CHAPTER 10

RISKS AND RETURNS

THEORIES:

1. The use of financial leverage by the firm has a potential impact on which of the
following?
(1) The risk associated with the firm
(2) The return experienced by the shareholder
(3) The variability of net income
(4) The degree of operating leverage
(5) The degree of financial leverage

A. 1, 3, 5
B. 2, 3, 4, 5
C. 1, 2, 3, 5
D. 1, 2, 5

2. Which of the following is not a key determinant of financial leverage?

A. Level of debt
B. Cost of debt
C. Technology
D. Capital structure
3. The degree of operating leverage for Alabang Company is 3.5, and the degree of
operating leverage for Paranaque Corporation is 7.0. According to this information,
which firm is considered to have greater risk?
A. Alabang Company
B. Paranaque Corporation
C. The degree of operating leverage is not a measure of business risk, so it is not possible
to tell which firm has the greater business risk given in the about information.
D. To determine which firm has the greater business risk, we need to know the operating
income (NOI or EBIT) of each firm. Paranaque Corporation would have less business
risk if its operating income is at least twice that of Alabang Company.
4. It refers to management strategy if financing assets which borrowed capital; such an
extensive use, raises the entire risk thereby impacting on the return on common
stockholders’ equity to be above or below the rate of return on total assets.
A. Factoring
B. Leverage
C. Mortgage
D. Resrtucturing
5. A decrease in the debt ratio will least likely affect:
A. Financial risk
B. Business risk
C. Systematic or market risk
D. Total risk
6. Which of the following changes would tend to increase the company cost of capital for a
traditional firm?
A. Decrease the proportion of equity financing
B. Increase the market value of the debt
C. Decrease the proportion of debt financing
D. Decrease the market value of the equity
7. When establishing their optimal capital structure, firms should strive to
A. minimize the weighted average cost of capital
B. minimize the amount of debt financing used
C. maximize the marginal cost of capital
D. none of the given choices
8. Although debt financing is usually the cheapest component of capital, it cannot be used
excessively because
A. the interest rates may change
B. the firm’s stock price will increase and raise the cost of equity financing
C. the financial risk of the firm may increase thus drive up the cost of all sources of
financing
D. none of the given choices
9. The mix of debt, preferred stock, and common equity with which the firm plans to raise
capital is called the
A. financial risk
B. operating leverage
C. business risk
D. target capital structure
10. Financial risk refers to the:
A. risk of owning equity securities
B. risk faced by equity holders when debt is used
C. general business risk of the firm
D. possibility that interest rates will increase
11. The mix of debt and equity minimizes the cost of capital is the
A. optimal operating leverage
B. target financial structure
C. optimal degree of combined leverage
D. optimal capital structure
12. Which of the following situations is likely to have the highest combined business and
financial risk impact upon business?
 A. A new labor-intensive operation is funded with operating cash flows
B. A fully automated plant is completed, funded with retained earnings
C. A fully automated plant is completed, funded with the issuance of 10-year bonds
D. An automated, but dated plant in the southern region is closed and operations are
resumed in a labor-intensive plant in Central Luzon.
13. The most commonly held view of capital structure is that the weighted average cost of
capital
A. falls first with moderate levels of leverage and then increases
B. does not change with leverage
C. increases proportionately with increases in leverage
D. increases with moderate amounts of leverage and then falls
14. The degree of financial leverage for April Company is 3.0, and the degree of financial
leverage for August Corporation is 6.2. According to this information, which firm is
considered to have greater overall risk?
A. April Company
B. August Corporation
C. The degree of financial leverage is a measure of financial risk, so the only
conclusion that can be made with the information given is that August Corporation
has greater financial risk than April Company – we cannot tell which firm has
greater total risk.
D. To determine which fir, has the greater total risk, we need to know the financial
breakeven point of each firm.
15. A high price-earnings ratio usually indicates that a firm is a:
A. value stock
B. growth stock
C. convertible stock
D. constant security
16. If a bond’s value rises above its par value during its life, interest rate have
A. gone up
B. gone down
C. stayed the same
D. there is no correlation with interest rates
17. What will be the price of a bond in which the YTM is higher than the coupon rate?
A. Below its face value
B. Above its face value
C. At face value
D. There is no relation between price and the yield
18. Which of the following statements is correct?
A. Bond prices and interest rates move in the same direction, i.e., if interest rates rise, so
will bond price.
B. The market price of a discount bond will approach the bond’s par value as the maturity
 date approaches. Barring changes in the probability of default, the value of the bond
cannot fail to increase each year as the time to maturity approaches.
C. The “current yield” on a non-callable discount bond will normally exceed the bond’s
yield to maturity.
D. The “current yield” on a non-callable discount bond will normally exceed the
