MAS - 05

Capital Budgeting / Cost of Capital / Financial Statement Analysis

Prof. John Michael Angelo Z. Lopo, CPA, RCA, MBA

Capital Budgeting:

A. Jeser Javier
Jeser Corporation is considering an investment that will require an initial cash outlay of
P200,000 to purchase non-depreciable assets. The project promises to return P60,000 per year
(after-tax) for eight years with no salvage value. The company's cost of capital is 11 percent.

Refer to Jeser Corporation. The company is uncertain about its estimate of the life
expectancy of the project. How many years must the project generate the P60,000 per year
return for the company to at least be indifferent about its acceptance? (Do not consider the
possibility of partial year returns.)
Present value tables or a financial calculator are required.

200,000 / 60,000 = 3.33 IRR Factor – 11% = 5 years

B. Rome Corporation
Rome Corporation is considering an investment in a new product line. The investment would
require an immediate outlay of P100,000 for equipment and an immediate investment of
P200,000 in working capital. The investment is expected to generate a net cash inflow of
P100,000 in year 1, P150,000 in year 2, and P200,000 in years 3 and 4. The equipment would be
scrapped (for no salvage) at the end of the fourth year and the working capital would be
liquidated. The equipment would be fully depreciated by the straight-line method over its four-
year life.

Refer to Rome Corporation. If Nicolas uses a discount rate of 16 percent, what is the NPV of
the proposed product line investment? What is the payback period of the investment

Present value tables or a financial calculator are required.

PV of CF =
1st 100,000 x 0.8621 = 86,210
2nd 150,000 x 0.7432 = 111,480
3rd 200,000 x 0.6407 = 128,140
4th 200,000 x 0.5523 = 110,460
4th 200,000 x 0.5523 = 110,460

Total PV of CF 546,750
Net Investment 300,000
(100,000 + 200,000)
NPV 246,750

Payback Period
1st 100,000 100,000 1
2nd 150,000 250,000 2
3rd 200,000 50,000 / 200,000 = 0.25

Payback = 2.25 years

C. Ezra Company
Ezra Company has an opportunity to invest in a project that will yield four annual payments of
P12,000 with no salvage. The first payment will be received in exactly one year. On low-risk
projects of this type, Ball requires a return of 6 percent. Based on this requirement, the project
generates a profitability index of 1.03953.

Present value tables or a financial calculator are required.

a. How much is Ezra required to invest in this project?
b. What is the internal rate of return on Ezra’s project?

PI = PV of CF / Net Investment
1.03953 = (12,000 * 3.4651) / x
1.03953 = 41,581.27 / (x)
X = Php40,000 (Net Investment)

1st step (IRR Factor)

40,000 / 12,000 = 3.33 – 4 years = 7%-8%

D. Ferelli Corporation
Ferelli Corporation is interested in purchasing a state-of-the-art widget machine for its
manufacturing plant. The new machine has been designed to basically eliminate all errors and
defects in the widget-making production process. The new machine will cost P150,000, and
have a salvage value of P70,000 at the end of its seven-year useful life. Cruz has
determined that cash inflows for years 1 through 7 will be as follows: P32,000; P57,000;
P15,000; P28,000; P16,000; P10,000, and P15,000, respectively. Maintenance will be
required in years 3 and 6 at P10,000 and P7,000 respectively. Cruz uses a discount rate of
11 percent and wants projects to have a payback period of no longer than five years.

Present value tables or a financial calculator are required.

a. Compute the net present value of the new machine.
PV of Cash Flow:
1st year 32,000 x 0.9009
2nd year 57,000 x 0.8116
3rd year (15,000 – 10,000) x 0.7312
4th year 28,000 x 0.6587
5th year 16,000 x 0.5935
6 year (10,000 – 7,000) x 0.5346
th

7th year 15,000 x 0.4817

7 year 70,000
th
x 0.4817
PV of CF 149,233.90
Net Investment (150,000.00)
NPV (766.10) N

b. Compute the firm's profitability index.

PI = PV of CF / Net Investment
= 149,233.90 / 150,000 = 0.995 N

c. Compute the payback period.

1 32,000 32,000
2 57,000 89,000
3 5,000 94,000
4 28,000 122,000
5 16,000 138,000
6 3,000 141,000
7 85,000 9,000 / 85,000 = 0.11

Payback period 6.11 N

d. Evaluate this investment proposal for XYZ Co.

E. Roy Corporation
Roy Corporation is contemplating the replacement of one of its bottles with a new one that will
increase revenue from Php25,000 to Php31,000 per year and reduce cash operating costs from
Php12,000 to Php10,000 per year. The new machine will cost Php48,000 and have an estimated
life of 10 years with no salvage value. The firm uses straight line depreciation and its subject to a
46 percent tax rate. The old machine has been fully depreciated and has no salvage value.

What is the incremental (relevant) cash inflows generated by the replacement?

Long Cut:
Depreciation new equipment (48,000 / 10 = 4,800 deprciation)

Revenue – Operating Cost - Depreciation = EBIT – Tax (46%) = EAT + Dep = CF

Old 25,000 - 12,000 - 0 = 13,000 - 5,980 = 7,020 + 0 = 7020
New 31,000 - 10,000 - 4,800 =16,200 - 7,452 = 8,748 + 4800 = 13,458
Incremental Cash Inflow 6,528
Short Cut:
Increase in Revenue x ((1 – tax) ((31,000 - 6,000) x 54%)) = 3,240
Less: Increase in Expense x (1 – tax) ((10,000 – 12,000) x 54%)) = 1,080
Add: Depreciation x (tax) ((4,800 – 0) x 46%)) = 2,208
Incremental Cash Flow 6,528

Multiple Choice Questions:

1. The long-term planning process for making and financing investments that affect a company’s
financial results over a number of years is referred to as
A. capital budgeting C. master budgeting
B. strategic planning D. long-range planning

2. Capital budgeting is the process

A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line

3. A capital investment decision is essentially a decision to:

A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from
investing activities.
D. exchange current cash inflows for future cash outflows.

4. The normal methods of analyzing investments

A. cannot be used by not-for-profit entities.
B. do not apply if the project will not produce revenues.
C. cannot be used if the company plans to finance the project with funds already available
internally.
D. require forecasts of cash flows expected from the project.

5. Which of the following represents the biggest challenge in the decision to purchase new
equipment?
A. Estimating employee training for the new project.
B. Estimating cash flows for the future.
C. Estimating transportation costs of the new equipment.
D. Estimating maintenance costs for the new equipment.

