FINANCIAL MANAGEMENT

ASSIGNMENT

RISK AND RETURNS

The MAGIGINGCPAAKO, Inc., a multinational company, is expanding its research and production
capacity to introduce a new line of products. Current plans call for the expenditure of P100M on four
projects of equal size (P25M each), but different returns.

Project A is in blood clotting proteins and has an expected return of 18 percent.

Project B relates to a hepatitis vaccine and carries a potential return of 14 percent.
Project C, dealing with cardiovascular compound, is expected to earn 11.8 percent.
Project D, an investment in orthopedic implants, is expected to show a 10.9 percent return.

The firm has P15M in retained earnings. After a capital structure with P15M in retained earnings
is reached (in which RE = 60% of financing), all additional equity financing must come in the form of new
common stock. These stocks are selling for P25 per share and underwriting costs are estimated at P3 if
new shares are issued. Dividends for next year will be P0.90 per share and earnings and dividends have
grown consistently at 11 percent.

The yield on comparative bonds have been hovering at 11 percent. The investment banker feels
that the first P20M of bond could be sold to yield 11 percent while additional debt might require a 2
percent premium and can be sold to yield 13 percent. The corporate tax rate is 30 percent. Debt
represents 40 percent of the capital structure.

The expected returns on common equity are:

1. Retained Earnings
= P15,000,000
2. Common Shares
= P5 000 000
3. What is the initial weighted average cost of capital?
= 7.70% * 40% + 60% *14.60% = 11.84%
4. At what size of the capital structure would there be a change in the cost of equity
component?
= Retained earnings/% of RE in capital structure = P15,000,000/.60 = P25000000
5. What is the marginal cost of capital at retained earnings breakpoint?
= 7.70 * 40% + 15.09 * 60% = 12.13%
6. At what size of capital structure will there be a change in the cost of debt?
= 20,000,000/40% =P50,000,000
7. The selection of the project is based on ranking of profitability. What is the expected
marginal cost of capital of financing Project C?
= 9.10% * 40% + 15.09% * 60% = 12.69
8. Which of the four projects will be accepted by the company?
= Project A
The following data are related to KAYAKOPA, Inc.: (no. 9 only)

Required return on common stock 15 percent

Beta coefficient 1.5
Risk-free rate 9 percent

9. The required market return is

= Market premium = Market return – risk free
= Risk free rate + BETA x Market Premium = .18

10. What is the asset beta given the debt beta is .2, the equity is 1.4, the market value of equity
is P45M, and the market value of debt is P15M?
= 1.04

BOND VALUATION
1. What is the value of a 15- year P1000 corporate bond with stated rate of 10% per annum? The bond
of similar quality yields 8%.

= P1 171.19

CPAINTHEMAKING Co. issued a zero-bond coupon bond with 15 years until maturity and a P1000 Face
value.

2. Determine the value if the discount rate is 8%

= M/(1 + r)n = 1000/(1 + 8%)15 = 1000/3.1722 = 315.24

3. Determine the value if the discount rate is 9%

= M/(1 + r)n = 1000/(1 + 9%)15 = 1000/3.6425 = 274.54

A P1000 CPAINPROCESS Co. corporate bond was issued on January 1, 2018 with an annual rate of 8%.
The current market value of the bond is P935.82 and it matures in 10 yrs.

4. Determine the discount rate or the yield to maturity = 0.67%

= [(FV/PV)/1 time period)-1] = (1000/935.82) 1/100 – 1= (1000/935.82)0.1-1 = 0.0067 =
0.67%

COA purchased on January 01, 2017 a P1000 face value bond issued by BSA corp. with 9% annual
coupon interest and 10 years to maturity for P950. If COA sold the bond on January 01, 2018 for P970 to
CPAAKO Co.:

5. What is the total rate of return earned by COA on the investment?

= CV – IV/IV x 100 = 870 – 950/950 x 100 = 2.11%

COA Corp. issued a ten-year, P1000 non-convertible bond which pays annual coupon of P80 on January
1, 2016. Assume that the bond with similar risk yields a rate of 8%:

6. Is the bond issued at face, at a premium or at a discount?

= P1000
7. What is the value of the bond upon issuance?
= P1 000
8. Determine the value of the bond 5 years after issuance.
 = P1 000
9. What is the amount of the interest expense paid on Dec. 31, 2017?
= P80
10. What is the value of the bond at maturity date?
= P1 000

