Chapter 12 Cost of capital 30

MULTIPLE CHOICE

1. Which of these statements are pertinent to cost of capital?

1. It is the return that investors demand for a given level of risk.
2. It may be employed as a benchmark for the evaluation of performance.
3. For investment decisions, it must be based on the current or prospective
cost of the various capital components rather than on their historical costs.
4. It may also be used in acquisition analysis, liquidation studies and source
of financing decisions.
5. It may differ from the hurdle rate used to reflect the alternative risk
attributed to a specific project, decision, or business unit.
All five statements. C. Statements 1, 2, 3 and 4 only.
Statements 1, 2 and 3 only. D. Statements 1, 2, 4 and 5 only. (rpcpa)

1. A
? The statement(s) pertinent to cost of capital.
 All of the five (5) given statements describe the concepts and uses of cost of capital.
Cost of capital is the cost of using funds (or monies) from investors. Investors include
both the long-term creditors and the owners. The cost of using creditors money is the
interest paid, net of tax. The cost of using preferred stockholders’ money is the
dividend per share over the market value per preferred share. The cost of using the
common stockholders’ money, using the Gordon Growth Model is dividends per
share over market price per share plus the growth rate. The average cost of capital
must be taken based on the amount of capital contributed by each class of money
providers.
The average cost of capital serves as the minimum required rate of return that a
project must earn so as not to impair the interest of the common stockholders. It also
serves as the benchmark for project evaluation. Additionally, cost of capital is
prospective as it relates to money to be raised in financing future investments. Cost
of capital may differ from the hurdle rate used to reflect the risk attributed to a specific
project, division, or business unit. In this sense, hurdle rate refers to the discount
rate, which includes the risk-free rate and the risk-premium rate.

2. MF Company has made the decision to finance next year’s capital projects through
debt rather than additional equity. The benchmark cost of capital for these projects
should be
The before-tax cost of new-debt financing
The after-tax cost of new-debt financing.
The cost of equity financing.
The weighted-average cost of capital. (cia)

2. D
? The benchmark cost of capital for a proposed project.
 Cost of capital is the cost of using money. There is cost of using debt, cost of using
preferred equity, and cost of using common equity. Under normal economic
conditions, the cheapest source of money is debt and the most expensive source of
money is the common equity. Each source of money, and each stakeholder thereon,
Chapter 12 Cost of capital 31

has to satisfy their interests, which may be different with the overall interest of the
organization. Because of this, the weighted average cost of capital is computed to
serve as a benchmark or the overall guide to managers in deciding to accept or reject
a project and evaluate the performance of existing projects. Choice-letter “d” is
correct.
Choice-letters “a” and “b” are incorrect because the cost of debt is subordinated
to the overall cost of capital (weighted average cost of capital) in making decisions.
Another, choice-letter “a” is surely incorrect because the cost of debt is determined
based on the after tax cost. Choice-letter “c” is incorrect because the cost of equity
financing, either preferred equity or common equity, is also an inferior benchmark
compared to the weighted average cost of capital in deciding capital projects. On top
of it, choice-letter “c” is not clear on what covers the word equity.

3. The minimum return that a project must earn for a company in order to leave the
value of the company unchanged is the
Current borrowing rate. C. Capitalization rate.
Discount rate. D. Cost of capital. (aicpa)

3. D
? The minimum return of a project that will not change the value of a company.
 The value of a company is measured by its stockholders’ equity, particularly the
common stockholders’ equity. A project should produce a return that will satisfy the
expected returns of the investors. This expected return of investors is also the cost
of using the investors’ money or the cost of capital. Therefore, a project should earn
at least the cost of capital to avoid dilution in the wealth of the company; particularly
the wealth of the common owners. A project that earns higher than the cost of capital
would contribute to the accumulation of the common stockholders’ equity (or wealth).
Choice-letter “a” is incorrect because current borrowing rate refers only to debt
and not to the overall capital structure of a business. Choice-letter “b” is incorrect
because a discount rate, which includes premium rate or profit rate, set by the
management is normally greater than the cost of capital. Choice-letter “c” is incorrect
because capitalization rate is used in estimating a project value and not necessarily
the minimum return required of a project.

