UNIVERSITY OF SAN JOSE RECOLETOS

COLLEGE OF COMMERCE ACCOUNTANCY DEPARTMENT

MANAGEMENT ADVISORY SERVICES PART 2
SECOND SEMESTER AY 2016-2017

I. TRUE OR FALSE

1. "Capital" is sometimes defined as funds supplied to a firm by

investors.
2. The cost of capital used in capital budgeting should reflect the
average cost of the various sources of long-term funds a firm uses
to acquire assets.
3. The component costs of capital are market-determined variables in
the sense that they are based on investors' required returns.
4. Suppose you are the president of a small, publicly-traded
corporation. Since you believe that your firm's stock price is
temporarily depressed, all additional capital funds required during
the current year will be raised using debt. In this case, the
appropriate marginal cost of capital for use in capital budgeting
during the current year is the after-tax cost of debt.
5. The before-tax cost of debt, which is lower than the after-tax
cost, is used as the component cost of debt for purposes of
developing the firm's WACC.
6. The cost of debt is equal to one minus the marginal tax rate
multiplied by the average coupon rate on all outstanding debt.
7. The cost of debt is equal to one minus the marginal tax rate
multiplied by the interest rate on new debt.
8. The cost of preferred stock to a firm must be adjusted to an after-
tax figure because 70% of dividends received by a corporation may
be excluded from the receiving corporation's taxable income. Assume
tax rate is 30%
9. The cost of perpetual preferred stock is found as the preferred's
annual dividend divided by the market price of the preferred stock.
No adjustment is needed for taxes because preferred dividends,
unlike interest on debt, are not deductible by the issuing firm.
10. The cost of common equity obtained by retaining earnings is the
rate of return the marginal stockholder requires on the firm's
common stock.
11. For capital budgeting and cost of capital purposes, the firm should
always consider retained earnings as the first source of capital--
i.e., use these funds first--because retained earnings have no cost
to the firm.
12. Funds acquired by the firm through retaining earnings have no cost
because there are no dividend or interest payments associated with
them, and no flotation costs are required to raise them, but
capital raised by selling new stock or bonds does have a cost.
13. The cost of equity raised by retaining earnings can be less than,
equal to, or greater than the cost of external equity raised by
selling new issues of common stock, depending on tax rates,
flotation costs, the attitude of investors, and other factors.
14. The firm's cost of external equity raised by issuing new stock is
the same as the required rate of return on the firm's outstanding
common stock.
15. The higher the firm's flotation cost for new common equity, the
more likely the firm is to use preferred stock, which has no
flotation cost, and retained earnings, whose cost is the average
return on the assets that are acquired.

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 16. For capital budgeting and cost of capital purposes, the firm should
assume that each peso of capital is obtained in accordance with its
target capital structure, which for many firms means partly as
debt, partly as preferred stock, and partly common equity.
17. In general, firms should use their weighted average cost of capital
(WACC) to evaluate capital budgeting projects because most projects
are funded with general corporate funds, which come from a variety
of sources. However, if the firm plans to use only debt or only
equity to fund a particular project, it should use the after-tax
cost of that specific type of capital to evaluate that project.
18. If a firm's marginal tax rate is increased, this would, other
things held constant, lower the cost of debt used to calculate its
WACC.
19. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt
is 8%, the current cost of equity is 16%, and the tax rate is 40%.
An increase in the debt ratio to 60% would decrease the weighted
average cost of capital (WACC).
20. Firms raise capital at the total corporate level by retaining
earnings and by obtaining funds in the capital markets. They then
provide funds to their different divisions for investment in
capital projects. The divisions may vary in risk, and the projects
within the divisions may also vary in risk. Therefore, it is
conceptually correct to use different risk-adjusted costs of
capital for different capital budgeting projects.

II. PROBLEMS
A. PLDT Telecom is considering a project for the coming year that will
cost 50 million. PLDT plans to use the following combination of
debt and equity to finance the said investment.

- Issue 15 million of 20-year bonds at a price of 101, with a

coupon rate of 8%, and flotation costs of 2% of par.

- Use 35 million of funds generated from earnings.

- The equity market is expected to earn 12%. Treasury bonds are

currently yielding 5%. The beta coefficient for PLDT is estimated to
be .60. DQZ is subject to an effective corporate income tax rate of
40%.

Assume that the after-tax cost of debt is 7% and the cost of equity
is 12%. Determine the weighted-average cost of capital.

B. Globe, Inc. is interested in measuring its overall cost of capital

and has gathered the following data. Under the terms described as
follows, the company can sell unlimited amounts of all instruments.

Globe can raise cash by selling 1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average
premium of 30 per bond would be received, and the firm must pay
flotation costs of 30 per bond. The after-tax cost of funds is
estimated to be 4.8%.
Globe can sell 8 preferred stock at par value, 100 per share.
The cost of issuing and selling the preferred stock is expected
to be 5 per share.
Globe' common stock is currently selling for 100 per share. The
firm expects to pay cash dividends of 7 per share next year, and
the dividends are expected to remain constant. The stock will
have to be underpriced by 3 per share, and flotation costs are
expected to amount to 5 per share.
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 Globe expects to have available 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.
Globe's preferred capital structure is:

Long-term debt: 30%

Preferred stock: 20%
Common stock: 50%

1. The cost of funds from the sale of common stock is

2. The cost of funds from retained earnings is
3. If Globe, Inc. needs a total of 200,000, the firm's weighted-
average cost of capital would be

C. Kenny Rogers Inc. operates a chain of restaurants located in the

Southeast. The Company has steadily grown to its present size of 48
restaurants. The board of directors recently approved a large-scale
remodeling of the restaurant, and the company is now considering two
financing alternatives.

The first alternative would consist of

Bonds that would have a 9% effective annual rate and would net
19.2 million after flotation costs
Preferred stock with a stated rate of 6% that would yield 4.8
million after a 4% flotation cost
Common stock that would yield $24 million after a 5% flotation
cost

The second alternative would consist of a public offering of bonds

that would have an 11% effective annual rate and would net 48
million after flotation costs.

Kenny Roger's current capital structure, which is considered

optimal, consists of 40% long-term debt, 10% preferred stock, and
50% common stock. The current market value of the common stock is
30 per share, and the common stock dividend during the past 12
months was 3 per share. Investors are expecting the growth rate of
dividends to equal the historical rate of 6%. Kenny Rogers is
subject to an effective income tax rate of 40%.

1. The after-tax cost of the common stock proposed in Kenny Rogers'

first financing alternative would be?
2. Assuming the after-tax cost of common stock is 15%, the after-tax
weighted marginal cost of capital for Kenny Rogers' first
financing alternative consisting of bonds, preferred stock, and
common stock would be?
3. The after-tax weighted marginal cost of capital for Kenny Rogers'
second financing alternative consisting solely of bonds would be?

END OF ASSIGNMENT

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