CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 1021:

  Jackson Corporation is evaluating the following four independent, investment opportunities: Project CostRate of Return A$300,000 14% B$150,000 10 C$200,000 13 D$400,000 11 Jackson's target capital structure is 60 percent debt and 40 percent equity. The yield to maturity on the company's debt is 10 percent. Jackson will incur flotation costs for a new equity issuance of 12 percent. The growth rate is a constant 6 percent. The stock price is currently $35 per share for each of the 10,000 shares outstanding. Jackson expects to earn net income of $100,000 this coming year and the dividend payout ratio will be 50 percent. If the company's tax rate is 30 percent, then which of the projects will be accepted?

  A. All of the investment projects will be taken.

  B. Projects A, C, and D.

  C. Projects A and C.

  D. None of the investment projects will be taken.

  E. Project A.

  Correct Answer: E

  Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then it will retain earnings of $50,000. The retained earnings breakpoint is $50,000/0.4 = $125,000. Since it will require financing in excess of $125,000 to undertake any of the alternatives, we can conclude the firm must issue new equity. Therefore, the pertinent component cost of equity is the cost of new equity. Calculate the expected dividend per share as $50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)] + 6% = 22.23%. Jackson's WACC is 7%(0.6) + 22.23%(0.4) = 13.09%. Only the return on Project A exceeds the WACC, so only Project A will be undertaken.

• Question 1022:

  Your company is planning to open a new gold mine which will cost $3 million to build, with the expenditure occurring at the end of the year. The mine will bring year-end after-tax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $0.5 million to close down the mine at the end of the third year of operation. What is this project's IRR?

  A. 12.70%

  B. 14.36%

  C. 10.17%

  D. 21.53%

  E. 17.42%

  Correct Answer: A

  Time line:

  -3,000,0002,000,0002,000,000-500,000

  Financial calculator solution: (In millions)

  Inputs: CF(0) = -3; CF(1) = 2; N(j) = 2; CF(2) = -.5.

  Output: IRR% = 12.699%.

• Question 1023:

  Firmica recently bought a fleet of trucks which fall in the 5-year MACRS class for $135,000, with an additional $10,000 for shipping, minor taxes and paperwork. The trucks are expected to last for 7 years and have a total salvage value of $25,620. The recovery allowance for year 1 in the 5-year MACRS class is 20% and in the second year, it is 32%. In the second year, the depreciation expense arising from the fleet equals ________.

  A. $46,400

  B. $34,560

  C. $43,200

  D. $37,120

  Correct Answer: A

  You should remember four things about MACRS:

  1.

  Salvage value is never considered in calculating the depreciable basis.

  2.

  The depreciable basis equals the purchase price plus all shipping and installation costs. 3. The depreciable basis does not change over the life of the asset in question.

  4. Depreciation expense for any given year equals the allowed recovery percentage in that MACRS class times the depreciable basis. Therefore, in this case, the depreciable basis equals $135,000 + $10,000 = $145,000 and the year 2 depreciation equals $145,000*32% = $46,400.

• Question 1024:

  Which of the following statements is correct?

  A. When the MCC (Marginal Cost of Capital) schedule is developed, the first break point always occurs as a result of using up retained earnings.

  B. Flotation costs must be included in the component cost of preferred stock.

  C. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.

  D. The WACC (Weighted Average Cost of Capital) should include only after-tax component costs. Therefore, the required rates of return on debt, preferred, and common equity must be adjusted to an after-tax basis before they are used in the WACC equation.

  E. The cost of retained earnings is generally higher than the cost of new common stock.

  Correct Answer: C

  If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T (the firm's marginal tax rate) were greater than 0. With a higher component cost of debt, the WACC would be increased. Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, i.e., its capital budget would be larger than if it were taxed.

• Question 1025:

  Consider the following information:

  Borrowing Rate 10%

  Marginal Tax Rate 40%

  Preferred Stock Par Price $50

  Preferred Dividend $5 Preferred Stock floatation cost 2.0% Cost of common equity 15.0% Preferred Stock issued at Par The Optimal Capital Structure is 45% debt, 50% common equity, and 5% preferred stock. Credit Rating BB + What is the firm's Weighted Average Cost of Capital (WACC)?

  A. 9.0%

  B. 7.14%

  C. 9.06%

  D. 10.71%

  E. 2.5%

  F. 28.00%

  Correct Answer: D

  The firm's Weighted Average Cost of Capital (WACC) is a weighted average of the component cost of capital. In this case 10%(borrowing rate) x (1-.4)Tax savings = 6% is the component cost of debt. $5 (preferred dividend) / 49(Par minus floatation cost) = 10.2% is the component cost of preferred stock. Thus the WACC = .45(6%) + .5(15%) + .05(10.2%) = 10.71%

• Question 1026:

  Which of the following is/are true for a project which needs only an initial outlay and no further expenses?

  I. The shorter the payback period, the greater the liquidity of the project.

  II. The discounted payback period is always more than the simple payback period.

  III.

  The payback period rule considers all the cash flows involved in a project.

  A.

  II and III

  B.

  II only

  C.

