Multiple Choice - Concepts

1. It is the minimum return that a project must earn to leave the value of the company unchanged.
a. Current borrowing rate.
b. Capitalization rate.
c. Cost of capital.
d. Discount rate.

2. It is the main objective of a firm in determining its capital structure

a. Minimizes the firm’s tax liability.
b. Maximizes the stock price of the firm
c. Minimizes firm’s risk.
d. Maximizes the firm’s degree of financial leverage.

3. Which of the following estimates the cost of equity capital for use in determining a firm's weighted-
average cost of capital?
a. Current dividends per share, expected growth rate in dividends per share, and, current book value
per share of common stock.
b. Current dividends per share, expected growth rate in dividends per share, the current
market price per share of common.
c. Current earnings per share, expected growth rate in dividends per share, and current market price
per share of common stock.
d. Current earnings per share, expected growth rate in earnings per share, and current book value per
share of common stock.

4. When using the IRR, a project should be accepted when it is:

a. equal to the project’s cost of capital
b. greater than the firm’s cost of capital
c. equal to the firm’s cost of capital
d. greater than the project’s cost of capital
e. greater than cost of debt

5. Which of the following statements is/are most correct?

I. The firm’s cost of capital is usually larger than the project’s cost of capital.
II. The more risky the project under consideration, the higher its cost of capital.
III. A firm should accept a project only if its IRR is greater than the firm’s cost of capital.

a. Only I is correct
b. Only II is correct
c. Only III is correct
d. I and II are correct
e. II and III are correct

6. All of the statements are correct, except

a. The cost of capital is the hurdle rate that the project must exceed.
b. The cost of capital is a key criterion in project evaluation.
c. When a firm ignores the cost of capital, investments in subpar projects destroy wealth.
d. When cash flows are uncertain, the cost of capital represents the interest rate the firm
would pay if it had to borrow the money to finance the investment.
7. Which of the following statement/s is/are correct?
 I. Preferred stock is considered a high breed financing
II. Preferred stock has preference over common stock in terms of payment of dividends.
III. Preferred stockholders have higher claim than bondholders in bankruptcy.

a. I and II are correct

b. II and III are correct
c. I and III are correct
d. Only II is correct
e. Only III is correct

8. Which of the following statements is false?

I. The firm’s cost of capital is a weighted average of the costs of debt and equity.
II. The cost of debt is the interest rate the firm pays when it issues debt on a before-tax basis.
III. The cost of equity is the minimum expected rate of return that the firm’s stockholders require.

a. I and II are correct

b. II and III are correct
c. I and III are correct
d. Only II is correct
e. Only III is correct

9. In evaluating an investment proposals, the projects’ expected rate of return are compared with the
weighted-average rate of return. This standard rate is the company must pay to the providers of
funds. It is the cost of using funds and is more commonly called as
a. discount rate.
b. capital expenditure.
c. capital.
d. cost of capital.

10. Which of the following is NOT a capital component when calculating the weighted average cost of
capital (WACC) for use in capital budgeting?
a. Long-term debt.
b. Short-term notes payable.
d. Common stock.
e. Preferred stock.

11. All of the following statements are wrong, except

a. A change in a company’s target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the individual capital
components.
c. Flotation costs associated with issuing new common stock normally reduce the WACC.
d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital
will decline.

12. For a company whose target capital structure calls for 50% debt and 50% common equity, which of
the following statements is CORRECT?
 I. The interest rate used to calculate the WACC is the average after-tax cost of all
the company's outstanding debt as shown on its balance sheet.
II. The WACC exceeds the cost of equity.
III. The cost of equity is always equal to or greater than the cost of debt.

a. I and II are correct

b. II and III are correct
c. I and III are correct
d. Only II is correct
e. Only III is correct

13. It is the rate of return a firm must earn on its investments in projects in order to maintain the market
value of its stock.
a. net present value
b. internal rate of return
c. cost of capital
d. accounting rate of return

14. Which of the following statements is correct? The cost of capital reflects the cost of funds
a. The cost of capital reflects the cost of funds over a short-run time period.
b. The cost of capital reflects the cost of funds at a given point in time.
c. The cost of capital reflects the cost of funds over a long-run time period.
d. The cost of capital reflects the cost of funds at current book values.

