RISKS, RETURNS and VALUATION

Suggested Answers @Solutions

THEORIES:

11. D 21. B 31, D 41. C 51. B

12. C 22. 8 32. A
2. C 13. A
42. D 52. A
23. A 33. B
3. B 14. C
43. C 53. A
4. B 24. A 34. B 44, B 54. C
15. B 25. A 35. B
5. B
16. B
45. C 55. C
6. C 26. D 36. D 46, C 56. B
7. A 17. A 27. B 37. C 47. B 57. D
18. D 28. D 38. B 58. D
8. C 48, D
19. D 29. A 39. A 59. B
9. D 49. B
10. B 20. A 30, B 40. C 50. D 60. B

PROBLEMS:

1. C 16. D 31. D 46. B 61. A

2. C 17. D 32. 47. D 62. B
3. A 18. B 33. B 48. B 63. C
4. C 19. B 34. D 49. B 64. A
5. C 20. C 35. B 50. A 65. C
6. A 21. B 36. B 51. G 66.
22. B 37. B 52. A 67. D
7.A
23. A 38. A 53. B 68. C
8. B
24. A 39. A 54. A 69. C
9. D
10. C 25. B 40. A 55. D 70. B
26. D 41. D 56. B
11. A
27. C 42. B 57. A
12. C
28. D 43. C 58. D
13. C
44. A 59. B
14. A 29. C
30. A 45. B 60. B
15. A

SOLUTIONS:

1 Answer: C
0.42857
Debt ratio: 0.75 + (1 +0.75) 0.57143
Equity ratio: (1.00-0.42857)
228,572
Increase in Equity: 0.57143 x 400,000 171,428
Increase in debt: 0.42857 x 400,000
2 Answer: C Second.
retained earnings as the total net income minus dividends.
by the equity
First, calculate the addition to breakpoint by dividing the addition to retained earnings
calculate the retained earnings
fraction of the capital structure. 100.0M
675M
Net income -32.5M
Deduct dividends (0.675 x 100M)
Ingrease in retained earnings
retained earnings: 50.OM
Capital budget supported by
32.5M + 0.65

463
 3 Answer: A
P 40M
EBIT 5M
Interest P 36 M
Before tax 14 M
Income tax 21 M
Net income 4M
Preferred dividend P 17 M
Available to common
sharès = P1.70
Per common share: 17Mx 0.20+ 2M
4 Answer: C
P 480,000
Interest (6M x 0.08) 2.000.000
Before-tax dividends (10M x0.12 + 0.6)
Total cash flow requirements to cover
dividends and interest P2,480.000
interest payments ignored because they are
The computation of cash fow required by thedividends
deductible in the computation of taxes. The ar calculated on a before-tax basis
because it is a residual amount.

5. Answer: C

BM-1.2M 4.8 M
Available eamings to Common
4.8M x .5 2.4 M
Retained income
Retained earnings Breakpoint 2.4 M + 0.6 P4.000,000
Retaind eanings breakpoint refers to the maximum amount of funds or financing required whereby
there is no need to issue common shares.

6 Answer: A
30.0 million
Expected earnings 12.0million
Deduct dividends (30M x 0.4)
Increase in retained earnings 18.Q million
Breakpoint: 18.0M + 0.4 45.0 milion

7. Answer: A

Net income 7,500,000

Financing required from equity 6M x0.6 3,600,000
Residual earnings for dividends 3,900.00Q

Payout ratio: 3,900,000/7,500,000 52%

8 Answer: B

Capital structure:
Debt: 1.5 + (1 + 1.5) 60.0%
Equity: 100% - 60% 40.0%

WCCo (0.6 x 11%) 6.6%

WCCE (0.4 x 17%) 6.8%
Weighted average cost of capital 13.4%

464
 Answer.: D
9

Earnings before interest

Interest P6,000,000
Preferred Dividends 1,000,000
(800,000/0.6) 1,333,333 2,333,333
Earnings after preferred dividends (before taxes) P3,666,66Z
DFL (6M + 3,666,667 164