4. A firm must select from among several methods of financing arrangements when
meeting its capital requirements. To acquire additional growth capital while attempting
to maximize earnings per share, a firm should normally
Attempt to increase both debt and equity in equal proportions, which preserves a
stable capital structure and maintains investor confidence.
Select debt over equity initially, even through increased debt is accompanied by
interest costs and a degree of risk.
Select equity over debt initially, which minimizes risk and avoids interest costs.
Discontinue dividends and use current cash flow, which avoids the cost and risk of
increased debt and the dilution of EPS through increased equity. (cia)

4. B
? A firm’s normal action to acquire additional growth capital while attempting to
maximize earnings per share.
Chapter 12 Cost of capital 32

 Additional growth capital may come from debt and owners’ financing. However, to
maximize earnings per share, the number of common shares outstanding should be
minimized or held in constant while attempting to maximize profit. This twin efforts
would bring an increase in earnings per share. To maintain the common shares
outstanding, financing should be raised from borrowing. This would increase interest
costs, degree of risk, reduce times interest earned, and, will increase earnings per
share under normal condition.
Choice-letter “a” is incorrect because maintaining an equal proportion of debt and
equity does not optimize return on common equity and earnings per share. Choice-
letter “c” is incorrect because choosing equity over debt entails higher cost of capital,
lower risk, and lower earnings per share. Choice-letter “d” is incorrect because
discontinuing dividends declaration and distribution, which have been expected of the
business, will erode investors’ confidence, contributes to slippages in stock price, and
higher cost of raising financing equity for long-term strategy.

5. A firm’s optimal capital structure

Minimizes the firm’s tax liability.
Minimizes the firm’s risk.
Maximizes the firm’s degree of financial leverage.
Maximizes the price of the firm’s stock. (cia)

5. D
? A description regarding a firm’s optimal capital structure.
 Choice-letter “d” is correct. Optimal capital structure brings in the highest possible
return on common stockholders after considering the benefits of each source of
money and their relative insolvency risk. Finding the right capital mix is a matter of
strategic financing decisions. Although, debt is the cheapest source of money, too
much exposure to debt would heighten the risk of insolvency of a firm. Therefore, an
optimal capital structure maximizes the use of debt to increase the wealth of common
stockholders, which is measured by the price of the firm’s stock.
Choice-letter ‘a” is incorrect because minimizing tax liability would mean an
increase in owners’ equity in financing resulting to a higher weighted average cost of
capital, and therefore, is not in consonance with the goal of optimizing capital
structure. Choice-letter “b” is incorrect because minimizing the firm’s risk does not
does not relate favorably to the goal of maximizing wealth; the lower the risk, the
lower the return, etc. Choice-letter “c” is incorrect because maximizing the degree of
financial leverage means employing total debt to finance the investing and operating
activities of a firm, which is extremely risky to manage and is not in consonance with
the prudent and calculated way of financial managing.

6. If K is the cost of debt and t is the marginal tax rate, the after-tax cost of debt, ki, is
best represented by the formula
ki = k/t. C. ki = k(t).
ki = k/(1-t). D. ki = k(1-t). (cma)

6. D
? The formula that best represents the cost of debt.
Chapter 12 Cost of capital 33

 The cost of debt is the interest expense. Since interest expense is a tax deductive
item, the cost of debt should be determined at interest expense, net of tax. Choice-
letter “d” is the best representation of the cost of debt.

7. The three elements needed to estimate the cost of equity capital for use in
determining a firm’s weighted-average cost of capital are
Current dividends per share, expected growth rate in dividends per share, and
current book value per share of common stock.
Current earnings per share, expected growth rate in dividends per share, and current
market price per share of common stock.
Current earnings per share, expected growth rate in earnings per share, and current
book value per share of common stock.
Current dividends per share, expected growth rate in dividends per share, the current
market price per share of common stock. (cma)
7. D
? The three elements used in estimating the weighted-average cost of equity capital.
 The equity capital referred to here is the common equity financing. The Gordon
Growth Model used in measuring the cost of new common issue uses the expected
dividend per share, market price per share and the growth rate. Hence, choice-letter
“d” is correct.
Choice-letters “a” and “c” are incorrect because book value per common share is
not used in computing cost of capital. Choice-letter “b.” is incorrect because earnings
per share is not a primary variable in estimating a firm’s cost of equity capital.