15. It is a weighted average of the cost of capital that reflects the interrelationship of external and internal
financing decisions.
a. risk premium
b. nominal cost
c. cost of capital
d. risk-free rate

16. It is the firm's desired optimal mix of debt and equity financing.
a. book value
b. market value
c. cost of capital
d. target capital structure

17. Which of the following needs a tax adjustment in determining the cost of funds?
a. common stock
b. preferred stock
c. long-term debt
d. retained earnings

18. Which of the following is the primary reason why debt is generally the least expensive source of
capital?
a. fixed interest payments.
b. its position in the priority of claims on assets and earnings in the event of liquidation.
c. the secured nature of a debt obligation.
d. the tax deductibility of interest payments.
19. The cost of retained earnings is
a. zero.
b. equal to the cost of a new issue of common stock.
c. equal to the cost of common stock equity.
d. irrelevant to the investment/financing decision.

20. The constant growth under the Gordon’s growth model is based on the assumption that the value of a
share of common stock is
a. the sum of the dividends and expected capital appreciation.
b. equal to the present value of all expected future dividends.
c. determined based on an industry standard P/E multiple.
d. determined by using a measure of relative risk called beta.

Problems
1. RDF2 provides you the following information:

Market price P48.00

Expected dividend P 3.50
EPS P 6.00
Beta 1.20
Expected rate of return on market 10.0%
Risk-free rate 5.0%
Constant growth rate 5.0%

RDF 2 is issuing new common stock for P44 per share, inclusive of flotation cost. Determine the cost
of external equity capital using the GGM.

Answer: ke = D1 + g = P3.50 + 0.05 = 0.1295 or 12.95%

P0 P44.0

2. Determine the weighted cost of capital of Illustrados that will finance its Project X44 with P80
million of long-term debt,12.5% and P120 million in retained earnings, 16.0%. The company's
marginal tax rate is 40%.

Answer: ke = (wd x kd) + (we x ke)

= (0.40 x 12.5%(1 - 0.4)) + (0.60 x 16.0%)
= 12.6%

3. What is the cost of debt of a P100 million debt issued by Zafra, Inc. Assume that Zafra, Inc. has a
40% marginal tax rate. This long-term debt issued has a yield 12% to the company.

Answer : kd = ki(1 - T) = 12%( 1- 0.40) = 7.2%

4. MC, Incorporated issues five percent preferred stock with selling price of P50 per share. The cost of
issuing and selling the stock was P2 per share. The firm's marginal tax rate is 30 percent. The cost of
the preferred stock is
 Answer: kp = D1 = 0.05(50) = 5.21%
P0 - F 50 - 2

5. The following information were provided by V-Power:

Beta 0.80.
Risk-free rate 6.5%
Expected return on the stock market 16.0%,

Determine the cost of equity capital for the firm using the CAPM.

Answer: ke = rf + b(rm - rf)

= 6.5% + 0.80(16% - 6.5%)
= 14.1%

6. The target capital structure of PNOC is 30 percent debt and 70 percent equity. If PNOC expects to
have a net income of P3.4 million and a dividend payout ratio of 40 percent, what will be its equity
break point?

Answer: Equity break point = NI(1 –DPO)

Equity ratio

= P3.4M(1 - 0.4)
0.7
= P2,914,286

7. Pinok, a manufacturing firm, provided you the following information:

Current dividend P2.50 per share

Constant growth rate 7.50%
Beta 1.45
Risk-free rate 9.30%

The firm is expecting a market rate of return of 13.5%. Using CAPM, what is Pinok’s cost of equity?

Answer: ke = rf + b(rm – rf)

= 0.093 + 1.45(0.135 - 0.093)
= 0.154

8. A firm is planning to sell P50 million of 3.25 percent preferred stock at a price of P25 per share. The
flotation cost is P1.00 per share. What is the cost of preferred stock? Assume a marginal income tax
rate of 30%.

Answer: kp = D1
P0 - f

= P3.25
(P25 - P1)
 = 13.54%
9. Travel Bureau is into a project of expanding its business using internal financing. The following
information were provided for the analysis:

Beta 1.10
Risk free rate of interest 7.5%,
Market rate of return 12.0 %.
Flotation cost 5.0%

Using CAPM, what is Travel Bureau’s cost of capital?

Answer:

Cost of capital = rf + β(rm - rf)

= 7.5%+1.10(12.0% - 7.5%)
= 12.45%

10. Micah Sara earned P800,000 before taxes this year. The firm has a debt ratio of 30 percent, a
marginal tax rate of 30 percent, and a dividend payout ratio of 50 percent. GQ has no preferred stock.
What is GQ's break point for equity?
a. P280,000 c. P571,429
b. P400,000 d. P800,000

Answer: Retained earnings = EBIT(1 – T)(1 – DPO)

= P800,000(1 - 0.30)(1 - 0.5) = P280,000

Break point = Retained earnings

1 – Debt ratio

= P280,000
(1 - 0.3)

= P400,000

11. Empire Company uses only debt and common equity. It can borrow unlimited amounts at an interest
rate of ki = 12% as long as it finances at its target capital structure, which calls for 40% debt and 60%
common equity. Its last dividend was P2, its expected constant growth rate is 5%, and its common
stock sells for P20. Empire’s tax rate is 40%. Two projects are available: Project X has a rate of
return of 13%, while Project Y’s return is 10%. These two projects are equally risky and about as
risky as the firm’s existing assets.

