 Essay Questions

Table 9.4

Operating Cash Inflows

$1,000 $1,000 $1,000 $1,000 $1,000

$2,500
(Initial outlay)

1. Given the information in Table 9.4 and 15 percent cost of capital,

(a) compute the net present value.
(b) should the project be accepted?
Answers:
(a) NPV  1,000 (PVIFA15%,5) – 2,500
 1,000 (3.352) – 2,500  $852
(b) Since NPV > 0, the project should be accepted.
Level of Difficulty: 3
Learning Goal: 3
Topic: Net Present Value

Table 9.5

Operating Cash Inflows

$25,000 $10,000 $50,000 $10,000 $10,000 $60,000

–$100,000
(Initial outlay)

2. Given the information in Table 9.5 and 15 percent cost of capital,

(a) compute the net present value.
(b) should the project be accepted?
Answers:
(a)
Year CF PVIF 15%,t PV
1 $25,000 0.870 $21,750
2 10,000 0.756 7,560
3 50,000 0.658 32,900
4 10,000 0.572 5,720
5 10,000 0.497 4,970
6 60,000 0.432 25,920
$98,820

NPV  98,820 – 100,000  –$1,180 < 0

(b) Since NPV < 0, the project should be rejected.
Level of Difficulty: 3
Learning Goal: 3
Topic: Net Present Value (Equation 9.1 and Equation 9.1a)
Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering replacing an existing piece of
equipment with a more sophisticated machine. The following information is given.

Table 9.6

Facts
Existing Machine Proposed Machine
Cost  $100,00 Cost  $150,000
Purchased 2 years ago Installation  $20,000
Depreciation using MACRS over Depreciation—the MACRS
a 5-year recover schedule 5-year recovery schedule will be used
Current market value  $105,000
Five year usable life remaining Five year usable life expected

Earnings before Depreciation and Taxes

Existing Machine
Year 1 $160,000 Year
2 150,000
3 140,000
4 140,000
5 140,000
Proposed Machine
1 $170,000
2 170,000
3 170,000
4 170,000
5 170,000

The firm pays 40 percent taxes on ordinary income and capital gains.

3. Given the information in Table 9.6, compute the initial investment.

Answer:

Cost of new equipment $150,000

Installation cost 20,000
Proceeds from sale of existing equip. –105,000
Tax effect on sale of existing equip. 22,800
Initial Investment $87,800

Level of Difficulty: 4
Learning Goal: 3
Topic: Initial Investment

4. Given the information in Table 9.6, compute the incremental annual cash flows.
Answer:

Calculation of Operating Cash Flows

Profits before Net Profits
Depreciation before Net Profits Cash
Year and Taxes Depreciation Taxes Taxes after Taxes Flow
Existing Machine
1 $160,000 $19,000 $141,000 $56,400 $84,600 $103,600
2 150,000 12,000 138,000 55,200 82,800 94,800
3 140,000 12,000 128,000 51,200 76,800 88,800
4 140,000 5,000 135,000 54,000 81,000 86,000
5 140,000 0 140,000 56,000 84,000 84,000
6 0 0 0 0 0 0
 Proposed Machine
1 $170,000 $34,000 $136,000 $54,400 $81,600 $115,600
2 170,000 54,400 115,600 46,240 69,360 123,760
3 170,000 32,300 137,700 55,080 82,620 114,920
4 170,000 20,400 149,600 59,840 89,760 110,160
5 170,000 20,400 149,600 59,840 89,760 110,160
6 0 8,500 –8,500 3,400 –5,100 3,400

Calculation of Incremental Cash Flows

Year Proposed Machine Existing Machine Incremental Cash Flows
1 $115,600 $103,600 $12,000
2 123,760 94,800 28,960
3 114,920 88,800 26,120
4 110,160 86,000 24,160
5 110,160 84,000 26,160
6 3,400 0 3,400

Level of Difficulty: 4
Learning Goal: 3
Topic: Incremental Operating Cash Flows

5. Given the information in Table 9.6, compute the payback period.

Answer:

Year Incremental Cash Flows Cumulative Cash Flow

1 $12,000 $12,000
2 28,960 40,960
3 26,120 67,080
4 24,160 91,240
5 26,160 115,400
6 3,400 118,800
PP  3  [(87,800 – 67,080)/24,160]  3.86 years.

