Chapter 18

PROBLEM 3
Budget A, capital of 230,000

Project Cost IRR AReturn on Investment

A P100,000 18% 18,000
B P80,000 16% 12,800
C P50,000 15% 7,500
38,300

Marginal Cost B(35,420)

Excess Return 2,880

Budget B, capital of 200,000

Project Cost IRR Return on Investment

A P100,000 18% 18,000
B P80,000 16% 12,800
30,800

Marginal Cost C(28,400)

Excess Return 2,400

The optimal capital budget is P230,000 for it yields a higher return.

A Return on Investment = Cost x IRR
B P230,000 x 15.4% = 35,420
C P200,000 x 14.2% = 28,400
PROBLEM 4
Cost of Ordinary Share: (Using the Capital Asset Pricing Model)
ROR = Risk-free Rate + (Return on Market – Risk-free Rate) β
= 10% + ( 15% – 10%) 1.38
= 16.9%

Cost of Debt:
Cost of Debt = Interest Rate x ( 1 – Tax Rate )
= 12% x ( 1 – 40%)
= 7.2%
Cost of Weighted Cost of
Capital Capital Weight Capital
Debt 16.9% 50% 8.45%
Ordinary Shares 7.2% 50% 3.6%
12.05%

The firm should accept the proposed project because the 13%
return exceeds the weighted cost of capital.
PROBLEM 5
Cost of Debt:
Cost of Debt = Interest Rate x ( 1 – Tax Rate )
= 12.4% x ( 1 – 35%)
= 8.06%

Cost of Preference Share:

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔
Cost of Preference Share =
𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆−𝑭𝒍𝒐𝒂𝒕𝒂𝒕𝒊𝒐𝒏 𝑪𝒐𝒔𝒕
= 4.75 / ( P50 – P1.4 )
= 9.77%

Cost of Ordinary Share:

𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔
Cost of Ordinary Share = + Growth Rate
𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆
= (P2.70 / P54) + 12%
= 17%
Weighted Cost of
Capital Cost of Capital Weight Capital
Debt 8.06% 35% 2.82%
Preference Share 9.77% 10% .977%
Ordinary Share 17% 55% 9.35%
13.147%
PROBLEM 6
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
Degree of Operating Leverage =
𝑬𝑩𝑰𝑻
= P300,000 / P150,000
=2

𝑬𝑩𝑰𝑻
Degree of Financial Leverage =
𝑬𝑩𝑰𝑻−𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
= P150,000 / (P150,000 – P60,000)
= 1.6667

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
Degree of Combined Leverage =
𝑬𝑩𝑰𝑻−𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
= P300,000 / (P150,000 – P60,000)
= 3.3333 OR
Degree of Combined Leverage = DOL x DFL
= 2 x 1.6667
= 3.3334
𝑭𝒊𝒙𝒆𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆
Break Even Point in Units =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕
Commented [JLM1]: This amount does not include interest
= P150,000 / P30 expense which is also a fixed expense.

= 3,000 units
 Commented [JLM2]: Reconsider your method of computing
PROBLEM 7 the net income. You deducted after-tax interest from EBIT (earnings
BEFORE interest and taxes). Its somewhat illogical in my opinion.

Current Capital Plan D Plan E

Debt P6,000,000 P9,000,000 P3,000,000
Ordinary Share P6,000,000 P3,000,000 P9,000,000

 Tax rate is 45%

 Under Plan D, Interest expense will increase by P360,000
(3,000,000 x 12%) and 375,000 ordinary shares will retire.
 Under Plan E, Interest expense will reduce by P300,000
(3,000,000 x 10%) and ordinary shares will increase by
375,000.
A. ROA of 10%

Current Capital Plan D Plan E

Interest Expense P600,000 P960,000 P300,000
Interest after Tax P330,000 P528,000 P165,000
Ordinary Shares 750,000 375,000 1,125,000

ANet Income P870,000 P672,000 P1,035,000

BEPS P1.16 P1.79 P.92

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙

ROA = or
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒔𝒔𝒆𝒕

Net Income = ( ROA x Average Asset ) – Interest After Tax

ANI = (10% x P12,000,000) – Interest After Tax
BEPS = Net Income / Ordinary Shares
B. ROA of 5%

Current Capital Plan D Plan E

Interest Expense P600,000 P960,000 P300,000
Interest after Tax P330,000 P528,000 P165,000
Ordinary Shares 750,000 375,000 1,125,000

ANet Income P270,000 P72,000 P435,000

EPS P0.36 P0.192 P0.387

ANI = (5% x P12,000,000) – Interest After Tax

Plan E is morefavorable if ROA is 5%.

ROA of 15%

Current Capital Plan D Plan E

Interest Expense P600,000 P960,000 P300,000
Interest after Tax P330,000 P528,000 P165,000
Ordinary Shares 750,000 375,000 1,125,000

ANet Income P1,470,000 P1,272,000 P1,635,000

EPS P1.96 P3.392 P1.453

ANI = (15% x P12,000,000) – Interest After Tax

Plan D is more favorable if ROA is 15%.

C. ROA of 10%, and Market Price of Ordinary Share is P12

  Under Plan E, ordinary shares will increase by 250,000 and
250,000 shares will retire under plan D.
*250,000 share = P3,000,000 / P12

Current Capital Plan D Plan E

Interest Expense P600,000 P960,000 P300,000
Interest after tax P330,000 P528,000 P165,000
Ordinary shares 750,000 500,000 1,000,000

ANet Income P870,000 P672,000 P1,035,000

EPS P0.36 P1.344 P1.035

ANI = (10% x P12,000,000) – Interest After Tax

Plan D is more favorable if ROA is 10%, and market price of the
share is 12.