ADDITIONAL PROBLEMS WITH SOLUTION

A. Retained Earnings Breakpoint

White Corp. has an optimal capital structure of 20% of debt, 30% of PS and 50% of
CS. Net income for the year amounts to P2M. Preferred stock dividends amount to
P200,000. White’s pay-out ratio is 40% (0.40).

What is the total amount of capital that can be raised before the company issues or
uses new CS, for capital budgeting purposes (or retained earnings breakpoint)?

Solution:

Available retained earnings

= (Net income - PS dividends) x plowback ratio or (1 – payout ratio)
= (P2M – P200K) x (1 – 0.40) = P1,080,000

RE-break point
= Available RE/CS% = P1,080,000/50% = P2,160,000

B. After-tax cost of Debt and Cost of RE (Using BY+RP approach)

Black Co.’s bond has coupon rate of 8%, face value of P1,000, and maturity of 10
years. It is currently selling at P950. The tax rate is 30%.

The judgmental risk premium applicable for the period ranges from 4 to 6%. Black
Co.’s bond is rated as high risk.

1) What is the after-tax cost of debt?

Solution:

Rd (YTM) = Coupon + ((FV – BP)/N) = P80 + ((P1,000 – P950)/10)

(BP x 0.60) + (FV x 0.40) (P950 x 0.60) + (P1,000 x 0.40)

= __P85__ = 8.76%
P970

After-tax cost of debt = Rd x (1 – tax rate) = 8.76% x (1 -0.70) = 6.13%

2) What is the cost of equity using the BY+RP approach?

Rs = Bond yield + judgmental risk premium

The bond yield is represented here by the company’s YTM. The judgmental risk
premium is based on the RP range for the period. Since the company’s bond is
considered as high risk, the highest RP will be used, that is 6%. If there is no RP
range given, then we will be using the one given in our text book, that is 3-5%. If this
is the case, the RP to be used will be 5%.

Rs = 8.76% + 6% = 14.76%

C. Cost of RE (Using the 3 approaches)

Red Inc. computed the following percentages for its cost of retained earnings:

CAPM = 9.50% DDM (DCF) = 10.30% BY+RP = 11.10%

Red Inc. has most confidence in the variables used to compute for the cost of RE using
the DDM (DCF) approach.

What is the cost of equity to be used for computing for WACC

Answer:

Cost of equity (Rs) = 10.30%

Since Red has most confidence in DDM (DCF) method, this is the best representative
of the company’s cost of equity. If Red has most confidence in either the CAPM or
BY+RP approach, then the percentages computed using either of the two approaches
will be used. If it is not mentioned, it is logical to assume that the company has equal
confidence in all the approaches. Hence, the average cost percentages using the three
methods will be used.

D. Capital Structure

Black Co. has the following Balance Sheet:

ASSETS LIABILITIES AND EQUITY

Current Assets P 500,000 Current liabilities P 200,000

Non-Current LT-liabilities 500,000
Assets 4,500,000 Preferred stock (20,000 shares) 1,000,000
Common stock (50,500 shares) 2,000,000
Share premium - CS 400,000
Retained earnings 900,000
Total Assets P5,000,000 Total Liabilities and Equity P 5,000,000

Black has the following costs of capital:

After-tax cost of debt = 5.5%

Cost of PS (RP) = 9.5%
Cost of CS (Rs) = 11.50%
Current liabilities only consist of accounts payable and accruals (not investor supplied
or demanded). The marginal tax rate is 30%.

1) The book values of Black’s debt, preferred stock and common stock approximate
their market values. What is Black Co.’s WACC?

Solution:

MV of Debt = P500,000 (same with the BV; excludes CL since these pertain to AP and
Accruals)
MV of PS = P1,000,000; same with the BV
MV of CS = P3,300,000 (P2,000,000 + P400,000 + P900,000); same with the BV

Total Value of the Capital (V) = P4,800,000 (P500,000 + P1,000,000 + P3,300,000)

WD = 10.42% (P500K/P4,800K)
WP = 20.83% (P1,000K/P4,800K)
WC = 68.75% (P3,300K/P4,800K)
V = 100%

WACC = 10.42% x 5.5% + 20.83% x 9.50% + 68.75% x 11.50% = 10.46%

The tax is not effected anymore in the computation because the given cost of debt is
already after-tax.

2) The market values of the outstanding capital are as follows:

LT Debt – The bond related to this was issued at par value. It consisted of 500 bonds
in multiples of P1,000 (par value). The current price of the bond per P1,000 bond is
P1,100.

PS – The current price of the PS is P55 per share.

CS – The current price of the CS is P70 per share.

What is Black Co.’s WACC?