For every 10 percentchange in EBIT, EPS changes by 16.4 percent (10% x1.64). Adding fnancial leverage
tooperating leverage increases the total risk of a Companý.
10. Answe. C

Increase in Earnings after tax:

(1,750,000- 1,250,000) 500,000
Percentage increase: (500,000 + 1,250,000) 40 percent

New EPS: 12.50 + (12.50 x 0.40) 1Z.50%

11. Answer: A

Return on Assets Asset turnover x Return on Sales

=.125 x.75
=,09375 or 9.375

Current Return on equity = 9.375 +,60

=15625 or 15.625%

Target ROE = 15,625 x 1.50 = 23.4375%

Let X = Debt Ratio
.234375 =(.15 x.75)
1-X
X = 52%

12. Answer: C

0.4 to 1
The Debt to Equity Ratio is
P12,000,000
RE + 0.40RE =
RE = P12,000,000 + 1,40
RE P 8,571,429
Dividends:
Available Retained Earnings for
(P10,000,000 - P8,571,429) P1,428,71

Answer: C
13.
PV of cash inflows, 8%, 5 periods
3.9927) P259.53
Interest (P85 x
Maturity value (P1,000 x 0.6806) 680.60
Total(Current Price) P940.12
Dience observe that the yield to maturity inversely varies with the present value (market price). since
of 6.5%, the price is lower than P1.000: f the VTM
the vield to maturity is higher than the coupon ratehigher
be than P1,000.
is lower than the coupon rate, the price should

465
14. Answer. A

R= RE B(RM -Rp) 12.5%

6% + (11% - 6%) x 1.3
P50.67
Price = PS7+(1+ 0.125)

15. Answer A calctated .

dividend is constent, the value of the preferred stock is
Inasmuch that the preferred
capitalizingthe P6 dlvidend forever at 10 percent.
P6 +0.10
Value of preferred stock:

16. Answer: D
P3.18
Amount of next dividend (D) P3.00x 1.06
P53.00
P, = P3.18/(0.12 - 0.06)

17. Answer D
P5.0825
D, = P4,75 x 1.07
P12706
P, = P5.0825 +(0.11-0.07)

18. Answer. B

Po = d (k-g) = P56.68
=(7.8 x 1.09) + (0.24 - 0.09)
19. Answer: B

The value of the stock is the present value of the dividends during the unusual growth
period plus the
present value of the stock price calculated as of the end of the unusual growth fbeginning of constant
growth).
Present value of first 3years' dividends:
Year 1: (5.90 x 1.19) + 1.12] 6.27
Year 2: ((7.02 x 1.19) + 1.12 6.66
Year 3: ((8.35 x 1.19) +1.12j 7.08
Total 20.01

Present value of Market Price at Year 3

(212.80 + 1.12) 151.44
Market price at the start of Period1 17145
Market price, end of Period 3:
P3 = da+ (k-g)
= 10.64 +(0.12- 0.07) 21280
20. Answer. C

k= kRF + B(KRM -kRF)

k=7.5%+ 1.75(11.3% -7.5%) 14.15%

Po =4.00+ (0.1415 - 0.07) P55.94

466.
 Answer: B
21.
Present Value of Dividends and Market Price:
Year 1: (6 + 1.2)
Year 2: (9 + 1.2) P 5.00
Market price of shares: (136 + 1.2) ? 6.25
Market Price at Period 0 94.44
P105.89
Answer B.
22.
Po= (P2OM + 2M shares) + 0.10
PI00
Answer: A
23.

