MAS – Long-term Financing, Cost of Capital and Capital Structure Decisions

Capital Structure
• Mix of long-term sources of funds used by the firm in long-term financing decisions.
• Objective:
o To maximize the stock price/minimize the cost of capital using sources of long-term funds
• Different to financial structure (comprises all sources including short-term financing)

Cost of Capital
• Cost of using funds (hurdle rate, required rate of return, cut-off rate)
• Long-term financing sources and funds:
Source Capital Cost of capital
Creditors Long-term debt (bonds, After-tax interest rate of the LTD -
mortgages, etc.) kd (1-T)
Owners of preferred stock Preferred stock kp = Div. Pref/Price per pref. share*
*if there is flotation cost, it should be
net of flotation costs
Owners of common stock Common stock CAPM or DGM

Capital Asset Pricing Model (CAPM)

• ks = kRF + β(kMR – kRF)
• ks – required rate of return of stock
• kRF – risk-free rate (based on government securities)
• kMR – market return
• β – beta coefficient which determines the correlation of the stock’s price variation to the volatility of the
individual stock

Dividend Growth Model (Gordon Model)

• ks/ke = (D1 / P0*) + g
• ks – cost of retained earnings
• D1 – next dividend
• P0 – current stock price
• g – growth rate (assume constant growth rate)
• ke – cost of issuing new common stock (*current stock price must be net of flotation cost)

Factors influencing capital structure decisions

• Business risk – riskiness inherent in the firm’s operations if it uses no debt.
o The lower the business risk, the higher its optimal debt ratio
• Tax position
o The higher the tax rate, the higher the debt since interest is tax-deductible.
• Financial flexibility
o Refers to the firm’s ability to raise capital on reasonable terms even under adverse conditions
• Managerial conservatism or aggressiveness
o Refers to some financial managers’ decline or inclination to use debt to boost profit.

Leverage
• Operating leverage – extent to which fixed costs are used in their operations
Degree of operating leverage (DOL) = (Sales – VC)/EBIT
• Financial leverage – extent to which debt and preferred stock are used in their capital structure
Degree of financial leverage (DFL) = EBIT/(EBIT – interest – preferred dividends)
• Total leverage – measure of total risk
Degree of total leverage = DOL x DFL

Problems:
1. Kimochi Construction’s CFO wants to estimate the company’s WACC. She has collected the following
information:
• The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon,
a face value of $1,000, and they currently sell for $945.
• The company’s stock has a beta = 1.20.
• The market risk premium equals 5 percent.
• The risk-free rate is 6 percent.
• The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock
sells for $25 a share.
• The company’s tax rate is 40 percent.
 • The company’s capital structure consists of 40 percent long-term debt, 40 percent common stock, and
20 percent preferred stock.
Required:
1. What is the company’s after-tax cost of debt?
2. What is the company’s after-tax cost of preferred stock?
3. What is the company’s after-tax cost of common equity?
4. What is the company’s WACC?

2. Yummy Tea Company, a growth stock, is planning to expand its facilities for the upcoming year. Currently,
Yummy Tea has a capital structure of 30% debt and 70% equity with P315 million debt, P525 million common
stock and P210 million retained earnings. Additional information is as follows:
• All financing must be in the form of retained earnings; otherwise all additional equity financing must
come in the form of new common stock. The cost of retained earnings is 15% and the cost of issuing
new common stock is 16.5%.
• The after-tax nominal yield to maturity of a semi-annual bond as assessed by investment bankers is
10%, and it will not change regardless of the amount of debt to be financed.
• Yummy Tea has two options to choose, whether to invest in a small building facility to start up new
product line worth P250 million or purchasing its alliance’s renowned beverage division worth P350
million, each of which has a rate of return at 14%.
Required:
1. Determine the amount of capital expenditure that would have a change in the cost of equity component
(in short, the retained earnings breakpoint).
2. Determine the initial WACC (without achieving retained earnings breakpoint).
3. Determine the marginal cost of capital after reaching the breakeven point in retained earnings.
4. Determine the project to be accepted by Yummy Tea.

3. Chiara Company had the following operations for the current year: Sales, P5,000,000; Variable costs,
P2,000,000; Fixed costs, P1,500,000; Interest expense, P500,000; Dividends to preferred shareholders,
P500,000 (no tax deducted). Assume 30% tax rate.
Required:
1. Calculate the DOL.
2. Calculate the DFL.
3. Calculate the DTL.

Questions:
1. In computing the cost of capital, the cost of debt capital is determined by
a. Annual interest payment divided by the proceeds from debt issuance.
b. Interest rate times (1 – the firm’s tax rate)
c. Annual interest payment divided by the book value of the debt.
d. The capital asset pricing model.

2. If a $1,000 bond sells for $1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
a. I and IV
b. I and V
c. II and IV
d. II and V

3. If bonds are issued at a premium and has a call provision, which of the following is true as to the
expectation of investors on the bond?
a. Investors should expect bond issuers not to call the bonds until maturity.
b. Investors should expect a call on the bonds before maturity.
c. Investors do not expect anything on whether the bond issuers call the bond before maturity.
d. Investors cannot determine whether bond issuers exercise the call provision or not.

