Exercises – Risks and Leverage & Financial Markets

1. Totsuki Academy is contemplating to build another campus in Manila City. The required investment is P100 million
and the company had maintained a capital mix of 60:40 for debt and equity, respectively. The advisors provided the
following capital financing alternatives to the management:

ALTERNATIVE 1
a. Bonds issued for P900 assuming par value of P1,000. Stated interest rate is 10% maturing in 5 years. Effective
tax rate is 40%
b. Preferred stocks that is currently selling at par value of P100 per share. Recently, the company had paid the
8% annual dividends.

ALTERNATIVE 2
a. Bonds issued for P1,100 assuming par value of P1,000. Stated interest rate is 10% maturing in 5 years. Effective
tax rate is 40%
b. Common stocks with par value of P10 per share and market value of P120 per share. Flotation costs upon
issuance is P20 per share. Recently, the company paid 10% dividends, which is expected to grow at a constant
rate of 5%

Required: Determine the following:

A. Compute for WACC under alternative 1 using YTM for after-tax cost-of-debt and dividend growth model on the
equity financing
B. Compute for WACC under alternative 2 using YTM for after-tax cost-of-debt and dividend growth model on the
equity financing

2. Noir Corporation’s common stock currently pays an annual dividend of P3.60 per share. The required return on the
common stock is 10%.

REQUIRED: Estimate the value of the common stock under each of the following dividend growth rate assumptions:
a. Dividends are expected to grow at an annual rate of 0% to infinity.
b. Dividends are expected to grow at a constant annual rate of 5% to infinity
c. Dividends are expected to grow at a constant annual rate of 5% to infinity and with flotation costs of 2%

3. Shokugeki Incorporated Stock’s Beta is 0.8, the risk-free rate is 4% and the market rate of return is 12%.

REQUIRED: Determine the following:

a. What is the required rate of return?
b. Assuming Shokugeki recently paid a P3.00 per share dividend to its common stockholders and the dividend
is expected to grow 5%. What is the company’s current stock price?
c. From the preceding number, what is the stock’s dividend yield today?

4. As at December 31, 2020, the condensed balance sheet of Alice Company shows the following capital structure at
book value:

Bonds payable P7,000,000

Preferred stock at 10 par value 1,000,000
Common stock at 35 par value 7,000,000

In its year-end strategic meeting, the board of directors of the company decided to venture in a project that will be
financed in the same proportion to the market value of the company’s present capital structure as shown above.
The firms’ bonds are currently selling at 80% of par, generating a current market yield of 9%, and the corporation
has a 40% tax rate. The preferred stock is selling at its par value and pays a 6% dividend. The common stock has
a current market value of P40 and is expected to pay a P1.20 per share dividend this fiscal year. Dividend growth
is expected to be 10% per year. Bugs weighted-average cost of capital is (round your calculations to tenths of a
percent)?

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Exercises – Risks and Leverage & Financial Markets

5. Bee-Cool, Inc. plans to introduce a new product. Returns largely depend on the degree of market acceptance:
Market Acceptance Probability Returns
Very weak 10% 0%
Weak 20% 10%
Moderate 40% 20%
Strong 20% 30%
Very Strong 10% 40%

Required:
a. Determine the expected value of the returns.
b. Determine the standard deviation of the returns.
c. Determine the coefficient of variation of the returns.

6. Moderna Company sells 50,000 units of a product at P 12 each. The unit variable cost is P 10 while the fixed
operating costs amounted to P 50,000. The company has current interest charges of P 6,000 and preferred
dividends of P 2,400. The corporate tax rate is 40%.

REQUIRED: Determine the following:

a. Degree of operating leverage (DOL)
b. Degree of financial leverage (DFL)
c. Degree of total leverage (DTL)
d. What happens to DOL, DFL and DTL if sales increase by 50%?

7. The value of ABC Company’s shares is P10 and dividend of P3 per share. It is expected that market value of share
will in increase 5 percent. What is fair value of this share assuming the investor will it after one year if discount rate
is 8 percent?

8. The expected divided per share on the equity share of Roadking Limited is P2. The dividend per share of Road king
Limited has grown over the past five years at the rate of 5 percent per year. This growth rate will continue forever
in future. What is a fair estimate of the intrinsic value of the equity share of Roadking Limited if the required rate is
15 percent?

9. Dividend for first, second and third year are expected in the amount of P1, P2 and P2.50 respectively and after that,
dividends will grow at a constant rate of 5% per year. Required rate is 10%. Calculate the value of stock?

10. A $100 par value bond bearing a coupon rate of 12 percent will mature after 5 years. What is the value of the bond,
if the discount rate is 15 percent?

11. A bond has a par value of $100, a coupon rate of 10.75% and matures in 5 years. If interest is paid annually and
the required rate of return is 10%, what is the bond’s value?