Market price = Expected Dividend + (Expected return -growth rate)

Market price = 1.50 + (0.10-0.05) P30.00
24. Answer: A

EarningsS per share: P75.2519 P3.96

Payout ratio: 2.28 +3.96 57 6%
25. Answer: 8

CY =Annual interest +Net proceeds

= (1,000 x0.1) + 900 11.11%
26. Answer: D

YTM = 90 +[(1,000 - 829)/41

(0.6 x 829) + (0.4 x 1,000)
YTM 14.80%

The computation of estimated yield to maturity used a weighted-average based on 60% market
price and 40% payable (face value).
An alternative solution may use simple average.
a bond is issued at a
Reminder: Remember that the bonds were iSSued at adiscount. Whenthe annual intereet
deducted from
premium, the annual amortization of the premium should be

27, Answer: C
P1,000)1
ytm' = (P150 + P3.6667) + [(0.6 x P978) + (0.4 x
= P153.6667 + P986.8
=15.69%
calculation) indicates a ytm close to 15%
The use of IRR(trial and error
1.150) P558.62
PV of interest E(150 ++ 1.156) 419.04
PVof interest (1,000 P977.66
Total

28. Answer: D
Frice of the bond and its Yield Inasmuch that
The problem ilustrated the inverse relatonship or the higher than
h Driee is LOWER than the face value OT P1,000, the bond's yield to maturity must be should
Computation is not necessary, then the candidateproceed
the coupon rate of 13 percent. tne choice that is higher than 13 percent and then
beseD because there is n0 otherexamination.
answering the next question in the

467
 = 8%
cash flows, n = 16; k
PVof
8.85137) P 57534
Interest (P85x(P1,000 x 0.29189)
Maturity value
Total
A

281,P. 81.2409 38.

Answer: C
29. Rememberthe relationship between the price of the bond and its yield. Because the pice of the bondis,
lowerthan P1,000, its yield should be higher than the coupon rate of 8%. Therefore, using tral and errox
12.17%.
either 9.57% or
calculation, the answer is
interest paymehts:
Present value of 6 3$
(40 x5.11078 204.49
n6, k =0.04785; (1,000 x 0.75545)
Present value of MV: 15545
Total PO59.22
Answer. A
30.
(0.07 x 1,00Ó) 7000
Annual interest received 1,054.47)
Loss on sale:
(1,037.19- 123
Net pesO returns 52.72
1,054.47) 5.00,
Rate of return: (52.72 +
Answerr D
31.
11.94%
11/(97-x 0.95)

32. Answer B

simpBe calculation of the nominal rate:

A XX
Real Rate of Return
XX
Add: inflation Rate
Combined effect (RRR x IR) XX
Nominal Rate
Inflation Rate:
0.14 = 0.06 +IR+0.061R
1.08IR + 0.08
IR= 0.0755 or Z55%
33. Answer: B

K, =[(2.20 x1.06) +40] +0.6 = 11.83%

Issuance cost is used only when computing cost of new common stocK
34. Answer: D 11.0%
5.0%
Yield (4.40 + P40) 16.0%
Growth (appreciation)
Expected rate of return
16.30%
35. Answer: B
(2.14 123) + 0.07
15.81%
38. Answer: B
[(3 x1.06)/32.40] + 0,06
37. Answer: B

468
 Expected returns 9.0%
Less yield on Platon's stock (3.6+ 60 x 100) 6.0%
Growth rate 3.0%
Answer: A
38.
Required return 9.0%
Less Yield on stock (7.20 + 120 x 100) 6.0%
Growth rate 3.0A

EPS for next year: 10.80 x 1.03 P11.12

39. Answer. A
15.0%
Expected returns
Less growth rate 10,0%
5.0
Yield rate

Dividend per share: P40 x 5%

P2.90

40. Answer: A
13.89%
k, = (P3.10 + P45) + 0.07
from the market price in computing
Note: The 12 percent of market price as flotation cost is deducted
retained earnings. The tax benefit is
the expected returns on common shares but not on cost of
applicable only on the computation of cost of debt.
41. Answer: D
13.00%
Growth rate: (28.25 - 25.00) + 25.00 14.00%
Yield (3.50 + 25) 27.00%
Rate of return