6. When a firm has the opportunity to add a project that will utilize factory capacity that is
currently not being used, which costs should be used to determine if the added project should be
undertaken?
A. Opportunity costs C. Net present costs
B. Historical costs D. Incremental costs

7. The only future costs that are relevant to deciding whether to accept an investment are those
that will
A. be different if the project is accepted rather than rejected.
B. be saved if the project is accepted rather than rejected.
C. be deductible for tax purposes.
D. affect net income in the period that they are incurred.

8. In connection with a capital budgeting project, an investment in working capital is normally

recovered
A. at the end of the project’s life
B. in the first year of the project’s life
C. evenly through the project’s life
D. when the company goes out of business

9. Which of the following is not a typical cash inflow in capital investment decisions?
A. Incremental revenues C. Salvage value
B. Cost reductions D. Additional working capital

10. If there were no income taxes,

A. depreciation would be ignored in capital budgeting.
B. the NPV method would not work.
C. income would be discounted instead of cash flow.
D. all potential investments would be desirable.

11. Relevant cash flows for net present value (NPV) models include all of the following
except
A. outflows to purchase new equipment
B. depreciation expense on the newly acquired piece of equipment
C. reductions in operating cash flows as a result of using the new equipment.
D. cash outflows related to purchasing additional inventories for another retail store.

12. When evaluating depreciation methods, managers who are concerned about capital
investment decisions will:
A. choose straight line depreciation so there is minimum impact on the decision.
B. use units of production so more depreciation expense will be allocated to the later years.
C. use accelerated methods to have as much depreciation in the early years of an asset’s life.
D. choice of depreciation method has no impact on the capital investment decision.

13. The tax consequences should be considered under which circumstances when making
capital investment decisions?
A. Positive net income C. Depreciation
B. Disposal of an asset D. All of the above

14. In addition to incremental revenues, cash inflows from capital investments can be generated
from all of the following sources except:
A. debt financing
B. cost savings
C. salvage value
D. reduction in the amount of working capital

15. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
A. The expected resale price of the existing machine.
B. The book value of the existing machine.
C. The original cost of the existing machine.
D. The depreciated cost of the existing machine.

16. The primary advantages of the average rate of return method are its ease of computation and
the fact that:
A. It is especially useful to managers whose primary concern is liquidity
B. There is less possibility of loss from changes in economic conditions and obsolescence
when the commitment is short-term
C. It emphasizes the amount of income earned over the life of the proposal
D. Rankings of proposals are necessary

17. There are several capital budgeting decision models that do not use discounted cash flows.
What is the name of the simple technique that calculates the total time it will take to recover,
using cash inflows from operations, the amount of cash invested in a project?
A. Recovery period C. External rate of return
B. Payback model D. Accounting rate of return

18. The technique most concerned with liquidity is

A. Payback method.
B. Net present value technique.
C. Internal rate of return.
D. book rate of return.

19. Which of the following is a potential use of the payback method?

A. Help managers control the risks of estimating cash flows
B. Help minimize the impact of the investment on liquidity
C. Help control the risk of obsolescence
D. All of the answers are correct

20. The cash payback technique:

A. should be used as a final screening tool.
B. can be the only basis for the capital budgeting decision.
C. is relatively easy to compute and understand.
D. considers the expected profitability of a project.

21. Which of the following is NOT a defect of the payback method?

A. It ignores cash flows because it uses net income.
B. It ignores profitability.
C. It ignores the present values of cash flows.
D. It ignores the pattern of cash flows beyond the payback period.

22. The payback method, as a capital budgeting technique, assumes that all intermediate cash
inflows are reinvested to yield a return equal to:
A. Zero C. The Discount Rate
B. The Time-Adjusted-Rate-of-Return D. The Cost-of-Capital

23. Which of the following capital budgeting methods is the least theoretically correct?
A. payback method C. internal rate of return
B. net present value D. none of the above

24. Which of the following methods of evaluating capital investment projects incorporates the
time value of money?
A. Payback period, accounting rate of return, and internal rate of return
B. Accounting rate of return, net present value, and internal rate of return
C. Payback period and accounting rate of return
D. Net present value and internal rate of return

25. Discounted cash flow analysis is used in which of the following techniques?
A. Net present value C. Cost of capital
B. Payback period D. All of the above

26. The primary capital budgeting method that uses discounted cash flow techniques is the
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.

27. The discount rate commonly used in present value calculations is the
A. treasury bill rate
B. weighted average return on assets adjusted for risk
C. risk free rate plus inflation rate
D. shareholders’ expected return on equity

28. Which is true of the net present value method of determining the acceptability of an
investment?
A. The initial cost of the investment is subtracted from the present value of net cash flows
B. The net cash flows are not adjusted to present value
C. A negative net present value indicates the investment should be undertaken
D. The net present value method requires no subjective judgments

29. The profitability index

A. does not take into account the discounted cash flows.
B. Is calculated by dividing total cash flows by the initial investment.
C. allows comparison of the relative desirability of projects that require differing initial
investments
D. will never be greater than 1.0.

30. According to the reinvestment rate assumption, which method of capital budgeting assumes
cash flows are reinvested at the project’s rate of return?
A. payback period C. internal rate of return
B. net present value D. none of the above

31. The rate of interest that produces a zero net present value when a project’s discounted
cash operating advantage is netted against its discounted net investment is the:
A. Cost of capital C. Cutoff rate
B. Discount rate D. Internal rate of return

32. A weakness of the internal rate of return method for screening investment projects is that
it:
A. Does not consider the time value of money
B. Implicitly assumes that the company is able to reinvest cash flows from the project at
the company’s discount rate
C. Implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
D. Fails to consider the timing of cash flows

33. If the present value of the future cash flows for an investment equals the required investment,
the IRR is
A. equal to the cutoff rate.
B. equal to the cost of borrowed capital.
C. equal to zero.
D. lower than the company’s cutoff rate return.

34. The relationship between payback period and IRR is that

A. a payback period of less than one-half the life of a project will yield an IRR lower than
the target rate.

the payback period is the present value factor for the IRR.
C. a project whose payback period does not meet the company’s cutoff rate for payback will
not meet the company’s criterion for IRR.
D. none of the above.