4. Which of the following is more likely to have high reinvestment risk?

a. 10-year, 10% coupon bonds
b. 1-year, 10% coupon bonds
c. 1 year, 0% bonds
d. 10-year, 0% bonds

5. A 10-year, 5% annual coupon bond with a face amount of P500,000 is issued at a price of P504,530.
What is the after-tax cost of debt of the bond, assuming the tax rate is 30%?
 a. 5.12%
b. 5%
c. 4.88%
d. 3.42%

6. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively, is the
a. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock
b. pretax rate of interest for bonds and stated annual dividend rate less the expected earnings per
share for preferred stock
c. pretax rate of interest for bonds and stated annual dividend rate for preferred stock
d. after-tax rate of interest for bonds and stated annual dividend rate less the expected earnings
per share for preferred stock

7. Which of the following statements is incorrect?

a. Preferred stockholders have priority over common stockholders.
b. One of the advantages of common stock financing is that a firm’s debt ratio will decrease.
c. A greater proportion of common stock in the capital structure increases the likelihood of a
takeover bid.
d. All of the above choices are correct.

8. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have given
estimates (below) on their fees and the selling price of the stock, as well as the expected dividend for
each:
Fees Selling Price Dividends
Underwriter 1 $5 $101 $10
Underwriter 2 7 102 11
Underwriter 3 3 97 7
Underwriter 4 3 98 8
Which underwriter will produce the lowest cost of funds for the preferred stock?
a. Underwriter 1
b. Underwriter 2
c. Underwriter 3
d. Underwriter 4

9. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend is
expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently has 1,600,000
shares of common stock outstanding. If the required rate of return for Frostfell is 12%, what is the best
estimate for the current price of Frostfell's common stock?
a. $65.80
b. $62.51
c. $47.00
d. $27.41

10. Assume that the average firm in your company’s industry is expected to grow at a constant rate of 5
percent, and its dividend yield is 4 percent. Your company is about as risky as the average firm in the
industry, but it has just developed a line of innovative new products, which leads you to expect that its
earnings and dividends will grow at a rate of 40 percent (D1 = D0(1.40)) this year and 25 percent the
following year after which growth should match the 5 percent industry average rate. The last dividend
paid (D0) was $2. What is the stock’s value per share?
a. $42.60
b. $82.84
c. $91.88
d. $101.15

11. Cost of capital is

a. The amount the company must pay for its plant assets.
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of equity or
long-term debt securities

12. Which of the following is not considered a capital component for the purpose of calculating the
weighted average cost of capital (WACC) as it applies to capital budgeting?
a. Long-term debt.
b. Common stock.
c. Accounts payable and accruals.
d. Preferred stock.
 13. For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are
after taxes.)
a. kd > ke > ks > WACC.
b. ks > ke > kd > WACC.
c. WACC > ke > ks > kd.
d. ke > ks > WACC > kd.

14. Which of the following will increase the expected cost of issuing new common stock?
a. Increase in the current stock market price
b. Large dividend payouts
c. Reduction in flotation costs of issuing new stock
d. None of the choices

15. Which of the following is true as to the beta coefficient in determining the required rate of return of
common stock?
a. It determines the volatility of the stock’s price with changes in the market.
b. It determines the risk-free rate based on government securities.
c. It is the required rate of return of common stock.
d. It is the market return rate of the common stock.

16. Which of the following is not associated with (or not a part of) business risk?
a. Demand variability
b. Sales price variability
c. Cost structure changes
d. Changes in required returns due to financing decisions

17. Which of the following relates to financial risk?

a. Operating leverage
b. Times-interest earned ratio
c. Breakeven point
d. Basic earnings power

18. From the information below, which of the following is the optimal capital structure of a company?
a. Debt = 40%; Equity = 60%; EPS = P2.95; Stock price = P26.50
b. Debt = 50%; Equity = 50%; EPS = P3.05; Stock price = P28.90
c. Debt = 60%; Equity = 40%; EPS = P3.18; Stock price = P31.20
d. Debt = 70%; Equity = 30%; EPS = P3.42; Stock price = P30.00

19. Which of the following is likely to encourage a company to use more debt in its capital structure?
a. Increase in corporate tax rate
b. Increase in degree of operating leverage
c. Increase in personal tax rate
d. All of the choices

For 20 and 21
Second Company will produce 50,000 units next year. Variable costs will equal 60% of sales, while fixed costs
will total P100,000. Assume that the company’s target EBIT is P40,000 with times-interest-earned ratio of 4
times.
20. What price must Second charge in order to achieve its target earnings before interest and taxes?
a. P4.66
b. P7.00
c. P4.20
d. Some other answers

21. What is the degree of total leverage?

a. 4.66 times
b. 3.50 times
c. 4.83 times
d. 1.33 times

22. The Altman Company has a debt ratio of 33.33 percent, and it needs to raise $100,000 to expand.
Management feels that an optimal debt ratio would be 16.67 percent. Sales are currently $750,000, and
the total assets turnover is 7.5. How should the expansion be financed so as to produce the desired
debt ratio?
a. 100% debt
b. 100% equity
c. 20% debt, 80% equity
 d. 80% debt, 20% equity

23. Stanley Corporation is considering a 5-year, $6,000,000 bank loan to finance service equipment. The
loan has an interest rate of 10 percent and is amortized over five years with end-of-year payments.
Stanley can also lease the equipment for an end-of-year payment of $1,790,000. What is the difference
in the actual out of pocket cash flows between the two payments? (choose the closest amount)
a. $90,000
b. $125,200
c. $207,200
d. $251,000

24. Reading Railroad’s common stock is currently priced at $30, and its 8 percent convertible debentures
(issued at par, or $1,000) are priced at $850. Each debenture can be converted into 25 shares of
common stock at any time before 2020. What are the conversion price and the conversion value of the
bond?
a. $25; $850
b. $25; $750
c. $40; $750
d. $40; $850

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