8. The explicit cost of debt financing is the interest expense. The implicit cost (s) of debt
financing is (are) the
Increase in the cost of debt as the debt-to-equity ratio increases.
Increases in the cost of debt and equity as the debt-to-equity ratio increases.
Increase in the cost of equity as the debt-to-equity ratio decrease
Decrease in the weighted-average cost of capital as the debt-to-equity ratio
increase. (cma)

8. B
? The implicit cost of debt financing.
 When debt financing is used, the risk of insolvency increases. This would instigate
other creditors to uplift interest rate to compensate the increment in the financing risk,
until such point that the cost of issuing debt shall be more expensive than the cost of
issuing owners’ equity. This point essentially becomes the optimum capital balance.
Choice-letter “a” is incorrect because not only the cost of debt increases but that
of equity as well. Choice-letter “c” is incorrect because it is the increase in debt that is
primarily the item of concern by the question. Choice-letter “d” is incorrect because
the weighted-average cost is an explicit expression of the cost of financing.

9. All of the following are examples of imputed costs except.

The stated interest paid on a bank loan.
The use of the firm’s internal cash funds to purchase assets.
Assets that are considered obsolete that maintain a net book value.
Decelerated depreciation. (cma)
Chapter 12 Cost of capital 34

9. A
? An exception to the example of imputed costs.
 Imputed costs are those implied or assumed to have been incurred under a
circumstance. This cost exists but is not expressly stated or recorded and is the
result of a process designed to recognize economic reality. Although theoretical in
nature, these costs are relevant in making decisions. The use of the firm’s internal
cash funds to purchase assets has an imputed cost which refers to the cost of money
borrowed (or interest paid) had the firm did not use its internal cash. An obsolete
asset maintained by the business carries with it carrying costs, although not
expressly stated in the financial records. Decelerated depreciation that recognizes
lower depreciation expense in the initial years of the asset, thereby foregoing tax
savings had the depreciation expense been recorded at a higher amount, is also an
example of an imputed cost.
Choice-letter “a” is the correct answer because it is not an imputed, but is an
expressed (or stated) cost.

10. Newmass, Inc. paid cash dividends to its common shareholders over the past 12
months at P2.20 per share. The current market value of the common stocks is P40
per share, and investors are anticipating the common dividends to grow at a rate of
6% annually. The cost to issue new common stocks will be 5% of the market value.
The cost of a new common stock issue will be
11.50% C. 11.83%
11.79% D. 12.14% (cma)

10. D
? The cost of a new common stock issue.
 Raising financing money from common equity may come from two sources –
issuance of common shares of stock and use of retained earnings. The cost of the
new common stock issued using the Gordon Growth Model shall be as follows:
Cost of new common share = EDPS / MPPS GR
where: EDPS = Expected dividend per share
MPPS = Market price per share (net)
GR = Growth rate
The expected dividend per share refers to current dividend per share adjusted to
growth rate for the next period. The market price of the new common shares to be
issued should be reduced by flotation costs. Flotation costs are those incurred in
underwriting or selling the common shares such as brokers’ and underwriting fees,
printing and supplies, taxes, and other regulatory fees related to the issuance of the
new common shares. Applying the formula, the cost of the new common share shall
be:
Cost of new
common share = [(P2.20 x 1.06) / (P40 x 95%) + 6%]
= (P2.332 / P38) + 6% = 12.14%

11. Gary, Inc. is planning to use retained earnings to finance anticipated capital
expenditures. The beta coefficient for Gary’s stock is 1.15. The risk-free rate of
Chapter 12 Cost of capital 35

interest is 8.5%, and the market return is estimated at 12.4%. If a new issue of
common stock were used in this model, the flotation costs would be 7%. By using the
capital asset pricing model (CAPM) equation [R = RF + ß (RM –RF)], the cost of
using retained earnings to finance the capital expenditures is
13.21% C. 12.40%
12.99% D. 14.26% (cma)

