MANAGEMENT ACCOUNTING 2 / FINANCIAL MANAGEMENT 2

CAPITAL BUDGETING PART 1 – Cost of Capital

PROBLEMS

1. If ABC Corporation can borrow at an interest rate of 12% and its marginal corporate
tax rate is 35%, its after tax cost of debt will be 7.8%.

2. ABC Company plans to issue 25-year bonds with a face value of P4,000,000. Each
bond has a par value of P1,000 and carries a coupon rate of 9.5%. However, the bond
is expected to sell for 98% of par value. The flotation costs are estimated to be
approximately P26 per bond and the firm’s marginal tax rate is 34 percent. (Assume
that interest payments are made annually).
Required :
a. Net proceeds per bond
b. The before – tax cost of this bond issue
c. The after – tax cost of the bond issue’s flotation costs

3. ABC Company plans to sell preferred share for its par value of P25.00 per share. The
issue is expected to pay quarterly dividends of P0.60 per share and to have flotation
costs of 3 percent of the par value of P1.50. What is the cost of the new preferred
share?

4. In today’s market, rRF = 5.6%, the market risk premium is RPm = 5.0%, and ZZZ’s
beta is 1.48. What is ZZZ’s cost of equity using the CAPM approach?

5. Seal Company’s ordinary equity shares sell for P32.75 per share. ABC expects to set
their next annual dividend at P1.54 per share. If Seal expects future dividends to
grow by 6% per year indefinitely, the current-risk-free rate is 3%, the expected
return on the market is 9%, and the stock has a beta of 1.3. What should the firm’s
cost of equity be?

6. Seal Company’s long – term bond rate is 9.5%. The firm management estimates that
its cost of equity should require a 3 percentage point of risk premium above the cost
of its own bonds. Using the generalized risk premium approach, the cost of ordinary
equity would be?

7. ZZZ stock sells for P23.06, its next expected dividend is P1.25, and analysts expect it
growth rate to be 8.3%. Thus, ZZZ’s expected and required rates of return are
expected to be?

8. Seal Company had earnings per share for the past year of P6.50, and the firm’s
ordinary equity share is currently priced at P45.00. Using the earnings – price ratio
method, the cost of retained earnings would be?
9. ABC Company’s ordinary equity shares are selling for P32.75 per share, and the
company expects to set its next annual dividend at P1.54 per share. All future
dividends are expected to grow by 6% per year, indefinitely. In addition, let’s also
suppose that ABC faces a flotation cost of 20% on new equity issues. Calculate the
flotation – adjusted cost of equity.

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 10. Seal Company’s ordinary equity share has a current market price of P45.00 and an
expected dividend growth rate of 5%. The firm is expected to pay P3.60 per share in
ordinary equity share dividends during the next year. The sale of new ordinary
equity share involves underpricing of P1.00 per share and underwriting fee of P0.80
per share. What is the cost of the new ordinary equity share?

11. The following data are available for CPA Company :

Existing Capital Structure based on Book
Source of Capital Value Specific Cost (%)
Amount Proportion
Bonds (P1,000 par, P15,000,000 30% 6.60
9.5% coupon)
Preferred share 5,000,000 10% 10.21
(200,000 shares at
P25 par)
Ordinary equity 20,000,000 40% 13.33
shares (1,000,000
shares at P20 par)
Retained Earnings 10,000,000 20% 13%
TOTAL P50,000,000 100%
Let’s assume the ff. market prices:
• Bonds = P980/bond
• Pref shares = P25/share
• Ord. Eq. shares = P45/share

a. Determine the WACC if the firm obtains new capital in Book Value Proportions.
b. Determine the WACC if the firm obtains new capital in Market Value Proportions

12. Suppose that Walt Corporation has a beta of .80. The market risk premium is 6%,
and the risk – free rate is 6%. Walter’s last dividend was P1.20 per share and the
dividend is expected to grow at 8% indefinitely. The stock currently sells for P45 per
share.

Required :
1. Using the CAPM approach, what is Walt’s cost of equity capital or expected return on
Walt’s ordinary equity share?
2. Using the dividend growth model, what is the expected return on Walt’s ordinary
equity share?
3. What is the average cost of equity?
4. In addition to the information given in the previous problem, Walt has a target debt
– equity ratio of 50%. Its cost of debt is 9% before taxes. If the tax rate is 35% what
is the WACC?
5. Suppose that Walt is seeking P30 million for a new project. The necessary funds will
have to be raised externally. Walt’s flotation costs for selling debt and equity are 2%
and 16% respectively. If flotation costs are considered, what is the true cost of the
new project?

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