Level of Difficulty: 4
Learning Goal: 3
Topic: Payback Method

6. Given the information in Table 9.6 and 15 percent cost of capital,

(a) compute the net present value.
(b) Should the project be accepted?
 Answers:
(a)
Year ICF PVIF15%,t PV
1 $12,000 0.870 $10,440
2 28,960 0.756 21,894
3 26,120 0.658 17,187
4 24,160 0.572 13,820
5 26,160 0.497 13,002
6 3,400 0.432 1.469
$77,812
NPV  77,812 – 87,800  –$9,988

(b) Since NPV < 0, the project should be rejected.

Level of Difficulty: 4
Learning Goal: 3
Topic: Net Present Value (Equation 9.1 and Equation 9.1a)

Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm’s fixed capital budget
of $10,000,000. Any unused portion of this budget will earn less than its 20 percent cost of capital. A summary of key data
about the proposed projects follows.

Table 9.7

PV of Inflows
Project Initial Investment IRR at 20%
A $3,000,000 21% $3,050,000
B 9,000,000 25 9,320,000
C 1,000,000 24 1,060,000
D 7,000,000 23 7,350,000

7. Use the NPV approach to select the best group of projects. (See Table 9.7)
Answer: Choose Projects C and D, since this combination maximizes NPV at $410,000 and only requires $8,000,000
initial investment.
Level of Difficulty: 3
Learning Goal: 6
Topic: NPV and Capital Rationing

8. Use the IRR approach to select the best group of projects. (See Table 9.7)
Answer:
IRR Approach
Project IRR Initial Investment NPV
B 25% $9,000,000 $320,000
C 24 1,000,000 60,000
D 23 7,000,000 350,000
A 21 3,000,000 50,000
Choose Projects B and C, resulting in a NPV of $380,000.
Level of Difficulty: 3
Learning Goal: 6
Topic: IRR and Capital Rationing

9. Which projects should the firm implement? (See Table 9.7)

Answer: Projects C and D
 Level of Difficulty: 3
Learning Goal: 6
Topic: NPV versus IRR and Capital Rationing

10. Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows
of $400 in each of the next 2 years. Project B also costs $600, and generates cash flows of $500 and $275 for the next 2
years, respectively. Sketch a net present value profile for each of these projects. Which project should the firm choose if
the cost of capital is 10 percent? What if the cost of capital is 25 percent? Show all work.
Answer:

Cost
of Capital Project X Project Y
0% $200 $175
5% $144 $126
10% $94 $86
15% $50 $43
20% $11 $8
25% $(24) $(24)

At a cost of capital of 10 percent, the firm would choose Project X. At a cost of capital of 25 percent, the firm
would choose neither.
Level of Difficulty: 3
Learning Goal: 6
Topic: Net Present Value Profiles (Equation 9.1 and Equation 9.1a)

11. Tangshan Mining Company is considering investing in a new mining project. The firm’s cost of capital is 12 percent and
the project is expected to have an initial after tax cost of $5,000,000. Furthermore, the project is expected to provide
after-tax operating cash flows of $2,500,000 in
year 1, $2,300,000 in year 2, $2,200,000 in year 3 and ($1,300,000) in year 4?
(a) Calculate the project’s NPV.
(b) Calculate the project’s IRR.
(c) Should the firm make the investment?
 Answer:

Time Cash Flow PVIF(12%) PV of CF

0 $(5,000,000) 1.0000 $(5,000,000)
1 $2,500,000 0.8929 $2,232,143
2 $2,300,000 0.7972 $1,833,546
3 $2,000,000 0.7118 $1,423,560
4 $(1,300,000) 0.6355 $(826,174)
NPV $(336,924)
IRR 6.80%

No the firm should not accept the project.