35. When comparing NPV and IRR, which is not true?

A. With NPV, the discount rate can be adjusted to take into account increased risk and the
uncertainty of cash flows
B. With IRR, cash flows can be adjusted to account for risk
C. NPV can be used to compare investments of various size or magnitude
D. Both NPV and IRR can be used for screening decisions
36. In capital budgeting, sensitivity analysis is used
A. to determine whether an investment is profitable.
B. to see how a decision would be affected by changes in variables.
C. to test the relationship of the IRR and NPV.
D. to evaluate mutually exclusive investments.

37. An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
A. the discounted cash flow technique.
B. the net present value method.
C. risk analysis.
D. sensitivity analysis.

38. Sensitivity analysis is the study of how the outcome of a decision making process
A. changes as one or more of the assumptions change
B. remains the same even though one or more of the assumptions change
C. changes even though one or more of the assumptions do not change
D. does not change as the assumptions do not change either

39. if the internal rate of return on an investment is zero:

A. its NPV is positive.
B. its annual cash flows equal its required investment.
C. it is generally a wise investment.
D. its cash flows decrease over its life.

40. Which of the following would decrease the net present value of a project?
A. A decrease in the income tax rate
B. A decrease in the initial investment
C. An increase in the useful life of the project
D. An increase in the discount rate

41. All other things being equal, as cost of capital increases

A. more capital projects will probably be acceptable.
B. fewer capital projects will probably be acceptable.
C. the number of capital projects that are acceptable will change, but the direction of the
change is not determinable just by knowing the direction of the change in cost of capital.
D. the company will probably want to borrow money rather than issue stock.

42. Assuming that a project has already been evaluated using the following techniques, the
evaluation under which technique is least likely to be affected by an increase in the estimated
residual value of the project?
A. Payback Period. C. Net Present Value.
B. Internal Rate of Return. D. Profitability Index.

43. If a payback period for a project is greater than its expected useful life, the
A. project will always be profitable.
B. entire initial investment will not be recovered.
C. project would only be acceptable if the company’s cost of capital was low.
D. project’s return will always exceed the company’s cost of capital.

44. An analysis of a proposal by the net present value method indicated that the present value
of future cash inflows exceeded the amount to be invested. Which of the following statements
best describes the results of this analysis?
A. The proposal is desirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis
B. The proposal is desirable and the rate of return expected from the proposal is less than the
minimum rate used for the analysis
C. The proposal is undesirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
D. The proposal is undesirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis

45. NPV indicates a project is deemed desirable (acceptable) when the NPV is
A. greater than or equal to zero
B. less than zero
C. greater than or equal to the risk-adjusted cost of capital
D. less than or equal to the risk-adjusted cost of capital

46. If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish a
cutoff rate of return, it must be sure that the cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.

47. The NPV and IRR methods give

A. the same decision (accept or reject) for any single investment.
B. the same choice from among mutually exclusive investments.
C. different rankings of projects with unequal lives.
D. the same rankings of projects with different required investments.

48. In choosing from among mutually exclusive investments the manager should normally select
the one with the highest
A. Net present value. C. Profitability index.
B. Internal rate return. D. Book rate of return.

49. Why do the NPV method and the IRR method sometimes produce different rankings of
mutually exclusive investment projects?
A. The NPV method does not assume reinvestment of cash flows while the IRR method
assumes the cash flows will be reinvested at the internal rate of return.
B. The NPV method assumes a reinvestment rate equal to the discount rate while the IRR
method assumes a reinvestment rate equal to the internal rate of return.
C. The IRR method does not assume reinvestment of the cash flows while the NPV assumes
the reinvestment rate is equal to the discount rate.
D. The NPV method assumes a reinvestment rate equal to the bank loan interest rate while
the IRR method assumes a reinvestment rate equal to the discount rate.

50. A thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed is called a
A. pre-audit. C. sensitivity analysis.
B. post-audit. D. risk analysis.

50. Companies use post audits to:

A. chastise managers whose project does not exceed projections.
B. prove to managers that they should have accepted projects they previously rejected.
C. have the managers revise poorly performing projects so the projects will have larger
return in the future.
D. provide feedback that enables managers to improve the accuracy of the projections of
future cash flows, thereby maximizing the quality of the firm’s capital investments.

Problems:
1. Hopwood Corporation bought a piece of machinery. Selected data is presented below:
Useful life 6 years
Yearly net cash inflow P45,000
Salvage value. –0-
Internal rate of return 18%
Cost of capital 14%
Present value tables or a financial calculator are required.
The initial cost of the machinery was
a. P157,392.
b. P174,992.
c. P165,812.
d. impossible to determine from the information given.

Use PV of Annuity for 6 years and 18%

P45,000 * 3.4976 = P157,392

2. Datasoft Industries is considering the purchase of a P100,000 machine that is expected to

result in a decrease of P15,000 per year in cash expenses. This machine, which has no residual
value, has an estimated useful life of 10 years and will be depreciated on a straight-line basis. For
this machine, the accounting rate of return would be
a. 10 percent. c. 30 percent.
b. 15 percent. d. 35 percent.
P15,000/(P100,000/2) = 30%
3. An investment project is expected to yield P10,000 in annual revenues, has P2,000 in fixed
costs per year, and requires an initial investment of P5,000. Given a cost of goods sold of 60
percent of sales, what is the payback period in years?
a. 2.50 b. 5.00 c. 2.00 d. 1.25
Net cash flow = P10,000 - P6,000 - P2,000
Net cash flow = P2,000
P5,000/P2,000 = 2.50 years

4. Clement Corporation. faces a marginal tax rate of 35 percent. One project that is currently
under evaluation has a cash flow in the fourth year of its life that has a present value of P10,000
(after-tax). Clement Corporation. assumes that all cash flows occur at the end of the year and the
company uses 11 percent as its discount rate. What is the pre-tax amount of the cash flow in year
4? (Round to the nearest peso.) Present value tables or a financial calculator are required.
a. P15,181 b. P23,356 c. P9,868 d. P43,375
P10,000 /0.65 = P15,384.61
Use PV Table for 4 years, 11%. Constant = 0.6587
P15384.61 / 0.6587 = P23,356.

Seaworthy Corporation
Seaworthy Corporation is considering the purchase of a new ocean-going vessel that could
potentially reduce labor costs of its operation by a considerable margin. The new ship would cost
P500,000 and would be fully depreciated by the straight-line method over 10 years. At the end of
10 years, the ship will have no value and will be scuttled. Seaworthy Company’s cost of capital
is 12 percent, and its marginal tax rate is 40 percent.

