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

• Question 1051:

  The capital budgeting director of Sparrow Corporation is evaluating a project, which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40 percent, what is the project's IRR?

  A. 18%

  B. 8%

  C. 12%

  D. -5%

  E. 14%

  Correct Answer: A

  $200,000 = $44,503(PVIFA(Irr,10)) PVIFA(Irr,10) = 4.49408 ;IRR = 18%.

• Question 1052:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 35%

  common equity, and 15% perpetual preferred equity. The following information applies to the firm:

  Before-tax cost of debt = 9.5%

  Combined state/federal tax rate = 35%

  Expected return on the market = 14.5%

  Annual risk-free rate of return = 6.25%

  Historical Beta coefficient of Clay Industries Common Stock = 1.24

  Annual preferred dividend = $1.55

  Preferred stock net offering price = $24.50

  Expected annual common dividend = $0.80

  Common stock price = $30.90

  Expected growth rate = 9.75%

  Given this information, and using the Dividend-Yield-plus-Growth-Rate approach to calculate the

  component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 9.82%

  B. 6.93%

  C. 8.36%

  D. 10.02%

  E. The WACC for Clay Industries cannot be calculated from the information provided.

  F. 9.79%

  Correct Answer: C

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the DividendYield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow, approach. To calculate the cost of common equity using this approach, divide the expected annual dividend by the selling price of the outstanding common stock, and add the expected growth rate. Using the DCF method, the cost of common equity can be found as follows: {[$0.80/$30.90] + 9.75%} = 12.34%. The after-tax cost of debt can be found by multiplying the yield to maturity of the firm's outstanding long-term debt (9.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 6.175%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.355%.

• Question 1053:

  As the director of capital budgeting for Raleigh/Durham Company, you are evaluating two mutually exclusive projects with the following net cash flows: Year Project XProject Z 0-$100-$100 150 10 240 30 330 40 410 60 Is there a crossover point in the relevant part of the NPV profile graph (the northeast, or upper right, quadrant)?

  A. Yes, at k = 13%

  B. Yes, at k = 9%

  C. No

  D. Yes, at k = 7%

  E. Yes, at k = 11%

  Correct Answer: D

  Financial calculator solution:

  Project X

  Inputs: CF(0) = -100; CF(1) = 50; CF(2) = 40; CF(3) = 30; CF(4) = 10.

  Output: IRR = 14.489%.

  Project Y

  Inputs: CF(0) = -100; CF(1) = 10; CF(2) = 30; CF(3) = 40; CF(4) = 60.

  Output: IRR = 11.79%.

  Calculate the NPVs of the projects at k = 0 discount rate.

  NPV(X,k = 0%) = -100 + 50+ 40 + 30 + 10 = 30.

  NPV(Y,k = 0%0 = -100 + 10 + 30 + 40 + 60 = 40.

  Calculate the IRR of the differential project, i.e., Project(X - Y)

  IRR(X - Y)Inputs: CF(0) = 0; CF(1) = 40; CF(2) = 10; CF(3) = -10; CF(4) = -50.

  Output: IRR = 7.167%.

  Solely using the calculator we can determine that there is a crossover point in the relevant part of an NPV

  profile graph. Project X has the higher IRR. Project Y has the higher NPV at k = 0. The crossover rate is

  7.17% and occurs in the upper right quadrant.

• Question 1054:

  Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings. The current market price of the firm's stock is $28; its last dividend was $2.20, and its expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15 percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital?

  A. 13.9%

  B. 14.3%

  C. 9.7%

  D. 15.8%

  E. 7.9%

  Correct Answer: D

  Calculate the retained earnings break point:

  Given:

  Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.

  Break point(RE) = $600(1 - 0.6)/0.6 = $400.

  Allison will need new equity capital; capital budget exceeds Break point(RE).

  Use the dividend growth model to calculate k(s):

  k(s) = D1/Po + g = 2.2(1.06)/28(1-.15) + .06 = 0.0979 + 0.06 = 0.1579 = 15.8%.

  k(s) = component cost of retained earnings or internal equity.

• Question 1055:

  Clay Industries, a diversified industrial firm, is considering investing into a new manufacturing facility which would allow the Company to expand its operations into a promising new market for industrial motors, specifically the High Temperature Superconducting, or HTS motors. This project is one of many currently under consideration for Clay Industries, and the amount of RandD expense allocated toward researching this new manufacturing facility is residual in nature. The following information applies to this new project. RandD expense for the quarter $15,000 Initial cash outlay ($45,000) t1: ($40,000) t2: ($10,000) t3: $40,000 t4: $40,000 t5: $16,000 t6: $25,000 Assuming no taxes and a $0.00 salvage value at t6, which of the following best represent the IRR for his project?

