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HOLY NAME UNIVERSITY

CPA Review
Tagbilaran

MANAGEMENT ADVISORY SERVICES

CAPITAL STRUCTURE AND LONG-TERM FINANCING DECISIONS

CAPITAL STRUCTURE – the mix of the long-term sources of funds used by the firm. This is different from
FINANCIAL STRUCTURE which is the mix of all firm’s assets.

Composition: Long-term debt, Preferred Stock, Common Stockholder’s equity

Capital Structure = Financial Structure – Current Liabilities

OPTIMAL CAPITAL STRUCTURE – mix of long-term sources of funds that will minimize the firm’s
overall cost of capital.

COST OF CAPITAL
- Cost of using funds; it is also called hurdle rate, required rate or return, cut-off rate
- The weighted average rate of return the company must pay to its long-term creditors and shareholders
for the use of their funds.

SOURCE CAPITAL COST OF CAPITAL

Creditors Long-term debt Interest (1 – TxR)

Stockholders:

Preferred Equity Preferred Stock

or
Common Equity Common Stock

or
Common Equity Retained Earnings

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OTHER WAY OF COMPUTING COST OF CAPITAL

1. Capital Asset Pricing Model (CAPM)

LEVERAGE – refers to that portion of the fixed costs which represents a risk to the firm.

A. OPERATING LEVERAGE – a measure of operating risk refers to the fixed operating costs found in the
firm’s income statement.

B. FINANCIAL LEVERAGE – a measure of financial risk refers to financing a portion of the firm’s
assets, bearing financing charges in hopes of increasing the return to the common stockholders.

C. TOTAL LEVERAGE – the measure of total risk

 a decrease in operating leverage would cause an increase in optimal amount of financial
leverage.
 A decrease in operating leverage would result into a decrease in the optimal amount of debt

SOURCES OF LONG-TERM FINANCING

Principal Sources
1. External sources : Debt, Equity and Hybrid Financing
2. Internal Sources : Operations

A. Debt Financing – major types of bonds or long-term debt:

a. Debenture bonds – unsecured loan
b. Mortgage bonds – a pledge of certain assets
c. Income bonds – pay interest only if the issuing company has earnings; this bonds are riskier than
other bonds
d. Serial bonds – bonds with staggered maturities.

B. Equity Financing – major source of common stocks and retained earnings

C. Hybrid Financing – sources of funds that possess a combination of features, these include:
a. Preferred stock
b. Leasing
c. Options securities such as warrants and convertibles

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EXERCISES:

1. Transformers Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55
percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity
portion of its capital budget. The before-tax cost of debt is 9 percent, and the company’s tax rate is 30
percent. If the expected dividend is P5 and the current stock price is P45, what is the company’s growth
rate? ___________

2. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent
preferred stock, and 50 percent equity. The interest rate on the company’s debt is 11 percent. The
preferred stock pays an annual dividend of P2 and sells for P20 a share. The company’s common stock
trades at P30 a share, and its current dividend of P2 a share is expected to grow at a constant rate of 8
percent per year. The flotation cost of external equity is 15 percent of the peso amount issued, while the
flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent.
Assume that the firm will not have enough retained earnings to fund the equity portion of its capital
budget. What is the company’s tax rate? ___________

3. SMB’s new financing will be in proportion to the market value of its present financing, shown below.
Book Value (P000 Omitted)

Long-term debt P7,000

Preferred stock (100 shares) 1,000

Common stock (200 shares) 7,000

The firms’ bonds are currently selling at 80% of par, generating a current market yield of 9%, and the
corporation has a 40% tax rate. The preferred stock is selling at its par value and pays a 6% dividend.
The common stock has a current market value of P40 and is expected to pay a P1.20 per share dividend
this fiscal year. Dividend growth is expected to be 10% per year. SMB’s weighted-average cost of
capital is (round your answer to the nearest tenths) ___________.

4. GMA Inc. uses only debt and internal equity to finance its capital budget and uses CAPM to compute its
cost of equity. Company estimates that its WACC is 12%. The capital structure is 75% debt and 25%
internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%. Risk free rate is 6% and market
risk premium is 8%. What would be the increase in value of the company’s individual stock if the
increase of the value of the stock market is 16%? (round your final answer to the nearest tenths)
____________.

