VALUATION METHOD Q1

QUIZ 1 - SPECIAL TRANSACTIONS

THEORIES
1. Flotation costs associated with issuing new equity cause the cost of external equity to be
lower than the cost of retained earnings

2. Your decision should be to invest if the expected rate of return in a stock investment is
less than the required rate of return.

3. The general idea of WACC or weighted average cost of capital is that for every peso of
asset raised, a portion is funded by a maximum of three sources namely: debt, preferred
equity and common equity.

4. Which of the following is correct?

A. the higher the required risk the higher the actual return
B. the higher the expected risk, the higher the actual return
C. the higher the expected risk the higher the expected return
D. the lower the required risk, the lower the expected return

5. Select the best among the investments?

A. JFZ with variance of .05123456 with exected value of 2%
B. SMZ with Standard deviation of 5% and Expected Value of 2%
C. VDO with Expected value of 7% and coefficient of variation of 1.15
D. GLOW with Standard deviation of 10% and Expected Value of 8%

6. Efficient market hypothesis provides that the expected rate of return is equal to required
rate of return because the presumption is all information are readily available to the
market for the investors.

7. Ceteris Paribus, Cost of New issuance is higher than Cost of retained earnings due to?
dividend declaration cost interest expense
flotation cost agency cost

8. Standard deviation is a measure of risk which is computed by?

a-square root of squared deviation c-sum of variance
b-square of variance d-square root of variance

9. Statement 1: cost of debt as a component of cost of capital must be after tax due to the
tax shield effect of interest expense.
Statement 2: cost of equity as a component of cost of capital must be after tax due to tax
shield effect of dividend declaration.

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10. Select is the best investment among the following stocks?

Stock A with Expected value of 10% and Standard deviation of 5%
Stock B with Standard Deviation of 10% and Expected Value of 5%
Stock C with Expected Value of 5% with Standard Deviation of 5%
Stock D with Expected Value of 2% with Standard Deviation of 5%

11. In reality the market is inefficient because not all the necessary information are available
to all investors.

12. This is the probability of unfavorable outcome or event?

Return Risk
Efficient Market Cost of Capital

13. As a firm's debt ratio approaches 100 percent, the after-tax cost of debt, rdT, at its lowest
level.

14. This is the point when the firm need additional funding from issunce of new shares.
Break even point match point
Retained earnings break point Break na tayo point

15. Which of the following is not a component of Weighted Average Cost of Capital?
Cost of long term Debt
Cost of preferred Stock
Cost retained earnings
cost of short term debt

16. Which of the following stocks will provide the highest return if the risk free rate is 5% and
the market risk premium is 6%?
Pabebe Stock with beta of 0.75
Tiktoker stock with beta of 1.5
Far Mali stock with beta of 2.1
Merry Smart stock with beta of 0.25

17. Ceteris Paribus, which of the following will will provide highest expected return on stock
investment?
defensive beta average beta
aggressive beta negative beta

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18. If a firm can shift its capital structure so as to change its weighted average cost of capital
(WACC), which of the following results would be preferred?.
A. The firm should try to increase the WACC because such an action will increase the
value of the firm.
B. The firm should try to decrease the WACC because such an action will increase the
value of the firm
C. The firm should try to decrease the WACC because such an action will decrease the
value of the firm.
D. The firm should try to increase the WACC because such an action will decrease the
value of the firm.

19. Statement 1:The required rate of return computed under the Capital Asset Pricing Model
is higher than the cost of equity computed under the dividend growth model.
Statement 2: The ratio of debt and equity that is optimal shall provide the lowest cost of
capital.

PROBLEMS

Problem: An analyst has collected the following information regarding Frances Co.:
● The company’s capital structure is 60 percent equity and 40 percent debt.
● The yield to maturity on the company’s bonds is 10 percent.
● The company’s year-end dividend is forecasted to be P0.10 a share.
● The company expects that its dividend will grow at a constant rate of 9 percent a year.
● The company’s stock price is P25.
● The company’s tax rate is 40 percent.
● The company anticipates that it will need to raise new common stock this year, and
total flotation costs will equal 20 percent of the amount issued.

