FINANCIAL MANAGEMENT 2

I. Solve the following problems. Show your computations in good form. It is expected to earn a constant 20 million per year on its assets. If
all earnings are paid out as dividends and the cost of capital is 10%,
1. What is the approximate yield to maturity for a $1000 par value bond calculate the current price per share for the stock.
selling for $1120 that matures in 6 years and pays 12 percent interest
annually? 10. Assume that the risk-free interest rate is 8%, the required rate of
return on the market portfolio (containing all stocks) is 15%, and the
2. A corporation has promised to pay $10,000 20 years from today for each beta coefficient of a particular stock is .9. According to the capital
bond sold now. No interest will be paid on the bonds during the twenty asset pricing model, the risk premium on that particular stock is
years, and the bonds are said to offer a 9% interest rate. Approximately
how much should an investor pay for each bond? 11. The Nunal Corporation finds that it is necessary to determine its
marginal cost of capital. Nunal’s current capital structure calls for
3. A firm has an issue of preferred stock outstanding that has a stated 45% debt, 15% preferred stock and 40% common equity. The costs of the
annual dividend of $4. The required return on the preferred stock has various sources of financing are as follows: debt, after-tax 5.6%;
been estimated to be 16 percent. The value of the preferred stock is preferred stock, 9%; retained earnings, 12%; and new common stock, 13.2%.
_____. If the firm has P12 million retained earnings, and Nunal has an
opportunity to invest in an attractive project that costs P45 million,
4. What is the after-tax cost of preferred stock that sells for $5 per share what is the marginal cost of capital of Nunal Corporation?
and offers a $0.75 dividend when the tax rate is 35%?
12. A firm's current investment opportunity schedule and the weighted
5. Wallace Inc. is expected to pay out a dividend of $2 in the next year, $3 marginal cost of capital schedule are shown below.
the year after that, and $5 the year subsequent to that. Thereafter, the Investment Opportunity IRR Initial
dividends are expected to increase at a constant rate of 8%. If the Schedule Investment
required rate of return is 16%, what is the current stock price? A 15% 200,000
B 12 300,000
6. Investors, Inc.’s stock is expected to generate a dividend and terminal C 19 100,000
value one year from now of P57.00. The stock has a beta of 1.3, the risk- D 10 400,000
E 16 300,000
free interest rate is 6%, and the expected market return is 11%. What
should be the equilibrium price of Investors’ stock in the market now?
Weighted Marginal Cost of Capital
Range of total new financing WMCC
7. Lamonica Motors just reported earnings per share of $2.00. The stock has a
$0 - $250,000 7.5%
price earnings ratio of 40, so the stock’s current price is $80 per share. 250,001 - 500,000 8.9
Analysts expect that one year from now the company will have an EPS of 500,001 - 1,000,000 10.0
$2.40, and it will pay its first dividend of $1.00 per share. The stock 1,000,001 - 1,500,000 12.0
has a required return of 10 percent. What price earnings ratio must the
The investment opportunities which should be selected are
stock have one year from now so that investors realize their expected
return?
13. Flaherty Electric has a capital structure that consists of 70 percent
equity and 30 percent debt. The company’s long-term bonds have a before-
8. Young Sook owns stock in a company which has consistently paid a growing
tax yield to maturity of 8.4 percent. The company uses the DCF approach to
dividend over the last 10 years. The first year Young Sook owned the
determine the cost of equity. Flaherty’s common stock currently trades at
stock, she received $4.50 per share and in the 10th year, she received
$45 per share. The year-end dividend (D1) is expected to be $2.50 per
$4.92 per share. What is the growth rate of the dividends over the last
share, and the dividend is expected to grow forever at a constant rate of
10 years?
7 percent 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
9. Universal Air is a no growth firm and has two million shares outstanding.