11. B
? The cost of using retained earnings to finance capital expenditures.
 Raising financing money from common equity may come from two sources –
issuance of common shares of stock and use of retained earnings. The cost of
common equity, both for the issuance of new common shares and use of retained
earnings, using the Capital Asset Pricing Model (CAPM) shall be as follows:
Cost of using
retained earnings = RF + ß (MR – RF)
= Risk-free rate + Beta coefficient (Market rate – Risk free rate)
= 8.5% + 1.15 (12.4% – 8.5%)
= 8.5% + 4.485% = 12.99%
The risk-free rate, or the certainty rate, represents the rate of return of investment
opportunities where risk is relatively inexistent such as treasury bills and time
deposits on universal banks. Market rate includes both the risk-free rate and the risk-
premium rate. Risk-premium rate refers to the normal business risks (e.g., the
possibility of incurring operating loss) and integrates the risk attributed to inflation,
macro-economic and financial adjustments (e.g., currency fluctuations, inflation) as
well as fair return on investment.
The beta coefficient measures the firm’s stock price changes in relation to the
overall price changes of the stock market. Say, the stock price of a company
increases to 1.3 while the overall stock price of the market increases to 1.15; the
company’s beta coefficient is 1.13 (i.e., 1.3/1.15).

12. KG Inc. has the following mix of funds and costs:

Type Amount Cost
Debt P150,000 .18%
Preferred stock 500,000 .15
Common equity 700,000 .12
Total funds P1,350,000
What is KG’s cost of capital?
13.78% C. 15.22%
12.22% D. 13.22%

12. A
? The weighted average cost of capital (WACOC).
 Cost of capital is the cost of using funds (or money). Financing money comes from
long-term creditors and owners. Each money generated from investor (creditors and
owners) has its costs. The cost of using long-term borrowing is the interest expense,
net of tax. The cost of using preferred stockholders’ money is the dividends per share
divided by market price per share. The cost using common equity is the quotient of
Chapter 12 Cost of capital 36

expected dividends per share over market price per share plus growth rate. The
individual costs of capital are already given. The average cost of capital is calculated
as follows:
Sources of Individual Financing Mix
Fund Amount COC Ratio WACOC
Debt P 150,000 18% 150/1350 2.00%
Preferred Stock 500,000 15% 500/1350 5.56
Common equity 700,000 12% 700/1350 6.22
P1,350,000 13.78%

13. Assume that nominal interest has just increased substantially but that the expected
future dividends for a company over the long run were not affected. As a result of the
increase in nominal interest rates, the company’s stock price should
Increase. C. Stay constant.
Decrease. D. Change, but in no obvious direction. (cia)

13. B
? The effect to the company’s stock price as a result of the increase in nominal interest
rates.
 The stock price may be calculated using the dividend growth model, as follows:
Stock price = Expected Dividend per share
Cost of common equity – Growth Rate
= EDPS / (COCE – GR)
An increase in the nominal interest rate would increase the effective interest rate,
the WACOC, and ultimately, the cost of common equity. This would result to a
decrease in the stock price.

14. In general, it is more expensive for a company to finance with equity capital than with
debt capital because.
Long-term bonds have a maturity date and must therefore be repaid in the future.
Investors are exposed to greater risk with equity capital.
Equity capital is in greater demand than debt capital.
Dividends fluctuate to a greater extent than interest rates.

14 B
? A reason why equity capital is more expensive than debt capital.
 Generally, owners are more exposed to business risk than creditors. In terms of
return, interest is mandated to be paid by virtue of contract while obligations to
dividend payments normally arise upon declaration. In times of liquidation, creditors
are protected by law and have their preference as to asset distribution. Creditors are
more protected against risk, owners are more exposed to risk. Since owners (e.g.,
equity capital) are exposed to greater risk than creditors, they ask for higher return on
their investment.
Choice-letter “a” is incorrect because the longer the credit period, the higher the
required return on investment would be, and therefore, does not explain why debt is
less expensive than stock. Choice-letter “c” is incorrect because generally debt
capital is more in demand that equity capital. Choice-letter “d” is incorrect because
Chapter 12 Cost of capital 37

interest rates are more subject to market fluctuations than dividends, which are more
subject to managerial discretion.