1. Assume the company accounts for flotation costs by adjusting the cost of capital.
Given this information, calculate the company’s last peso WACC.
8.1% 8.5% 9.15% 9.3%

Problem: Colt, Inc. is planning to use retained earnings to finance anticipated capital
expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5%,
and the market return is estimated at 12.4%. If a new issue of common stock were used in this
model, the flotation costs would be 7%.
2. By using the Capital Asset Pricing Model (CAPM) equation [R = RF + ß(RM - RF)], the
cost of using retained earnings to finance the capital expenditures is
12.4% 8.5% 4.49% 12.99%

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PROBLEM: Veryeasy Company’s fund manager has a P20,000,000 portfolio with a beta of 1.5.
The risk-free rate is 4.5% and the market risk premium is 5.5%. The manager expects to receive
an additional P5,000,000, which she plans to invest in a number of stocks. After investing the
additional funds, she wants the fund’s required return to be 13%.
3. What is the required rate of return for additional P5M investment?
12.75 percent 12.89 percent 13.00 percent 14.00 percent
4. What should be the average beta of the new stock or stocks to be added to the
portfolio? (use two decimal places) __________

Problem: The earnings, dividends and stock price of Babawi Inc. (BI) are expected to grow at
7% per year after this year. BI’s common stock sells for P23 share, its last dividend was P2.00
and will pay P2.14 at the end of the current year. BI should pay P2.50 floatation cost.
Currently, risk-free rate is stated at 8% and the average return on the market is 12%. BI’s stock
was beta of 1.75.
5. What would be the new required rate of return on BI’s stock if the inflation rate rose by
3.5%? 13.23 percent 15.50 percent 18.50 percent 19.50 percent
6. Using the CAPM approach, what is the expected rate of return on BI’s stock?
10.23 percent 12.00 percent 14.23 percent 15.00 percent

Problem: The portfolio that you manage has total variance of .05123456 and expected value of
11.317526%.
7. What is the coefficient of variation? (Use whole number)_________

Problem: Bouchard Company's stock sells for P20 per share, its last dividend (D0) was P1.00,
its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20
percent if it sold new common stock. Retained earnings for the coming year are expected to be
P1,000,000, and the common equity ratio is 60 percent.

8. If Bouchard has a capital budget of P2,000,000, what component cost of common

equity will be built into the WACC for the last peso of capital the company raises?
12.25% 12.63% 11.3% 11%

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PROBLEM: Notjustlucky Industries (NJLI) has a beta of 1.8, while Studywell Industries’ (SWI)
beta is 0.6. The risk-free rate is 6% and the required rate of return on an average stock is 13%.
The expected rate of inflation built into the risk-free rate falls by 1.5 points, the real risk-free rate
remains constant, the required return on the market falls to 10.5%, and all betas remain
constant.
9. What is change in the required rate of return of NJLI as a consequence of the above
changes? Increase / (decrease)
3.3 percent 2.3 percent (2.3 percent) (3.3 percent)

PROBLEM: You are to manage the P5 million portfolio of Notransmuneeded Incorporated that has a
beta of 1.25 and a required rate of return of 12%. The current risk-free rate is 5.25%. Assume that you
receive another P500,000 and invest it in a stock with a beta of 0.75.
10.What is the new beta of the portfolio? 0.75 1.00 1.20 1.25

PROBLEM: Your company’s stock sells for P50 per share, its last dividend was P2.00, its growth rate is
a constant 5 percent, and the company will incur a flotation cost of 20 percent if it sells new common
stock.
11. What is the firm’s cost of new equity, kn?
4.94% 9% 10% 10.25%

PROBLEM: J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt,
10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of
debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred
stock currently sells for P90 a share and pays a dividend of P10 per share; however, the firm will
net only P80 per share from the sale of new preferred stock. Ross expects to retain P15,000 in
earnings over the next year. Ross' common stock currently sells for P40 per share, but the firm
will net only P34 per share from the sale of new common stock. The firm recently paid a
dividend of P2 per share on its common stock, and investors expect the dividend to grow
indefinitely at a constant rate of 10 percent per year.