42. Answer: B
12.4%
Expected returns 8.8%
P39.77)
Less yield on stock (P3.50 + 3.6%
Growth rate

43. Answer C
4: 1.25x P2.20 P5.37
Amount of dividend per share, Year
x 5.37 P5.92
Dividend per share, Year 6: 1.05

44.
Answer: A

Risk free rate 6.0%

6%)1.5 13.5%
Risk premium (15% -
Required return 19.5%
Answer: B
45.
K =Re + B(RM -Re)
(RM - RE) = Market premium
18.95%o = 6.4% + 8.2B
B 153
 54. 53. 52. 48.
51. 50. 49. 47.
55. 46.

Answer. D Answer: C Answe: A

WACCWCCEWCCp Answer A
Asset Answet BBeta Equity Debt Answer. A Adjusted K= B
Answer:Risk-free
19.50
RM=1.5 Return premium Less
Risk Answer
Expected B Risk RiskAnswer: D Answer.
Required RevisedCurrent
Change B
-Average Capital 8%
beta: 13%RM = 15 15 premium free
Common
PreferredDebt ofratio:ratio: Kk +
the = =9.0=9.0 rate rate rate rate expected expected in
155+ =5% kRF+risk-free
RF = 1.75(12% isk
(15 Asset: 0.8
+ + + +
of of of(6% of
20 +
1- +
20x 60 0.4444 + 0.8(12%-B(KRM
rate 1.5 1.5 B retum return return retum premium rate
rate
x (RM- - x
20% 8% x (0.4444 (1+0.8) (RM-9.0) RM 8%) 1.25)
Cost 0.2) -k (3% of of
- return return
of 5%) RF) + 13,50 RF)
+ x0.4)
Capital (45 2%)
+
60% 20% 20%
60 (0.5556 +
Composition x
1.4)
x
1.2)

14% 11% Cost

8% Market
coefficient
Beta
B=rateRMNote:
RF
=
Risk

free

12.20%
8.40%2.20%
Weighted
1.60% Cost rate

15.0% L5% 7.5% 20.5%2.5%18.0%

44.44%
55.56% 5.0% 4.8% 9.8%
10.6% 15%
170%15.0% 2.0% 0.84 5%
11
 59. Answer:57. A
61. 60. Answer:58. D 56.