bond’s coupon interest rate.
19. The price of a stock is the:
A. future value of all expected future dividends, discounted at the dividend growth rate.
B. present value of all expected future dividends, discounted at the dividend growth rate.
C. future value of all expected future dividends, discounted at the investor’s required
return.
D. present value of all expected future dividends, discounted at the investor’s
required return.
20. What happens when a bond’s expected cash flows are discounted at a rate lower than the
bond’s coupon rate?
A. The price of the bond increases
B. The coupon rate of the bond increases
C. The par value of the bond decreases
D. The coupon payments will be adjusted to the new discount rate
21. The discount rate that makes the present value of bond’s payments equal to its price is
termed the:
A. rate of return
B. yield to maturity
C. current yield
D. coupon rate
22. The value of the stock
A. Increases as the dividend growth rate decreases
B. Increases as the required rate of return decreases
C. Increases as the required rate of return increases
23. The overall cost of long-term financing for the firm is called the:
A. weighted average cost of capital
B. cost of preferred stock
C. retained earnings breakpoint
D. none of the given choices
24. The overall weighted average cost of capital is used instead of costs for specific sources
of funds because
A. the use of the cost for specific sources of capital would make investment decisions
inconsistent
B. a project with the highest return would always be accepted under the specific cost
criteria.
 C. an investment funded by equity or debt is not relevant to this question
D. none of the given choices
25. Which of the following is not a component used in calculating the cost of capital?
A. Cost of short-term debt.
B. Cost of long-term debt.
C. Cost of common stock.
D. Cost of retained earnings.
26. The most expensive source of financing for a firm is:
A. debt
B. preferred stock
C. retained earnings
D. new common stock
27. The cost of capital at the retained earnings breakpoint is the:
A. weighted average cost of capital
B. marginal cost of capital
C. cost of new stock
D. none of the given choices
28. Which of the following is not associated with the cost of capital concept?
A. Minimum rate of return on new projects.
B. Weighted average of cost of new funds raised.
C. The required rate of return of investors
D. The historical cost of funds.
29. Which of the following is likely to increase a firm’s cost of capital?
A. Increasing the proportion of equity in the firm.
B. Increasing the proportion of debt in the firm.
C. The consideration of a below-average risk project.
D. Expectation of lower inflation in the future.
30. Which of the following are acceptable criteria for determining the weights in the
weighted average cost of capital?
A. Market value of the capital structure and historical costs of financing.
B. Market value of capital structure and target mix of debt and equity.
C. Using the after-tax cost of debt and the market value of the capital structure.
D. Using book values of the capital structure and the prior level of debt and equity.
31. The dividend growth model, when used, assumes that the total return on a share of
common stock is comprised of a:
A. capital gains yield and a dividend growth rate.
B. capital gains growth rate and a dividend growth rate.
C. dividend yield and the expected price next year.
D. dividend yield and a capital gains yield.
32. The capital asset pricing model (CAPM) states the expected:
A. risk premium on an investment is proportional to its beta.
 B. rate of return on an investment is proportional to its beta.
C. rate of return on an investment depends on the risk-free rate and the market rate of
return.
D. rate of return on an investment is dependent on the risk-free rate.
33. The drawback of the CAPM is that it:
A. ignore the return on the market portfolio
B. requires a single measure of systematic risk
C. ignores risk-free return
D. utilizes too many factors
34. Firms generally decide to call their bonds when interest rates:
A. rise.
B. drop.
C. remain the same.
D. there is no relationship between interest rates and the call provision.
35. If an individual stock’s beta is higher than 1.0, that stock is:
A. exactly as risky as the market.
B. riskier than the market.
C. less risky than the market.
D. none of the given choices
36. The component of risk-adjusted discount rate is derive from the risk of Treasury
securities is:
A. risk premium
B. cost of capital
C. call premium
D. risk-free rate
37. The component of the risk-adjusted discount rate that compensates the investor for
holding risky assets is the:
A. risk-free rate
B. cost of capital
C. risk premium
D. none of the given choices
38. Which of the following is incorrect regarding the measurement and interpretation of the
beta of a security?
A. Not all securities are equally affected by fluctuations in the market.
B. The sensitivity of a stock to market movements is known as alpha.
C. Stocks with a beta greater than 1.0 are particularly sensitive to market fluctuations.
Those with a beta of less than 1.0 are not so sensitive to such movements.
D. The average beta of all stocks is 1.0.
39. If you were willing to bet that the overall stock market was heading up on a sustained
basis, it would be logical to invest in:
A. high beta stocks
 B. low beta stocks.
C. stocks with large amounts of unique risk.
D. stocks that plot below the security market line.
40. What will happen to the expected return on a stock with a beta of 1.5 and a market risk
