SUCCEED REVIEW CENTER

FINANCIAL MANAGEMENT

M. B. GUIA

Cost of Capital
Problem 1 (CAPM Approach) Assuming that the prevailing risk-free rate (

rm
1.
6.
7.

8.
1.
2.

rf

) is 7 percent and the current market return (

) 13 percent. Determine the cost of common equity using the CAPM approach under the following beta:
0

2.

.5

3.

4.

1.5

5.

Problem 2 (Growth Model) Assume that the Carter Company issues a P 1,000, 8 percent, 20-year bond whose net
proceeds are P940. The tax rate is 40 percent. The company has preferred stock that pays a P13 dividend per share
and sells for P100 per share in the market. The flotation (or underwriting) cost is 3 percent, or P3 per share. Also,
assume that the market price of the Carter Companys stock is P40. The dividend to be paid at the end of the coming
year is P4 per share and is expected to grow at a constant annual rate of 6 percent. The current market flotation cost is
10%.
Required: Using the Gordons growth model,
The cost of bonds;
3. The cost of retained earnings (or internal equity);
The cost of preferred stock;
4. The cost of new common stock (or external equity);

5.

Problem 3 (Growth Model) The Gamma Products Corporation has the following capital structure, which it considers
optimal:
6. Bonds, 7% (now selling at par)
7. P
300,000
8. Preferred stock (P5.00 par)
9. 240,000
10. Common stock
11. 360,000
12. Retained Earnings
13. 300,000
14. TOTAL
15. P
1,200,00
0
16. Dividends on common stock are currently P3 per share and are expected to grow at a constant rate of 6 percent.
Market price share of common stock is P40, and the preferred stock is selling at P50. Flotation cost on new issues of
common stock is 10 percent. The interest on bonds is paid annually. The companys tax rate is 40 percent.
17. Required: Compute the following:
1. The cost of bonds;
2. The cost of preferred stock;
3. The cost of retained earnings (or internal equity);
4. The cost of new common stock (or external equity); and
5. The weighted average cost of capital.
18.
19. Additional Financing Needs
20. Problem 4: Batangas Corporation projects its sales for next year to equal P4 million which is 125% of total sales of the
period just ended. Cost of goods sold equals 70% of sales, administrative expense equals P 500,000 and depreciation
expense is P 300,000. Interest expense equals P 50,000 and income is taxed at a rate of 40%. Finally, selling expense
equals 5% of sales. Batangas statement of financial position as of the end of the period just ended follows:
21. Assets
22.
23. Liabilities and Owners Equity
24. Current Assets

25. P 640,000

26.

27. Accounts Payable

29. Non-Current
Assets (net)
34.

30. 1.920,000

31.

32. Long-Term Debts

36.

37. Share Capital

40. _________
_

41.

42. Retained Earnings

45. P
2,560,000

46.

47. TOTAL

39.
44. TOTAL
49.
50.
51.
52.
53.

35.

28. P
480,0
00
33. 1,000
,000
38. 500,0
00
43. ____
580,0
00
48. P
2,560
,000

Required:
1. Use the percent of sales method to prepare the pro-forma income statement of the firm.
2. Determine the firms additional financing needs for the coming period.
Problem 5: Laguna Corporation is evaluating its financing requirements for the coming year. The firm has only been in
business for one year, but its chief financial officer predicts that the firms operating expenses, current assets, net fixed
assets, and current liabilities will remain at their current proportion of sales. Last year Laguna had P12 million in sales
with after-tax net income of P1.2 million. The firm anticipates that next years sales will reach P 15 million. The firms
statement of financial position for the year just ended follow:
54. Assets
55.
56. Liabilities and Owners Equity
57. Current Assets

58. P
3,000,000

59.

60. Accounts Payable

61. P
3,000
,000
62. Non-Current
63. 6,000,000
64.
65. Long-Term Debts
66. 2,000
Assets (net)
,000
67.
68.
69.
70. Share Capital
71. 2,80
0,000
72.
73. _________
74.
75. Retained Earnings
76. ___1,
_
200,0
00
77. TOTAL
78. P
79.
80. TOTAL
81. P
9,000,000
9,000
,000
82. The company is subject to the 20% income tax rate and is planning to distribute 50% of its earnings in dividends.
83. Required: Compute for the firms additional financing needs using the percentage of sale method.
84.
85. Leverage
86. Problem 6: (Effect of Leverage, ROE): Consider the information pertaining to two hypothetical firms:
87. Occidental
88. No debt
Corporation
89. P 20,000 in assets
90. 40% Tax rate
91. Oriental
92. P 10,000 debt @ 12%
Corporation
93. P 20,000 in assets
94. 40% Tax rate
95. Both companies have the same operating leverage, business risks, and an operating income of P 3,000.
96. Required:
97. 1. Compute the net income of both companies.

98. 2. Compute the Return on Equity of both companies

99.