STOCK VALUATION
CPAINPROCESS Inc. just paid a dividend of P1.5 per share. The dividend is expected to grow at 5% a year
and the rate of return on the said stock is 12%

1. What is the expected dividend per share in year 5?

= 22.55= 28.71

2. What is the price of the stock today?

= 1.5(1.05)/.12 - .05 = 22.5

3. What is the price of the stock after two years?

= 22.52 = 24.8

If an investor of CPAINPROCESS Inc. sold his shares at P25 per share in year 1 after receiving dividend:

4. What is the dividend yield?

= 1.5/22.5 = .06

5. What is the capital gains yield?

= 1.5 - .12/.12 = 11.5

6. What is his total return from investment?

= .05 + (25*(.12 - .05)) = 1.8

WALANGSUSUKO Corp. is expected to pay a dividend of P2 per share at the end of the year despite the
decline in the sales of the company. Due to increase in production cost, the company’s earnings and
dividends are declining at a constant rate of 5%. The rate of return on this stock is 8%.

7. What is the expected dividend per share in year 1?

= P2 per share

8. What is the expected dividend per share in year 3?

= P6 per share

9. What is the price of the stock today?

 = P39

10. What is the price of the stock after four years?

= P44

COST OF CAPITAL
The KAYAKOPA Co. uses a target capital structure when calculating the cost of capital. The target
structure and the current component costs based on market conditions are as follow:

Component Mix Cost*

Debt 25% 8%
Preferred stock 10 12
Common equity 65 20
*The costs of debt and preferred stock are already adjusted for taxes and/or flotation costs. The
cost of equity is unadjusted.

The firm expects to earn P20M next year and plans to invest P18M in new capital projects. It
generally pays dividends equal to 60% of earnings. Flotation costs are 10% for common and preferred
stock.

1. What is the initial WACC?

Component Mix (a) Cost (b) Factors (a*b)

Debt 25% 8% 2%
Preferred Stock 10% 12% 1.2%
Common Stock 65% 20% 13%
WACC 16.20%

2. What is the RE breakpoint? (round to nearest P1M)

Retention Ratio = 1- 0.6 =.0.4 or 40%

Available retained earnings = P20,000,000 * 40% = P 8 Million

Breakpoint= P 8 Million/0.65 = P12.3 Million

3. What is the new WACC after breakpoint?

Cost of new equity = Ke/ (1-0.1) = 20%/0.9 = 22.2%

Component Mix Cost Factors

Debt 25% 8% 2%
Preferred Stock 10% 12% 1.2%
Common Equity 65% 22.2% 14.4%
WACC 17.6%
 4. The company can borrow up to P4M at a net cost of 8% as shown. After that, the net cost of

debt rises to 12%. Where is the 2nd break in the MCC i.e. What is the debt breakpoint?

- The Second break in the MCC

P4000000/0.25 = P16M

5. What is the new WACC after the increase in the cost of debt?

Component Mix Cost Factors

Debt 25% 12% 3%
Preferred Stock 10% 12% 1.2%
Common Equity 65% 22.2% 14.4%
WACC 18.6%

DIAKOSUSUKO Co. has a beta of 0.7. The yield on a 3-month treasury bills is 4% and the yield on a 10-
year T-bond is 10%. The market return is 12%.

6. What is the estimated cost of common equity using CAPM?

Ra= Rrf + [Ba x ( Rm – Rrf)]
Ra= 10 + [ 0.7 x (12 - 10 )]
Ra= 10 % + [ 0.7 x 2%)]
Ra = 10% + 1.4%
Ra= 11.4%

X Corp. just paid a dividend of P6 per share on its stock. The dividends are expected to grow at a
constant rate of 10% per year, indefinitely.

7. If investors require a 12% return on X Corp.’s stocks, what is the current price?

= P330

8. What will the price be in 3 years?

= P1 320

Y Corp.’s common stock is currently trading at P50 a share. The stock is expected to pay a dividend
of P4 a share and the dividend is expected to grow at a constant rate of 10% a year.
9. What is the common equity?
= P54.4 a share
The P100 par value preferred stock of Z Corp. pays an annual dividend of 8%. It has a required rate
of return of 10 %.
10. Compute the price of the preferred stock.
= P99.30