Solutions Manual

CHAPTER 27

CALCULATING THE COST OF CAPITAL

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Multiple Choice Questions

1. D 4. C 7. C 10. A
2. A 5. D 8. D
3. C 6. A 9. C

II. Problems

Problem 1

The approximate before-tax cost of new debt is:

P120 + (P1,000 P970) / 15
kd = (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:

P4.50
kp = P47.50

= 0.0947 or 9.47%

27-1
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:
Ending dividend
FVIF i,4= 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:
P2.65
kr= P40.00 + 0.06

= 0.0663 + 0.06
= 0.1263 or 12.63%

(c) The cost of new ordinary equity share is:

P2.65
ks= P40.00 P3.00 + 0.06

= 0.0716 + 0.06
= 0.1316 or 13.16%

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%

27-2
 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
kr=
P40.00

= 0.1500 or 15.00%

Problem 7
The market value of each source of capital is found as follows:

Number of Market Market

Source of Securities Price Value
Capital (1) (2) (1) (2)
Bonds 3,000 * P965 P 2,895,000
Preferred share 25,000 18 450,000
Ordinary equity share 200,000 40 8,000,000
Total P11,345,000

*3,000,000 book value / P1,000 per bond = 3,000 bonds

Problem 8
(a) The book value weights are:
P2,000,000 P500,000
Long-term debt= P4,000,000 Preferred share= P4,000,000

= 0.500 = 0.125

P1,500,000
Ordinary equity share= P4,000,000

= 0.375

27-3
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 P600,000
Long-term debt= P6,000,000 Preferred share= P6,000,000

= 0.30 = 0.10

P3,600,000
Ordinary equity share= 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:

P26,000,000
BPi= 0.65

= P40,000,000

27-4