Level of Difficulty: 3
Learning Goal: 5
Topic: NPV and IRR (Equation 9.1, Equation 9.1a, Equation 9.2 and Equation 9.2a)

7-30 Expanding a Product Line (30 minutes)

1. The desk should be introduced. The net present value is $92,200.

Tax Cash Flows

Sales (5,000 x $300) $1,500.0 $1,500.0
Variable costs at $120 600.0 600.0
Contribution margin at $260 900.0 900.0
Fixed cash operating costs 400.0 400.0
Cash flow, before taxes 500.0 500.0
Depreciation ($1.5 million/5) 300.0
Increase in taxable income 200.0
Increased taxes (40%) $ 80.0 80.0
Increase in net cash flow $ 420.0
Present value factor, 5 years, 10% 3.791
Present value of future cash flows $1,592.2
Investment 1,500.0
Net present value $ 92.2

2. About 3.57 years ($1,500.0/$420.0)

3. About 12.4% from Lotus 1-2-3. Students using tables will see that the rate is
about 12%. The factor 3.57 lies just below 3.605, the factor for 12%.

7-31 Buying Air Pumps (15-20 minutes)

The memo should present a recommendation to buy the pumps and the NPV of the
purchase alternative (shown below). The memo could also include a brief comment on
the implications of a change in the lease payments.

Lease pumps
Revenue $2,400
Operating expenses $550
Lease expense 850
Total expenses 1,400
Income before taxes $1,000
Buy versus lease
Tax Cash Flow
Annual lease savings $850 $ 850
Less depreciation ($1,500/3) 500
Increase in taxable income 350
Increase in income tax (40%) $140 140
Net cash flow $ 710
Present value factor, 3 years, 10% 2.487
Present value of future flows $1,766
Less investment 1,500
Net present value in favor of buying $ 266

Note to the Instructor: The chapter points out that financing and investing
decisions should be separated. This is an apparent exception, though we do not view
a year-to-year lease as a financing arrangement. Note also that the company has
already decided to acquire the air pumps. Moreover, revenues exceed operating costs
and lease payments, so acquiring the pumps is profitable. Hence, the only question
is how to acquire them. (Some students will not see this point and will spend time
trying to develop separate NPV analyses for the two alternatives.)

7-32 Charitable Donation (15-20 minutes)

1. $976,404 ($6,000,000/6.145, the present value factor for a 10-year annuity at

10%)

2. The lump sum, because her discount rate is lower than the university's.

Pay $6,000,000 now:

Outflow $6,000,000
Tax saving at 35% 2,100,000
Net cash outflow $3,900,000

Pay $976,404 annually:

Donation $ 976,404
Tax saving at 35% 341,741
Net cash outflow $ 634,663
Present value factor, 9%, 10 years 6.418
Present value of outflows 4,073,267
Difference (in favor of lump-sum payment) $ 173,267

7-33 Increasing Capacity (25 minutes)

1. A 200,000 increase in volume is not enough to justify the investment.

Tax Cash Flows

Contribution margin (200,000 x $3) $600,000 $ 600,000
Cash fixed costs 200,000 200,000
Pretax cash flow 400,000 400,000
Depreciation ($1,200,000/5) 240,000
Increase in pretax income 160,000
Income tax at 40% $ 64,000 64,000
Net cash flow $336,000
Present value factor, 5 years, 14% 3.433
Present value of future flows $1,153,488
Investment 1,200,000
Net present value ($ 46,512)
2. A 250,000 increase in volume is enough to justify the investment.

Tax Cash Flows

Contribution margin (250,000 x $3) $750,000 $ 750,000
Cash fixed costs 200,000 200,000
Pretax cash flow 550,000 550,000
Depreciation ($1,200,000/5) 240,000
Increase in pretax income 310,000
Income tax at 40% $124,000 124,000
Net cash flow $ 426,000
Present value factor, 5 years, 14% 3.433
Present value of future flows $1,462,458
Investment 1,200,000
Net present value $ 262,458

Note to the Instructor: You might wish to point out that requirement 2 can be
solved by looking at differences. The additional 50,000 pairs give:

Additional contribution margin (50,000 x $3) $150,000

Times (1 - 40% tax rate) 60%
Equals after-tax cash flow $ 90,000
Times relevant present value factor 3.433
Equals additional NPV $308,970

The $308,970 plus the negative $46,512 add up to $262,458.

