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

• Question 1131:

  Calculate the cost of debt for the following firm:

  Borrowing Rate 9.5%

  Historical Beta .97

  Marginal Tax Rate 40%

  Credit Rating BB+

  Owner's Equity 15%

  Quick Ratio 1.7

  EPS $1.70

  P/E ratio 12

  Estimated Dividends $.30

  A. 8.075%

  B. 6.27%

  C. 1.43%

  D. 5.7%

  E. 1.5%

  F. 9.5%

  Correct Answer: D

  The cost of debt is simply the rate of borrowing less the tax savings. Due to the fact that interest expense is tax deductible, the cost of debt in this case is 9.5%(1 - .4) = 9.5%(.6) = 5.7%.

• Question 1132:

  The Ace Company is considering investing in a piece of property, which costs $105,000. The property will return a constant cash flow forever. If the firm's cost of capital is 9 percent and the corporate tax rate is 40 percent, what is the minimum after-tax cash flow that would make the investment acceptable to Ace?

  A. $2,375

  B. $15,942

  C. $5,000

  D. $10,831

  E. $9,450

  Correct Answer: E

  $105,000 = CF(AT)/0.09; CF(AT) = $9,450.

• Question 1133:

  The percentage mix of debt, preferred stock, and common equity that will maximize a firm's stock price is known as:

  A. Marginal cost of capital

  B. Weighted average cost of capital (WACC)

  C. After tax cost of capital

  D. Marked to market value of equity

  E. Target (Optimal) Capital Structure

  Correct Answer: E

  The target or optimal capital structure of a firm is that percentage mix of debt, preferred stock, and common equity that will maximize the firm's stock price.

• Question 1134:

  In comparing two mutually exclusive projects of equal size and equal life, which of the following statements is most correct?

  A. None of these answers are correct.

  B. The project with the higher NPV may not always be the project with the higher IRR.

  C. The project with the higher NPV may not always be the project with the higher MIRR.

  D. The project with the higher IRR will always be the project with the higher MIRR.

  E. All of the answers are correct.

  Correct Answer: B

  Due to reinvestment rate assumptions, NPV and IRR can lead to conflicts; however, there will be no conflict between NPV and MIRR if the projects are equal in size (which is one of the assumptions in this question).

• Question 1135:

  After getting her degree in marketing and working for 5 years for a large department store, Sally started her own specialty shop in a regional mall. Sally's current lease calls for payments of $1,000 at the end of each month for the next 60 months. Now the landlord offers Sally a new 5-year lease which calls for zero rent for 6 months, then rental payments of $1,050 at the end of each month for the next 54 months. Sally's cost of capital is 11 percent. By what absolute dollar amount would accepting the new lease change Sally's theoretical net worth?

  A. $4,681.76

  B. $3,803.06

  C. $4,299.87

  D. $3,243.24

  E. $2,810.09

  Correct Answer: B

  CF(0) = 0 CF(1-6) = 0 CF(7-60) = 1,050 I = 11/12 = 0.9167 Solve for NPV = -$42,189.97. Therefore, the PV of payments under the proposed lease would be less than the PV of payments under the old lease by $45,993.03 - $42,189.97 = $3,803.06. Sally should accept the new lease because it would raise her theoretical net worth by $3,803.06.

• Question 1136:

  Mid-State Electric Company must clean up the water released from its generating plant. The company's cost of capital is 10 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low- risk projects. Clean-up Plan A, which is of average risk, has an initial cost of -$1,000 at Time 0, and its operating cost will be -$100 per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of -$300, and its annual operating cost over Years 1 to 10 will be -$200. What is the proper PV of costs for the better project?

  A. -$1,642.02

  B. -$1,430.04

  C. -$1,728.19

  D. -$1,525.88

  E. -$1,614.46

  Correct Answer: E

  The first thing to note is that risky cash outflows should be discounted at a lower discount rate, so in this case we would discount the riskier Project B's cash flows at 10% - 2% = 8%. Project A's cash flows would be discounted at 10%. Now we would find the PV of the costs as follows: Project AProject B CF(0) = -1,000CF(0) =-300 CF(1-10) = -100CF(1-10)=-200 I =10.0I= 8.0 Solve for NPV = -$1,614.46. Solve for NPV = -$1,642.02. Project A has the lower PV of costs. If Project B had been evaluated with a 12% cost of capital, its PV of costs would have been -$1,430.04, but that would have been wrong.

• Question 1137:

  A firm has just issued 6%, 10-year coupon bonds, which have a yield-to-maturity of 7.1%. The firm has old debt, which pays a coupon of 8%. The firm is in the 45% tax bracket. Its marginal after-tax cost of debt equals ________.

  A. 3.3%

  B. 3.2%

  C. 4.4%

  D. 3.9%

  Correct Answer: D

  Since debt interest is tax-deductible, the after-tax cost of debt equals 7.1%*(1-45%) = 3.9%. Note that you must use the yield-to-maturity of the new bonds while calculating the cost of debt since this is the rate at which interest expense is computed in maintaining the accounts. The coupon rate does not enter directly in this calculation (though it does matter since it affects the yield-to-maturity).

• Question 1138:

  Intelligent Semiconductor is considering issuing additional common stock. The current yield to maturity on the firm's outstanding senior long-term debt is 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. In the past, the firm has assumed a 265 basis point risk premium when calculating the cost of equity. What is the cost of equity for this proposed common stock issue using the Bond-Yield-plus-Risk-Premium approach?

  A. 15.65%

  B. 16.15%

  C. 18.24%

  D. 11.20%

  E. The cost of equity using the Bond-Yield-plus-Risk-Premium approach cannot be calculated from the information provided.

  Correct Answer: A

  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 Bond-Yield-plus- Risk-Premium approach. This method is a rather ad hoc procedure used by finance professionals, and involves adding a subjective "risk premium" to the yield to maturity of the firm's outstanding debt. This approach should be used with a degree of caution, as the subjective nature of the procedure leaves significant room for variation in estimates. In using the Bond-Yield-Plus-Risk-Premium approach, a subjective risk premium is added to the yield to maturity of the firm's outstanding long-term debt, and the calculation of the correct answer in this case is as follows: {yield to maturity of the outstanding senior debt 13% + subjective risk premium 2.65%} =15.65%.

• Question 1139:

  Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average, its fresh produce division has average risk, and its institutional foods division has below-average risk. Dandy adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is the risk-adjusted required rate of return for a low-risk project in the yogurt division?

  A.8%

  B. 10%

  C. 14%

  D. 12%

  E. 6%

  Correct Answer: B

  k(YD) = 10% + 2% = 12%.

  However, for a low-risk project, Dandy Product subtracts 2 percentage points. Therefore, the required rate

  of return is 10 percent.

  k(YD,Low risk project) = 10% + 2% - 2% = 10%.

• Question 1140:

  Alvarez Technologies has sales of $3,000,000. The company's fixed operating costs total $500,000 and its variable costs equal 60 percent of sales, so the company's current operating income is $700,000. The company's interest expense is $500,000. What is the company's degree of total leverage (DTL)?

  A. 3.500

  B. 6.000

  C. 1.714

  D. 3.100

  E. 3.250

  Correct Answer: B

  DTL = (S - VC)/(EBT - I)

  = ($3,000,000 - $1,800,000)/($700,000 - $500,000)

  = 6.