FM2QU2S1920 | SerJaboo | Page 1 of 2

 common stock issued is 10 percent, and the company’s tax rate is 40 30 $2,200,001 and above
percent. What is the company’s weighted average cost of capital, WACC?
The firm expects to have $350,000 of current retained earnings in the
14. Williams, Inc., which is interested in measuring its overall cost of coming year at a cost of 20 percent; once these retained earnings are
capital has gathered the following data. Under the terms described below, exhausted, the firm will issue new common stock. The company’s target
the company can sell unlimited amounts of all instruments. capital structure proportions are used in calculating the weighted
 Williams can raise cash by selling $1,000, 8%, 20-year bonds with average cost of capital follow.
annual interest payments. In selling the issue, an average premium of Source of Capital Target Capital Structure
$30 per bond would be received, and the firm must pay flotation costs of Long-term debt 0.30
$30 per bond. The after-tax cost of funds is estimated to be 4.8%. Preferred stock 0.20
Common stock equity 0.50
 Williams can sell 8% preferred stock at $105 per share. The cost of
issuing and selling the preferred stock is expected to be $5 per share.
1. Calculate the firm’s cost of capital prior to exhausting the firm’s
 Williams' common stock is currently selling for $100 per share. The
available current retained earnings.
firm expects to pay cash dividends of $7 per share next year, and the
2. Calculate the firm’s cost of capital for $2,000,000 of total new
dividends are expected to remain constant. The stock will have to be
financing.
underpriced by $3 per share, and flotation costs are expected to amount
3. Given the following information on the available investment
to $5 per share.
opportunities below, determine which projects should be selected.
 Williams expects to have available $100,000 of retained earnings in (See Table 11.4.)
the coming year; once these retained earnings are exhausted, the firm
Investment Initial Internal Rate
will use new common stock as the form of common stock equity financing.
Opportunity Investment of Return
Williams' preferred capital structure is A 600,000 22%
Long-term debt 30% B 400,000 21
Preferred stock 20 C 450,000 19
Common stock 50 D 500,000 17
E 600,000 16
a. The cost of funds from the sale of common stock for Williams, Inc. is F 700,000 16
b. The cost of funds from retained earnings for Williams, Inc. is
c. If Williams, Inc. needs a total of $200,000, the firm's weighted- II. TRUE OR FALSE. Write True if the statement is True otherwise explain what
average cost of capital would be makes the statement FALSE.
d. If Williams, Inc. needs a total of $1,000,000, the firm's weighted 16. The MINIMUM required rate of return for accepting any investment proposal
average cost of capital would be should be the one that keeps the common stock price (at the least) unchanged.
a. 7.6%; b. 7.0%; c. 6.6% 17. A firm's overall cost of capital is simply the sum of the firm's cost of
15. North Sea Oil has compiled the following data relative to current costs equity, cost of debt, and cost of preferred stock.
of its basic sources of external capital—long-term debt, preferred stock, 18. The tax advantage that comes from debt financing is of special benefit to
and common stock equity—for variant ranges of financing. a firm that is losing money.
Table 11.4 19. The complexity of the CAPM is offset by the fact that it gives an exact
Source of Cost Range of Total New Financing measure of the cost of equity capital.
Capital 20. A good proxy for E(Rm), the expected return for the market, is the
Long-term debt 7% $0–$2,000,000 expected return on a broad-based stock market index such as Standard and
8 $2,000,001–$3,000,000 Poor's 500.
10 $3,000,001 and above
Preferred stock 19% $0–$ 960,000
21 $960,001 and above
Common stock 20% $0–$ 700,000
24 $700,001–$1,600,000
26 $1,600,001–$2,200,000

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1. 9.4%
2 .Answer (C) is correct. The present value of $10,000 to be received in 20 years is
$1,784.30 based on a 9% present value table.
Answer (A) is incorrect because the price will be less than $10,000 since no interest is
paid until after 20 years. Answer (B) is incorrect because $9,174 is what you would pay
for a bond maturing in one year. Answer (D) is incorrect because $900 is a nonsense
answer.

3 $25
4 15%
5 50.4
6 50.67
7 36.25
8 1%
9 100
10
11 8.83%
12 B
13
.WACC = [0.3  0.084  (1 - 0.4)] + [0.7  ($2.5/($45  (1 - 0.1)) + 0.07)] = 10.73%.