B required TheAnswer:
dividends
Present B Growth Theaverage rateUsing The The
Answer: B
Present
valueof.Answer:
: percent ThePresentPresent Expected
returnsDividend
rateyield
TheAnswer: A YearYear Year Year Weighted-Average Capital
Çurrent
dividendDividend,
Dividend, market value amount can growth solution
formula Liquidating the Common
Preferred.15
Marginal x
Retained9.0% Debt Common Debt
to price value 4 3 2value 1 rate of
1.728+
1.5291.5931.659 as of also
value perpetuity- price 7table in =45
to end end well of th e of
percent. requires
of of of be peso costshare
compute one + + + four return underpricing of earning x
of ofof of market as stock 5.6%
1.12*1.12 1.12 1.12 calculated Future
the year year the share declining the amount of Cost
of the capital.1333 40% 60%
Compositign
the stock stock,
1+ price, constant today (P5.24
31 12 computation .266
77.
1. 0
1 0
85 + 0.12 of Value of
current 1.185 50 +
3.501.185
3.+ the percent. should of x Capital
end end dividends equals x by
dividend 13.2% x
or 1.07) 12.0%
perpetual computing of
8.333 ofstock of
market year be 1,
year The the +
(P100 included the in of
price 4 4 aggregate
present growth
dividends. rateterms
471 is 8.333+ the
calculated - corresponding
of P2-P1) as annual of
rate. 15.00%5.20%
After-tax
Cost
the value
present deduction future
stock 1.12*
of
by the growth value
using discounting value
dividends from to of
the of rate 4
the periods is1
dividend all
the includes the market and 1.31
then 8.83% 1.76 3.20 1.35 2.52
Constant future is or 9.12%6.00%3.12%
growth price (5.247 Weighted
Cost
1.3225
0.97171.1339 1.5429 the computing percent.
dividends of
model P1 first +
the 4.00).
dividend four
is stock. the The
- declining using
39.050
10744. 2.1032.954 10.2668 5.2958 4.9710 12.8%7.0% growth
simpie
at 5.8%
12 the
 63. 62.
65. 64.
Answer:6 . C
common
shares
new Answer: A
This
earnings This C increase.Note:
equity, TheAnswer: however, |(3 Po The
ofthe TheAnswer. Market market
price Present
C Market Curent Present
perpetual TheAnswer: B(2.44 Po
the 21.7061.11 + Year Year 3 Year
4 Year 2 1 =
structure
represents "After-tax
WACC: initial shares
Retained
TheCommon Expected
returns: =
Captal question end cuTent x [(dodividend [do
i.e., both The 1.05'") xstock, market
0.85)
are weighted dividend of price price value vaBue x x
(0.4 the (1 (1
fully underpricing elevenprice 1.11*.801.11
1.+76 1.1.+
7121 1.68 +
+1.11dividends price + -9)
cost
after-tax computation eamings: + is +
the exactiy (0.125 end of of
used, x 1.845 =Year in
market first
(0.16 declining g)]+
+
total 7.7")+ofaverage indicated of ten
years of
15WO.6
size = bonds: 10 that the
four + (K (ke-g)
the cost +(0.11-0.025)
-0.05) years years 4 0.15) +
investment' and 0.90125 is
(0.6 and of 0.90/(25 +0.11-3) at value dividends: thatstock
9) at
retained
therefore returns is a calculated a
11% x of cost flotation the growth
is: from would constant
14.6) first + at consists
of amount 0.11 now year.4
funded earnings x
0.7 series on
a capital of by grow
marginal costs
retained can rate,
of percent 5 using of
7.7% expected be atthe
by a and
bonds wil are calculated
472 retainedbreakpoint, the constant
aggregate
cost use eamings
considered
and 15.1%
14.6% (3.15 dividend therefore,
to
of the be
earning: capital the - rate
least always paid 3)/3. by preSent
the cost Computing to of the
11.84%
in
wil
capital th e next Using be 2.5 6.69
expensive of ignores
formula
computation paid
occur. retained year, percent.value
structure the the end
therefore
the of wll
dividend of be
earnings. cost expected the
armount year
components of first reversed
size expected 5,
it growth four
where of is dividend 1.845
flotation not
given model., dividende
he for returns (1.80x1.025).
per
cOst, an
rela deo e
thshare
25.0M on. 1170 68.41 21.706 19.681 14.298 1.1861.2871.3961.514
a price .
at
67. Answer: D

Marginal cost of capital occurs in this structure size because the company will use common shares
instead of retained earnings. However, the amount of frst series of bonds, the lower-cost bonds, is not
yet fully used.
12.14%
MCC =(0.4 x 7.7) + (0.6 x 15.1)
68. Answer: C

The question asked t

ne investment s0ze that can be supported by the 20M bonds, at 40% composite ratio. This structure
indicated that the 20M with an after-tax cost of 7.7% is fully used. Therefore, this is ancther breakpOint, a
marginal cost of capital will occur.
50.0 Million
Debt breakpoint: 20M/0.4
69. Answer: C
Debt Breakpoint. Át this level, the cost of
fhe question asked the marginal cost of capital to occur at
capital is based on common shares and the second series of bonds.

The cost of capital of 12.7% will apply to Project C and D.

12.7%
MCC: (0.4 x 9.1) + (0.6 x 15.1)

70. Answerr B
Returns Cost of Capital Decision
Proiect 18.0 11.84 Accept
A 12.14 Accept
14.0
B 12.70 Reject
11.8
10.9 12.70 Reject
D