COST OF CAPITAL

2nd Semester, AY 2023-24

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Credit to PINNACLe CPA Review School
Problem 1. Emmanuel Corporation has a target capital structure consisting of 20% debt, 20% preferred
stock, and 60% common equity.
• Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget.
• Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and sell for
P1,000.
• The firm could sell, at par, P100 preferred stock that pays a 12% annual dividend, but flotation
costs of 5% would be incurred.
• The firm’s beta is 1.2, the risk-free rate is 10%, and the market risk premium is 5%.
• The corporation is a constant growth firm that just paid a dividend of P2.00, sells for P27.00 per
share, and has a growth rate of 8%.
• Flotation costs on new common stock total 10%.
• The firm’s marginal tax rate is 40%.
Requirements:
1. What is the component cost of debt?
A. 10.0%
B. 8.6%
C. 9.1%
D. 7.2%

2. What is the cost of preferred stock?

A. 10.0%
B. 12.0%
C. 11.0%
D. 12.6%

3. What is the cost of retained earnings using the CAPM approach?

A. 13.6%
B. 16.0%
C. 14.1%
D. 16.6%

4. What is the cost of retained earnings using the DCF approach?

A. 13.6%
B. 16.6%
C. 14.1%
D. 16.9%
E. 16.0%

Problem 2. Cristy Company’s stock currently has a price of P50 per share and is expected to pay a
year-end dividend of P2.50 per share (D1 = P2.50). The dividend is expected to grow at a constant rate
of 4% per year. The company has insufficient retained earnings to fund capital projects and must,
therefore, issue new common stock. The new stock has an estimated flotation cost of P3 per share.
What is the company’s cost of equity capital?
A. 10.14%
B. 9.45%
C. 9.21%
D. 9.32%

Problem 3. Ronelo Electric has a capital structure that consists of 70% equity and 30% debt.
• The company’s long-term bonds have a before-tax yield to maturity of 8.4%.
• The company uses the DCF approach to determine the cost of equity.
• The company’s common stock currently trades at P45 per share.
• The year-end dividend (D1) is expected to be P2.50 per share, and the dividend is expected to
grow forever at a constant rate of 7% a year.
• The company estimates that it will have to issue new common stock to help fund this year’s
projects.
• The flotation cost on new common stock issued is 10%.
• The company’s tax rate is 40%.
What is the company’s weighted average cost of capital, WACC?
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COST OF CAPITAL
2nd Semester, AY 2023-24
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A. 10.73%
B. 11.31%
C. 10.30%
D. 7.48%

Problem 4. Marjon Corporation is estimating its WACC. The company has collected the following
information:
• Its capital structure consists of 40% debt and 60% common equity.
• The company has 20-year bonds outstanding with a 9% annual coupon that are trading at par.
• The company’s tax rate is 40%.
• The risk-free rate is 5.5%.
• The market risk premium is 5%.
• The stock’s beta is 1.4.
What is the company’s WACC?
A. 9.71%
B. 8.31%
C. 9.66%
D. 11.18%

Problem 5. Princess Industries finances its projects with 40% debt, 10% preferred stock, and 50%
common stock.
• The company can issue bonds at a yield to maturity of 8.4%.
• The cost of preferred stock is 9%.
• The risk-free rate is 6.57%.
• The market risk premium is 5%.
• The company’s beta is equal to 1.3.
Assume that the firm will be able to use retained earnings to fund the equity portion of its capital
budget. The company’s tax rate is 30%. What is the company’s weighted average cost of capital
(WACC)?
A. 8.33%
B. 9.79%
C. 8.95%
D. 10.92%

Problem 6. Catherine Corporation has a capital structure that consists of 20% equity and 80% debt.
The company expects to report P3 million in net income this year, and 60% of the net income will be
paid out as dividends. How large must the firm’s capital budget be this year without it having to issue
any new common stock?
A. P 1.20 million
B. P 1.50 million
C. P13.00 million
D. P 6.00 million
Credit to ReSA Review School of Accountancy
Problem 7. Spain, Inc. is interested in measuring its overall cost of capital and has gathered the following
data. Under the terms described below, the company can sell unlimited amounts of all instruments.
• Spain can raise cash by selling P 1,000, 8%, 20-year bonds with annual interest payments. In
selling the issue, an average premium of P 30 per bond would be received, and the firm must
pay flotation costs of P 30 per bond. The after-tax cost of funds is estimated to be 4.8%.
• Spain can sell 8% preferred stock at P 105 per share. The cost of issuing and selling the preferred
stock is expected to be P 5 per share.
• Spain’s common stock is currently selling for P 100 per share. The firm expects to pay next year
cash dividends of P 7 per share, and the dividends are expected to remain constant. The stock
will have to be underpriced by P 3 per share, and flotation costs are expected to amount to P 5
per share.
• Spain expects to have available P 100,000 of retained earnings in the coming year, once these
retained earnings are exhausted, the firm will use new common stock as the form of common
stock equity financing.
• Spain’s preferred capital structure is: Long-term debt 30%, Preferred stock 20%, and Common
stock 50%.
Requirements:
What is the cost of funds from sale of common stock for Spain?
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2nd Semester, AY 2023-24
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A. 7.0%
B. 7.6%
C. 7.4%
D. 8.1%

What is the cost of funds from retained earnings for Spain?

A. 7.0%
B. 7.6%
C. 7.4%
D. 8.1%

If Spain needs a total of P 200,000, what would be the firm’s weighted average cost of capital?
A. 4.8%
B. 6.8%
C. 6.5%
D. 19.80%

If Spain needs a total of P 1,000,000, what would be the firm’s weighted average cost of capital?
A. 4.8%
B. 6.8%
C. 6.5%
D. 27.4%

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