7-34 Funding a Pension Plan (15 minutes)

Cash Flows
Annual cash outflows $ 25,000
Less tax savings at 40% 10,000
Net cash outflows $ 15,000
Present value factor for 10 years at 16% 4.833
Present value of outflows $ 72,495
Divided by (1 - 40% tax rate) 60%
Equals maximum before-tax amount $120,825

7-35 Research and Development Investment (15-20 minutes)

The investment is desirable, NPV of $1.15 million, IRR of about 14.5%.

Year Cash Flow After-Tax PV Factor Present Value

20X1 -$4.5 -$2.7 1.000 -$2.70

20X2 - 6.2 - 3.72 .893 - 3.32
20X3 - 8.5 - 5.1 .797 - 4.07
20X4 - 3.2 - 1.92 .712 - 1.37
20X5 7.0 4.2 .636 2.67
20X6 9.0 5.4 .567 3.06
20X7 11.0 6.6 .507 3.35
20X8 13.0 7.8 .452 3.53
NPV $1.15

This assignment differs from others in that it does not have a single investment at
time zero. Students should still see that the NPV is the present value of all cash
flows. For convenience, the chapter refers to future flows and investment.
7-36 Capital Budgeting by a Municipality (20 minutes)

1. The center should be built; the net present value of the project is
$3,893,400.

Rentals of space, etc. $ 1,800,000

Tax receipts* 1,000,000
Total receipts to city 2,800,000
Operating costs 500,000
Net cash flows $ 2,300,000
Present value factor for 30-year annuity at 8% 11.258
Present value of future receipts $25,893,400
Less investment required 22,000,000
NPV $ 3,893,400

* 200,000 persons spending $500 each gives $100,000,000 in spending per

year, and the city collects 1% of this sum, or $1,000,000.

2. Like all not-for-profit entities, a city is not trying to provide a

return to owners as a business entity must. Rather, its purpose is to
provide services for which the residents and others will pay and from which
they will receive benefits. Thus, the only element of cost of capital is the
interest rate.

Note to the Instructor: We ask students whether the investment should

be made even if it would not directly pay for itself (say if the cost were
$28,000,000). Some suggest that there are likely to be fringe benefits to
the city's businesses. Some suggest that having the convention center could
stimulate tax receipts by attracting other tax-paying businesses to the city. That
suggestion prompts other students to point out the likelihood of
additional costs (e.g., for added police and fire protection) if the city
grows as a result of the center. There are likely to be some students who
will argue that a convention center and possible growth are the last things a
city needs. Overcrowding, congestion, pollution, and other undesirable
features could emerge from the building of the center. Additionally the estimates
are very subjective. Hence the initial question eventually leads students to
recognize the possibility of conflict
between qualitative and quantitative factors.

7-37 Comparison of NPV and Profit (25-30 minutes)

1. The capital-intensive process gives the higher income.

Labor Capital
Intensive Intensive
Sales (100,000 x $50) $5,000,000 $5,000,000
Variable costs at $20, $10 2,000,000 1,000,000
Contribution margin 3,000,000 4,000,000
Fixed costs* 1,400,000 2,100,000
Taxable income 1,600,000 1,900,000
Income taxes (40%) 640,000 760,000
Net income $ 960,000 $1,140,000

* $400,000 + ($4,000,000/4); $600,000 + ($6,000,000/4)

