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

• Question 1041:

  Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 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-plusrisk- premium method to find k(s). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' WACC once it starts using new common stock financing?

  A. 16.6%

  B. 13.6%

  C. 14.1%

  D. 16.9%

  E. 16.0%

  Correct Answer: C

  k(e) = $2.16/ $27.00(1-.10) + 0.08 = 0.08889 + 0.08 = 0.169 = 16.9%. WACC = 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.9%) = 14.1%.

• Question 1042:

  Which of the following equations correctly illustrates the calculation of the cost of equity using the Discounted Cash Flow approach?

  A. (Retention rate)*(ROE)

  B. Last annual dividend/(1 + required rate of return)

  C. Next annual dividend/current stock price

  D. (1-tax rate)

  E. (Next annual dividend/current stock price) + expected growth rate

  F. (Last annual dividend/[expected return - required return])

  G. expected growth rate

  H. Risk-free rate of return + beta(expected return on the market - risk-free rate of return)

  Correct Answer: E

  The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The fourth choice illustrates the Capital Asset Pricing Model, while the fifth represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.

• Question 1043:

  While calculating the weights of various components of the capital structure, one must use:

  A. minimum of book or market values.

  B. book values.

  C. liquidation values.

  D. market values.

  Correct Answer: D

  WACC calculations are based on current market values, not historical cost.

• Question 1044:

  Assume the following information about two individual projects. Project A Initial cash outflow: $175,000 Expected cash inflows t1: $75,000 t2: $65,000 t3: $35,000 t4: $35,000 t5: $15,000 Project B Initial cash outflow: $100,000 Expected cash inflows t1: $15,000 t2: $15,000 t3: $18,000 t4: $45,000 t5: $45,000 Assuming these projects are not mutually exclusive, and the cost of capital is 10%, which of the two should be undertaken according to NPV? Additionally, which of the two projects has the steeper NPV profile?

  A. Project B should be accepted, project A has a steeper NPV profile

  B. Project A should be accepted, project A has a steeper NPV profile

  C. Project B should be accepted, project B has a steeper NPV profile

  D. Both projects should be accepted, project A has a steeper NPV profile

  E. Project A should be accepted, project B has a steeper NPV profile

  F. Neither project should be accepted, project B has a steeper NPV profile

  Correct Answer: E

  The NPV of project B is found to be ($1,766.21), and thus should not be accepted. However, project A has a positive NPV of $6,416.14, and should be accepted. Project B is characterized as having the majority of its cash inflows occurring in later time periods, and thus is more sensitive to changes in the cost of capital. This is exemplified by a steeper NPV profile for project B.

• Question 1045:

  A project has the following cash flows over the next 5 years: $800, $300, $400, $900 and $1,200. Assume all cash flows occur at the end of a year. The project requires an initial cash outlay of $1,750. The firm faces a marginal borrowing rate of 8%. The payback period for the project equals ________.

  A. 3.86 year

  B. 4.19 years

  C. 4 years

  D. 3.28 years

  Correct Answer: D

  The payback period is defined as the expected number of years that would be required to recover the original investment. In particular, Payback period = Years before full recovery + (unrecovered cost at the start of payback year)/(net cash flow in the payback year) In this case, the recovery occurs in the 4th year. At the beginning of the 4th year, the unrecovered cost equals 1,750 - 800 300 - 400 = 250. Total cash flow in the 4th year equals 900. Therefore, payback period = 3 + 250/900 =

  3.28 years. Note that the discount rate does not figure in the calculation of payback period.

• Question 1046:

  A firm's capital structure has a debt-to-equity ratio of 0.8. The pretax cost of debt is 7%. The beta of the stock is 1.3 in an environment with risk-free rate of 5.5% and an expected market return of 16%. The firm is in the 45% tax bracket. The weighted average cost of capital of the firm equals ________.

  A. 12.35%

  B. 9.43%

  C. 6.91%

  D. 13.81%

  Correct Answer: A

  Using CAPM, the cost of equity equals 5.5% + 1.3*(16% - 5.5%) = 19.15%. Since the debt interest is tax deductible, the after-tax cost of debt equals 7%*(1-0.45) = 3.85%. Now, the D/E ratio = 0.8. Hence, (D+E)/ E = 1.8, giving E/(D+E) = 0.556. Thus, equity forms 55.6% of the capital while debt forms 44.4%. The WACC is then equal to 0.556*19.15% + 0.444*3.85% = 12.35%.

• Question 1047:

  Which of the following statements is false?

  A. When IRR = k (the cost of capital), NPV = 0.

  B. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

  C. The IRR can be positive even if the NPV is negative.

  D. The NPV will be positive if the IRR is less than the cost of capital.

  E. The NPV method is not affected by the multiple IRR problem.

  Correct Answer: D

  If the IRR is less than the cost of capital, then taking on the project imposes a cost on current stockholders. If the cost of capital is greater than the IRR, the NPV will be negative.

• Question 1048:

  Which of the following is/are true about the MACRS?

  I. MACRS does not use economic life of an asset while calculating depreciation.

  II. Under the MACRS system, the depreciation expense is larger in the early years, leading to lower taxes.

  III.

  Depreciation under MACRS must be calculated using the accelerated depreciation method.

  A.

  III only

  B.

  II only

  C.

  I, II and III

  D.

  II and III

  E.

  I only

  F.

  I and II

  Correct Answer: F

  MACRS classifies assets into several classes based on a pre-determined length of time called the "recovery period." The recovery period, while positively correlated with actual economic life, does not track the economic lives of individual assets precisely. In particular, recovery periods are shorter than actual economic lives, leading to higher depreciation expenses and lower taxes. For long-recovery period classes (>27 years), straight-line depreciation must be used while accelerated methods may be used for shorter life assets.

• Question 1049:

  In the calculation of WACC, which of the following should be ignored?

  A. none of these answers.

  B. long-term debt.

  C. current liabilities.

  D. preferred equity.

  Correct Answer: C

  Short-term debt is not a part of the capital structure. The capital budgeting process allocates resources to long-term asset investments and as such is financed by liabilities/capital of similar maturity. Hence, short-term/current liabilities do not enter into WACC calculations.

• Question 1050:

  Under the Residual Dividend Policy, a firm pays out:

  A. none of these answers.

  B. only net earnings left over after financing the current optimal capital budget requirements, consistent with the target capital structure.

  C. all of its earnings left over after taxes and expenses as dividends.

  D. only net earnings from new projects as dividends, using the rest to finance current capital requirements.

  Correct Answer: B

  Under the Residual Dividend Policy, a firm first determines the amount of capital it requires for sufficiently profitable projects. It then uses retained earnings to supply equity capital and raises debt in the proper amount to maintain the target capital structure. If any earnings are left over after this, they are paid out as dividends. If not, the firm will not only not pay any dividends but also issues new equity for financing.