5. Refer to Seaworthy Corporation. What is the present value of the depreciation tax benefit of
the new ship? (Round to the nearest peso.) Present value tables or a financial calculator are
required.
a. P113,004 b. P282,510 c. P169,506 d. P200,000
Annual depreciation = P50,000
Tax savings = P20,000
Use PV of Annuity table 10 years, 12%; Constant = 5.6502
P20,000 * 5.6502 = P113,004

6. Refer to Seaworthy Corporation. If the ship produces equal annual labor cost savings over its
10-year life, how much do the annual savings in labor costs need to be to generate a net present
value of P0 on the project? (Round to the nearest peso.) Present value tables or a financial
calculator are required.
a. P68,492 b. P114,154 c. P88,492 d. P147,487
NPV of Labor Savings = P500,000
Use PV of Annuity Table 10 years, 12%; Constant = 5.6502
P500,000 / 5.6502 = P88,492
Fleming Company
Fleming Company is considering an investment in a machine that would reduce annual labor
costs by P30,000. The machine has an expected life of 10 years with no salvage value. The
machine would be depreciated according to the straight-line method over its useful life. The
company's marginal tax rate is 30 percent.
7. Refer to Fleming Company. Assume that the company will invest in the machine if it
generates an internal rate of return of 16 percent. What is the maximum amount the company can
pay for the machine and still meet the internal rate of return criterion? Present value tables or a
financial calculator are required.
a. P180,000 b. P210,000 c. P187,500 d. P144,996
Use PV of Annuity Table; 10 years, 16%; Constant = 4.8330
P30,000 * 4.8330 = P144,496

8. Refer to Fleming Company. Assume the company pays P250,000 for the machine. What is the
expected internal rate of return on the machine? Present value tables or a financial calculator are
required.
a. between 8 and 9 percent c. between 17 and 18 percent
b. between 3 and 4 percent d. less than 1 percent
P250,000/P30,000 = 8.33
Using PV of Annuity Table and 10 years, this constant falls between 3% and 4%

9. A project under consideration by Close Corporation would require a working capital

investment of P200,000. The working capital would be liquidated at the end of the project's 10-
year life. If Close Corporation has an after-tax cost of capital of 10 percent and a marginal tax
rate of 30 percent, what is the present value of the working capital cash flow expected to be
received in year 10? Present value tables or a financial calculator are required.
a. P36,868 b. P77,100 c. P53,970 d. P23,130
The return of capital is tax-free.
Use PV of P1 10 years, 10%; Constant = 0.3855
P200,000 * 0.3855 = P77,100

10. Biggs Industries is considering two alternative ways to depreciate a proposed investment.
The investment has an initial cost of P100,000 and an expected five-year life. The two alternative
depreciation schedules follow:
Method 1 Method 2
Year 1 depreciation P20,000 40,000
Year 2 depreciation 20,000 30,000
Year 3 depreciation 20,000 20,000
Year 4 depreciation 20,000 10,000
Year 5 depreciation 20,000 -0-
Assuming that the company faces a marginal tax rate of 40 percent and has a cost of capital
of 10 percent, what is the difference between the two methods in the present value of the
depreciation tax benefit? Present value tables or a financial calculator are required.
a. P7,196 b. P0 c. P2,878 d. P6,342
 Year Difference After-Tax PV of P1 Discounted
in Difference Table Value Value
Depreciatio
n
1 P 20,000 P 8,000 0.9091 P 7,272
2 P 10,000 P 4,000 0.8265 P 3,306
3 P -0- P 0- 0.7513 P -0-
4 P(10,000) P(4,000) 0.6830 P(2,732)
5 P(20,000) P(8,000) 0.6209 P(4,967)
Total P 2,878
======

Webber Corporation
Webber Corporation is considering an investment in a labor-saving machine. Information on this
machine follows:
Cost P30,000
Salvage value in five years P0
Estimated life 5 years
Annual depreciation P6,000
Annual reduction in existing costs. P8,000

11. Refer to Webber Corporation. What is the internal rate of return on this project (round to the
nearest 1/2%)? Present value tables or a financial calculator are required.
a. 37.5% b. 25.0% c. 10.5% d. 13.5%
IRR = P30,000 / P8,000 = 3.75
Using PV of Annuity Table 5 years. The constant of 3.75 corresponds to a rate of 10.5%

12. Refer to Webber Corporation. Assume for this question only that Hefty Co. uses a discount
rate of 16 percent to evaluate projects of this type. What is the project's net present value?
Present value tables or a financial calculator are required.
a. P(6,283) b. P(3,806) c. P(23,451) d. P(22,000)
Use PV of Annuity Table 16%, 5 years. Corresponding constant is 3.2743
Annual reduction in costs P8,000 * P 26,194
3.2743
Investment (30,000)
Net Present Value ( 3,806)
=======

13. Refer to Webber Corporation. What is the payback period on this investment?
a. 4 years b. 2.14 years c. 3.75 years d. 5 years

Payback Period = Initial Investment/Cash Savings

= P30,000/P8,000
= 3.75 years
Ruston Ironworks
Ruston Ironworks is considering a proposal to sell an existing lathe and purchase a new
computer- operated lathe. Information on the existing lathe and the computer-operated lathe
follow:
Existing Lathe Computer-operated Lathe
Cost P100,000 P300,000
Accumulated depreciation 60,000 0
Salvage value now 20,000
Salvage value in 4 years 0 60,000
Annual depreciation 10,000 75,000
Annual cash operating costs 200,000 50,000
Remaining useful life 4 years 4 years

14. Refer to Ruston Ironworks. What is the payback period for the computer-operated lathe?
a. 1.87 years b. 2.00 years c. 3.53 years d. 3.29 years

Payback Period = [(New Lathe Cost - Old Lathe Salvage)/Cost Savings from New Lathe]
Payback Period = [(300,000 - 20,000)/150,000] = 1.87 years

15. Refer to Ruston Ironworks. If the company uses 10 percent as its discount rate, what is the
net present value of the proposed new lathe purchase? Present value tables or a financial
calculator are required.
a. P236,465 b. P256,465 c. P195,485 d. P30,422

PV Table
Amount Constant Present
Value
Annual Cost P 150,000 3.1699 P 475,485
Savings
Salvage Value 60,000 0.6830 40,980
Initial Investment (280,000) 1.0000 (280,000)
Net Present Value P 236,465
========

Rhodes Corporation
Rhodes Corporation is involved in the evaluation of a new computer-integrated manufacturing
system. The system has a projected initial cost of P1,000,000. It has an expected life of six years,
with no salvage value, and is expected to generate annual cost savings of P250,000. Based on
Rhodes Corporation's analysis, the project has a net present value of P57,625.