5. A company finances its operations with 40 percent debt and 60 percent equity. Its net income is P16
million and it has a dividend payout ratio of 25%. Its capital budget is P15 million this year. The annual
yield on the company’s debt is 10% and the company’s tax rate is 30%. The company’s common stock
trades at P55 per share, and paid dividend of P5 per share for this year and is expected to grow at a
constant rate of 10% a year. The flotation cost of external equity, if it is issued, is 5% of the peso amount
issued. What is the company’s WACC? _________.

6. A new company requires P1 million of financing and is considering two arrangements as shown in the
table below:

Amount of Amount of Before-Tax

Arrangement Equity Raised Debt Financing Cost of Debt

#1 P700,000 P300,000 8% per annum

#2 P300,000 P700,000 10% per annum

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In the first year of operations, the company is expected to have sales revenues of P500,000, cost of sales
of P200,000, and general and administrative expenses of P100,000. The tax rate is 30%, and there are no
other items on the income statement. All earnings are paid out as dividends at year-end.

If the cost of equity is 12%, the weighted-average cost of capital under arrangement #1, to the nearest
full percentage point, would be __________.

7. On January 1, 2017, Unicorn has a capital structure that consists of 60 percent long-term debt and 40
percent common stock. The company’s CFO has obtained the following information:
 The company’s current capital structure shows 4%, 5-year bonds with face amount of P10,000,000
due on December 31, 2017 and beginning carrying amount of P9,616,400.
 The company’s common stock paid P3.00 dividend out from the earnings in 2016, and the dividend
is expected to grow at a constant rate of 7 percent a year. The common stock currently sells for P60 a
share.
 Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
 The company’s tax rate is 40 percent.

1) What is the company’s cost of long-term debt? __________ 4.89%

2) What is the cost of retained earnings? _____________ 12%
3) What is the company’s weighted average cost of capital (WACC)? (Round-off your final answer
to two-decimal places) ____________

8. Optimus Prime has a capital structure with 30 percent debt (all long-term bonds) and 70 percent
common equity. The yield to maturity on the company’s long-term bonds is 8 percent, and the firm
estimates that its overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent, the
market risk premium is 5 percent, and the company’s tax rate is 40 percent. Prime uses the CAPM to
determine its cost of equity. The price volatility of the individual stock is 14.2%. What is price volatility
of the stock market? __________

9. Bee Corporation has 50,000, P20 par ordinary shares and P2 million in debt equity (8% bonds). Its after-
tax weighted-average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting
decisions. During the past year, its operating income before tax and interest was P500,000. P2 out from
the earnings per share was retained by Bee and the excess is paid as dividends to its ordinary
shareholders. Dividends are estimated to grow at a constant rate of 6.4%. Its tax rate is 40%.

1) What is the company's cost of equity capital? ________ 26.4%

2) What is the ordinary share’s current market value? _________ 10.4

10. Based on the following information about stock price increases and decreases, make an estimate of the
stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3
= Stock -2.5%, Market -2.0%.
a. Beta is greater than 1.0. c. Beta equals 1.0
b. Beta is less than 1.0. d. There is no consistent pattern of returns.

11. What is the yield to maturity on Fishbook Inc.'s bonds if its after-tax cost of debt is 9% and its tax rate is
34%? (round-off your answer to two-decimal places) _________ 13.64%

12. Fish Ball Corporation has sold P50 million of P1,000 par value, 12% coupon bonds. The bonds were
sold at a discount and the corporation received P985 per bond. If the corporate tax rate is 40%, the
approximate after-tax cost of these bonds for the first year is ____________. 7.31%

13. The Choco Balls Company believes that it can sell long-term bonds with a 6% coupon but at a price that
gives a yield-to-maturity of 9%. If such bonds are part of next year’s financing plans, which of the
following should be used for bonds in their after-tax (40%) cost-of-capital calculation? _____. 9%
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14. Aina Corporation’s capital structure is as follows:

Bonds Payable, 10 years, 10% P1,000,000
10% preferred stocks, P200 par value,
10,000 shares issued and outstanding 2,000,000
Common stocks, P50 per share,
30,000 shares issued and outstanding 1,500,000
Retained Earnings 500,000
TOTAL P5,000,000

The company’s earnings per common share (EPS) is P12. The common shares current market price is
P60, while that of preferred shares is P250.

