SOLUTION TO AVERAGE AND DIFFICULT QUESTIONS

THEORY

10-1 Probable Effect on

rd(1 T) rs WACC

a. The corporate tax rate is lowered. + 0 +

b. The Federal Reserve tightens credit. +1 +1 +1

c. The firm uses more debt; that is, it increases

its debt/assets ratio. 02/+ +3 0/+/-4

d. The dividend payout ratio is increased. 0 0/+/-5 0/+/-6

e. The firm doubles the amount of capital it raises

during the year. 0 or +7 0 or +7 0 or +7

f. The firm expands into a risky new area. + + +

g. The firm merges with another firm whose earnings

are counter-cyclical both to those of the first firm and
to the stock market.

h. The stock market falls drastically, and the firms stock

price falls along with the rest. 0 + +

i. Investors become more risk averse. + + +

j. The firm is an electric utility with a large investment in

nuclear plants. Several states propose a ban on
nuclear power generation. + + +

1 This will result to difficulty in borrowing money, hence, less money supply. This tends
to increase interest rates, therefor, increase the after tax cost of debt. If this results to
the increase in risk-free rate (t-bills or t-bonds), cost of equity will also increase (using
CAPM).)
2 No effect if the increase in debt is within the debt breakpoint;
3 Risk of the company increases thats why risk of the shareholders will increase, thus
requiring a high return on the stock;
4 It depends on the effect of the tax savings (lowers WACC), increase in risks of
bondholders and shareholders (increases WACC) or just an offset between the two
factors (no effect on WACC);
5 Increase in dividend decreases the RE, thus may increase the cost of equity (use new
CS if required capital exceeds the new RE breakpoint), otherwise, cost of equity stays
the same; the cost of equity may decrease if investors like dividends (will increase the
demand for the stocks, thus increases the stock price; using the DCF/DDM approach,
this occurs if the % increase in the stock price (denominator) is greater than the %
increase in the dividends (numerator), try to assume figures to determine the effect of
this;
6 The effect on the WACC depends on the effect on the cost of equity;
7 If the increase in the amount of debt (doubling of debt) increases both the interest rate
and cost of equity (since risk of the company increases), the WACC will increase,
otherwise, there will be no effect.
PROBLEMS

10-11 (Cost of Equity and Wd)

rs = D1/P0 + g
= P2(1.07)/P24.75 + 7%
= 8.65% + 7% = 15.65%.
Let X = Wd and (1 X) = Wc

WACC = X (rd)(1 T) + (1-X) (rs);

13.95% = X (11%)(1 0.35) + (1 X)(15.65%)

0.1395 = 0.0715 X + 0.1565 0.1565 X
-0.017 = -0.085 X
X = 0.20 = 20%.

Note: For questions like this and all related questions, wherein the sum of
components (e.g. Wc + Wd) equals 100%, always represent the unknown as X and
the other component as 1 X (use algebra)

10-14 (Cost of Preferred Stocks with Flotation Costs)

P11
rp = = 11.94%.
P92.15

Note: If flotation costs are given, always include these in computing for the cost
of preferred stocks (rp)same with the cost of new CS (re)

10-15 (WACC, Cost of Retained Earnings, Growth Rate in Dividends)

a. 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(rd)(1 T) + wc(rs)

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

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

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

b. 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%.

* P6,000 million (Equity) = P10,000 billion x 60%

Note: In computing for the ROE, the NI and Equity should be of the same time
frame. Normally, the NI and Equity in the books are used (historical). In this
 problem, ROE is computed by using the expected NI and the equity portion of the
capital to be raised, which are both in the future.