16. Refer to Rhodes Corporation. What discount rate did the company use to compute the net
present value? Present value tables or a financial calculator are required.
a. 10% b. 11% c. 12% d. 13%

NPV = P 57,625
Initial Cost = P1,000,000
PV of Cash Inflows = P1,057,625
Annual Cost Savings =P 250,000
P1,057,625/P250,000 = 4.2305 PV of Annuity Constant
At 6 years, the constant corresponds to a discount rate of 11%.

17. Refer to Rhodes Corporation. What is the project's profitability index?

a. 1.058 b. .058 c. .945 d. 1.000

PI = P1,057,625/1,000,000 = 1.058

18. Refer to Rhodes Corporation. What is the project's internal rate of return? Present value
tables or a financial calculator are required.
a. between 12.5 and 13.0 percent c. between 11.5 and 12.0 percent
b. between 11.0 and 11.5 percent d. between 13.0 and 13.5 percent

P1,000,000/P250,000 = 4.000
Using the Present Value of Annuity Table for 6 years, the rate falls between 12.5% and 13%

19. Carol Jones recently invested in a project that promised an internal rate of return of 15
percent. If the project has an expected annual cash inflow of P12,000 for six years, with no
salvage value, how much did Carol pay for the project? Present value tables or a financial
calculator are required.
a. P35,000 b. P45,414 c. P72,000 d. P31,708

Use Present Value of Annuity Table (6 years,15%)

P12,000 * 3.7845 = P45,414

20. John Browning recently invested in a project that has an expected annual cash inflow of
P7,000 for 10 years, and an expected payback period of 3.6 years. How much did John invest in
the project?
a. P19,444 b. P36,000 c. P25,200 d. P40,000

x/P7,000 = 3.6 years

x = P25,200

21. The Rand Corporation is considering an investment in a

project that generates a profitability index of 1.3. The present value of the
cash inflows on the project is P44,000. What is the net present value of this project?
a. P10,154 b. P13,200 c. P57,200 d. P33,846

PV Cash Inflows/Cash Outflows = Profitability Index

P44,000/Cash Outflows = 1.3
P44,000/1.3 = P33,846
PV Cash Inflows - Cash Outflows = Net Present Value
P44,000 - P33,846 = P10,154
Cody’s Retail is considering an investment in a delivery truck. Cody has found a used truck that
he can purchase for P8,000. He estimates the truck would last six years and increase his store's
net cash revenues by P2,000 per year. At the end of six years, the truck would have no salvage
value and would be discarded. Cody will depreciate the truck using the straight-line method.
22. Refer to Cody's Retail. What is the accounting rate of return on the truck investment (based
on average profit and average investment)?
a. 25.0% b. 50.0% c. 16.7% d. 8.3%
B
P2,000/P4,000 = 50%
Average Investment = (P8,000 + 0)/2 = P4,000

23. Refer to Cody's Retail. What is the payback period on the investment in the new truck?
a. 12 years b. 6 years c. 4 years d. 2 years

P8,000/P2,000 = 4 years

24. Willard Boone has just turned 65. He has P100,000 to invest in a retirement annuity. One
investment company has offered to pay Willard P10,000 per year for 15 years (payments to
begin in one year) in exchange for an immediate P100,000 payment. If Willard accepts the offer
from the investment company, what is his expected return on the P100,000 investment (assume a
return that is compounded annually)? Present value tables or a financial calculator are required.
a. between 5 and 6 percent
b. between 6 and 7 percent
c. between 7 and 8 percent
d. between 8 and 9 percent

P100,000/P10,000 = 10.000 PV of annuity Table Factor

For 15 years, this factor represents a return on investment between 5 and 6 percent.

25. Gleason Armored Car Co. is considering the acquisition of a new armored truck. The truck is
expected to cost P300,000. The company's discount rate is 12 percent. The firm has determined
that the truck generates a positive net present value of P17,022. However, the firm is uncertain as
to whether its has determined a reasonable estimate of the salvage value of the truck. In
computing the net present value, the company assumed that the truck would be salvaged at the
end of the fifth year for P60,000. What expected salvage value for the truck would cause the
investment to generate a net present value of P0? Ignore taxes. Present value tables or a financial
calculator are required.
a. P30,000 b. P0 c. P55,278 d. P42,978

Using the Present Value of P1 table (12% and 5 years), the constant is 0.5674.
P17,022/0.5674 = P30,000 salvage value that would yield a salvage value of 0
26. Steele Publishers is considering an investment that would require an initial cash outlay of
P400,000 and would have no salvage value. The project would generate annual cash inflows of
P75,000. The firm's discount rate is 8 percent. How many years must the annual cash flows be
generated for the project to generate a net present value of P0? Present value tables or a financial
calculator are required.
a. between 5 and 6 years c. between 7 and 8 years
b. between 6 and 7 years d. between 8 and 9 years

P400,000 / P75,000 = 5.33

Using the Present Value of an Annuity at 8%, the constant falls between 7 and 8 years.

27. The weighted average cost of capital represents the

a. cost of bonds, preferred stock, and common stock divided by the three sources.
b. equivalent units of capital used by the organization.
c. overall cost of capital from all organization financing sources.
d. overall cost of dividends plus interest paid by the organization.

28. Bruell Company is considering to replace its old equipment with a new one. The old
equipment had a net book value of P100,000, 4 remaining useful life with P25,000 depreciation
each year. The old equipment can be sold at P80,000. The new equipment costs P160,000, have
a 4-year life. Cash savings on operating expenses before 40% taxes amount to P50,000 per year.
What is the amount of investment in the new equipment?
A. P160,000 C. P 80,000
B. P 72,000 D. P 68,000

Answer: B
Initial amount of investment 160,000
Less Cash inflow (decrease in outflow) at period 0:
MV of old equipment 80,000
Tax benefits on loss on sales (20,000 x .4) 8,000 88,000
Net investment 72,000

29. Taal Company is considering the purchase of a machine that promises to reduce operating
costs by equal amounts every year of its 6-year useful life. The machine will cost P840,000 and
has no salvage value. The machine has a 20% internal rate of return. Taal Company is subject
to 40% income tax rate. The present value of 1 for 6 periods at 20% is 3.326, and at the end of 6
periods is 0.3349.
The approximate annual cash savings before tax is closest to:
A. P252,555 C. P187,592
B. P112,555 D. P327,592

Answer: D
ATCF = Net investment ÷ Payback period
ATCF (840,000 ÷ 3.326) 252,555
Net income (252,555 – 140,000) 112,555
Before-tax income (112,555 ÷ 0.60) 187,592
 Before-tax savings (187,592 + 140,000) 327.592
The computation of after-tax cash flows, given the amount of investment and internal rate of return or PV of
annuity of 1 discounted at IRR is the reverse of the computation of payback period. Remember that the payback
method, though a nondiscounted technique, is closely related to internal rate of return because the payback
period is exactly the present value of annuity of 1 if they are discounted using the internal rate of return.