15. The “inflation element” refers to the

Impact that future price increases will have on the original cost of capital expenditure.
Fact that the real purchasing power of a monetary unit usually increases over time.
Future deterioration of the general purchasing power of the monetary unit.
Future increases in the general purchasing power of the monetary unit. (rpcpa)

15. C
? A description of the inflation element.
 Choice-letter “c” is correct, inflation refers to the future deterioration of the general
purchasing power of the monetary unit. Inflation refers to the average increase in the
prices of commodities generally brought about by an imbalance in the supply and
demand situation that results to a reduction in the purchasing power of money.
Choice-letter “a” is incorrect because inflation primarily refers to the ability of money
to purchase commodities and not an impact on the cost of capital. Choice-letters “b”
and “d” are incorrect because inflation does not increase the general purchasing
power of the monetary unit but decreases it instead.

16. If a company has a higher dividend-payout ratio, then, if all else is equal, it will have
A higher marginal cost of capital.
A lower marginal cost of capital.
A higher investment opportunity schedule.
A lower investment opportunity schedule. (cia)

16. A
? The effect of a higher dividend-payout ratio.
 Dividend-payout ratio is determined by dividing dividend per share over earnings per
share. A higher payout ratio signifies more dividends paid to stockholders, lesser
reinvestment ratio, higher need of financing money for investment, more debt, more
risk, thereby effectively increasing the equity cost of capital. Another, increasing
dividends paid would exhaust retained earnings forcing a company to source out
more external money to finance its investment opportunities which may alter the
composition of the firm’s optimal capital structure, and will eventually increase the
firm’s cost of capital.
Choice-letter “a” is incorrect because a higher dividend-payout ratio pushes up
the marginal cost of capital. Choice-letters “c” and “d” are incorrect because
investment opportunity schedule has no relation with the cost of capital.

Questions 17 through 20 are based on the following information. Z Company, which

is interested in measuring its overall cost of capital and, has gathered the following
data. Under the terms described below, the company can sell unlimited amounts of
all instruments.
Z can raise cash by selling P1, 000, 8%, 20-year bonds with annual interest
payments. In selling the issue, an average premium of P30 per bond would be
received, and the firm must pay flotation costs of P30 per bond. The after tax
cost of funds is estimated to be 4.8%.
Chapter 12 Cost of capital 38

Z can sell 8% preferred stock at P105 per share. The cost of issuing and selling
the preferred stock is expected to be P5 per share.
Z’s common stock is currently selling for P100 per share. The firm expects to
pay cash dividends of P7 per share next year, and the dividends are expected to
remain constant. The stock will be underpriced by P3 per share, and flotation
costs are expected to amount to P5 per share.
Z expected to have available P100,000 of retained earnings in the coming year.
Once these retained earnings are exhausted, the firm use common stock as the
form of common equity financing.
Z’s preferred capital structure is
Long-term debt 30%
Preferred stock 20
Common stock 50

The cost of funds from the sale of common stock for Z Company is
A. 7.0% C. 7.4%
B. 7.6% D. 8.1%

17. B
? The cost of selling a common equity.
 The cost of the common equity is computed as follows:
Cost of common equity = EDPS / (MPPS, net – GR))
= P7 / (P100 – P3 – P5) = 7.6%
The problem does not provide the growth rate of the firm, hence, no apparent
deduction from the net market price of the stock.

The cost of funds from retained earnings for Z Company is

A. 7.0% C. 7.4%
B. 7.6% D. 8.1%

18. A
? The cost of funds from retained earnings.
 The cost of retained earnings is determined as follows:
Cost of retained earnings = EDPS / (MPPS – GR)
= P7 / P100 = 7%
(where EDPS = expected dividend per share, MPPS = market price per
share, and GR = growth rate of common stock)
The cost of retained earnings does not consider the floatation costs and other
deductions from market price of the common stock.

19. If Z needs a total of P200, 000, the firm’s weighted average cost of capital would be
A. 19.8% C. 6.5%
B. 4.8% D. 6.8%

19. C
? The weighted average cost of capital (WACOC).
Chapter 12 Cost of capital 39

 The total financing need is P200,000. Fifty percent of this amount or P100,000 (i.e.,
P200,000 x 50%) should come from the common equity as per optimal capital
structure of the firm. This needed common equity could be financed using the
available retained earnings.
The cost of debt after tax is given at 4.8%. The cost of preferred equity is 8%
[i.e., (P100 x 8%) / (P105 – P5)]. The cost of using retained earnings is 7%.
Therefore, the weighted average cost of capitals is as follows:
Debt equity 4.8% x 30% = 1.44%
Preferred equity 8.0% x 20% = 1.60
Common equity 7.0% x 50$ = 3.50
WACOC 6.54%

