Chapter 18

Problem 1

Cost of Weighted
Capital Capital Weight Cost of Capital
Debt 7% 35% 2.45%
Preference
Share 10% 15% 1.50%
Ordinary
Share 13% 50% 6.50%
10.45%

*WCC = cost of capital x Weight

Problem 2

Cost of Weighted
Capital Capital Weight Cost of Capital
Debt 6.6% 30% 1.98%
Preference
Share 9.11% 10% .911%
Ordinary
Share 11% 60% 6.6%
9.491%

*WCC = cost of capital x Weight

Problem 3

Budget A, capital of 230,000

A
Return on
Project Cost IRR
Investment
A P100,000 18% 18,000
B P80,000 16% 12,800
C P50,000 15% 7,500
38,300
Marginal
B
Cost (35,420)
Excess
Return 2,880

Budget B, capital of 200,000

Return on
Project Cost IRR
Investment
A P100,000 18% 18,000
B P80,000 16% 12,800
30,800
Marginal
C
Cost (28,800)
Excess
Return 2,400

*optimal capital budget is P230,000, it will yield higher return

A
return on investment = cost x IRR
B
P230,000 x 15.4%
C
P200,000 x 14.2%

Problem 4

Cost of Ordinary share:

= 10% + ( 15% – 10%)1.38

= 16.9%

*use the capital asset pricing model

Cost of Debt:

= 12% x ( 1 - .4)

= 7.2%

Cost of Weighted Cost

Capital Capital Weight of Capital
Debt 16.9% 50% 8.45%
Ordinary
Share 7.2% 50% 3.6%
12.05%

*Accept the project because the (13%)return exceeds the weighted

cost capital.
Problem 5

Cost of Debt:

= 12.4% x ( 1 - .35)

= 8.06%

Cost of Preference Share:

P4.75 / ( P50 – P1.4 ) = 9.77%

Cost of Ordinary Share:

(P2.70 / P54) + 12%

= 17%

Cost of Weighted cost

Capital Capital Weight of Capital
Debt 8.06% 35% 2.82%
Preference
Share 9.77% 10% .977%
Ordinary
Share 17% 55% 9.35%
13.147%
Problem 6

Degree of Operating Leverage

= P300,000 / P150,000

=2

Degree of Financial Leverage

= P150,000 / P150,000 – P60,000

= 1.6667

Degree of Combined Leverage

= P300,000 / P150,000 – P60,000

= 3.3333

Or

= 2 x 1.6667

= 3.3334

Break Even Point in Units

= P150,000 / P30

= 3,000 units
Problem 7

Current
Capital Plan D Plan E
Debt P6,000,000 P9,000,000 P3,000,000
Ordinary
Share P6,000,000 P3,000,000 P9,000,000

*tax rate of 45%

*additional P360,000 interest expense under Plan D

*Additional 375,000 ordinary shares under Plan E

A. ROA of 10%

Current
Capital Plan D Plan E
Interest
Expense P600,000 P960,000 P300,000
Interest after
tax P330,000 P528,000 P165,000
Ordinary
share(units) 750,000 375,000 1,125,000

A
Net Income P870,000 P672,000 P1,035,000
B
EPS P1.16 P1.79 P.92

A
NI = (10% x P12,000,000) – interest after tax
B
EPS = Net Income/Ordinary share
B. ROA of 5%

Current
Capital Plan D Plan E
Interest
Expense P600,000 P960,000 P300,000
Interest after
tax P330,000 P528,000 P165,000
Ordinary
share(units) 750,000 375,000 1,125,000

A
Net Income P270,000 P72,000 P435,000
EPS P.36 P.192 P.387

A
NI = (5% x P12,000,000) – interest after tax

*Plan E is most favorable if ROA is 5%

ROA of 15%

Current
Capital Plan D Plan E
Interest
Expense P600,000 P960,000 P300,000
Interest after
tax P330,000 P528,000 P165,000
Ordinary
share(units) 750,000 375,000 1,125,000

A
Net Income P1,470,000 P1,272,000 P1,635,000
EPS P1.96 P3.392 P1.453
A
NI = (15% x P12,000,000) – interest after tax

*Plan D is most favorable if ROA is 15%

C. ROA of 10%, and Market price of ordinary share 12

*additional 250,000 ordinary share under plan E, and 250,000 share will
be retired under plan D

*250,000 share = P3,000,000/P12

Current
Capital Plan D Plan E
Interest
Expense P600,000 P960,000 P300,000
Interest after
tax P330,000 P528,000 P165,000
Ordinary
share(units) 750,000 500,000 1,000,000

A
Net Income P870,000 P672,000 P1,035,000
EPS P.36 P1.344 P1.035

A
NI = (10% x P12,000,000) – interest after tax

*Plan D is most favorable if ROA is 10%, and market price of the share is
12.