30. Mayon Company is considering replacing its old machine with a new and more efficient one.
The old machine has book value of P100,000, a remaining useful life of 4 years, and annual
straight-line depreciation of P25,000. The existing machine has a current market value of
P80,000. The replacement machine would cost P160,000, have a 4-year life, and will save
P50,000 per year in cash operating costs. If the replacement machine would be depreciated using
the straight-line method and the tax rate is 40%, what should be the increase in annual income
taxes?
A. P14,000 C. P40,000
B. P28,000 D. P 4,000

Answer: A
Annual savings on expenses P50,000
Less: Additional depreciation (40,000 – 25,000) 15,000
Additional taxable income 35,000
Additional tax (35,000 x 40%) P14,000
Additional depreciation can be easily calculated by subtracting the book value of the old machine from the cost
of new machine and then the difference divided by the useful life (160,000 – 100,000) ÷ 4 = 15,000.

Cost of Capital:
A. Geston Corporation
1. Geston corporation is considering a capital project for the coming year. If the firm has the
following target capital structure and costs, what should their decision be and why?
Source of Capital Proportion After-Tax Cost
Long-term debt 0.30 10%
Preferred stock 0.10 15%
Common stock equity 0.60 20%

a. Calculate the firm’s weighted average cost of capital.

Source of Capital Proportion After-Tax Cost WACC
Long-term debt 0.30 x 10% = 3%
Preferred stock 0.10 x 15% = 1.5%
Common stock equity 0.60 x 20% = 12%
WACC 16.5%

b. The project has an internal rate of return of 14 percent. If the firm has the following
target capital structure and costs, what should their decision be and why?

Cost of Capital 16.5% vs 14% IRR = No, Cost of Capital is higher than the IRR

c. Explain why debt cost less than preferred and common stocks.
 Tax on interest expense – PS / CS – Dividends is not subject to Tax

d. Calculate the firm’s weighted average cost of capital assuming the firm has the following
target capital structure and costs, what should their decision be and why?
Source of Capital Proportion After-Tax Cost
Long-term debt 0.60 x 10%
Preferred stock 0.10 x 15%
Common stock equity 0.30 x 20%
WACC 13.5%
e. Differentiate the weighted average cost of capital in No.1 and No. 2, and discuss the
significance in terms of risks and returns trade-off.

Cost of Capital 13.5% vs IRR 14% = Yes, because the Cost of Capital is less than the IRR

B. Ramos Co.
Ramos Co. has compiled the following financial data:
Source of Capital Book Value Market Value Cost
Long-term debt P10,000,000 P8,500,000 5.0%
Preferred stock 1,000,000 1,500,000 14.0
Common stock equity 9,000,000 15,000,000 20.0
P20,000,000 P25,000,000
(a) Calculate the weighted average cost of capital using book value weights.
Source of Capital Book Value BV % Value Cost WACC
Long-term debt P10,000,000 50% x 5.0% =
Preferred stock 1,000,000 5% x 14.0 =
Common stock equity 9,000,000 45% x 20.0 =
P20,000,000
WACC 12.20%

(b) Calculate the weighted average cost of capital using market value weights.
Source of Capital Market Value Market Value % Cost WACC
Long-term debt P 8.500,000 34% x 5.0%
Preferred stock 1,500,000 6% x 14.0
Common stock equity 15,000,000 60% x 20.0
P25,000,000
WACC 14.54%

C. Valdez Company
Valdez Company can sell 15-year, P1,000 par value bonds paying annual interest at a 12%
coupon rate. Because of rising interest rates, the bonds can be sold for P1,010 each. However,
P30 floatation cost per bond will be incurred. Valdez is in the 40% tax bracket.

(ki) Cost of debt – I + ((M – V)/n))

(M + V)/2
Cost of debt = Ki (1-t)

a. Find the net proceeds from the sale of the bonds. (1,010 – 30) = Php980

b. Show the cash flows of the bonds from Valdez’s standpoint. Financing Activities

c. Use the approximation formula to estimate the before and after tax cost of debt.

(ki) Cost of debt – I + ((M – V)/n))

(M + V)/2

Cost of debt = Ki (1-t)

Cost of debt = 120 + ((1,000 – 980)/15years))

(1,000 + 980)/2
= 12.26%

Cost of debt after tax = (12.26% x 60%) = 7.35%

d. Explain the relationship between the value of the bonds and current interest rates.

e. Use the approximation formula to estimate the before and after tax cost of debt if the
bonds can be sold for P1,030 each instead of P1,010, assuming all things being equal.

Cost of debt = 120 + ((1,000 – 1,000)/15years))

(1,000 + 1,000)/2
= 12%

Cost of debt after tax = (12% x 60%) = 7.20%

f. Use the approximation formula to estimate the before and after tax cost of debt if the
bonds can be sold for P1,050 each instead of P1,010, assuming all things being equal.

Cost of debt = 120 + ((1,000 – 1,020)/15years))

(1,000 + 1,020)/2
= 11.75%

Cost of debt after tax = (11.75% x 60%) = 7.05%

g. Contrast and explain the answers in c, e and f.