2. The labor-intensive process gives the higher book rate of return on
average investment.
Labor Capital
Intensive Intensive
Net income $ 960,000 $1,140,000
Divided by average investment $2,000,000 $3,000,000
Equals book rate of return 48% 38%
3. The labor intensive process has the higher NPV.
Labor Capital
Intensive Intensive
Contribution margin from requirement 1 $3,000,000 $4,000,000
Fixed cash operating costs 400,000 600,000
Change in pretax cash flow 2,600,000 3,400,000
Depreciation ($4,000,000/4; $6,000,000/4) 1,000,000 1,500,000
Increase in taxable income 1,600,000 1,900,000
Increased taxes (40%) 640,000 760,000
Increase in net income 960,000 1,140,000
Add back depreciation (not a cash flow) 1,000,000 1,500,000
Net cash flow $1,960,000 $2,640,000
Present value factor, 4 years, 16% 2.798 2.798
Present value of future cash flows $5,484,080 $7,386,720
Investment required 4,000,000 6,000,000
Net present value $1,484,080 $1,386,720
Difference in NPVs = $97,360

4. The memo should report the NPVs of the two alternatives and express a
preference for the labor-intensive process because of its higher NPV. The
memo should also note the relatively small difference between the NPVs and
urge further consideration of qualitative factors that might tip the decision
one way or the other. The memo should emphasize that the preference was based on NPV
rather than book rate of return, and it could point out that book rates of return
overstate the differences between the two alternatives.

7-38 Capital Budgeting for a Computer Service Company (25 minutes)

Tax Cash Flows

Additional revenues (12 x $40,000) $480,000 $ 480,000
Additional cash expenses (12 x $4,000) 48,000 48,000
Cash flow before taxes 432,000 432,000
Depreciation (given) 225,000
Income before taxes 207,000
Income taxes, 40% $ 82,800 82,800
Net cash flow after taxes $ 349,200
Present value factor, 4 years, 16% 2.798
Present value of future annual cash flows $ 977,062
Present value of salvage value ($300,000 x .552) 165,600
Total present value of investment 1,142,662
Investment 1,200,000
Net present value ($ 57,338)
7-39 Reevaluating an Investment (20 minutes)

An analysis using discounted cash flow techniques shows that the investment was
unwise. Both NPV and IRR suggest the same answer.

Net present value method

Tax Cash Flows
Annual cost savings $69,000 $ 69,000
Depreciation 25,000
Increase in taxable income 44,000
Income tax at 40% rate $17,600 17,600
Net cash flow $ 51,400
Present value factor, 10 years, 16% 4.833
Present value of returns $248,416
Investment 250,000
Net present value ($ 1,584)

Note to the Instructor: It's important to point out that the wisdom of
the original investment decision has no bearing on whether the machinery
should be replaced now. Similar machinery purchased now might yield a return
greater than 16%. What can be said is that if the machinery available now
 would cost $250,000, have a 10-year life with no salvage value, provide $69,000 in
savings, and be depreciated using the straight-line method, it is unwise to buy it,
though just barely.

Problem 1]
Purchase price P140,000
Trade-in allowance ( 7,000)
Saving from repairs ( 25,000)
Additional tax on savings (P25,000 x 40%) 10,000
Net cost of investment for decision analysis P118,000

[Problem 2]
Purchase price P4,800,000
Freight and installation 45,000
Trade-in allowance ( 200,000)
Salvage value of other assets 12,000
Tax savings – other assets ( 8,000)
Savings from repairs ( 400,000)
Add’l tax on savings from repairs(P400,000 x 40%) 160,000
Additional working capital 350,000
Net cost of investment for decision analysis P4,759,000

[Problem 3]
Purchase price P900,000
Freight charge 25,000
Installation costs 22,000
Special attachment 55,000
Add’l working capital 110,000
Proceeds from sale of old assets ( 22,000)
Tax savings (P38,000 x 25%) ( 9,500)
Savings from repairs ( 120,000)
Add’l tax on savings from repairs (P120,000 x 25%) 30,000
Net cost of investment for decision analysis P990,500

[Problem 4]
Furnishing and equipment P 500,000
Rental deposits 200,000
Accounts receivable (P9M x 1/3 x 2/3) 2,000 000
Inventory 400,000
Cash 120,000
Net cost of investment for decision analysis P5,020,000

