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:
kd =

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:

kdt =
=

(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%

27-1

10.

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%
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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=

=

27-3

P1,500,000
P4,000,000
0.375

P500,000
P4,000,000
0.125

Chapter 27

Calculating the Cost of Capital

The firms 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 firms 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

27-5

Chapter 27