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Integrated MAS

Cost of Capital

15 SEPTEMBER 2018
Cost of Capital – Exercise 1

Robbins Corporation has a target capital structure


consisting of 20 percent debt, 20 percent preferred
stock, and 60 percent common equity. Assume the
firm has insufficient retained earnings to fund the
equity portion of its capital budget. Its bonds have a
12 percent coupon, paid semiannually, a current
maturity of 20 years, and sell for P1,000. The firm
could sell, at par, P100 preferred stock that pays a 12
percent annual dividend, but flotation costs of 5
percent would be incurred.
Cost of Capital – Exercise 1

Robbins’ beta is 1.2, the risk-free rate is 10 percent,


and the market risk premium is 5 percent. Robbins is
a constant growth firm that just paid a dividend of
P2.00, sells for P27.00 per share, and has a growth
rate of 8 percent. The firm’s policy is to use a risk
premium of 4 percentage points when using the
bond-yield-plus-risk-premium method to find ks.
Flotation costs on new common stock total 10
percent, and the firm’s marginal tax rate is 40
percent.
Cost of Capital – Exercise 1

a. What is Robbins’ component cost of debt?

Component cost of debt = 7.2%


Cost of Capital – Exercise 1

b. What is Robbins’ cost of preferred stock?

Cost of Preferred Stock = 12.6%


Cost of Capital – Exercise 1

c. What is Robbins’ cost of retained earnings using


the CAPM approach?

Cost of Retained Earnings (CAPM) =


16.0%
Cost of Capital – Exercise 1

d. What is the firm’s cost of retained earnings using


the DCF approach?

Cost of Retained Earnings (DCF) = 16.0%


Cost of Capital – Exercise 1

e. What is Robbins’ cost of retained earnings using


the bond-yield-plus-risk-premium approach?

Cost of Retained Earnings (BYPRP) = 16.0%


Cost of Capital – Exercise 1

f. What is Robbins’ WACC, if the firm has insufficient


retained earnings to fund the equity portion of its
capital budget?

WACC if insufficient RE = 14.1%


Cost of Capital – Exercise 2

The Galaxy Advertising Company has a marginal tax rate of


40 percent. The company can raise debt at a 12 percent
interest rate and the last dividend paid by Galaxy was
P0.90. Galaxy’s common stock is selling for P8.59 per
share, and its expected growth rate in earnings and
dividends is 5 percent. If Galaxy issues new common
stock, the flotation cost incurred will be 10 percent.
Galaxy plans to finance all capital expenditures with 30
percent debt and 70 percent equity.
Cost of Capital – Exercise 2

a. What is Galaxy’s cost of retained earnings if it can


use retained earnings rather than issue new
common stock?

Cost of Retained Earnings = 16.0%


Cost of Capital – Exercise 2

b. What is the cost of common equity raised by


selling new stock?

Cost of Common Equity = 17.22%


Cost of Capital – Exercise 2

c. What is the firm’s weighted average cost of capital


if the firm has sufficient retained earnings to fund
the equity portion of its capital budget?

WACC = 13.36%