20. If Z needs a total of P1, 000, 000, the firm’s weighted average cost of capital would
be
A. 6.8% C. 6.5%
B. 4.8% D. 27.4%

20. A
? The weighted average cost of capital.
 The total financing need is P1 million. Fifty percent of this amount or P500,000 would
come from the common equity as per optimal capital structure of the firm. This
common equity shall be shared by retained earnings and common stock, P100,000
from the retained earnings and the balance of P400,000 from common stock
issuances.
The individual cost of capital remains the same. The WACOC shall be
determined as follows:
Debt equity 4.8% x 30% = 1.44%
Preferred equity 8.0% x 20% = 1.60
Common stock 7.6% x 40% = 3.04
Retained earnings 7.0% x 10% = 0.70
WACOC 6.78%

Questions 21 through 23 are based on the following information. D Telecom is

considering a project for the coming year that will cost P50 million. D plans to use
the following combination of debt and equity to finance the investment
Issue P15 million of 20-year bonds at a price of 101, with a coupon rate of 8%,
and flotation costs of 2% of par.
Use of P35 million of funds generated from earnings.
The equity market is expected to earn 12%. Philippine Treasury bills are currently
yielding 5%. The beta coefficient for D is estimated to be .60. D is subject to an
effective corporate income tax rate of 40%.

The before-tax cost of D’s planned debt financing, net of flotation costs, in the first
year is
A. 11.60% C. 10.00%
B. 8.08% D. 7.92%

21. A
Chapter 12 Cost of capital 40

? The before cost of debt.

 The before tax cost of debt shall be determined as follows:
Cost of debt = Before tax rate / Market price, net of flotation
= 8% / (101% - 2%) = 8.08%

Assume that the after-tax cost of debt is 7% and the cost of equity is 12%.
Determine the weighted-average cost of capital
A. 10.50% C. 9.50%
B. 8.50% D. 6.30%

22. A
? The weighted average cost of capital (WACOC).
 The WACOC is the average of the cost of common equity and cost of debt, after tax.
The cost of debt and common equity are readily given. The financing of debt and
common equity is 15:35. The WACOC shall be:
Debt equity 7% x (15/50) = 2.10%
Common equity 12% x (35/50) = 8.40
WACOC 10.50%

The capital asset pricing model (CAPM) computes the expected return on a security
by adding the risk-free rate of return to the incremental yield of the expected market
return, which is adjusted by the company’s beta. Compute D’s expected rate of
return using the CAPM.
A. 9.20% C. 7.20%
B. 12.20% D. 12.00%

23. A
? The cost of fund using the capital asset pricing model (CAPM).
 The cost of common capital using the CAPM shall be as f0ollows:
Cost of common equity = Risk-free + Beta (Market rate – Risk-free rate)
= 5% + 0.60 (12% - 5%) = 9.20%

Questions 24 through 27 are based on the following information. R Company

operates a chain of restaurants located in the metropolis. The company has steadily
grown to its present size of 48 restaurants. The board of directors recently approved
a large-scale remodelling of the restaurant, and the company is now considering two
financing alternatives.
The first alternative would consist of
Bonds that would have 9% coupon rate and would net P19.2 million after
flotation costs
Preferred stock with a stated rate of 6% that would yield P4.8 million after a
4% flotation cost
Common stock that would yield P24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would
have an 11% coupon rate and would net P48 million after flotation costs.

R’s current capital structure, which is considered optimal, consists of 40% long-term
debt, 10% preferred stock, and 50% common stock. The current market value of the
Chapter 12 Cost of capital 41

common stock is P30 per share, and the common stock dividend during the past 12
months was P3 per share. Investors are expecting the growth rate of dividends to
equal the historical rate of 6%. R is subject to an effective income tax rate of 40%.

