Name: _____________________ Section: ____________________

Part I: Theories

1.5 pts. each. Modified True or False: If the statement is true, write the letter “T”. If the statement is
false, change the underlined word to make it true. Write your answers in the answer sheet provided.

__________ 1. Short-term debt such as working capital requirements is also considered to be part of the
capital structure.

__________ 2. Dividend growth model is useful because it explicitly accounts for an investment's
riskiness and can be applied by any company, regardless of its dividends. However, the components are
estimates and also implicitly relies on past performance to predict the future.

__________ 3. Firms who have special-purpose assets such as land, and building, will tend to use debt
rather heavily.

__________ 4. Concerning asset structure, real estate companies are usually highly leveraged, whereas
companies involved in technological research are not.

__________ 5. The interest paid on debt is deductible for tax purposes, whereas dividends paid on
common stock are not deductible.

__________ 6. The dividend growth model is simple and straightforward, but it does not apply to
companies that don't pay dividends, and it assumes that dividends grow at a constant rate over time.
The dividend growth model also quite sensitive to changes in the dividend growth rate, and it does not
explicitly consider the risk of the investment.

__________ 7. The return investors expect from a completely risk free investment is the beta.

___________ 8. Therefore, the lower a firm’s tax rate, the greater the advantage of debt.

___________ 9. In case the company is interested in retaining control, it should prefer the use of debt.
However, excessive use of debt may lead to loss of control and other bad consequences.

___________ 10. Managers should choose the capital structure that maximizes the company’ wealth.

Part II: Problems

2.5 pts. each. When solving, do not round off amounts. In representing your final answer, round off to
two decimal places.

1. BA4FM Company has issued 7% debentures. The risk free rate is 12%. If the company’s marginal tax
rate is 32%, what is the cost of debt?

2. The Kaya Niyo Yan Company has common stock outstanding that has a current price of $15 per share
and a $0.5 dividend. The dividend for next year is estimated to be $7.50. The beta on Kaya Niyo Yan’s
stock is .88. The expected risk-free rate of interest is 4%, whereas the rate of return in the market is 8%.
Using the capital asset pricing model, what is the cost of equity?

3. Pray Harder, Inc.’s shares sells at $15.00 per share. Currently, dividends given out are $7.5%. The
previous year’s dividends were $6.00 and follow a constant growth rate. What is cost of equity using the
dividend valuation model?

4. What is the weighted average cost of capital for a company if it has the following capital structure:
30% equity, 20% preferred stock, and 50% debt; Its marginal cost of equity is 11%, its marginal cost of
preferred stock is 9%, its before-tax cost of debt is 8%, and its marginal tax rate is 40%?

5. Suppose that company XYZ has the following capital structure: 25% equity, 10% preferred stock, and
65% debt. Its marginal cost of equity is 12%, its marginal cost of preferred stock is 9%, and its after-tax
cost of debt is 7%. If the marginal tax rate is 35%, what is company XYZ’s WACC?

For items 6-10. Kaya Pa Ba, Co. is evaluating its cost of capital under alternative financing arrangements.
Kaya Pa Ba expects to be able to issue new debt at par with a yield of 6.5%, the risk-free rate is
estimated to be 4%. The company issues $1,000 par value cumulative preferred stock carrying a fixed
coupon rate of 8% per year. The preferred stock has a current market price of $800 at year end. The
common stock of Kaya Pa Ba, Co. is currently selling for $25.00 a share with a $2 dividend. Market
analysts foresee a constant growth in dividends. With a net income of $200,000 and $800,000 of equity,
dividends given out are $50,000. Kaya Pa Ba, Co.'s marginal tax rate is 40%.

6. What is the cost of debt?

7. What is the cost of equity?
8. What is the cost of preferred shares?
9. If Kaya Pa Ba raises capital using 40% debt, 10% preferred stock, and 50% common stock, what is Kaya
Pa Ba's weighted average cost of capital?
10. If Kaya Pa Ba raises capital using 35% debt, 5% preferred stock, and 60% common stock, what is Kaya
Pa Ba’s weighted average cost of capital?

“Trust in the Lord with all your heart and lean not on your own understanding. In all your ways,
acknowledge Him, and He will make your paths straight.”Proverbs 3:5-6

“But blessed is the one who trusts in the Lord, whose confidence is in Him.”Jeremiah 17:7