Ammen, Neil D.

MM BM 2

BM 222 (Managerial Finance)

May 3, 2016
The Case of Cosmo Solar Power Corporation
(Cost of Capital)

Case Background
Cosmo Solar Energy, Inc. is in the process of determining its capital
budget for the coming fiscal year. Cosmos balance sheet reflects five
sources of long-term funds. The current outstanding amounts from these five
sources are shown below and represent the companys historical sources of
funds fairly accurately.
Source of Funds
Mortgage bonds (P1,000 par,
7.5%)
Securities (P1,000 par, 8%, due
2016)
Preferred stock (P100 par,
7.5%)
Common Stock (P10 par)
Retained earnings
Total

PhP Amount (in

Millions)
P 135

Percentag
e
15.0%

225

25.0%

90

10.0%

150
300
P 900

16.7%
33.3%
100%

Cosmo will raise the funds necessary to support the selected capital
investment projects so as to maintain its historical distribution among the
various sources of long-term funds. Thus, 15 percent will be obtained from
additional mortgage bonds on new plant, 25 percent from securities, 10
percent from preferred stock, and 50 percent from some common equity
source. Cosmos policy is to reinvest the funds derived from each years
earnings in new projects. Cosmo issues new common stock only after all
funds provided from retained earnings have been exhausted.
Management estimates that its net income after taxes for the coming
year will be P4.50 per common share. The dividend payout ratio will be 40
percent of earnings to common shareholders (P1.8 per share), the same ratio
as the prior 4 years. The preferred stockholders will receive P6.75 million.

Ammen, Neil D.
MM BM 2

BM 222 (Managerial Finance)

May 3, 2016

The earnings retained will be used as needed to support the capital

investment program.

The capital budgeting staff, in conjunction with Cosmos investment

broker, has developed the following data regarding Cosmos sources of funds
if it were to raise funds in the
current market.
Source of
Funds
Mortgage bonds
Securities
Preferred stock
Common stock

Par Value
(PhP)
1,000
1,000
100
10

Interest or Dividend
Rate (%)
14
14.5
13.5

Issue Price
(PhP)
1,000.00
1,000.00
99.25
67.50

The estimated interest rates on the debt instruments and the dividend
rate on the preferred stock are based upon the rates being experienced in
the market by firms which are of the same size and quality as Cosmo. The
investment banker believes that the price of P67.50 for the common stock is
justified, since Cosmos price/earnings ratio of 15 is consistent with the 10
percent earnings growth rate that the market is capitalizing.
Cosmo is subject to a 40 percent income tax rate.
Required:
(a) Calculate the after-tax marginal cost of capital for each of the five
sources of capital for
Cosmo Solar Energy, Inc.
(b)Calculate Cosmos after-tax weighted average cost of capital.
(c) Cosmo follows a practice that 50 percent of any funds raised will be
derived from common equity sources. Determine the point of

Ammen, Neil D.
MM BM 2

BM 222 (Managerial Finance)

May 3, 2016

expansion at which Cosmos source of common equity funds would

switch from retained earnings to new common stock in the coming
year.
(d)If the basic business risks are similar for all firms in the industry in
which Cosmo Solar Energy, Inc. participates, would all firms in the
industry have approximately the same weighted average cost of
capital? Explain your answer.

Case Solution:
(a)

For a mortgage bond:

kd = current yield (1 - tax rate) = 14% (1 0.4) = 8.4%
For securities:
kd = current yield (1 - tax rate) = 14.5% (1 - 0.4) = 8.7%
For preferred stock:
kp = dividend / issue price = P13.5 / P99:25 = 13.6%
For common stock:
ke = (current dividend / current price) + expected growth rate
= (P1.80 / 67.50) + 10% = 12.67%
For retained earnings:
ks = opportunity rate of return on common stock = ke = 12.67%

(b)

The weighted average cost of capital is calculated as follows:

Source

Mortgage bond
Securities
Preferred stock

Current
Component Cost
8.4
8.7
13.6

Weight
s
0.15
0.25
0.10

Weighted
Average Cost
0.0126
0.0217
0.0136

Ammen, Neil D.
MM BM 2
Common stock
Retained
earnings
Total

BM 222 (Managerial Finance)

May 3, 2016
12.67
12.67

0.167
0.333

0.0212
0.0422
0.1113

The weighted average cost of capital is 11.13 percent

(c)

The maximum expansion from retained earnings before a new common

stock is required is calculated as follows (in millions pesos):
Net income (P4.50/common share x 15 milion shares)
P67.50
Less: Dividend payout (P1.80/common share x 15 million shares)
27.00
Preferred stock dividend

6.75
Retained earnings available for expansion
P33.75
If common equity is to be 50 percent of total capital, then the P33.75
million increase in retained earnings would be matched by raising an
additional P33.75 million from debt and preferred stock for a total of P67.5
million expansion before common shares would be issued.

(d)

The weighted average cost of capital may vary among firms in the
industry even if the basic business risk is similar for all firms in the
industry. This is true because each firm selects the degree of financial
leverage it desires. A firm with a high degree of financial leverage
would be assigned a high-risk premium by investors.