The after-tax cost of the common stock proposed in R’s first financing alternative
would be
A. 16.005 C. 16.60%
B. 16.53% D. 17.16%

24. D
? The after-tax cost of the common stock in the first proposed financing alternative.
 The cost of the common equity is 17.16%, computed as follows:
Cost of common equity = (EDPS / MPPS, net) + GR
= [(P3 x 106%) / (P30 x 95%)] + 6%
= 17.16%

The after-tax weighted average cost of capital under the first financing alternative is
A. 11.365% C. 17.40%
B. 17.16% D. 11.34%

25. A
? The after-tax weighted average cost of capital under the first alternative.
 The proposed first financing alternative is composed of bonds, preferred equity, and
common equity.
The cost of bonds should be expressed after-tax. The par value of the preferred
sock is P5 million (i.e., P4.8 million / 96%). The preferred dividends shall be
P300,000 (i.e., P5 million x 6%). Hence, the cost of preferred equity is 6.25% (i.e.,
P300,000 / P4.8 million).
The cost of the common equity is 17.16%, computed as follows:
Cost of common equity = (EDPS / MPPS, net) + GR
= [(P3 x 106%) / (P30 x 95%)] + 6%
= 17.16%
Therefore, the WACOC shall be
Bonds (9% x 60%) 5.4 % x 40% = 2.160%
Preferred equity 6.25% x 10% = 0.625
Common equity 17.16% x 50% = 8.580
WACOC 11.365%

Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal
cost of capital for R’s first financing alternative consisting of bonds, preferred, and
common stock would be
A. 5.4% C. 10.285%
B. 6.25% D. 11.700%

26. C
? The after-tax weighted average cost of capital under the first alternative, assuming
the cost of common stock is 15%.
Chapter 12 Cost of capital 42

 The cost of debt is still 5.4% and preferred equity is 6.05. The WACOC, assuming
the cost of common stock is 15%, shall be:
Debt 5.4% x 40% = 2.16%
Preferred equity 6.0% x 10% = 0.625
Common equity 15% x 50% = 7.50
WACOC 10.285%

The after tax weighted marginal cost of capital for R’s second financing alternative
consisting solely of bonds would be
A. 5.13% C. 6,27%
B. 5.40% D. 6.60%

27. D
? The after tax weighted marginal cost of capital for R’s second financing alternative.
 The second financing alternative consists purely of long-term debt. The after-cost of
debt is 6.6% (i.e., 11% x 60%).

28. It refers to the practice of financing assets with borrowed capital. Its extensive use
may impact on the return on common stockholders’ equity to be above or below the
rate or return on total assets.
Discounting. C. Leverage
Mortgage D. Arbitrage (rpcpa)

28. C
? The practice of financing assets with borrowed capital.
 Choice-letter “c” is the correct answer. Leverage refers to the use of debt in financing
investments. The reason hinges on the notion that the cost of long-term debt is much
lower than the cost of using common equity funds.
If the use of financial leverage is successful, it will result to higher return on
common equity. An unsuccessful use of financial leverage ends up diminishing the
return in common equity. There is an expected successful use of leverage if the
times-interest earned ratio is high.
Choice-letters ”a”, “b” and “d” are modes of raising financing money and are
included within the practices of leverage management.

29. Which of the changes in leverage would apply to a company that substantially
increases its investments in fixed assets as a proportion of total assets and replaces
some of its long-term debt with equity?
Financial Operating
Leverage Leverage
Increase Decrease
Decrease Increase
Increase Increase
Decrease Decrease (cia)

29. B
Chapter 12 Cost of capital 43

? The effects to financial and operating leverages if a company substantially increases

its investment in fixed assets as a proportion of total assets and replaces some of its
long-term debt with equity.
 When debt is replaced with more equity capital, the firm’s financial leverage
decreases. An increase in debt means heightened interest, plus the increase in fixed
assets give rise to an increased fixed costs and higher operating leverage. Choice-
letter “b” is correct.
Leverage, generally, means the ability of the firm to increase its wealth by using
key variables. There are two leverages used by businesses – one is found in the
balance sheet (the financial leverage), and the other is found in the income statement
(the operating leverage). The expression of business wealth is found in the balance
sheet, particularly the owners’ equity side. To increase the owners’ equity, a higher
operating leverage ratio should be maintained. Operating leverage ratio measures
the ability of the firm to change its profit in relation to a change in sales, and is
computed by dividing contribution margin over earnings before interest and tax
(EBIT). When fixed assets are more applied, fixed costs increase thereby making
operating leverage higher.
Another, to maximize the return of increased profit brought by an increased
operating leverage, the equity capital should at least be maintained to increase the
return on equity. Therefore, to finance the operating activities, debt capital should be
tapped. This inches up more debt participation in the balance sheet, more risk of
insolvency, however, higher return on equity. The use of debt is the financial
leverage. The more debt is used, the more financially leveraged the firm is. These
twin leverages, operating leverage and financial leverage, when properly managed,
will greatly contribute in increasing the wealth of a firm.

