FINANCIAL MANAGEMENT 2

Weighted Average Cost of Capital and Company

ValuationIndividual Exercise

1. T/F: Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing.

2. T/F: If investors become more risk averse, the probable effects are as follows: increase in cost of debt, decrease in cost of equity, and increase in WACC.

3. T/F: A value-maximizing firm will determine its optimal capital structure (which is defined as the mix of debt, preferred, and common equity that causes its stock price to be maximized), use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. 4. T/F: Failing to adjust the WACC for differences in risk would lead the firm to accept too many risky projects and reject too many safe ones.

5. What will be the effect of using book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued? A) There will be no effect on WACC decisions.B) The debt-to-value ratio will be overstated. C) The debt-to-value ratio will be understated. D) None of the above.Note: Value = MV of debt + MV of equity

6. For a company that pays no corporate taxes, its WACC will be equal to: A) the total value of its assets.B) the expected return on it assets. C) the expected return on its debt. D) the expected return on its equity.

7. Which of the following statements is most correct?A) Theoretically, the weights should be based on

market values, but if a firm’s book value weights are reasonably close to its market value weights, book value weights can be used as a proxy for market value weights. B) In general, the WACC should include the types

of capital used to pay for long-term assets, and these are typically short-term and long-term debt, preferred stock (if used), and common stock.C) The relevant WACC component costs are today’s historical costs rather than marginal costs.D) Since preferred dividends are tax deductible to the issuer, there is a need for a tax adjustment.

8. Which of the following will increase the WACC?A) Decrease in interest ratesB) Increase in corporate taxesC) Decrease in dividend and capital gains taxes

D) Decrease in stock prices

9. What is the WACC for a firm with 60% debt and 40% equity that pays 12% on its debt, 20% on its equity, and has a 35% tax rate?

10. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if: the tax rate is 35%, there is P10 million in common stock requiring a 10% return, and P8 million in bonds requiring an 6% return?

11. Information on the Balance Sheet of Heaven Corp are as follows:Total Assets = P6,000 Pref. Stock = P 300CL = P 500 Com. Stock = P1,800LT Liabilities = P1,500 RE = P1,900

Other information are as follows:EPSo = P18 g = 10%Plowback ratio = 0.60 After-tax cost of debt = 11%Stock Price = P50 Tax rate = 40%Flotation cost = 9% rp = 13%

What is the company’s WACC if new common stock (external equity) is used?

12. If the market risk premium is 7%, the risk free rate is 5%, and the beta is 1.5, what is the cost of common equity from retained earnings using the CAPM method?

13. In relation to no.11 and 12, what is the cost of new common stock based on CAPM? (Hint: Find the difference between Rs and Re, as determined by the DCF method and add that differential to the CAPM value for Rs.)

14. The current price of the firm’s 12% coupon, semi-annual payment, non-callable bonds with 5 years remaining to maturity is P1,162. It’s face value is P1,000. If the tax rate is 40%, what is the cost of debt?

15. The company’s stock currently sells for P50.00 per share. It is expected to pay a dividend of P4.00 next year, its growth rate is a constant 9.0%, and the company will incur a flotation cost of 8.0% of the market value if it sells new common stock. The firm's tax is 35%. What is the firm's cost of retained earnings?

ANSWERS:

1. F 9. 12.68%

2. F 10. P2.02M

3. T 11. 22.14%

4. T 12. 15.50%

5. C 13. 17.07%

6. B 14. 4.8%

7. A 15. 17%

8. D