Solution:

MV of Debt = P550,000 (500 x P1,100, excludes CL since these pertain to AP and

Accruals)
MV of PS = P1,100,000 (20,000 x P55)
MV of CS = P4,545,000 (50,500 x P90)

Total Value of the Capital (V) = P6,195,000 (P550,000 + P1,100,000 + P4,545,000)

WD = 8.88% (P550K/P6,195K)
WP = 17.76% (P1,100K/P6,195K)
WC = 73.37% (P4,545K/P6,195K))
V = 100.01% (0.01% due to rounding-off difference)

WACC = 8.88% x 5.5% + 17.76% x 9.50% + 73.37% x 11.50% = 10.61%

E. Weighted Costs

Green Industries has the following optimal capital structure: 30% Debt, 40% PS, 30%
CS. Its YTM is at 8%, cost of PS is 10%, cost of equity is 12%. The marginal tax rate
is 40%.

1) What is Green Industries’ weighted after-tax cost of debt?

Solution:

Weighted after-tax cost debt = 30% x 8% x (1-0.40) = 1.44%

2) What is Green Industries’ weighted cost of PS?

Solution:

Weighted cost of PS = 40% x 10% = 4%

3) What is Green Industries’ weighted cost of CS?

Solution:

Weighted cost of CS = 30% x 12% = 3.60%

F. Cost of Preferred Stocks

Purple Joy 8%, P100 par value preferred stock is currently selling at P120.

1) What is the cost of Purple Joy’s PS for WACC purposes?

RP = (0.08 x P100)/ P120 = P8/P120 = 6.67%

2) If the flotation cost for PS is P5 per share, what is the cost of PS?

RP = P8/(P120-P5) = P8/P115 = 6.96%

G. After-Tax Cost of Debt with Flotation Costs

Gray Inc. can raise debt selling P1,000 par value, 10% coupon interest rate , 10-year
bonds on which annual interest payments will be made. To sell the issue, an average
discount of P30 per bond must be given. The firm must also pay flotation costs of P20
per bond. Its marginal tax rate is 40%.

What is Gray Inc.’s after-tax cost of debt?

Note: Flotation costs are deducted from the bond price to get the net proceeds. Bond
price is computed by deducting the discount or adding the premium. Hence, the net
proceeds (per bond is computed as):

Net proceeds = P1,000 – P30 – P20 = P950

Using the net proceeds as replacement for the bond price in the YTM formula, the YTM
is computed as:

YTM = P100 + ((P1,000 – P950)/10) = P105 = 10.82%

(P950 x 0.60) + (P1,000 x 0.40) P970

After-tax cost of debt = 10.82% x (1-0.40) = 6.49%

H. Cost of New Common Stock with Flotation Costs and Underpricing

Note: Flotation costs are costs incurred in issuing new securities like common stocks.
These include a) underwriting costs – compensation earned or amount paid to
investment bankers for selling the new securities and b) administrative costs – issuer
expenses like legal and accounting costs.

Underpricing is selling securities, like stocks, at a discount from its current market price.
It is the difference between the current market price and the issue price.

Both flotation costs and underpricing are deducted from the current market price to get
the cost of issuing new CS.

Silver Corp.’s common stock is currently selling for P80 per share. The firm expects to
pay cash dividends of P6 per share next year. The firm’s dividends have been growing
at an annual rate of 6%, and this rate is expected to continue in the future. The stock
will have to be underpriced by P4 per share, and the flotation costs are expected to
amount to P4 per share.

What is the cost of new common stock (RE)?

RE = (P6/(P80 – P4 – P4)) + 6% = (P6/P72) + 6% = 14.33%

I. Total Capital to be Raised Based on Projects to be Accepted

Gold Enterprises has a target capital structure of 60% CS and P40% Debt. It has
available retained earnings of P300,000. If Gold uses retained earnings as the form of
equity financing, its WACC will be 10.40% If Gold uses new common stock as the
form of equity financing, its WACC (the marginal cost of capital or last peso WACC)
will be 10.70%.

The following are the projects considered by Gold for acceptance, as follows:

Investment Opportunity Expected Rate of Return Initial Investment

A 11.20% P100,000
B 9.70% 500,000
C 12.90% 150,000
D 16.50% 200,000
E 11.80% 150,000
F 10.10% 600,000
G 10.50% 300,000

In which, if any, of the investments shown in the table above do you recommend that
the firm invest? How much new financing is required?

Solution:

Investment Internal Rate Initial Cumulative Project Cost

Opportunity of Return (IRR) Investment Investment of Capital
D 16.50% P200,000 P200,000 10.40%
C 12.90% 150,000 350,000 10.40%
E 11.80% 150,000 500,000 (RE-BPT) 10.40%
A 11.20% 100,000 600,000 10.70% (MCC)
G 10.50% 300,000 900,000 10.70%
F 10.10% 600,000 1,500,000 10.70%
B 9.70% 500,000 2,000,000 10.70%

Since the available RE amounts to P300,000, the RE-breakpoint is P500,000

(P300,00/0.60). Hence, total capital to be raised for the first P500,000 worth of
investments will use RE for its equity financing. Therefore, its project cost of capital
will be 10.40%. For investments after the first P500,000, capital to be raised will now
cost 10.70%, its marginal cost of capital, which will be the project cost of capital.

Projects D,C, E, and A should be accepted because their respective IRRs exceed their
project’s cost of capital. They will require P600,000 of total new financing.