10-17 (Growth Rate and Expected EPS)

D1
a. rs = +g
P0
P3.60
0.09 = +g
P60.00
0.09 = 0.06 + g
g = 3%.

b. Current EPS P5.400 Alternatively:

Less: Dividends per share 3.600 EPS1 = EPS0(1 + g2) = P5.40(1.03) =
Retained earnings per share P1.800 P5.562.
Rate of return 0.090
Increase in EPS P0.1621
Plus: Current EPS 5.400
Next years EPS P5.562

Note: 1 Since it was mentioned that the retained earnings (or earnings/income
retained and reinvested) will earn the same return as with the expected rate of
return on the stock, the increase in EPS is computed as the amount retained
times the stocks expected rate of return.

2 In general, the company increases its dividend based on the increase (growth)
in its performance, which is shown in the increase (growth) in its net income or
EPS. Thus the growth rate in EPS may be applied as the growth rate in
dividends. But this is not absolute.

10-16 (Growth Rate with Period of More than 1 Year and Cost of Retained Earnings)

a. The computation for growth rate given a period of more than 1 year is similar
with the computation of IRR or rate of return for capital budgeting (but without
the annual cash flows; only the cash outflow today or cost of investment and
cash inflow at the end of the projects life are present) and YTM for bond
computation (but without the annual coupon like a zero coupon bond; only the
bond price or value and face or maturity value are present).

Hence, to compute for the growth rate, the following can be used and done:

1) Exact IRR or YTM computation (using financial calculator or excel)

Using excel, encode the following:

= rate (N, annual cash flow/coupon, cost of investment/bond price/PV,

cash inflow at the end of the project/face value/FV)

=rate(5, 0, -4.42, 6.50) g = 8.02%

2) Estimated or approximate YTM computation (formula)

g= (P6.50-P4.42)/ 5 years = 0.416 = 7.92%

(P4.42 x .60) + (P6.50 x .40) 5.252

b. D1 = D0(1 + g) = P2.60(1.08) = P2.81.

c. rs (using the estimated g) = D1/P0 + g = P2.81/P36.00 + 7.92% = 15.73%.

 Note: For item a, the EPS in year 2007 (P4.42) is considered as the cost of
investment or bond price because it is the earlier or beginning amount (present
value) while the EPS in 2012 (P6.50) is considered as the cash inflow at the end
of the project or face value because it is the later or ending amount (future
value). In addition, 5 years is the period or N since growth rate is applicable 5
times (first is from 2007 to 2008, second is from 2008 to 2009 and so on until
2012).

For item c, the estimated growth rate (as opposed to the exact growth rate) was
used since for classroom purposes, the exact growth rate cannot be computed
(absence of financial calculator or excel function). But in application situation or
real-life scenario, the exact growth rate should be used.

10-20 (Growth Rate with Period of More than 1 Year and WACC)

a. After-tax cost of new debt: rd(1 T) = 0.09(1 0.4) = 5.4%.

Cost of common equity: Calculate g as follows:

1) Exact g (using excel)

Encode =rate(9, 0, -3.90, 7.80) g = 8.01%

2) Estimated or approximate g

g= (P7.80-P3.90)/ 9 years = 0.433 = 7.94%

(P3.90 x .60) + (P7.80 x .40) 5.46

D1 (0.55)(P7.80)
rs (using the estimated g) = +g= + 0.0794
P0 P65.00
P 4.29
= + 0.0794 = 0.1454 = 14.54%.
P65.00

b. WACC calculation:
Target After-Tax Weighted
Component Weight Cost = Cost
Debt 0.40 5.4% 2.16%
Common equity (RE) 0.60 14.54 8.72
WACC= 10.88%

Note: For the computation of g (growth rate) and rs (cost of retained earnings),
same concept with that of 10-16 applies.

For the computation of the expected dividend or D1 or D2013, since it is mentioned

in the problem that the expected dividend at the end of the current year
(12/31/13) is 55% of the 2012 EPS, the computation is to multiply 0.55 by
P7.80 (2012 EPS). However, if it is not stated, the most logical computation of
D1 or D2013 is to apply the growth rate of 7.94%, thus increasing the amount from
P4.29 to P4.63 (P4.29 x 1.0794).