premium of 9% if the Treasury bill yield increases from 3% to 5%?
A. The expected return will remain unchanged.
B. The expected return will increase by 1.0%.
C. The expected return will increase by 2.0%.
D. The expected return will increase by 3.0%.
41. Which one of the following statements is true regarding the beta coefficient?
A. Beta is a measure of unsystematic risk.
B. A beta greater than one represents less systematic risk than the market.
C. Generally speaking, the higher the beta, the higher the expected return.
D. A beta of one indicates an asset is totally risk-free.
42. The major benefit of diversification is to:
A. increase the expected return
B. remove negative risk assets from the portfolio
C. reduce the portfolio’s systematic risk
D. reduce the expected risk
43. Stocks that have high financial rewards are generally accompanied by:
A. high dividend payments
B. low dividend payments because of internally generated growth
C. high risk
D. all of the given choices
44. The market risk premium is the:
A. difference between rate of return on an asset and the risk-free rate.
B. difference between rate of return the on market portfolio and the risk-free rate.
C. risk-free rate
D. market rate of return.
45. If a firm uses the same company cost of capital for evaluating all projects, which of the
following is likely?
A. Rejecting good low-risk projects
B. Accepting poor high-risk projects
C. Both choices are correct
D. Neither of the choices is correct
46. Using the company’s cost of capital to evaluate a project is:
A. always correct
B. always incorrect
C. correct for projects that are about as risky as the average of the firm’s other
assets.
D. none of the given choices
47. The use of the company’s cost of capital as the discount rate for a capital budgeting
proposal is inappropriate if:
A. it calculates a negative NPV for the proposal
B. the proposal has different degree of risk.
C. the company has unique risk.
D. the company expects to earn more than the risk-free rate.
48. In calculating the cost of common stock equity, the model that has the stronger
theoretical foundation is the:
A. constant growth model
B. variable growth model
C. Gordon model
D. capital asset pricing model
49. In general, it is more expensive for a company to finance with equity that with debt
because
A. Long-term bonds have a maturity data and must, therefore, be repaid in the future
B. Investors are exposed to greater risk with equity capital
C. The interest on debt is a legal obligation.
D. Equity capital is in greater demand than debt capital.
50. Which of the following is not a characteristic of the capital asset pricing model for
estimating the cost of equity?
A. The model is simple to understand and implement.
B. The model can be applied to all firms.
C. The model does not rely on any dividend assumptions or growth of dividends.
D. It is based upon the stock’s actual market price.
51. If nominal interest rates increase substantially but expected future earnings and dividend
growth for a firm over the long run are not expected to change, the firm’s stock price will
A. Increase
B. Decrease
C. Stay constant
D. Change, but in no determinable direction
52. Which of the following methods explicitly recognizes a firm’s risk when determining the
estimated cost of equity?
A. Capital asset pricing mode
B. Dividend-yield-plus-growth model
C. Bond-yield model
D. Return on equity
53. In practice, dividends
A. usually exhibit greater stability than earnings
B. fluctuate more widely than earnings
C. tend to be a lower percentage of earnings for mature firms
D. are usually changed every year to reflect earnings changes
54. According to the Capital Asset Pricing Model (CAPM), the relevant risk of a security is
its
A. Company-specific risk
B. Diversifiable risk
C. Systematic risk
D. Total risk
55. A measure that describes the risk of an investment project relative to other investment in
general is the
A. Coefficient of variation
B. Standard deviation
C. Beta coefficient
D. Expected return
56. A firm with a higher degree of operating leverage when compared to industry average
implies that the
A. Firm has higher variable costs
B. Firm’s profits are more sensitive to changes in sales volume
C. Firm is more profitable
D. Firm is less risky
57. When a company increases its degree of financial leverage
A. The equity beta of the company falls
B. The systematic risk of the company falls
C. The unsystematic risk of the company falls
D. The standard deviation returns on the equity of the company
58. The common stock of Homer Company pays a constant annual dividend. Thus, the
market price of Homer company’s stock will
A. increase over time.
B. decrease overtime
C. increase when the market rate of return increases
D. decrease when the market rate of return increases
59. The underlying assumption of the dividend growth model is that a stock is worth
A. the same amount to every investor regardless of the investor’s desired rate of return.
B. the present value of the future cash flows which it generates.
C. an amount computed as the next annual dividend by the market rate of return.
D. the same amount as any other stock that pays the same current dividend and has same
required rate of return.
E. an amount computed as the next annual dividend divided by the required rate of return.
60. Supernormal growth refers to a firm that increases its dividend by
A. three or more percent per year.
B. A rate of which is most likely not sustainable over an extended period of time
C. a constant rate of 2 or more percent per year
D. 5 or more per year
PROBLEMS:

1. If the pro form balance sheet shows that total assets must increase by P400,000 while
retaining a debt-equity ratio of .75 then:
A. debt must increase by P300,000.
B. equity must increase by the full P400,000
C. debt must increase by P171,428
D. equity must increase by P100,000
2. Leverage Corporation has a capital structure that consists of 65% and 35% debt. The
company expects to report P100 million in net income this year, and 67.5% of the net
income will be paid out as dividends. How large can the firm’s capital budget be this year
without having to include the cost of new common stock in its cost of capital analysis?
A. P100.0 million
B. P 67.5 million
C. P 50.0 million
D. P 32.5 million
3. The Equity Company projects the following for the upcoming year:

Earnings before interest and taxes P40 million

Interest expense P 5 million
Preferred stock dividends P 4 million
Common stock dividend payout ratio 20%
Average number of common shares outstanding 2 million
Effective corporate income tax rate 40%

The expected dividend per share of common stock is

A. P1.70
B. P1.86
C. P2.10
D. P1.00
4. How much will a firm need in cash flow before tax and interest to satisfy debt holders
and equity holders if the tax rate is 40%, there is P10 million in common stock requiring
a 12% return, and P6 million in bonds requiring an 8% return?
A. P1,392,000
B. P1,488,000
C. P2,480,000
D. P2,800,000
5. During the past five years, Pledge Company had consistently paid 50% of earnings
available to common as dividends. Next year, the Pledge Company projects it net income,
before the P1.2 million preferred dividends, at 6 million.

The capital structure for the company is maintained at:

Debt 25.5%
Preferred Stock 15.0%
Common Equity 60.0%

What is the retained earnings break-point next year?

A. P5,760,000
B. P4,800,000
C. P4,000,000
D. P6,000,000
6. Cartel Company expects P30 million in earnings next year. Its dividend payout ratio is
40%, and its equity asset ratio is 40%. Cartel Company uses no preferred stock.

At what amount of financing will there be a break point in Cartel’s cost of capital?
A. P45 million
B. P20 million
C. P30 million
D. 18 million
7. Deep Sea Company expects next year’s after-tax income to be P7,500,000. The firm’s
debt ratio is currently 40%. Deep Sea Company has P6,000,000 of profitable investment
opportunities, and it wishes to maintain its existing debt ratio. According to the residual
dividend policy, what is the expected dividend payout ratio next year?
A. 52.0%
B. 75.0%
C. 48.0%
D. 25.0%
8. The Florida Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a
cost of debt is 11%. What is the weighted average cost of capital of the firm? (Assume
tax rate of 33%)
A. 3.06%
B. 13.40%
C. 16.97%
D. 15.52%
9. Calculate the DFL for a firm with EBIT of P6,000,000, fixed cost of P3,000,000, interest
expense of P1,000,000, preferred stock dividends of 800,000, and a 40% tax rate
A. 6.0
B. 9.0
 C. 1.43
D. 1.64
10. A firm is expected to generate P1.5 million in operating income and pay P250,000 in
interest. Ignoring taxes, this will generate P12.50 earnings per share. What will happen to
EPS if operating income increases to P2.0 million?
A. EPS increase to P15.63.
B. EPS increase to P16.67.
C. EPS increase to P17.50.
D. EPS increase to P20.00.
11. The board of directors of Moderate Company was unhappy with the current return on
common equity. Though the return on sales (profit margin) was impressively good at
12.5%, the asset turnover was 0.75. The present debt ratio is 0.40.

Ms. Norma Flor, the vice-president of corporate planning, presented a proposal as

follows:
- Profit margin should be raised to 15%.
- The new capital structure will be revised by raising debt component.
- The asset turnover will be maintained at 0.75

The proposed adjustment is estimated to raise return on equity by 50%.

