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Show Solutions and explain how did they solve  (Cost of Capital, Financial Leverage and Capital Structure)

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Problem 1

X Company wants to raise P20,000,000 to expand its portfolio of second mortgages and substandard auto loans. Bank financing agreements limit X Company to a maximum of 75% debt. They can borrow money at 14%, and they are in the 35% tax bracket. New retained earnings are P200,000. X Company can privately place P1,000,000 of preferred stock at 12%, and preferred floatation costs are 8.0%. Their current stock price is P20; dividends are P0.85, and have been growing at 11% per year; and flotation costs are P5 per share.


Compute the weighted average cost of capital considering the following strategy.

a. What is the weighted average cost of new capital using only new retained earnings (30%) and debt (70%)?

b. What is the weighted average cost of new capital from the preferred stock offering with a blend of 25% preferred and 75% debt?

c. What is the weighted average cost of new capital maintaining a mix of 25% newly issued common stock and 75% debt? 


Problem 2

Compute the cost of capital for retained earnings of Iceland using the given information: Iceland's last dividend was P0.50 per share. Their cash flow for the last five years has been growing at a steady 12% per year. Their current stock price is P22. Their long-term bonds have a yield to maturity of 8.6%. Pinelands has a beta of 0.75. Right now, the equity risk premium is 8%, and the risk-free rate of return is 4.8%. The policy is to use a 5% judgment risk premium on any company that, like Iceland, has under $100 million in revenue.

Compute the cost of new retained earnings capital using

(a) the dividend method,

(b) the CAPM method 


Problem 3

Real's capital structure consists of: (1) 20% accounts payable and other non-interest-bearing debt, (2) 45% bank debt on which they pay 10% interest, (3) 5% preferred stock, (4) 15% retained earnings, and (5) 15% stock at par plus additional paid in capital. They are in the 40% tax bracket. They have outstanding preferred stock with a P75 coupon rate for every P1,000 of par value. They have estimated their cost of common equity at 13.8%.

What is their present WACC? 


Problem 4

Company Z has a bond issue outstanding that matures in fourteen years. The bonds pay interest semiannually. Currently, the bonds are quoted at 98 percent of face value and carry an 8 percent coupon. The firm's tax rate is 35 percent.

What is the firm's after-tax cost of debt? 


Problem 5

Google is evaluating its cost of capital under alternative financing arrangements. In consultation with investment bankers, Google expects to be able to issue new debt at par with a coupon rate of 9.0% and to issue new preferred stock with a P2.90 per share dividend at P24 a share. The common stock of Google is currently selling for P23.00 a share. Google expects to pay a dividend of P1.60 per share next year. Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year. Google' marginal tax rate is 35%. If Google raises capital using 25% debt, 10% preferred stock, and 65% common stock,

what is Google's cost of capital?


Problem 6

Carolina Fastener, Inc., makes a patented marine bulkhead latch that wholesales for P6.00. Each latch has variable operating costs of P3.50. Fixed operating costs are P60,000 per year. The firm pays P12,000 interest and preferred dividends of P8,500 per year. At this point, the firm is selling 30,000 latches per year and is taxed at a rate of 30%.

Compute for the DOL, DF, and DTL.

If the sales increased by 25%, by how much is the increase or decrease in the EPS?

If the sales decreased by 20%, by how much is the increase or decrease in the operating profit?


Problem 7

Medallion Cooling Systems, Inc., has total assets of P10,000,000, EBIT of P2,000,000, and preferred dividends of P200,000 and is taxed at a rate of 30%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment: 


Capital structure debt ratio Cost of debt, rd Number of common stock shares Required return, rs  

0% 0% 200,000 12%

15% 8 170,000 13

30% 9 140,000 14

45% 12 110,000 16

60% 15 90,000 20

Choose the optimal capital structure. Justify your choice

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