Increase in proceeds = Decrease the cost of debt

D. Cost of Preferred Stocks
Compute the cost of the following preferred stocks.
Company Par Selling Floatation Annual Dividend
Value(P) Price(P) Cost(P)or (%) (P) or (%)
Gako Co. 100 101 9 11%
Dela Merced Corp. 40 38 3.50 8%
Maranan Inc. 35 37 4 P5
Villavieja Co. 30 26 5% of par P3
Cruz Inc. 20 20 2.50 9%

Cost of PS = Dividends / Proceeds

Dividends = (PV x % of dividends)

Proceeds = (MV – Flotation Cost – Underpricing/Underwriting)

Gako = (100 x 11%) / (101 – 9) = 11.96%

Dela Merced = (40 x 8%) / (38 – 3.50) = 9.28%
Maranan = 5 / (37 – 4) = 15.15%
Villavieja = 3 / ((26 – (30 x 5%)) = 12.24%
Cruz = (20 x 9%) / (20 – 2.50) = 10.29%

E. Cost of Ordinary Shares / Retained Earnings

Data of the Ordinary Shares of the following companies are listed below:

Company Market Dividend Projected Underpricing Floatation

Value(P) Growth Dividends Per Cost Per
Rate (%) Share (P) Share(P)
Escueta Co. 50 8 2.25 2 1
Dacome Corp. 20 4 1 0.50 1.50
Magno, Co 42.50 6 2 1 2
Castro Co. 19 2 2.10 1.30 1.70
a. Compute the cost of retained earnings using the constant growth
valuation model or the Gordon model.
b. Compute the cost of new common stocks using the constant growth valuation model or
the Gordon model.
 Dividend 1 + G% Dividends 1 + G%
Proceeds Proceeds (1 – FC – UC)

Cost of RE Cost of OS

Escueta 2.25 + 8% = 12.5% 2.25 + 8% = 12.79%

50 (50 – 2 – 1)

Dacome 1 + 4% = 9% 1 + 4% = 9.56%
20 (20 – 0.50 – 1.50)

Magno 10.71% 11.06%

Castro 13.05% 15.13%

c. Why is the cost of new common stocks more costly than cost of retained earnings?
Flotatation Cost / Underwrting/Underpricing

d. Why is the cost of common stocks the same as the cost of retained earnings?
No Flotation Cost
Cost OS = Equity
Cost of OS = Cost of RE = Equity

e. Why is it necessary to under price new common stocks? (watered stock)

F. Cost of Ordinary Shares (Capital Asset Pricing Model)

Abalos Co. common stock has a beta of 1.2. The risk free rate is 6% and the market return is
11%.

Cost of Equity = rf + b(rm – rf)

Rf = risk free rate

b = beta
rm = expected return / market return
(rm – rf) = market premium / risk premium

a. Determine the cost of common stock using the capital asset pricing model
Cost of Equity = rf + b(rm – rf)
= 6% + 1.2(11% - 6%)
= 12%
b. Determine the required return the common stock should provide to investors. 12%
c. What is the risk premium of the common stock? 5%

d. Determine the cost of common stock using the capital asset pricing model
assuming a beta of 1 instead of 1.2, assuming all things being equal.

Cost of Equity = rf + b(rm – rf)

= 6% + 1(11% - 6%)
= 11%

e. Determine the cost of common stock using the capital asset pricing model
assuming a beta of .90 instead of 1.2, assuming all things being equal.

Cost of Equity = rf + b(rm – rf)

= 6% + 0.90(11% - 6%)
= 10.5%

f. Explain the concept of risk free rate, market return and beta.

Multiple Choice:
1. Cost of capital is
a. The amount the company must pay for its plant assets
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of equity or
long term debt securities.

2. In an investment in plant asset, the return that keeps the market price of the firm stock
unchanged is
a. Net present value c. Adjusted rate of return
b. Cost of capital d. Unadjusted rate of return

3. A company with cost of capital of 15% plans to finance an investment with debt that bears
10% interest. The rate it should use to discount the cash flows is
a. 10% c. 25%
b. 15% d. 150%

4. If bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
a. Market interest rates have increased
b. Additional debt can be issued more cheaply than the original debt
c. There should be no difference; cost of debt is the same as the bonds’ market yield
d. Interest is deductible for tax purposes
5. Tabaco Co. has 5% preferred stock with a par value of P 100. Selling price is P 123.50 per
share and flotation costs are P 0.50 per share. If tax rate is 20%, then what is the cost of preferred
stock?
a. 4.03% c. 4.7%
b. 4.07% d. 5%

Kp = d / p
Kp = 100 x 5%
123.50 – 0.50
Kp = 5 / 123 = 4.07

6. Malaysia Company’s 10% preferred stock that has a par value of P 100 per share is sold for P
101, gross of underwriting fees of P 5 per share. If the tax rate is 40%, what is the cost of funds
for preferred stock?
a. 4.2% c. 10.0%
b. 6.2% d. 10.4%

Kp = d / p
Kp = 100 x 10%
101 – 5
Kp = 10 / 96 = 10.4%

7. The term “underwriting spread” as an example of flotation costs refers to the

a. Commission percentage an investment banker receives for underwriting a security issue
b. Discount investment bankers receive on securities they purchase from the issuing company
c. Difference between the price the investment banker pays for a new security issue and the
price at which the securities are resold
d. Commission a broker receives for either buying or selling a security on behalf of an investor.

8. The three elements needed to estimate the cost of equity capital for use in determining a firm’s
weighted average cost of capital are
a. Current dividends per share, expected growth rate in dividends per share, and current book
value per share of common stock
b. Expected earnings per share, expected growth rate in dividends per share, and current market
price per share of common stock
c. Current earnings per share, expected growth rate in earnings per share, and current book value
per share of common stock
d. Expected dividends per share, expected growth rate in dividends per share, the current
market price per share of common stock

9. Pili Company is attempting to compute the cost of internal and external equity. The
company’s common stock is currently selling at P 62.50 per share with flotation cost of P 5 per
share. The next dividend per share is P 5.42. Earnings and dividends are expected to grow at a
constant rate of 5%. What is the cost of new common stock (C/S) and retained earnings (R/E)?
a. C/S: 13.67%; R/E: 13.67% c. C/S: 13.67%; R/E: 14.43%
b. C/S: 14.43%; R/E: 13.67% d. C/S: 14.43%; R/E: 14.43%
CS = d + g = 5.42 + 5% = 14.43%
P 62.50 – 5
CS = d + g = 5.42 + 5% = 13.67%
P 62.50

10. The investment-banking firm of Syria & Associates will use a dividend valuation model to
appraise the shares of the Lebanon Corporation. Dividends (D1) at the end of the current year
will be P 1.20. The growth rate (g) is 9 percent and the discount rate (K) is 13 per cent. What
should be the price of the stock to the public?
a. P 28.75 c. P 30.00
b. P 29.00 d. P 31.50
CS = d + g = 1.20 + 9% = 13%
P x