Questions 19 to 22 are based on the following information. Carmelo Company

currently sells 400,000 bottles of perfume each year. Each bottle costs P.84 to
produce and sells for P1.00. Fixed costs are P28,000 per year. The firm has annual
interest expense of P6,000, preferred stock dividends of P2,000 per year, and a 40%
tax rate.

30. The degree of operating leverage for Carmelo Company is

2.4 C. 2.13
1.78 D. 1.12 (cma)

30. B
? The degree of operating leverage (DOL).
 The DOL is contribution margin divided by operating income, as follows:
Contribution margin (400,000 units x P0.16) P64,000
- Fixed costs and expenses 28,000
Operating income P36,000
Degree of operating leverage (P64,000/P36,000) 1.78 to 1

31. The degree of financial leverage for Carmelo Company is

2.4 C. 1.35
1.78 D. 1.35 (cma)
Chapter 12 Cost of capital 44

31. C
? The degree of financial leverage (DFL).
 The DFL may be expressed in terms of debt-to-equity ratio. Another way of
expressing DFL is as follows (where EBIT = earnings before interest and taxes):
DFL = EBIT/(EBIT –Interest expense – Preferred dividends before tax)
= P36,000 / [P36,000 – P6,000 – (P2,000/60%)]
= P6,000/[P36,000 – P6,000 – P3,333] = P36,000/P26,667 = 1.35

32. If Carmelo Company did not have preferred stock, the degree of total leverage would
Decrease in proportion to a decrease in financial leverage.
Increase in proportion to a decrease in financial leverage.
Remain the same.
Decrease but not be proportional to the decrease in financial leverage. cma)
32. A
? The degree of total leverage (DTL) if there is no preferred stock.
 The degree of total leverage is equal to the DOL (degree of operating leverage) times
the DFL (degree of financial leverage), expressed as follows:
DTL = DOL x DFL
If there is no preferred stock, no preferred dividends, then the DFL and the DTL
will decrease. And the percentage of decrease in DFL is equal to the percentage of
decrease in DTL.

33. In its first year of operations, a firm had P50,000 of fixed operating costs. It sold
10,000 units at a P10 unit price and incurred variable costs of P4 per unit. If all prices
and costs will be the same in the second year and sales are projected to rise to
25,000 units, what will the degree of operating leverage (the extent to which fixed
costs are used in the firm’s operations) be in the second year?
1.25 C. 2.0
1.50 D. 6.0 (cia)
33. B
? The degree of operating leverage (DOL).
 Operating leverage measures the firm’s ability to change its profit as sales change. It
is computed by dividing contribution margin over fixed costs. The unit contribution
margin is P6 (i.e., P10 – P4). The DOL shall be determined as follows:
Contribution margin (25,000 units x P6) P150,000
- Fixed costs 50,000
Operating income P100,000
DOL (P15,000/P100,000) 1.5 : 1

34. If two companies, company X and Y, are alike in all respects except that company X
employs more debt financing and less equity financing than company Y does, which
of the following statements is true?
Company X has more net earnings variability than company Y.
Company X has more operating earnings variability than company Y.
Company X has less operating earnings variability than company Y.
Company X has less financial leverage than company Y. (cia)
Chapter 12 Cost of capital 45

34. A
? The true statement given the condition for companies X and Y.
 Company X employs more debt and is therefore more financially leveraged than
company Y. This means higher fixed costs, as contributed by greater interest
expense, and a higher degree of operating leverage (i.e., contribution margin / EBIT).
And a higher degree of operating leverage (DOL) means a greater variation in net
income, where a change in net income equals DOL times change in net sales. A
higher DOL contributes to more earnings volatility in the part of company X.
Choice-letters “b” and “c” are incorrect because the level of fixed financing
charges does not affect earnings before interest and taxes. Choice-letter “d” is
incorrect because company X has more financial leverage than company Y.

 done 
Chapter 12 Cost of capital 46