What debt ratio did Ms. Flor propose in order to raise the return on equity (ROE) to
150% of the present level?
A. 0.52
B. 0.68
C. 0.61
D. 0.72
12. Eclipse Company expects to generate P10 million internally which could be available for
financing part of its P12 million capital budget for this coming year. Eclipse’s
management believes that a debt-equity ratio of 40% is best for the firm. How much
should be paid in dividends if the target debt-equity ratio is to be maintained?
A. P2,800,000
B. P8,571,429
C. P1,428,571
D. P4,000,000
13. A five-year P1,000 par value bond pays 6.50% annual coupon. Given a YTM of 8.0%,
what is the price of the bond today?
A. P1,040
B. P 860
C. P 940
D. P1,000
14. Paramount Company’s stock is expected to generate a dividend and terminal value one
year from now of P57.00. The stock has a beta of 1.3, the risk-free interest rate is 6%, and
the expected return market return is 11%. What should the equilibrium price of investors;
stock in the market now?
A. P50.67
B. P43.85
C. P53.77
D. P41.22
15. The beach Corporation pays annual dividends of P6.00 on the cumulative preferred stock.
What is the current value of this stock if an investor requires a 10% annual rate of return?
A. P 60
B. P 6
C. P600
D. P 10
16. What is the current price of a share of stock when last year’s dividend was P3.00m the
growth rate is 6%, and the investors’ required rate of return is 12%?
A. P25.00
B. P26.50
C. P50.00
D. P53.50
17. What is the current price of a share of stock when the current dividend is P4.75, the
growth rate is 7%, and the investor’s require rate of return is 11%.
A. P118.75
B. P 43.16
C. P 46.20
D. P127.06
18. You are planning to invest in common stock of Eagle, Inc. Lately, the firm paid a
dividend of P7.80. You have projected that dividends will grow at a rate of 9.0% per year
indefinitely. If you want an annual return of 24%, what is the most you should pay for the
stock now?
A. P52.00
B. P56.68
C. P32.50
D. P35.43
19. Dangling, Inc. is a firm that is experiencing rapid growth. Lately, the firm paid a dividend
of 5.90. You believe that dividends will grow at a rate of 19.0% per year for three years,
and then at a rate of 7.0% per year thereafter. If you expect an annual rate of return of
12.0% on this investment and you plan to hold the stock indefinitely, what is the most
you would pay for the stock now?
A. P155.22
B. P171.45
 C. P131.09
D. P185.60
20. OPQ Company is considering buying common shares in Oceanic Company. OPQ has
projected that the next dividend the company will pay will equal P4.00 and that dividends
will grow at a rate of 7.0% per year thereafter. The firm’s beta is 1.75, the risk0free rate
is 7.5%, and the market return is 11.3%. What is the most you should pay for the stock
now?
A. P30.25
B. P59.86
C. P55.94
D. P89.12
21. Filam’s Company expects to pay a dividend of P6 per share at the end of year one, P9 per
share at the end of the year two, and then be sold for P136 per share. If the required rate
on the stock is 20%, what is the current value of the stock?
A. P100.10
B. P105.69
C. P110.00
D. P120.29
22. Constantly Company is a no growth firm and has 2 million shares outstanding. It is
expected to earn a constant P20 million per year on its assets. If all earnings are paid out
as dividends and the cost of capital is 10%, calculate the current price per share for the
stock.
A. P200
B. P100
C. P150
D. P 50
23. Lion Company will pay a dividend of P1.50 per share at the end of next 12 months. The
required rate of return for Lion’s share is 10% and the constant growth is 5%.

The approximately current market price per common share of Lion stock is
A. P30.00
B. P10.00
C. P15.00
D. P26.23
24. Calculate the dividend payout ratio based on the following values for a listed company.
Dividend 2.28
P/E 19.00
Close 75.25

