stock 20% P0–P 700,000
24 P700,001–P1,600,000
26 P1,600,001–P2,200,000
30 P2,200,001 and above
The firm expects to have P350,000 of current retained earnings in the coming year at a cost
of 20 percent; once these retained earnings are exhausted, the firm will issue new common
stock. The company’s target capital structure proportions are used in calculating the
weighted average cost of capital follow.
Source of Capital Target Capital Structure
Long-term debt 0.25
Preferred stock 0.25
Common stock equity 0.50
12. Calculate the firm’s cost of capital prior to exhausting the firm’s available current
retained earnings. (See Table 11.4.)
13. Calculate the firm’s cost of capital for P2,000,000 of total new financing. (See Table
11.4.)
84
12. Answer: ka =
(7)(0.25) + (19)(0.25) +
(20)(0.50) = 16.5%.
13. Answer: ka =
(7)(0.25) + (21)(0.25) +
(26)(0.50) = 20%.
85