In addition, to assist your analysis, if specific dates are given, you need to
establish and determine the current date. In the problem, the current date is
1/1/13.

10-18 (WACC and Project Acceptance; No adjustment on Project Cost of Capital)

a. rd(1 T) = 0.10(1 0.3) = 7%.

rp = P5/P49 = 10.2%.
 rs = P3.50/P36 + 6% = 15.72%.

b. WACC: After-Tax Weighted

Component Weight Cost = Cost
Debt 0.15 7.00% 1.05%
Preferred stock 0.10 10.20 1.02
Common stock 0.75 15.72 11.79
WACC= 13.86%

c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

10-19 (Project Acceptance with Adjustments for Project Cost of Capital, Capital
Constraints and Additional Capital)

a. If all project decisions are independent, the firm should accept all projects whose
returns exceed their risk-adjusted costs of capital. The appropriate costs of capital
are summarized below:
Required Rate of Cost of
Project Investment Return (IRR) Capital
A P4 million 14.0% 12%
B 5 million 11.5 12
C 3 million 9.5 8
D 2 million 9.0 10
E 6 million 12.5 12
F 5 million 12.5 10
G 6 million 7.0 8
H 3 million 11.5 8

Therefore, Ziege should accept projects A, C, E, F, and H.

b. With only P13 million to invest in its capital budget, Ziege must choose the best
combination of Projects A, C, E, F, and H. Collectively, the projects would
account for an investment of P21 million, so naturally not all these projects may
be accepted.

Looking at the excess return created by the projects (rate of return minus the
cost of capital or the IRR method of accepting/rejecting projects), we see that
the excess returns for Projects A, C, E, F, and H are 2%, 1.5%, 0.5%, 2.5%, and
3.5%. The firm should accept the projects which provide the greatest excess
returns. Using that rationale, the first project to be eliminated from
consideration is Project E. This brings the total investment required down to
P15 million, therefore one more project must be eliminated. The next project
with the lowest excess return is Project C. Therefore, Ziege's optimal capital
budget consists of Projects A, F, and H, amounting to P12 million.

c. Since Projects A, F, and H are already accepted projects, we must adjust the
costs of capital for the other two value producing projects (C and E).

Required Rate of Cost of

Project Investment Return Capital
C P3 million 9.5% 8% + 1% = 9%
E 6 million 12.5 12% + 1% = 13%

If new capital must be issued, Project E ceases to be an acceptable project. On

the other hand, Project C's expected rate of return still exceeds the risk-
adjusted cost of capital even after raising additional capital. Hence, Ziege's new
capital budget should consist of Projects A, C, F, and H and requires P15 million
of capital, so an additional P2 million must be raised above the initial P13
million constraint.
 Note: For item b, if there are capital constraints, selecting which projects
to accept (prioritizing projects) should be best based on the profitability
index (PI). After using the PI, get the combination of projects which will
give the highest net present value to get the projects to be accepted. But
since the PIs and NPVs are not available, the next best tool to use is the
rate of return or IRR method. Prioritization is based on the excess of the
projects rate of return over the projects cost of capital.

You may ask, why not use the product of the rate of return or IRR and the
required investment (the resulting amount) and treat this as the NPV to be
used as the basis of the prioritization? NPV is more superior than IRR.

The answer is that the computation will not directly result to the NPV.
The computation may result to the NPV assuming that the projects have
the same lives. But since no information is given about the length of the
investments, it is safe and more accurate to use the rate of return or IRR
method.

NOTES TO PROBLEMS

10-21

1) Since the problem states that In it cost of capital computations, the company
considers only long-term capital; hence, it disregards current liabilities for
calculating WACC., current liabilities should not be included in computing for
the Wd.

2) Since two answers can be arrived at in getting the cost of retained earnings
(DCF/DDM and CAPM), and that there is no mention which of the following
methods has the better estimate of the input variables, the best figure to use as
the cost of retained earnings is the average of the two methods.