A. 57.6%
B. 23.3%
 C. 12.0%
D. 3.0%
25. The current yield on a bond worth P900 with a par value of P1,000 and a current rate of
10% is:
A. 10.00%
B. 11.11%
C. 12.05%
D. 9.75%
26. The Lakeview Company’s bonds have 4 years remaining to maturity. Interest is paid
annually; the bonds have a P1,000 face value and the coupon interest rate is 9%.
A. 8.23%
B. 13.10%
C. 10.86%
D. 14.80%
27. What is the expected YTM on a bond that pays a P150 coupons annually, has a P1,000
par value, and matures in six years if the current price of the bond is P978?
A. 18.9%
B. 36.7%
C. 15.6%
D. 13.9%
28. You are considering the purchase of a bond with a 13% coupon rate paid and
compounded semi-annually. The bond will mature in 8 years, and has a P1,000 face
value. The bond currently sells for P867. Calculate the annual yield to maturity for this
bond. (Round to nearest percentage.)
A. 8%
B. 9%
C. 13%
D. 16%
29. What is the yield to maturity (APR) of a bond with the following characteristics?
Coupon rate: 8% with semi-annual payments
Current price: P960
Maturity: three years until maturity

A. 4.78%
B. 5.48%
C. 9.57%
D. 12.17%
30. What is the rate of return for an investor who pays P1,054.47 for a three-year bond with a
7% coupon and sells the bond one year late for P1,037.19?
A. 5.00%
B. 5.33%
 C. 6.46%
D. 7.00%
31. Heidi Company plans to issue some P100 preferred stock with an 11% dividend. The
stock is selling on the market for P97, and Heidi must pay flotation costs of 5% of the
market price. The company is under the 40 % corporate tax rate.
A. 7.16%
B. 11.34%
C. 6.80%
D. 11.94%
32. If a share of stock provided a 14.0% nominal rate of return over the previous year while
the real rate of return was 6.0%, then the inflation rate was:
A. 1.89%
B. 7.55%
C. 8.00%
D. 9.12%
33. Milky Way, Inc. paid a cash dividend to its common shareholders over the past 12
months of P2.20 per share. The current market value of the common stock is P40 per
share and investors are anticipating the common dividend to grow at a rate of 6% per
annum. The cost to issue new common stock will be 5% of the market value. The
expected returns on retained earnings is
A. 12.14%
B. 11.83%
C. 11.79%
D. 14.05%
34. What is the estimated required rate of return for equity investors if a stock sells for 40
and will pay a P4.40 dividend that is expected to grow at a constant rate of 5%?
A. 7.6%
B. 12.0%
C. 12.6%
D. 16.0%
35. The earnings, dividends, and stock price of Sum Company are expected to grow at 7%
per year after this year. Sum Company’s common stock sells for P23 per share, its last
dividend was P2.00 and the company pay P2.14 at the end of the current year. Sum
Company should pay P2.50 flotation cost.

Using the dividend growth model, what is the expected cost of retained earnings for Sum
Company?
A. 10.44%
B. 16. 30%
 C. 9.30%
D. 17.44%
36. The Wind Company’s last dividend was P3.00, its growth rate is 6% and the stock now
sells for P36. New stock can be sold to net the firm P32.40 per share.

What is the Wind Company’s cost of new common stock?

A.14.83%
B. 16.81%
C. 15.26%
D. 9.69%
37. Platter Company’s stock is currently selling for P60 per share. The firm is expected to
earn P5.40 per share and to pay a year-end dividend of P3.60.

If investors require a 9% return, what rate of growth must be expected for Platter?
A. 0 growth
B. 3.0%
C. 40.0%
D. 50.0%
38. Okkawa Company’s stock is currently selling for P120 a share. The firm is expected to
earn P10.80 per share and to pay a year-end dividend of P7.20. Investors require a 9%
return.

If Okkawa Company reinvests retained earnings in projects whose aggregate return is