14 A. The cost of funds from the sale of common stock is 7.6%.

The cost to the firm of selling new common stock can be determined using the Gordon Model
(dividend capitalization model). This formula states:
kcm = (D1 / (PO – u – f)) + g
= (7 / (100 – 3 – 5)) + 0
= 7 / 92
= 7.6%

B. The cost of retained earnings is 7.0%.

The cost of retained earnings, using the Gordon Model, ignores flotation costs and
underpricing, since the firm does not need to issue new stock. However, it must earn a
return for the owners of the retained earnings, that is, the existing shareholders, as
follows:
krm = (D1 / PO) + g, or krm = 7 / 100 + 0% = 7.0%

C. 20.2% represents the sum of the three elements of cost. What is needed is the weighted
average of the costs of the three components of capital, weighted according to each one's
weight in the mix of total capital.
An answer of 6.9% can be obtained only if new stock will be sold to fulfill the common stock
portion of the new capital. New stock will not be sold because the company needs $200,000,
of which 50%, or $100,000, will come from common stock. There will be no need to sell stock
when the total capital required is only $200,000. Since the full $100,000 needed from common
stock is available in retained earnings, the company will use its retained earnings to
fulfill the common stock portion of the spending. The cost of the retained earnings is lower
than the cost of new common stock, because there are no issuance fees.
Williams' preferred capital structure includes 50% common stock. $100,000 of retained
earnings (50% of the required $200,000 of capital) will be used before any common stock is
issued. Thus, no new common stock will need to be issued. The weighted-average cost of
capital will be determined based on the respective costs of the bonds, preferred stock, and
retained earnings. The after-tax cost of the bonds is given as 4.8%. The cost of the
preferred stock is 8.4%, calculated as the annual dividend of $8 per share divided by the
sale proceeds of $95. The cost of the retained earnings is 7% ($7 annual dividend divided by
the $100 market price of the common stock). These three costs are then weighted by the
preferred capital structure ratios: Long-term debt: 30% × 4.8% = 1.44% Preferred stock: 20%
× 8.4% = 1.68% Common equity: 50% × 7.0% = 3.50% Total (weighted average) 6.62% Rounding to
the nearest tenth produces the correct answer of 6.6%.
4.8% is the cost of the long-term debt. All funding will not be obtained from debt because
the firm wants to maintain a capital structure in which debt represents only 30% of the
total capital.
D. 27.8% represents the sum of the four elements of cost. What is needed is the weighted
average of the costs of the four components of capital, weighted according to each one's
weight in the mix of total capital.
4.8% is given as the cost of the long-term debt.
6.6% would be correct only if the equity capital were obtained totally from retained
earnings. Because only $100,000 of retained earnings is available, the remainder of the
equity capital must come from sale of new stock.
The after-tax cost of the bonds is given as 4.8%. The cost of the preferred stock is 8.4%,
calculated as the annual dividend of $8 per share divided by the sale proceeds of $95. The
cost of the retained earnings is 7% ($7 annual dividend divided by the $100 market price of
the common stock). The cost of new common stock is 7.6% ($7 dividend divided by the $92 net
proceeds from the sale). Retained earnings of $100,000 will be used to fulfill the common
stock portion of the capital before any new common stock is sold. The common stock portion
of all of the funding is 50% of $1,000,000, or $500,000. Since $100,000 of that will come
from retained earnings, that leaves $400,000 or 40% of the total funding that will need to
come from the issuance of new common stock. The new capital will therefore be as follows:
Long-term debt 30% $300,000 Preferred stock 20% 200,000 Retained earnings 10% 100,000 New
common stock 40% 400,000 And the weighted average cost of capital will be: Long-term debt
30% × .048 = 1.44% Preferred stock 20% × .084 = 1.68% Retained earnings 10% × .07 = 0.70%
New common stock 40% × .076 = 3.04% WACC 6.86% Rounding to the nearest tenth of one percent
results in the correct answer of 6.9%.
15 1. ka  (7)(0.25)  (19)(0.25)  (20)(0.50)  16.5%
2. ka  (7)(0.25)  (21)(0.25)  (26)(0.50)  20%.
3. Projects A, B, and C
16 T
17 F
18 F
19 F
20 T