Required:
a) For purposes of computing the company’s overall cost of capital, the cost of common stocks
and retained earnings is 20%
b) The cost of debt is 7%
c) The cost of preferred stocks is 8%
d) What is the weighted average cost of capital? 12.60%

15. Vangie Corporation believes that it can sell long-term bonds with an 8% coupon rate, although the
effective rate is 10%. If such bonds are part of Vangie Corporation’s financing plans for next year, what
is the after-tax cost of bonds for purposes of calculating the corporation’s cost of capital? 7%

16. At present, Jacee Corporation’s capital structure is composed of 200,000 shares of common stocks
outstanding with a market price of P20 per share. It also has P4 million in 8% bonds and P2 million in
10%, P10 par value preferred stocks, both currently selling at par.
The company is considering a P3-million expansion program which can be financed with:
1. All common stocks at P20 per share
2. All bonds at 10% interest rate
3. All preferred stocks
If the expansion program is undertaken, the company estimates that it can earn Earnings before interests
and taxes (EBIT) of P2,000,000. The expected earnings per share under each alternative sources of
financing are:

All Common Stocks All Bonds All Preferred Stocks

a. P4.71 P 3.69 P3.21
b. 3.26 4.69 5.71
c. 2.69 4.78 5.71
d. 2.78 3.83 3.38

17. Cristy Corporation is planning to invest in project. Two investment opportunities are being considered:
Alternative 1 Cost of Investment Expected ROI
1 P100 M 11%
2 P100 M 15%

Christy Corporation can invest in only one of the alternatives. The investment project will be financed
by issuing common stocks. The company uses the Capital Asset Pricing Model (CAPM) in computing
cost of capital (common stock). At present, the market rate is 12% and the risk-free rate is 8%. The beta
coefficient if 1.3.

Which investment alternative should the company chooses? Alternative 2 only

18. Kheim Corporation is considering a project for the coming year that will require an investment cost of
P100M. The company plans to finance the project by a combination of debt and equity, as follows:

 Issue P20M of 10-year bonds at a price of 102, with an interest rate of 10%, and flotation cost of
3% of par.
 Use P80M of funds generated from earnings retained in the business.

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The expected market rate of return if 14%. The current rate of Treasury Bills is 8%. The beta coefficient
for Kheim Corporation is 1.2.

Required:
a. What is the effective rate of interest of the bonds? 10.10%
b. What is the after-tax effective cost of bonds? 7.07%
c. Using the CAPM, what is the cost of equity capital for Queenie Corporation? 15.20%
d. Assume that the after-tax cost of debt is 7% and the cost of equity capital is 5%, what is the
weighted average cost of capital for Queenie Corporation? 13.40%

19. Albe Corporation is planning to issue P20M bonds at an effective interest rate of 10%. The company
pays income tax at a rate of 30%. What is the cost of debt capital? 7%

20. Rastine Corporation is planning to issue 100,000 shares of 10%, P50 par value preferred stocks for P80
per share. The company pays income tax a rate of 30%. What is the cost of capital?
a. 10% c. 6.25%
b. P5 d. 4.25%

21. Chris Company common stocks currently sell for P40 per share. The estimated dividend payment at the
end of this year is P4 per share. Such dividend is expected to grow by P2.40 at the end of five years.
Using the dividend growth model, the cost of capital is ____________.22%

22. Mutz Corporation expects to pay dividends of P4.80 per share at the end of the current year. The
dividend growth rate is 10% and the cost of common equity capital is 14%.

If the dividend growth model is used to appraise Mutz Corporation’s share of stock, the price of the
stocks to the public is __________ P120

-END OF HANDOUTS-

RM MONTALBAN MAS 1813