Risks, Returns and Capital Structure

FAR EASTERN UNIVERSITY

Institute of Accounts Business and Finance
FINANCIAL MARKETS
HANDOUT NO. 1 – RISKS, RETURNS AND CAPITAL STRUCTURE

PROBLEM NO. 1
Tubao Motors’ bonds have 5 years remaining to maturity. Interest is paid annually. The bonds have a P1,000 face
value, and the coupon interest rate is 6 percent. The bonds have a yield to maturity of 7.5 percent.
1. What is the current market price of these bonds?
2. Assuming that the YTM is 5.25%, what is the current market price?

PROBLEM NO. 2
Richmond Company is planning to issue P10 million bonds that will mature in ten years. The bonds have a face value
of P1,000 and a yield to maturity of 8 percent. They pay interest annually and have a 9 percent coupon rate. What
is their current yield?

PROBLEM NO. 3
Balls Company’s bonds have 10 years to go until maturity. They have P1,000 face value and carry coupon rates of 6
percent. Approximately what do the bonds yield at the following prices?
1. P960
2. P1,080

PROBLEM NO. 4
Fedestal Company issued preferred stock with a stated dividend of 6 percent of par value. Preferred stock of this
type currently yields 5.20 percent, and the par value is P100. Assume that the company expects to pay cash d ividends
annually. What is the market price of one Fedestal’s preferred stock?

PROBLEM NO. 5
Airways Industries plans to issue perpetual preferred stock with a P7.50 dividend. The stock is currently selling for
P95.00; but flotation costs will be 5% of the market price. What is the cost of the preferred stock?

PROBLEM NO. 6
PC Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to
pay dividends of P1.40 per share, and the current price of its common stock is P80 per share. The expected annual
dividend growth rate is 5% and the flotation cost is P2.00 per share.
1. Compute the cost of retained earnings.
2. Compute the cost of new common stock.

PROBLEM NO. 7
Exact Holdings Limited’s stock currently sells for P50.00 a share. It just paid a dividend of P1.50 a share. The dividend
is expected to grow at a constant rate of 4.5% a year.
1. What is the cost of retained earnings?
2. What stock price is expected 4 years from now?

PROBLEM NO. 8
Melo Enterprises recently paid a dividend of P1.20. It expects to have non -constant growth of 40% for 3 years followed
by a constant rate of 5% thereafter. The firm’s required return is 7.5%.
1. How far away is the terminal date?
2. What is the firm’s horizon or terminal value?
3. What is the firm’s intrinsic value today, P 0?

PROBLEM NO. 9
Siargao Coal Mining Company’s ore reserves are being depleted, so its sales are falling. Also, because its pit is getting
deeper each year, its costs are rising. As a result, the company’s earnings and dividends are declining at the constant
rate of 5% per year. If D 0 = P6 and the expected return is 10%, what is the value of Siargao Coal Mining’s stock?

PROBLEM NO. 10
Genoa Corp. pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were
P5.00 per share and the dividend was just paid to shareholders. The current price of shares is P42.00. The firm's tax
rate is 30%. The cost of common equity is closest to ______.

PROBLEM NO. 11
Use the basic equation for the capital asset pricing model (CAPM) to work each of the following:
1. Find the required return for an asset with a beta of 0.80 when the risk-free rate and market return are 5 percent and
10 percent, respectively.
2. Find the beta for an asset with a required return of 9.75 percent when the risk-free rate and market return are 6
percent and 9 percent respectively.

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 Risks, Returns and Capital Structure

PROBLEM NO. 12
Fatty Paints Corporation has a target capital structure of 40% debt and 60% common equity, with no preferred stock.
Its before-tax cost of debt is 8%, and its marginal tax rate is 30%. The current stock price is P24. The last dividend
was P1.80, and it is expected to grow at a 5% constant rate. What is the cost of its common equity and WACC?

PROBLEM NO. 13
The following data pertain to Dana Industries:
Interest rate on debt capital 9%
Cost of equity capital 12%
Before-tax operating income P35 million
Market value of debt capital P60 million
Market value of equity capital P120 million
Total assets P150 million
Income tax rate 30%
Total current liabilities P15 million

Requirements:
1. Compute Dana's weighted-average cost of capital.
2. Compute Dana's economic value added.

PROBLEM NO. 14
Cargo Corporation is expected to pay the following dividends over the next four years: P8, P6, P3, and P2. Afterwards,
the company pledges to maintain a constant 4 percent growth rate in dividends, forever. If the required return on
the stock is 9 percent, what is the current price per share of common stock?

PROBLEM NO. 15
The Occidental Bank just issued some new preferred stock. The issue will pay an annual dividend of P3.60 in
perpetuity, beginning 4 years from now. If the market requires a 6 percent return on this investment, how much is
the price of one preferred share today?

PROBLEM NO. 16
Texas Company’s common stock is currently selling for P20 per share. Security analysts at SG Specialists, Inc. have
assigned the following probability distribution to the price of (and rate of return on) Texas’ stock one year from now:
Price Rate of Return Probability
P16 -20% 0.25
20 0% 0.30
24 +20% 0.25
28 +40% 0.20

Assuming that Texas is not expected to pay any dividends during the coming year, determine the expected rate of return
on Texas’ Stock.

PROBLEM NO. 17
Donna has P3,000 invested in IABF with an expected return of 11.6 percent; P10,000 in IAS with an expected return of
12.8 percent; and P6,000 in IL with an expected return of 12.2 percent. What is Donna's expected return on her portfolio?

PROBLEM NO. 18
Determine the beta of a portfolio consisting of equal investments in the following common stocks
Security Beta
Apple Computer 1.15
Coca-Cola 1.05
Harley-Davidson 1.50
Homestake Mining 0.50

PROBLEM NO. 19
Yohanne Corporation is expanding its research and production capability to introduce a new line of products. Current
plans call for the expenditure of P100 million on four projects of equal size (P25 million each), but different returns.
Project A is in blood clotting proteins and has an expected return of 14 percent. Project B relates to a hepatitis vaccine
and carries a potential return of 12.5 percent. Project C, dealing with a cardiovascular compound, is expected to earn
11.8 percent and Project D, an investment in orthopedic implants, is expected to show a 10.5 percent return.

The firm has P15 million in retained earnings. After a capital structure with P15 million in retained earnings is reached (in
which retained earnings represent 60 percent of the financing), all additional equity financing must come in the form of
new common stock.
Common stock is selling for P24 per share and underwriting costs are estimated at P3 if new shares are issued. Dividends
for the next year will be P2.00 per share (D 1), and earnings and dividends have grown consistently at 6 percent.
The yield on comparative bonds has been hovering at 9.2 percent. The investment banker feels that the first P20 million
of bonds could be sold to yield 9.2 percent while additional debt might require a 2 percent premium and be sold to yield
11.2 percent. The corporate tax rate is 40 percent. Debt represents 40 percent of the capital structure.

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 Risks, Returns and Capital Structure

Requirements:
1. Based on the two sources of financing, what is the initial weighted average cost of capital?
2. At what capital structure size will the firm run out of retained earnings?
3. What will the marginal cost of capital be immediately after that point?
4. At what capital structure size will there be a change in the cost of debt?
5. What will the marginal cost of capital be immediately after that point?
6. Based on the information about potential returns on investments in the first paragraph and information on marginal
cost of capital (in parts 1, 3, and 5), how large a capital investment budget should the firm use?

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