Multiple Choice Questions:

1. In an investment in plant asset, the return that keeps the market price of the firm stock unchanged is
a. Net present value c. Cost of capital
b. Adjusted rate of return d. Unadjusted rate of return

2. If bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
a. Market interest rates have increased
b. Additional debt can be issued more cheaply than the original debt
c. There should be no difference; cost of debt is the same as the bonds’ market yield
d. Interest is deductible for tax purposes

3. Malaysia Company’s 10% preferred stock that has a par value of P 100 per share is sold for P 101, gross of
underwriting fees of P 5 per share. If the tax rate is 40%, what is the cost of funds for preferred stock?
a. 4.2% c. 6.2%
b. 10.0% d. 10.4%

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4. The term “underwriting spread” as an example of flotation costs refers to the

a. Commission percentage an investment banker receives for underwriting a security issue
b. Discount investment bankers receive on securities they purchase from the issuing company
c. Difference between the price the investment banker pays for a new security issue and the price at which the
securities are resold
d. Commission a broker receives for either buying or selling a security on behalf of an investor.

5. The three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted average
cost of capital are
a. Current dividends per share, expected growth rate in dividends per share, and current book value per share of
common stock
b. Expected earnings per share, expected growth rate in dividends per share, and current market price per share
of common stock
c. Current earnings per share, expected growth rate in earnings per share, and current book value per share of
common stock
d. Expected dividends per share, expected growth rate in dividends per share, the current market price per share
of common stock

6. Ceteris paribus, the market value of a firm’s outstanding common shares will be higher if
a. Investors have a lower required return on equity
b. Investors expect lower dividend growth
c. Investors have longer expected holding periods
d. Investors have shorter expected holding periods

7. Under CAPM, the required rate of return on a security is the sum of a risk premium and
a. Risk-free rate
b. Operating risk
c. Financial risk
d. Diversifiable risk

8. The type of investment risk that can be avoided through proper diversification is called
a. Systematic risk
b. Market risk
c. Unsystematic risk
d. Non-controllable risk

9. A firm with a higher degree of operating leverage when compared to industry average implies that the
a. Firm is less risky
b. Firm is more profitable
c. Firm has higher variable costs
d. Firm’s profits are more sensitive to changes in sales volume

10. Securing of funds for investment at a fixed rate of return to fund suppliers, to enhance the well-being of the common
stockholders is known as:
a. Financial leverage
b. Prudent borrowing
c. Fund management
d. Financial arbitrage

11. Financial leverage is concerned with the relationship between

a. Changes in EBIT and changes in EPS
b. Changes in EBIT and changes in operating income
c. Changes in volume and changes in EPS
d. Changes in volume and changes in EBIT

12. A company has unit sales of 300,000, unit variable cost of P 1.50, unit sales price of P 2.00 and annual fixed costs
of P 50,000. Furthermore, the annual interest expense is P 20,000, and the company has no preferred stock.
Accordingly, what is the degree of combined leverage?
a. 1.875
b. 1.25
c. 1.50
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Exercises – Risks and Leverage & Financial Markets
d. 1.20

13. Combined leverage is concerned with the relationship between

a. Changes in EBIT and changes in EPS
b. Changes in volume and changes in EPS
c. Changes in EBIT and changes in net income
d. Changes in volume and changes in EBIT

14. Generally speaking, the most expensive source of financing is:

a. Debt c. Preferred stock
b. Retained earnings d. New common stock

15. Which of the following is an advantage of equity financing in comparison to debt financing?
a. Issuance costs are greater than for debt
b. Ownership is given up with respect to the issuance of common stock
c. The company has no firm obligation to pay dividends to common shareholders
d. Dividends are not tax deductible by the corporation whereas interest is tax deductible

16. With everything else held constant, if investors expect high growth in dividends, then:
a. Price and dividend yield will be low
b. Price and dividend yield will be high
c. Price will be low and dividend yield will be high
d. Price will be high and dividend yield will be low

17. The expected return of an investment or a portfolio is measured by the

a. Beta c. Variance
b. Weighted average d. Standard deviation

18. Standard deviation divided by expected return is used to calculate

a. Coefficient of variation b. Coefficient of correlation
c. Coefficient of determination d. Co-variance of a portfolio

19. The expected rate of return for ABC stock is 20%, with a standard deviation of 15%. The expected rate of return for
XYZ stock is 10%, with a standard deviation of 9%. The riskier stock is:
a. ABC because its return is higher
b. XYZ because its standard deviation is lower
c. ABC because its standard deviation is higher
d. XYZ because its coefficient of variation is higher

20. In primary markets, the first time issued shares to be publicly traded, in stock markets is considered as:
a. Traded offering c. Issuance offering
b. Public markets d. Initial public offering

21. The financial market where debt and stocks are traded and maturity period is more than a year is classified as
a. Shorter term markets c. Counter markets
b. Capital markets d. Long-term markets

22. The example of derivative securities include(s)

a. Swap contract c. Futures contract
b. Option contract d. All of the above

23. In capital markets, the major suppliers of trading instruments are

a. Government and corporations c. Instrumental corporations
b. Liquid corporations d. Manufacturing corporations

24. All of the following are money market instruments except:

a. Time deposit c. Savings account
b. Demand deposit d. Treasury bond

25. Which of the following will generally increase in value if the interest rates are increased by a Federal/Central Bank
a. Corporate Bonds c. Preferred Stock
b. Common Stock d. Savings Accounts

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