  A. 7.039%

  B. This project will have multiple IRR at any discount rate

  C. The IRR cannot be calculated due to the fact that no discount rate has been provided

  D. The IRR cannot be calculated due to the fact that the project has uneven cash flows

  E. 2.639%

  Correct Answer: A

  Remember that the quarterly RandD expense is a sunk cost, and one which cannot be directly attributable to this project. Because this quarterly RandD expense is not incremental in nature, it should be omitted from the IRR calculation. Additionally, the fact that this project has uneven cash flows is irrelevant for our calculation of IRR. To determine the IRR for this project, the following information is necessary: the initial investment outlay, the amount of each period's cash inflow, and the number of periods. In calculating IRR, no discount rate is necessary, so the last answer is incorrect. The calculation of the IRR is found as follows: incorporate the initial investment outlay of ($45,000) as Cfo, for CO1= ($40,000), CO2=($10,000), CO3=$40,000, CO4=$40,000, CO5=$16,000, CO6=$25,000, CPT IRR. This yields an IRR of 7.039%.

• Question 1056:

  Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, with the yield to maturity on the firm's outstanding senior long-term debt at 13%. The company's combined federal/state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be 13.5%. Shares of Intelligent Semiconductor have a historical beta of 1.6, and in the past, the firm has assumed a 265 basis point risk premium when calculating the cost of equity. The firm's next dividend is expected to be $0.50 per share, and the dividend has been growing at a 12% annual rate. Finally, the firm's common stock is priced at $24.78. What is the cost of equity for this firm using the Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF) approach?

  A. 18.24%

  B. The cost of equity using the DCF approach cannot be calculated from the information provided.

  C. 16.15%

  D. 14.02%

  E. 15.65%

  F. 11.20%

  Correct Answer: D

  The cost of issuing common stock can be calculated using several methods, including the Bond-YieldPlus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. In this example, you have been asked to calculate the cost of equity using the Discounted Cash Flow method, which is commonly referred to as the Dividend-Yield-plus-Growth-Rate approach. In calculating the cost of equity using this approach, the following components are necessary: next expected annual dividend, growth rate of dividends, and the current stock price. Everything else provided in this example is largely irrelevant. The calculation of the cost of equity using the DCF approach is as follows: {[next annual dividend $0.50 / common stock $24.78] + expected dividend growth rate 12%} = 14.018%.

• Question 1057:

  If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is most correct?

  A. The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt.

  B. The percentage change in EBIT will equal the percentage change in net income.

  C. The percentage change in net operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income (NI).

  D. Since debt is used, the degree of operating leverage must be greater than 1.

  E. The percentage change in net operating income will be less than the percentage change in net income.

  Correct Answer: E

  The greater the use of fixed assets, the more sensitive EBIT will be to changes in sales. Interest charges on debt are included in net income and not operating income, as the use of debt financing will have an impact on net income when sales change.

• Question 1058:

  Hensley Corporation uses breakeven analysis to study the effects of expansion projects it considers. Currently, the firm's plastic bag business segment has fixed costs of $120,000, while its unit price per carton is $1.20 and its variable unit cost is $0.60. The firm is considering a new bag machine and an automatic carton folder as modifications to its existing production lines. With the expansion, fixed costs would rise to $240,000, but variable cost would drop to $0.41 per unit. One key benefit is that Hensley can lower its wholesale price to its distributors to $1.05 per carton (i.e., its selling price), and this would likely more than double its market share, as it will become the lowest cost producer. What is the change in the breakeven volume with the proposed project?

  A. 100,000 units

  B. 75,000 units

  C. 0 units

  D. 175,000 units

  E. 200,000 units

  Correct Answer: D

  Calculate the old and new breakeven volumes using the old data and new projections: Old Q(BE) =

  $120,000/($1.20 - $0.60) = $120,000/$0.60 = 200,000 units.

  New Q(BE) = $240,000/($1.05 - $0.41) = $240,000/$0.64 = 375,000 units.

  Change in breakeven volume = 375,000 - 200,000 = 175,000 units.

• Question 1059:

  A project requires an initial outlay of $600. Over the next 5 years, it expects to have cash outflows of $200, $300, $175, $350 and $150. The revenues over the same period equal $100, $400, $700, $550 and $800. Assume that these cash flows occur at year-end. The project's payback period equals ________.

  A. 2.91 years

  B. 3.38 years

  C. 4.11 years D. 3.82 years

  Correct Answer: B

  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) To calculate the payback period, you must have the stream of net cash flows = Revenues - out flows. The net cash flows over the next 5 years are $(100200), $(400-300), $(700-175), $(550-350) and $(800-150) i.e. the net cash flows are: -$100, $100, $525, $200 and $650. The complete recovery of the total outlay of $600 + $100 (year 1 net outflow) occurs in the 4th year. At the beginning of the 4th year, the outstanding balance equals 600+100-100- 525 = $75. Therefore, payback period = 3 + 75/200 = 3.375 years.

• Question 1060:

  Woodson Inc. has two possible projects, Project A and Project B with the following cash flows: Year Project AProject B 0-150,000-100,000 1100,00045,000 2105,00065,000 340,00080,000 At what cost of capital do the two projects have the same net present value (NPV)?

  A. 34.8%

  B. 10.3%

  C. 13.5%

  D. 15.8%

  E. 21.7%

  Correct Answer: E

  To determine the crossover rate, find the differential cash flows between the 2 projects and then calculate the IRR of those differential cash flows. tProject change, A - B 0-50,000 155,000 240,000 3-40,000 IRR = 21.7%.