3) In computing for the cost of new CS (re) using CAPM, find the difference between
re and rs using DCF/DDM and add the differential percentage to the cost of
retained earnings (rs) using CAPM.

4) In relation to item 2, since two answers can also be arrived at in getting the cost
of new CS (DCF/DDM and CAPM), the best figure to use is the average of the
two methods.

5) If the WACC is asked and the problem states that the company expands rapidly
that it must issue new common stock, since WACC represents more of the
composite cost of capital, the equity portion should consists both of the retained
earnings and new CS. But since it cannot be determined in the problem
whether the equity will come from both retained earnings and new common
stock or new common stock only because no specific capital budget is given, it
is logical to assume that the problem asks for the marginal cost of capital or last
peso WACC. Hence, in computing for the WACC, consider only that the equity
consists of new CS.

10-22

1) In relation to question a.1), current liabilities are generally excluded in the

computation of Wd, specifically if these consist of accounts payable and
accruals, since these are not used to pay long-term assets/investments. Short-
term interest-bearing debt, such as notes payable, is included, if it is used to
pay for the portion of long-term assets/investments (e.g. to acquire fixed assets
rather than just to finance working capital needs such as inventories).
2) In relation to question a.2), component costs should be computed on an after-
tax basis. For debt, because interest expense results to tax savings, the interest
rate should be adjusted for the effect of taxes. For equity, stockholders (both
preferred and common stockholders) are primarily concerned with their
dividends. Since dividends come from retained earnings, the accumulation of
net income after tax, no tax adjustments are necessary. The dividends to be
used in computing for the cost of preferred stock and cost of common stock
(using DCF/DDM) are already after-tax.

3) In relation to question a.3), since WACC is primarily used for capital budgeting
purposes, this relates to the cost of raising new capital. Hence, relevant costs
are marginal costs rather than historical costs.

4) In relation to question b, no interest rate or YTM is given, other than the coupon
rate (12%). Since the bond price (P1,153.72), remaining maturity (life or N; 15
years), and face value (P1,000) are given, in addition to the coupon rate, the
YTM can be computed to represent the return on debt (rd). The coupon rate
may not be used as rd in this case. (Note: In the book of Brigham, for problems
on bond computation, if silent, face value is assumed to be P1,000).

In addition, although the bond has no flotation costs since it is privately placed,
in case the bond incurs flotation costs, it should be deducted from the bond
price of P1,153.72 to get the YTM.

5) In relation to question d.2., since no t-bill rate is given, the t-bond rate (7%) is
used as the rf to compute for the cost of retained earnings using CAPM method.
In practice, the t-bond rate, specifically the yield for a 10-year t-bond, is used as
the rf. Again, the rationale for this one is because equity is long-term, the
appropriate rate to be used in computing for the cost of equity should also be
long-term.

6) In relation to question f., the interest rate to be used as the bond yield in
computing for the cost of retained earnings using the bond-yield-plus-risk
premium approach is the interest rate on the companys bond. Based on the
problem, the best rate to represent this is the YTM on the companys bond
(computed in question b).

7) In relation to question g, the final estimate of the cost of retained earnings (rs)
should be based on the method which gives the best estimate of the input
variables. Generally, if silent, the average of the three methods (CAPM,
DCF/DDM, and Bond-yield-plus-risk premium) is used. If one has the superior
or better estimate over the others, it is used. If weights are given to represent
the accuracy of the estimates, weighted average of the 3 is used.

In addition, some financial analysts believe that a method is more appropriate

to a specific company or industry over the others. In this case, the method
considered as appropriate is used.

8) In relation to question i.1., the two methods in adjusting for flotation costs are
the addition to the cost of capital (using DCF/DDM) and addition to the cost of
investment (reduction in the rate of return or IRR).

9) In relation to question l, the composite WACC reflects the risk of an average

project undertaken by the firm. Therefore, the WACC only represents the
hurdle rate for a typical project with average risk. Different projects have
different risks. The projects WACC should be adjusted to reflect the projects
risk.