1. Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?

● After-tax cost of debt is frequently used to calculate for WACC for a reason that we are trying
to determine the net cost of debt of the company or organization by the adjustment of gross
cost of debt for tax savings. At the end of the day, we are trying to maximize the stock value
of the company and prices of stocks depend on the after-tax cost of debt.

2. Is a tax adjustment made to the cost of preferred stock? Why or why not?
● There is no tax adjustment to the cost of preferred stock because, notably, dividends from
preferred stocks are not tax deductible.

3. Why must a cost be assigned to retained earnings?

● Retained earnings are owned by the shareholders, as an investment capital for the company.
In addition, costs are allocated to retained earnings because shareholders’ venture in
investment expects a return. Hence, costs are applied.

4. Suppose interest rates in the economy increase. How would such a change affect the costs of both
debt and common equity based on the CAPM?
● Adjustment to interest rates causes changes in risk free rate and WACC of the company. If
interest rates increase, the company will borrow money from the shareholders, and the cost
of debt of the company will also increase for a reason that the company borrowed money
and it also needs to pay it back to the shareholders. Similarly, if prices of stock decrease, it
pulls down the stock price of the company resulting in an increase of the company's cost of
equity.

5. Identify some problem areas in the cost of capital analysis. Do these problems invalidate the cost of
capital procedures discussed in this learning packet?
● The problems that I have encountered in the analysis of cost of capital are:
1. The computation of cost of equity when stocks are not traded and the tax
deductions of it, most especially for small businesses; and
2. Practical difficulties in estimating cost of equity that the assurance of accuracy of the
cost of equity is low.
In accordance with it, I believed that it is not a big deal that can affect the whole
procedure in the analysis of cost of capital, since it is used even before I am nurtured with
finance.

6. The future earnings, dividends, and common stock price of Snape Technologies Inc. are expected
to grow 7% per year. Snape’s common stock currently sells for P23.00 per share; its last dividend
was P2.00; and it will pay a P2.14 dividend at the end of the current year.
a. Using the DCF approach, what is its cost of common equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the average return on the market is 13%,
what will be the firm’s cost of common equity using the CAPM approach?
c. If the firm’s bonds earn a return of 12%, based on the bond-yield-plus-risk-premium
approach, what will be the cost of common equity using retained earnings? Use the
midpoint of the risk premium range.
d. If you have equal confidence in the inputs used for the three approaches, what is your
estimate of Snape’s cost of common equity?
7. The Lily Company’s next expected dividend, D1, is P3.18; its growth rate is 6%; and its common
stock now sells for P36.00. New stock (external equity) can be sold to net P32.40 per share.
a. What is Lily’s cost of retained earnings, ke?
b. What is Lily’s percentage flotation cost, F?
c. What is Lily’s cost of new common stock, kn?

8. Dolly Paints Corporation has a target capital structure of 40% debt and 60% common equity, with
no preferred stock. It’s before-tax cost of debt is 12%, and its marginal tax rate is 40%. The
current stock price is P0 22.50. The last dividend was D0 = 2.00, and it is expected to grow at a
7% constant rate. What is its cost of common equity and its WACC?

9. BT Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt,
and its tax rate is 40%. BT must raise additional capital to fund its upcoming expansion. The firm
will have P2 million of retained earnings with a cost of retained earnings of 12%. New common
stock in an amount up to P6 million would have a cost of common equity at issuing new shares
of 15%. Furthermore, BT can raise up to P3 million of debt at an interest rate of 10% and an
additional P4 million of debt at P12%. The CFO estimates that a proposed expansion would
require an investment of P5.9 million. What is the WACC for the last peso raised to complete the
expansion?