  I and II

  D.

  III only

  E.

  I and III

  F.

  I only

  G.

  I, II and III

  Correct Answer: C

  The payback period measures how quickly you recover your initial investment. The shorter this period, the greater the liquidity in terms of cash recovery. The payback rule ignores cash flows beyond the payback period. The discounted payback period is defined as the expected number of years that would be required to recover the original investment using discounted cash flows. Hence, (II) is true if there are no negative cash flows after the initial investment since discounting reduces the present value of the future cash flows.

• Question 1027:

  The following information applies to a company's preferred stock: Current price $105.00 per share Par value $100.00 per share Annual dividend $5.00 per share The company issued the preferred stock at par and incurred a 10% floatation cost. If the company's marginal corporate tax rate is 40%, what is the after-tax cost of preferred stock?

  A. 5.0%

  B. 10.0%

  C. 3.0%

  D. 4.8%

  E. 5.6%

  F. 2.9%

  Correct Answer: E

  The cost of preferred stock is calculated as the preferred stock dividend divided by the net issuing price. The dividend for this preferred stock is $5.00, and the net issuing price was $90.00. Thus the cost of preferred stock is 5 divided by 90 or 5.6%. There are no tax savings associated with the use of preferred stock, therefore no tax adjustments are made when calculating the cost.

• Question 1028:

  Which of the following projects would likely result in multiple Internal Rates of Return? Project A Initial investment outlay: ($450,000) t1: $400,000 t2: ($40,000) t3: $190,000 Project B Initial investment outlay: ($50,000) t1: $0.00 t2: $0.00 t3: $75,000 Project C Initial investment outlay: ($300,000) t1: $15,000 t2: ($34,000) t3: $0.00 t4: $400,000 Project D Initial investment outlay: ($100,000) t1: $150,000 t2: $380,000 t3: $45,000 t4: $45,000 Project E Initial investment outlay: ($1,000,000) t1: $1,500,000 t2: $1,300 t3: $0.00 t4: $60,000

  A. None of these choices

  B. Project B, Project D

  C. The answer cannot be determined from the information provided

  D. Project C, Project E

  E. Project A, Project C,

  F. Project D, Project E

  Correct Answer: E

  In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects A, and C involve cash outflows superimposed within their cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as these, it is advisable to use either the NPV or MIRR methods, which are not subject to the problem of multiple IRRs. From observation alone, we can determine that project A and C are non-normal projects, and are thus likely to result in multiple IRR calculations. While project B, D, and E have periods of zero cash flow, they have only one change of sign in the overall cash flow process, and therefore should be characterized as "normal." While the cost of capital has been provided, it is not necessary for the determination of the correct answer in this case. What you should look for are projects with non-normal cash flows, and this should not involve any computational analysis. Besides, the cost of capital is not incorporated into the Internal Rate of Return calculation, rather is a component of the NPV and MIRR.

• Question 1029:

  Clay Industries, a large industrial firm, has begun the development of an underwater drilling system which will greatly increase the efficiency of deep-sea petroleum extraction. In their analysis of the project's cash-flow potential, the corporate finance division of Clay Industries does not factor in the initial RandD costs for the quarter, rather examines only the initial cash outlay and expected cash inflows specific to the underwater drilling system. The RandD costs involved for this quarter could best be described as which of the following?

  A. Externality

  B. None of these answers

  C. Opportunity cost

  D. Implicit cost

  E. Sunk cost

  F. Incremental cost

  Correct Answer: E

  In this example, the RandD expenditures are an example of a sunk cost. In an analysis of any project, sunk

  costs are not included. This is because sunk costs represent outlays which have already occurred or have

  already been committed.

  These costs are not incremental, and hence are not affected by the decision under consideration.

• Question 1030:

  Consider the following two projects: Project A Initial cash outflow:$1,000,000 Cash inflows as follows t1: $500,000 t2: $450,000 t3: $250,000 t4: $150,000 t5: $150,000 Project B Initial cash outflow: $1,000,000 Cash inflows as follows t1: $150,000 t2: $150,000 t3: $250,000 t4: $450,000 t5: $500,000 Assuming a cost of capital of 9%, no taxes, and a $0.00 salvage value for each project at the end of year 5, what is the NPV of each project? Additionally, which of the two projects has the steeper NPV profile?

  A. Project A NPV: $88,596.13, Project B NPV: $110,900.51, Project A has a steeper NPV profile

  B. Project A NPV: $114,078.88, Project B NPV: $100,669.59, Project has B has a steeper NPV profile

  C. Project A NPV: $234,270.95, Project B NPV: $100,669.59 , Project A has a steeper NPV profile

  D. Project A NPV: $234,270.95, Project B NPV: $100,669.59, Project B has a steeper NPV profile

  E. Project A NPV: $234,270.95, Project B NPV: $100,669.59, Project A has a steeper NPV profile

  Correct Answer: D

  Due to the fact that project B has the majority of its cash inflows coming in later periods, it is more sensitive to changes in the cost of capital than is project A, which has the majority of its cash flows coming in earlier periods. This is exemplified by a steeper NPV profile.