[Problem 5]
1. Sales P6,000,000
Materials ( 800,000)
Labor ( 1,200,000)
Factory overhead ( 540,000)
Selling and administrative expenses ( 700,000)
Depreciation expense (P1,200,000  5 yrs) ( 240,000)
Income before income tax 2,520,000
Tax (30%) ( 756,000)
Net income 1,764,000
Add back: Depreciation expense 240,000
2. Annual net cash flows P2,004,000

[Problem 6]
1. Weighted Average Cost of Capital (WACOC) = ?
Sources of
capital Market values Individual Cost of Capital Mix WACOC
Capital Fraction
Mortgage bonds (P300,000 x 105%) = P315,000 (10% x 55%) = 5.5% 315 / 1.007 1.72%
Preferred equity (2000 sh x P96) = 192,000 (P12 / P96) = 12.5 192 / 1.007 2.38%
Common equity (50,000 sh x P10) = 500,000 P1.50 / P10 = 15.0 500 / 1.007 7.45%
Total P1,007,000 11.55%
Preferred dividends = 12% x P100 = P12 / sh
Earnings per share = P75,000 / 50,000 sh = P1.50

2.
Proposed Investment ROI WACOC Advise
A 7% 11.55% Reject
B 10% 11.55% Reject
C 14% 11.55% Accept

Investments are to be accepted if the WACOC is higher than the ROI.

[Problem 7]
1. New WACOC = ?
Cost of Package 1 Package 2 Package 3
Sources of WACO WACO
Money Capital Amount C Amount C Amount WACOC
Long-term
debt 6% P10,000,000 3% P 2,000 000 0.60% P 6,000,000 1.80%
Preferred
equity 11% 3,000,000 1.65% 11,000 000 6.05% 5,000,000 2.75%
Common 7,000,
equity 14% 7,000,000 4.90% 000 4.90% 9,000,000 6.30%
Total P20,000,000 9.55% P20,000,000 11.55% P20,000,000 10.85%

2. Package 1 gives the invest WACOC at 9.55%.

[Problem 8]
Before Bonds Retirement After Bonds Retirement
Amount WACOC Amount WACOC
Bonds P 5,000,000 (8% x 60% x 5/10) = 2.4% P4,000,000 (8% x 60% x 4/10) = 1.92%
Preferred
equity 1,000,000 (9% x 1/10) = 0.9% 1,000,000 (9% x 1/10) = 0.90%
Common
equity 4,000,000 (12.5% x 4/10) = 5% 4,000,000 (12.5% x 4/10) = 5.0%

Lease 1,000,000 10% x 60% x 1/10) = 0.60%

P
Totals P10,000,000 8.30% 10,000,000 8.42%

[Problem 9]
a. WACOC = ?
Individual Cost of
Funds Amount Capital WACOC
Mortgage bonds P20,000,000 [(6.5% x 50%) / 95%] 3.42% 0.684%
Common stock 25,000,000 [(P4 x 105%) /P94 + 5%] 9.47 2.3675%
Ret earnings 55,000,000 9.47 5.2085%
Total P100,000,000 8.26%

b. The weighted average cost of capital is used as a benchmark in evaluating the acceptability or rejection of proposed
investment because it measures the point of expected return where the minimum required return of each class of investor is
met by reason of cross-subsidizing from one class of security to another.
 [Problem 10]
a. WACOC under each alternative

Alternative A Alternative B
Debt (9% x 50% x 2/6) = 1.5% (12% x 50% x 4/6) = 4.0%
Equity {[(P1/P20) + 7%] x 4/6} = 8.0% {[(P0.90/P20) + 12%] x 2/6} = 5.5%
WACOC 9.5% 9.5%

b. In alternative B, the amount of debt increases thereby increasing the debt equity ratio signalling the firm is highly leveraged
and more risky for investment. This tends to increase the nominal rate of the bonds.

c. Yes; it is logical for stockholders to expect a higher dividend growth rate under alternative B to compensate the higher rate
implied by an increase in the debt exposure of the firm and to validate the theory that the more debt is used in the financing
portfolio, the higher the profitability rate of the firm, thereby, the higher the growth rate.