equal to the stock’s expected rate of return, what will be next year’s Earnings per Share?
A. P11.12
B. P10.80
C. P 7.42
D. P11.77
39. Cielo del Mar, and investor, receives a 14% total return by purchasing a stock for P40
and selling it after one year with a 10% capital gain. How much was received in dividend
income during the year?
A.P2.00
B. P2.20
C. P4.00
D. P6.00
40. Alternate Company’s stock currently sells for P45.00 per share. It is expected to pay a
dividend of P3.10 next year, its growth rate is a constant 7.0%, and the company will
incur a flotation cost of 12.0% of the market value if it sells new common stock. The
firm’s tax is 40%. What is the firm’s cost of retained earnings?
A. 13.89%
B. 14.37%
 C. 15.38%
D. 14.83%
41. If a stock is purchased for P25 per share and held one year, during which time a P3.50
dividend is paid and the price climbs to P28.25, the nominal rate of return is:
A. 13.00%
B. 14.00%
C. 23.01%
D. 27.00%
42. Given a stock price of P39.77 and an expected return to shareholders of 12.4%, what is
the likely growth rate if the annual dividend next year is expected to be P3.50?
A. 0.0%
B. 3.6%
C. 8.4%
D.12.4%
43. Dalmatian Co. is currently paying a dividend of P2.20 per share. The dividend are
expected to grow at 25% per year for the next four years and then grow 5% per year
thereafter. Calculate the expected dividend in year 6.
A. P5.37
B. P2.95
C. P5.92
D. P8.39
44. According to CAPM estimates, what is the cost of equity for a firm with beta of 1.5 when
the risk-free interest is 6% and the expected return on the market portfolio is 15%?
A. 19.5%
B. 21.0%
C. 22.5%
D. 24.0%
45. The expected return on Glove Oil stock is 18.95%. If the market premium is 8.2% and
the risk-free rate is 6.4%, what is the beta of Globe Oil stock?
A. 2.88
B. 1.53
C. 1.30
D. 6.97
46. An investor was expecting an 18% return on his portfolio with beta of 1.25 before the
market risk premium increased from 8% to 10%. Based on this change, what return will
now be expected on the portfolio?
A. 20.0%
B. 20.5%
C. 22.5%
D. 26.0%
47. The expected rate of return stock of Phoslate Company, given a beta of 1.25, risk-free
rate of 7.5%, and a market risk premium of 6%, is:
A. 9.0%
B. 13.5%
C. 15.4%
D. 15.0%
48. What is the risk-free rate given a beta of 0.8, a market risk premium of 6%, and an
expected return of 9.8%?
A. 3.2%
B. 5.0%
C. 5.2%
D. 6.8%
49. The earnings, dividends and stock price of Equity, Inc. are expected to grow at 7% per
year after this year, Equity’s common stock sells for P23 per share, its last dividend was
P2.00 and will pay P2.24 at the end of the current year. Equity should pay P2.50 flotation
cost.

If the firm’s beta is 1.75, the risk-free rate is 8%, and the average return on the market is
12%, what will be the firm’s cost of equity using CAPM approach?
A. 16.05%
B. 15.00%
C. 14.27%
D. 14.00%
50. The following data are related to Samba stock:

Required return on Samba common 15%

Beta coefficient 1.5
Risk0free rate 9.0%

The required market return is

A. 13.0%
B. 18.0%
C. 25.0%
D. 15.0%
51. What is the required rate of return for a security with a beta of .8 when the market return
is 12 percent, the real rate of return is 3%, and the expected inflation premium is 2%?
A. 17.8%
B. 8.6%
C. 10.6%
D. 12.6%
52. The beta of debt is 0.4 and beta of equity is 1.2. The debt-equity ratio is 0.8. Calculate the
beta of the assets of the firm. (Assume no taxes.)
A. 0.84
B. 0.48
C. 1.60
D. None of the above
53. What is the asset beta given debt is .2, the equity beta is 1.4, the market value of equity is
P45 million, and the market value of debt is P15 million?
A. 0.20
B. 1.10
C. 1.40
D. 1.50
54. The market value of Negros Company’s equity is P15 million, and the market value of its
risk-free debt is P5 million. If the required rate of return on the equity is 20% and that on
the debt is 8%, calculate the company’s cost of capital. (Assume no taxes.)
A. 17%
B. 20%
C. 8.1%
D. None of the above
55. Assume the following information about a firm’s capital components:

Capital Structure Cost

Debt P2M 8%
Preferred Stock P2M 11%
Common Stock P6M 14%

What is the firm’s weighted-average cost of capital?

A. 11.00%
B. 11.90%
C. 12.05%
D. 12.20%

56. The company cost of capital for a firm with a 60/40 debt/equity split, 7% cost of debt,
15% cost of equity, and 35% tax rate would be:
A. 7.02%
B. 9.12%
C. 10.80%
D. 13.80%
57. The nut Corporation finds that it is necessary to determine its marginal cost of capital.
Nut’s current capital structure calls for 45% debt, 15% preferred stock and 40% common
equity. The costs of the various sources of financing are as follows: debt, after-tax 5.6%;
preferred stock, 9%; retained earnings, 12%; and new common stock, 13.2%. If the firm
has P12 million retained earnings, and Nut has an opportunity to invest in an attractive
project that costs P45 million, what is the marginal cost of capital of Nut Corporation?
A. 8.83%
B. 8.91%
C. 9.95%
D. 12.40%
58. A firm has common stock with a market price of P100 per share and an expected
dividend of P5.61 per share at the end of 2007. A new issue of stock is expected to be
sold for P98, with a P2 per share representing the underpricing necessary in the
competitive capital market. Flotation costs are expected to total P1 per share. The
dividends paid on the outstanding stock last 5 years are:
Year Dividend
2002 P4.40
2003 4.28
2004 4.58
2005 4.90
2006 5.24

