Risks, Returns and Capital Structure

FAR EASTERN UNIVERSITY

Institute of Accounts Business and Finance
FINANCIAL MARKETS
HANDOUT NO. 1 – RISKS, RETURNS AND CAPITAL STRUCTURE (BOND VALUATION,
STOCK VALUATION AND COSTS OF CAPITAL)

PROBLEM NO. 1
Tubao Motors’ bonds have 5 years remaining to maturity. Interest is paid annually. The bonds have a P1,000 face
value, and the coupon interest rate is 6 percent. The bonds have a yield to maturity of 7. 5 percent.
1. What is the current market price of these bonds?
2. Assuming that the YTM is 5.25%, what is the current market price?

PROBLEM NO. 2
Richmond Company is planning to issue P10 million bonds that will mature in ten years. The bonds have a face
value of P1,000 and a yield to maturity of 8 percent. They pay interest annually and have a 9 percent coupon rate.
What is their current yield?

PROBLEM NO. 3
Graham Company’s 5-year 8% bonds are issued at P1,075 per bond.
1. What is the yield to maturity for these bonds?
2. What is the YTM for these bonds assuming they are issued at P975 before P50 flotation costs.

PROBLEM NO. 4
Case A
The bonds issued by Priceless Jewelers bear a 7.5 percent coupon, payable semiannually. The bond s mature in 13
years and have a P1,000 face value. Currently, the bonds sell at par. What is the yield to maturity?
a. 7.33% c. 7.46%
b. 7.41% d. 7.50%

Case B
Wesley Company bonds have an 8.25 percent coupon and pay interest annually. The face value is P1,000 and the
current market price is P1,004.60 per bond. The bonds mature in 17.5 years. What is the yield to maturity?
a. 7.82 percent c. 8.20 percent
b. 7.97 percent d. 8.25 percent

Case C
Culpepper Supply has a bond issue outstanding that pays a 7.5 percent coupon and matures in 14 years. The
bonds have a par value of P1,000 and a market price of P942.90. Interest is paid semiannually. What is the yield
to maturity?
a. 7.50 percent c. 8.19 percent
b. 7.67 percent d. 8.60 percent

PROBLEM NO. 5
Alpha Company issued preferred stock with a stated dividend of 8 percent of par value. Preferred stock of this type
currently yields 9 percent, and the par value is P100. Assume that the dividends are paid annually. What is the value
of Alpha’s preferred stock?

PROBLEM NO. 6
Timex Industries plans to issue perpetual preferred stock with a P6 dividend based on P100 par value. The stock
is currently selling for P96.50 subject to flotation costs of 7.5% of the market price. What is the cost of the
preferred stock, including flotation?

PROBLEM NO. 7
Lodi Company wants you to analyze its cost of common stock. During the next 12 months, the company expects
to pay dividends of P1.20 per share, and the current price of its common stock is P36 per share. The expected
growth rate is 4.5%. The issue requires 8 percent flotation cost.
a. Compute the cost of retained earnings.
b. Compute the cost of new common stock.

PROBLEM NO. 8
Enrico Company’s stock currently sells for P30.00 a share. It just paid a dividend of P0.75 a share. The dividend
is expected to grow at a constant rate of 5% a year.
1. What is the expected rate of return on retained earnings?
2. What stock price is expected 2 years from now?

PROBLEM NO. 9
Orange Enterprises recently paid a dividend of P1.20. It expects to have non-constant growth of 40% for 3 years
followed by a constant rate of 5% thereafter. The firm’s required return is 9%.
1. How far away is the terminal date?
2. What is the firm’s horizon or terminal value?
3. What is the firm’s intrinsic value today, P0?

ACT 1109 HO-01 – 1 of 2

 Risks, Returns and Capital Structure

PROBLEM NO. 10
Samar Mining Company’s ore reserves are being depleted, so its sales are falling. Also, because its pit is getting
deeper each year, its costs are rising. As a result, the company’s earnings and dividends are declining at the
constant rate of 5% per year. If D0 = P1.50 and the expected return is 7.5%, what is the value of Samar Mining’s
stock?

PROBLEM NO. 11
Subic Corporation is expected to pay the following dividends over the next four years: P6, P4, P3, and P2.
Afterwards, the company pledges to maintain a constant 5 percent growth rate in dividends, forever. If the required
return on the stock is 10 percent, what is the current price per share of common stock?

PROBLEM NO. 12
The Orient Bank just issued some new preferred stock. The issue will pay an annual dividend of P3.60 in perpetuity,
beginning 4 years from now. If the market requires a 9 percent return on this investment, how much does a share
preferred stock cost today?

PROBLEM NO. 13
Use the basic equation for the capital asset pricing model (CAPM) for the following:
1. Find the required return for an asset with a beta of 1.25 when the risk-free rate and market return are 4 and 9
percent, respectively.
2. Find the required return for an asset with a beta of 0.90 when the risk-free rate and market return are 6 percent
and 10 percent, respectively.
3. Find the beta for an asset with a required return of 11 percent when the risk-free rate and market return are 5
percent and 8 percent respectively.

PROBLEM NO. 14
Use the following information:
State Probability Return
Boom 20% 40%
Normal 60% 15%
Recession 20% (20%)

1) Calculate your company's expected return.

2) Calculate the standard deviation.
3) Calculate the coefficient of variation.

PROBLEM NO. 15
Yohanne Corporation is expanding its research and production capability to introduce a new line of products.
Current plans call for the expenditure of P100 million on four projects of equal size (P25 million each), but different
returns. Project A is in blood clotting proteins and has an expected return of 14 percent. Project B relates to a
hepatitis vaccine and carries a potential return of 12.5 percent. Project C, dealing with a cardiovascular compound,
is expected to earn 11.8 percent and Project D, an investment in orthopedic implants, is expected to show a 10.5
percent 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 percent of the financing), all additional equity financing must come in the form
of new common stock.
Common stock is selling for P24 per share and underwriting costs are estimated at P3 if new shares are issued. Dividends
for the next year will be P2.00 per share (D1), and earnings and dividends have grown consistently at 6 percent.
The yield on comparative bonds has been hovering at 9.2 percent. The investment banker feels that the first P20 million
of bonds could be sold to yield 9.2 percent while additional debt might require a 2 percent premium and be sold to yield
11.2 percent. The corporate tax rate is 40 percent. Debt represents 40 percent of the capital structure.
1. Based on the two sources of financing, what is the initial weighted average cost of capital?
2. At what capital structure size will the firm run out of retained earnings?
3. What will the marginal cost of capital be immediately after that point?
4. At what capital structure size will there be a change in the cost of debt?
5. What will the marginal cost of capital be immediately after that point?
6. Based on the information about potential returns on investments in the first paragraph and information on marginal
cost of capital (in parts 1, 3, and 5), how large a capital investment budget should the firm use?

“Excellence is not an act, but a Habit.” –Aristotle

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ACT 1109 HO-01 – 2 of 2