[Problem 11]
1. Marginal Cost of Capital for each fund
2. WACOC = ?
[a] Capital Mix [b]
Sources Individual COC Rate WACOC
Mortgage bonds (14% x60%) = 8.4% 15.00% 1.26%
Debentures (145% x 60%) = 8.7% 25.00% 2.175%
Preferred stock (P13.50/ P99.25) = 13.60% 10.00% 1.36%
(P1.80 / P67.50 +
Common stock 10%)=12.67% 16.67% 2.11%
Retained earnings = 12.67% 33.33% 4.22%
100.00% 11.125%
3. Maximum point of expansion for retained earnings:
Net income (P4.50 x 15 million shares) P67,500,000
Common dividends (P67,000,000 x 40%
or P1.80 x 15 million) ( 27,000,000)
Preferred stock dividends ( 6,750,000)
Retained earnings available for expansion P33,750,000
Common equity = 50% of total capitalization
Maximum point of expansion before common stock
shares are issued = P33,750,000 / 50% = P67.5M

4. The WACOC varies among firms in the industry even if the basic business risk is similar for all firms in the industry. This is
true because each firm selects the degree of financial leverage it desires. This financial leverage affects the capital mix
structure of a firm that affects the determination of the weighted average cost of capital.

[Problem 12]
1. WACOC before and after bond retirement:
[1] Before Bond Retirement [2] After Bond retirement
Capital Amount WACOC Amount WACOC
Lease P1,000,000 (10% x 60% x 1/10) = 0.6%
8% Debentures P5,000,000 8% x 60% x 5/10) = 2.4% 4,000,000 (8% 60% x 4/10) = 1.92%
9% Preferred
stock 1,000,000 (9% x 1/10) = 0.9% 1,000,000 {same} 0.9%
Common stock 2,000,000 (13% x 2/10) = 2.6% 2,000,000 {same} 2.6%
Retained
earnings 2,000,000 (13% x 2/10) = 2.4% 2,000,000 {same} 2.4%
P10,000,000 8.30% P10,000,000 8.42%
2. The component costs and the weighting used to calculate the WACOC in a-1 is different in a-2 because P1 M of debentures
are replaced by lease which is more expensive (from 8% to 10% nominal rate). This brings up the WACOC to 8.42%.
3. Market values should be used in calculating the WACOC because COC calculation is used to estimate the current marginal
cost of capital for the company. The use of market values
a. recognizes the current investor attitudes regarding the company’s risk position and will reflect current rates for capital.
b. recognizes better the capital proportions the company must consider in the capital sources decision; and
c. ignores the influence of past values which are not relevant to future decision.

[Problem 13]
1. The board member’s agreement is incorrect because the facts seem to indicate that Kia Corporation’s capitalization is not in
optimum mix (i.e., equilibrium). The issuance of new debt will increase the financial leverage of the firm, increases the risk,
increases the note’s nominal rate, and decreases the earnings multiple. While the marginal cost of capital is a combination of
explicit interest cost on the notes and the additional cost of earnings that must occur to compensate the common stockholders
for the decline in the earnings multiple. The 14% return in this project should be compared with the new weighted average
cost of capital if the issuance of note is undertaken.

2. New level of annual earnings of the earnings multiple declines to 9 =?

1. Present market price per share = 10(P2.70) = P27.00
Required EPS (new) = P27/9 = P3.00
Required earnings before tax
(P3.00 x 10,000,000 shares / 50%) P 60,000,000
Interest expense
[(P10 M x 8%) + (P50M x 10%)] 5,800,000
Required earnings before interest and taxes 65,800,000
Less: Old earnings before interest and taxes
{[(P2.70 x 10,000,000 shares) / 50%] + P800,000} 54,800,000
Additional earnings before interest and taxes P 11,000,000

Additional informational analysis:

If the earnings multiple declines to 9, the additional earnings provided by the new assets to maintain the same
market price per share of P27 shall be:
X = additional earnings
(new P/E) (new EPS) = P27
9 ( P2.70 + X) = P27
2.70 + X = P3
X = P0.30

[Problem14]
1. Breaks = ?
Breaks or increases in weighted marginal cost of capital will recur as follows:
For Debt = Debt / Debt Ratio = P100,000 / 40% = P250,000
For Equity = Equity / Equity Ratio = P150,000 / 60% = P350,000

2. WACOC = ?
a. Before the break (P1 – P250,000 amount of financing)
i. Debt = 7% x 40% = 3.2%
ii. Equity = 18% x 60% = 10.8%
iii. WACOC 14.0%
b. After the break (P250,001 – above amount of financing)
Debt = 10% x 40% = 4.0%
Equity = 22% x 60% = 13.2%
WACOC 17.2%
3. Graph of marginal cost of capital (MCC) schedule and investment opportunities schedule (IOC):
26
24 IRR ( )
22 A MCC (------)
20
18 B MCC
16
14
12 C
10
8
6
4
2

0
100 200 225 300 400 450 500 (new financing,
thousands of
pesos)
4. Projects are to be accepted as long as the IRR is greater than the MCC. Projects A and B are acceptable; based on the
following:
Project IRR MCC Advise
A 19% 14% Accept
B 15% 14% Accept
C 12% 17.20% Reject

[Problem15]
1. EPS and market price per share = ?
a. Raise P100,000 by issuing 10-year, 12% bonds
Case 1 Case 2 Case 3
Sales P 400,000 P 600,000 P 800,000
- Costs and operating expenses (90%) 360,000 540,000 720,000
EBIT 40,000 60,000 80,000
-Interest charges
[P2,000 + (12% x P100,000)] 14,000 14,000 14,000
IBIT 26,000 46,000 66,000
- Tax (50%) 13,000 23,000 33,000
Net Income P 13,000 P 23,000 P 33,000

Earnings per share

(NI / 10,000 shares) P1.30 P2.30 P3.30
Price / earnings rates 10x 10x 10x
Market price per share P13 P23 P33
EPS (old) = P36 / 12 = 3
No. of shares = P30,000 / P3 = 10,000 sh
b. Raise P100,000 by issuing new column stock
Case 1 Case 2 Case 3
Sales P 400,000 P 600,000 P 800,000
- Costs and D Exp (90%) 360,000 540,000 720,000
EBIT 40,000 60,000 80,000
-Interest expense 2,000 2,000 2,000
IBIT 38,000 58,000 78,000
- Tax (50%) 19,000 29,000 39,000
Net Income P 19,000 P 29,000 P 39,000
Earnings per share
(NI / 13,000Shares) P1.46 P2.23 P3.00
Price / earnings rates 12x 12x 12x
Market price per share P17.52 P26.76 P36
No. of shares
(P100,000 / P33.33 + 10,000) 13,000 13,000 13,000

2. Recommended proposal = ?
The recommendation shall be based on the following criteria:
Wealth Maximization Profit Maximization
 Brief desorption of  Wealth maximization is  Profit maximization is a
the criteria primordial among shareholders short-run strategy to satisfy
in as much as this is the end the interest of shareholders.
objective of business. This This profit maximization
wealth maximization principle strategy is .best represented
is represented by the market by the earnings per share.
price per share.
 The proposal chosen  The total sales of the firm
should be higher than
P600,000, since its sales last
year was already at P600,000.
At this level and more, the
market price per share is higher
by issuing a new share of
stock. Wealth maximization is
a strategic reason of managing
a business, hence, at guides
organization in its long-term
decisions, such as financing
decision.
3. No, the financing package chosen would be the same. The higher the level of sales in excess of P600,000, the more
favorable it is on the part of the business!

4. The investment banker would rationalize that issuance of more debt securities would mean a greater variability in
earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and principal. This
would bring restrain by diminishing the earnings multiple to compensate the increased risk in leverage.