Requirement:
1. Compute for the following:
a. Cost of debt

Answer: kd = ki(1 – T) = 12%(0.6) = 0.072 or 7.2%

b. Cost of equity
 Answer: ke = P2(1.05) + 5% = 15.5%
P20

c. WACC

Answer: WACC = wd(kd) + we(ke)

= 0.12 (1 - 0.40) (.40) + 0.60(15.50%)

= 12.18%

2. Which projects should Midwest accept?

Answer: Since the firm’s WACC is 12.18% and each of the projects is equally risky and
as risky as the firm’s other assets, Empire should accept Project X. Its rate of
return is greater than the firm’s WACC. Project Y should not be accepted, since
its rate of return is less than Empire’s WACC.

12. Pacquio Corporation has compiled the following financial data:

Source of Capital Book Value Market Value Cost

Long-term debt P10,000,000 P 8,500,000 5.0%
Preferred stock 1,000,000 1,500,000 14.0
Common stock equity 9,000,000 15,000,000 20.0
P20,000,000 P25,000,000

Requirement: Compute for the following

a. WACC using book value weights.

Answer: ka = (.5)(5) + (.05)(14) + (.45)(20) = 2.5 + .7 + 9 = 12.2%

b. WACC using market value weights.

Answer: ka = (.34)(5) + (.06)(14) + (.60)(20) = 1.7 + .84 + 12 = 14.5%

13. Della Corporation has a target capital structure of 60% common equity and 40% debt to fund its P10
billion in operating assets. Furthermore, Della Corporation has a WACC of 13%, a before-tax cost of
debt of 10%, and a tax rate of 40%. The company’s retained earnings are adequate to provide the
common equity portion of its capital budget. Its expected dividend next year (D 1) is P3, and the
current stock price is P35.

Requirement:
a. What is Della Corporation’s expected growth rate?
 Answer: Examining the DCF approach to the cost of retained earnings, the expected
growth rate can be determined from the cost of common equity, price, and
expected dividend. However, first, this problem requires that the formula for
WACC be used to determine the cost of common equity.

WACC = wd(kd)(1 – T) + we(ke)

13.0% = 0.4(10%)(1 – 0.4) + 0.6(ke)
10.6% = 0.6rs
ke = 0.17667 or 17.67%.

From the cost of common equity, the expected growth rate can now be
determined.

ke = D1/P0 + g
0.17667= P3/P35 + g
g = 0.090952 or 9.10%.

b. If the Della Corporation’s net income is expected to be P1.1 billion, what portion of its net
income is the firm expected to pay out as dividends?

Answer: From the formula for the long-run growth rate:

g = (1 – Div. payout ratio)  ROE = (1 – Div. payout ratio)  (NI/Equity)

0.090952 = (1 – Div. payout ratio)  (P1,100 million/P6,000 million)
0.090952 = (1 – Div. payout ratio)  0.1833333
0.496104 = (1 – Div. payout ratio)
Div. payout ratio = 0.503896 or 50.39%.

14. DCP’s balance sheet shows a total of noncallable P40 million long-term debt with a coupon rate of
8.00% and a yield to maturity of 10.00%. This debt currently has a market value of P50 million. The
balance sheet also shows that the company has 10 million shares of common stock, and the book
value of the common equity (common stock plus retained earnings) is P60 million. The current stock
price is P20.00 per share; stockholders' required return, k e, is 15.00%; and the firm's tax rate is 30%.
The CFO thinks the WACC should be based on market value weights, but the president thinks book
weights are more appropriate. What is the difference between these two WACCs?

Answer:

Book value weights

Capital Weights Cost of capital WACC

Debt P 40.00 40.00% 7.00% 2.80%
Equity 60.00 60.00% 15.00% 9.00%
Total P100.00 100.00% 11.80%

Market value weights

Capital Weights Cost of capital WACC
Debt P 50.00 20.00% 7.00% 1.40%
Equity P200.00 80.00% 15.00% 12.00%
 Total P250.00 100.00% 13.40%

Difference in WACC = 13.40% - 11.80% = 1.60%