12. What will be the WACC above P30,000 capital size? (use 3 decimal and NO need to
include % sign) (example: 12.675 OR 2.124) ______

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PROBLEM: Your boss, Jamylca, is interested in acquiring No Fail Inc. (NFI) shares of stock. He
asks you to provide certain information with regards to NFI’s riskiness. You have gathered the
probability distribution for NFI and is presented below:
Performance Of NFI Probability of this Rate of return
occurring if this demand occurs
Weak 10% -20%
Below Average 20% -5%
Average 40% 8%
Above Average 20% 25%
Strong 10% 50%
13. What is the expected value? 9% 10.% 10.2% 11.2%

PROBLEM: Iann-Jam Corporation has established a target capital structure of 40 percent debt
and 60 percent common equity. The current market price of the firm’s stock is P30; its last
dividend was P2.20, and its expected dividend growth rate is 8 percent.
14. What will Iann-Jam’s marginal cost of retained earnings be?
14.33% 14.86% 15.33% 15.92%

PROBLEM: RicaBebe Corporation has a target capital structure that consists of 40 percent
debt, 40 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The
company has projects in which it would like to invest with costs that total P3,000,000. RicaBebe
will retain P750,000 of net income this year. The last dividend was P5, the current stock price is
P80, and the growth rate of the company is 10 percent. If the company raises capital through a
new common equity issuance, the flotation costs are 10 percent. The cost of preferred stock is 8
percent and the cost of debt is 7 percent.

15. What is the retained earnings breakpoint?

750,000 1,875,000 2120,000 3,000,000
16. What is the weighted average cost of capital last peso? ____

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PROBLEM: Hilliard Corp. wants to calculate its weighted average cost of capital (WACC). The
company’s CFO has collected the following information:
● The company’s long-term bonds currently offer a yield to maturity of 8 percent.
● The company’s stock price is P32 a share.
● The company recently paid a dividend of P2 a share.
● The dividend is expected to grow at a constant rate of 6 percent a year.
● The company pays a 10 percent flotation cost whenever it issues new common stock.
● The company’s target capital structure is 75 percent equity and 25 percent debt.
● The company’s tax rate is 40 percent.
● The firm will be able to use retained earnings to fund the equity portion of its capital budget.

17. What is the company’s WACC?

10.67% 10.39% 11.47% 11.19%

PROBLEM: Merry Smart Corporation has established a target capital structure of 40 percent
debt and 60 percent common equity. The firm expects to earn P600,000 in after-tax income
during the coming year, and it will retain 40 percent of those earnings. The current market price
of the firm's stock is P0 = P28; its last dividend was D0 = P2.20, and its expected dividend
growth rate is 6 percent.Merry Smart can issue new common stock at a 15 percent flotation
cost.

18. What will Merry Smart's last peso or marginal cost of equity capital (not the WACC) be
if it must fund a capital budget requiring P400,500 in total new capital?
8.33% 9.79% 14.33% 15.79%

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VALUATION METHOD Q1 (KEY TO CORRECTION)

THEORY PROBLEMS

1 FALSE 26. 1 8.1%

2 FALSE 27 2 12.99%

3 TRUE 28 3 14.00 percent

4 C 29 4 1.72

5 C 30 5 18.50 percent

6 TRUE 31 6 15.00 percent

7 flotation cost 32 7 2

8 D 33 8 11.3%

9 True; False 34 9 (3.3 percent)

10 A 35 10 1.20

11 TRUE 36 11 10.25%

12 Risk 12 11.885

13 FALSE 13 10.2%

14 Retained earnings break point 14 15.92%

15 D 15 1,875,000

16 C 16 10.5

17 aggressive beta 17 10.67%

18 B 18 15.79%

19 19

20 20

21 21

22 22

23 23

24 24

25 25

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