What is the expected return on the new issue of common stock in January 2006?
A. 5.8%
B. 7.7%
C, 10.8%
D. 12.8%

59. Silverwares Company is expecting their sales to decline due to the increased interest in
disposable wares. Thus, the company has announced that they will be reducing their
annual dividend by 4% a year for the next 4 years. After that, they will maintain a
constant dividend of P1 per share. Last year, the company paid P1.80 per share. What is
this stock worth to you if you require a 12% rate of return?
A. P9.29
B. P10.27
C. P11.30
D. P12.07

60. Home Builders, Inc. is a very cyclical type of business which reflected in their dividend
policy. The firm pays a P3.50 per share dividend every other year. The next dividend will
be paid end of this year. Four years from now, the company plans to pay P77 liquidating
 dividend per share. What is the current market value of this stock if the market rate of
return is 18.5%?
A. P43.32
B. P44.11
C. P46.59
D. P48.37
61. Last week, Tutuban Company paid and annual dividend of P2.44 per share. The company
has been reducing the dividends by 15% each year. How much are you willing to pay to
purchase stock in this company if your required rate of return is 16%?
A. P6.69
B. P7.87
C. P36.60
D. P244.00
62. Peach Boutique recently paid P1.65 as an annual dividend. Future dividends are projected
at P1.68, P1.72, P1.76, and P1.80 over the next four years, respectively. Beginning five
years from now, the dividend is expected to increase by 2.5% annually.

What is one share of this stock worth to you if you require an 11% rate of return on
similar investments?
A. P18.49
B. P19.68
C. P21.33
D. P24.33
63. River Poker Company will pay annual dividend of P3.15 a share on their dividend
common stock end of this year. Last year, the company paid a dividend of P3.00 a share.
The company adheres a constant rate of growth dividend policy. What will one share of
this common stock be worth 10 years from now if the applicable discount rate is 12.5%?
A. P53.78
B. P65.16
C. P68.41
D. P71.83ained

The Solar Laboratories, Inc., a multinational company, is expanding its research and
production capacity to introduce a new line of products. Current plans call for the
expenditure of P100 million on four projects of equal size (25 million each), but different
returns. Project A is in blood clotting proteins and has an expected return of 18%. Project
B relates to a hepatitis vaccine and carries a potential return of 14%. Project C, dealing
with a cardiovascular compound, is expected to earn 11.8% and Project D, an investment
in orthopedic implants, is expected to show a 10.9% return.

The firm has P15 million in retained earnings. After a capital structure with P15 million
 in retained earnings is reached (in which retained earnings represent 60% of the
financing), all additional equity financing must come in the form of new common stock.
Common stock is selling for P25 per share and underwriting costs are estimated at P3 id
new shares are issued. Dividends for the next year will be P.90 per share (D), and
earnings and dividends have grown consistently at 11%.

The yield on comparative bonds has been hovering at 11%. The investment banker feels
that the first P20 million of bonds could be sold to yield 11% while additional debt might
require a 2% premium and be sold to yield 13%. The corporate tax rate is 30%. Debt
represents 40% of the capital structure.

64. The expected returns on common equity are:

Retained Earnings Common Shares
A. 14.6% 15.1%
B. 15.0% 15.5%
C. 15.1% 14.6%
D. 15.5% 15.0%

65. What is the initial weighted average cost of capital?

A.13.2%
B.12.1%
C. 11.8%
D. 9.2%
66. At what size of the capital structure would there be a change in the cost of equity
component?
A. P15 million
B. P20 million
C. P25 million
D. P50 million
67. What is the marginal cost of capital at retained earnings break point?
A. 11.84%
B. 9.42%
C. 12.38%
D. 12.14%
68. At what size of capital structure will there be a change in the cost of debt?
A. P20 million
B. P25 million
C. P50 million
D. P75 million
69. The selection of the project is based on ranking of profitability. What is the marginal cost
of capital? What is the expected marginal cost of capital of financing project C?
 A. 12.9%
B. 12.4%
C. 12.7%
D. 10.2%
70. Which of the following four projects will be accepted by the company?
A. Project A only.
B. Project A and B only.
C. Project A, B, C.
D. All of them.