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.
Crater Company’s bonds have 8 years remaining to maturity. Interest is paid annually. The bonds have a P1,000
face value, and the coupon interest rate is 5 percent. The bonds have a yield to maturity of 6 percent.
1. What is the current market price of these bonds?
2. Assuming that the YTM is 4.5.0%, what is the current market price?

PROBLEM NO. 2.
Excel Company is planning to issue 500,000 bonds that will mature in 10 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 7.5 percent coupon rate. What
is their current yield?

PROBLEM NO. 3.
Graham Company’s 5-year 8% bonds are issued at P1,075 per bond.
1. What is the yield to maturity for these bonds?
2. What is the YTM for these bonds assuming they are issued at P975 before P50 flotation costs.

PROBLEM NO. 4.
Case A
The bonds issued by Priceless Jewelers bear a 7.5 percent coupon, payable semiannually. The bonds mature in 13
years and have a P1,000 face value. Currently, the bonds sell at par. What is the yield to maturity?
a. 7.33% c. 7.46%
b. 7.41% d. 7.50%

Case B
Wesley Company bonds have an 8.25 percent coupon and pay interest annually. The face value is P1,000 and the
current market price is P1,004.60 per bond. The bonds mature in 17.5 years. What is the yield to maturity?
a. 7.82 percent c. 8.20 percent
b. 7.97 percent d. 8.25 percent

Case C
Culpepper Supply has a bond issue outstanding that pays a 7.5 percent coupon and matures in 14 years. The bonds
have a par value of P1,000 and a market price of P942.90. Interest is paid semiannually. What is the yield to
maturity?
a. 7.50 percent c. 8.19 percent
b. 7.67 percent d. 8.60 percent

PROBLEM NO. 5.
Bona Company issued preferred stock with a stated dividend of 8 percent of par value. Preferred stock of this type
currently yields 7.5 percent, and the par value is P100. Assume that the company expects to pay cash dividends
annually.
1. What is the market price of one share of Bona’s preferred stock?
2. Suppose interest rate declines to the point where the preferred stock now yields 6.75%. What would be the
value of Bona’s preferred stock?

PROBLEM NO. 6.
BOD Industries plans to issue perpetual preferred stock with a P5 dividend. The stock is currently selling for P95.00
subject to flotation costs of 5% of the market price. What is the cost of this preferred stock?

PROBLEM NO. 7.
Star Electronics wants you to calculate its cost of common stock. At the end of 12 months the company expects to
pay dividends of P1.20 per share, and the current price of its common stock is P36 per share. The expected annual
dividend growth rate is 4% and the flotation cost is P2.50 per share.
1. Compute the cost of retained earnings.
2. Compute the cost of new common stock.

PROBLEM NO. 8.
Enrico Company’s stock currently sells for P30.00 a share. It just paid a dividend of P0.75 a share. The dividend is
expected to grow at a constant rate of 5% a year.
1. What is the expected rate of return on retained earnings?
2. What stock price is expected 2 years from now?

PROBLEM NO. 9.
Orange 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 9%.
1. How far away is the terminal date?
2. What is the firm’s horizon or terminal value?

ACT 1109 HO-01 – 1 of 2

 Risks, Returns and Capital Structure

3. What is the firm’s intrinsic value today, P 0?

PROBLEM NO. 10.

Samar 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 earning s and dividends are declining at the constant
rate of 5% per year. If D 0 = P1.50 and the expected return is 7.5%, what is the value of Samar Mining’s stock?

PROBLEM NO. 11.

Subic Corporation is expected to pay the following dividends over the next four years: P 6, P4, P3, and P2. Afterwards,
the company pledges to maintain a constant 5 percent growth rate in dividends, forever. If the required return on
the stock is 10 percent, what is the current price per share of common stock?

PROBLEM NO. 12.

The Orient Bank just issued some new preferred stock. The issue will pay an annual divi dend of P3.60 in perpetuity,
beginning 4 years from now. If the market requires a 9 percent return on this investment, how much does a share
preferred stock cost today?

PROBLEM NO. 13.

Use the basic equation for the capital asset pricing model (CAPM) for the following:
1. Find the required return for an asset with a beta of 1.25 when the risk-free rate and market return are 4 and 9
percent, respectively.
2. Find the required return for an asset with a beta of 0.90 when the risk-free rate and market return are 6 percent and
10 percent, respectively.
3. Find the beta for an asset with a required return of 11 percent when the risk-free rate and market return are 5 percent
and 8 percent respectively.

PROBLEM NO. 14.

Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the
company's stock?
State of Probability of Expected
the Economy Occurring Return
Boom 0.45 25%
Normal 0.50 15%
Recession 0.05 5%

PROBLEM NO. 15.

Metropharma 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 14.0 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 11.0 percent and Project D, an investment in orthopedic implants, is expected to show a 10.75
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 P22 per share and underwriting costs are estimated at P2.50 if new shares are issued. Dividends
for the next year will be P1.80 per share (D1), and earnings and dividends have grown consistently at 5 percent.
The investment banker feels that the first P20 million of bonds could be sold to yield 9.5 percent while additional debt
might require a 2 percent premium and be sold to yield 11.5 percent. The corporate tax rate is 40 percent. Debt represents
40 percent of the 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?
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?

– end -

ACT 1109 HO-01 – 2 of 2