Chapter 27 - Answer

Solutions Manual

CHAPTER 27 CALCULATING THE COST OF CAPITAL SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Multiple Choice Questions 1. 2. 3.

D A C

4. 5. 6.

C D A

7. 8. 9.

C D C

II. Problems Problem 1 The approximate before-tax cost of new debt is: k’d =

P120 + (P1,000 – P970) / 15 (P1,000 + P970) / 2 P122 P985

= =

0.1239 or 12.39%

The approximate after-tax cost of new debt is: k’dt = =

(12.39) (1 − 0.34) 8.18%

Problem 2 The cost of new preferred share is: kp = =

P4.50 P47.50

0.0947 or 9.47%

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10.

A

Chapter 27

Calculating the Cost of Capital

Problem 3 (a) The compound annual growth rate (FVIF i,n) at which dividends grew from P1.98 to P2.50 over 4 years is as follows: FVIF i,4=

= =

Ending dividend Beginning dividend P2.50 P1.98 1.263

As shown in the table for Future Value of P1 for 4 periods of 1.263. (b) The expected dividends to be received during 20x5, D 1, equal P2.65 (1.06 x P2.50). The cost of retained earnings is: kr=

P2.65 P40.00

+

=

0.0663 + 0.06

=

0.1263 or 12.63%

0.06

(c) The cost of new ordinary equity share is: ks=

P2.65 P40.00 − P3.00 +

=

0.0716 + 0.06

=

0.1316 or 13.16%

0.06

Problem 4 The estimated cost of retained earnings is: kr=

0.05 + 0.95 (0.13 − 0.05)

=

0.050 + 0.076

=

0.1260 or 12.60% 27-2

Calculating the Cost of Capital

Chapter 27

Problem 5 The cost of retained earnings using the generalized risk premium method is: kr=

0.100 + 0.025

=

0.1250 or 12.50%

Problem 6 The cost of retained earnings using the earnings-price ratio is: P6.00 P40.00

kr= =

0.1500 or 15.00%

Problem 7 The market value of each source of capital is found as follows: Number of Securities (1)

Source of Capital Bonds Preferred share Ordinary equity share Total

Market Price (2)

3,000 * 25,000 200,000

Market Value (1) (2)

P965 18 40

P 2,895,000 450,000 8,000,000 P11,345,000

*3,000,000 book value / P1,000 per bond = 3,000 bonds

Problem 8 (a) The book value weights are: Long-term debt= =

P2,000,000 P4,000,000

Preferred share= =

0.500

Ordinary equity share= =

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P1,500,000 P4,000,000 0.375

P500,000 P4,000,000 0.125

Chapter 27

Calculating the Cost of Capital

The firm’s weighted average cost of capital is: WACC =

(0.500) (0.0700) + (0.125) (0.1200) + (0.375) (0.1600)

=

0.0350 + 0.0150 + 0.0600

=

0.1100 or 11.00%

(b) The market value weights are: P1,800,000 P6,000,000

Long-term debt= =

Preferred share= =

0.30

Ordinary equity share= =

P600,000 P6,000,000 0.10

P3,600,000 P6,000,000 0.60

The firm’s weighted average cost of capital is: WACC =

(0.30) (0.0700) + (0.10) (0.1200) + (0.60) (0.1600)

=

0.0210 + 0.0120 + 0.0960

=

0.1290 or 12.90%

Problem 9 The break-even point of total new investment (financing) is: BPi= =

P26,000,000 0.65 P40,000,000

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Calculating the Cost of Capital

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Chapter 27