11. Ceteris paribus, the market value of a firm’s outstanding common shares will be higher if
a. Investors have a lower required return on equity
b. Investors expect lower dividend growth
c. Investors have longer expected holding periods
d. Investors have shorter expected holding periods

12. With everything else held constant, if investors expect high growth in dividends, then:
a. Price and dividend yield will be low
b. Price and dividend yield will be high
c. Price will be low and dividend yield will be high
d. Price will be high and dividend yield will be low

13. France Co. paid cash dividends to its common stockholders over the past 12 months at P 2.20
per share. The current market value of the common stocks is P 40 per share, and investors are
anticipating the common dividends to grow at a rate of 6% annually. The cost to issue new
common stocks will be 5% of the market value. What will be the cost of the new common stock
issue?
a. 11.50% c. 11.83%
b. 11.79% d. 12.14%

CS = d + g = 2.20 x 1.06 + 6% = 12.14%

P 40 – (40 x 5%)

14. The weighted average cost of capital approach to decision making is not directly affected by
the
a. Value of common stock
b. Cost of debt outstanding
c. Current budget for expansion
d. Proposed mix of debt, equity, and existing funds used to implement the project
15. The market value of Bato Company’s common stock (book value: P 65M) is estimated at P
60 M and the market value of its interest bearing debt (book value: P 35M) is estimated at P
40M. The average before tax yield on these liabilities is 15% per year. Income taxes are 40%.
The company is expected to pay a dividend of P 10 per share and the stock is selling at a price of
P 100 per share. The growth rate of dividend is projected to be 2.5% per year. What is the
weighted average cost of capital (WACC) of the company as a whole?
a. 9% c. 21.5%
b. 11.1% d. 25%

Kd = 15% x 60% = 0.09 x 40% = 0.036

Ke = 10 + 2.5% = 0.125 x 60% = 0.075

100
WACC 11.1%
16. Which of the following are acceptable criteria for determining the weights in WACC?
a. Book value and target capital structure c. Market value and target capital structure
b. Book value and historical capital structure d. Market value and historical capital structure

17. A company has P 1,000,000 in shareholders’ equity and P 2,000,000 in debt (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 P
500,000. Its tax rate is 40%. What is the company’s cost of equity capital?
a. 8% c. 15%
b. 12% d. 26.4%

kd (8% x 60%) x 2/3 = 0.032 0.032

Ke ? x 1/3 = 0.067
WACC = 12%

18. A single, overall cost of capital is often used to evaluate projects because:
a. It avoids the problem of computing the required rate of return for each investment
proposal.
b. It acknowledges that most new investment projects offer about the same expected return.
c. It acknowledges that most new investment projects have about the same degree of risk.
d. It is the only way to measure a firm's required return.

19. Which model explicitly recognizes a firm’s risk when determining the estimated cost of
equity?
a. Capital asset pricing model c. Bond-yield-plus model
b. Dividend-yield-plus-growth model d. Return on equity model
20. Under CAPM, the required rate of return on a security is the sum of a risk premium and
a. Risk-free rate c. Operating risk
b. Financial risk d. Diversifiable risk

21. Using Capital Asset Pricing Model (CAPM), what is the required rate of return for a firm
with a beta of 1.25 when the market rate is 14% and the risk-free rate is 6%?
a. 6% c. 14%
b. 7.5% d. 16%

r = Rf + B(Rm – Rf)
r = 6% + 1.25(14% - 6%)
r = 16%

22. If an individual stock’s beta is higher than 1.0, that stock is:
a. Riskier than the market c. Less risky than the market
b. Exactly as risky as the market d. The exact opposite of market directions

23. The dividend growth rate is relevant to which of the following costs of capital?
a. Cost of debt and equity
b. Cost of common and preferred equity
c. Cost of common equity and retained earnings
d. Cost of debt, common equity and retained earnings

24. When calculating the cost of capital, the cost assigned to retained earnings should be
a. Zero
b. Equal to the cost of external common equity
c. Lower than the cost of external common equity
d. Higher than the cost of external common equity

25. Using the Capital Asset Pricing Model (CAPM) approach of computing the cost of common
equity and retained earnings, which among the following formulas is correctly stated?
a. KRF - (KM + KRF) β c. KRF + (KM - KRF) β
b. (KRF + KM) β d. (KM - KRF) β

26. The _________ is the rate of return required by the market suppliers of capital in order to
attract their funds to the firm.
(a) yield to maturity (c) cost of capital
(b) internal rate (d) gross profit margin

27. The four basic sources of long-term funds for the business firm are
(a) current liabilities, long-term debt, common stock, and preferred stock.
(b) current liabilities, long-term debt, common stock, and retained earnings.
(c) long-term debt, paid-in capital in excess of par, common stock, and retained earnings.
(d) long-term debt, common stock, preferred stock, and retained earnings.
28. A tax adjustment must be made in determining the cost of _________.
(a) long-term debt (c) common stock
(b) preferred stock (d) retained earnings

29. The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent.
The after-tax cost of debt is
(a) 4.8 percent. (c) 7.2 percent.
(b) 6.0 percent. (d) 12 percent.

30. Debt is generally the least expensive source of capital. This is primarily due to
(a) fixed interest payments.
(b) its position in the priority of claims on assets and earnings in the event of liquidation.
(c) the tax deductibility of interest payments.
(d) the secured nature of a debt obligation.

31. The cost of ordinary share equity may be estimated by using the
(a) yield curve. (c) Gordon model.
(b) net present value method. (d) DuPont analysis.

32. The cost of ordinary share equity may be estimated by using the
(a) yield curve. (c) internal rate of return.
(b) capital asset pricing model. (d) DuPont analysis.

33. The cost of retained earnings is

(a) zero.
(b) equal to the cost of a new issue of ordinary share.
(c) equal to the cost of ordinary share equity.
(d) irrelevant to the investment/financing decision.

34. Generally, the order of cost, from the least expensive to the most expensive, for long-term
capital of a corporation is
(a) new common stock, retained earnings, preferred stock, long-term debt.
(b) common stock, preferred stock, long-term debt, short-term debt.
(c) preferred stock, retained earnings, common stock, new common stock.
(d) long-term debt, preferred stock, retained earnings, new common stock.

35. The cost of new common stock financing is higher than the cost of retained earnings due to
(a) flotation costs and underpricing.
(b) flotation costs and overpricing.
(c) flotation costs and commission costs.
(d) commission costs and overpricing.