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

• Question 1141:

  Green Grocers is deciding among two mutually exclusive projects. The two projects have the following cash flows: Project A Project B Time Cash Flows Cash Flows 0-$50,000-$30,000 110,000 6,000 215,000 12,000 340,000 18,000 420,000 12,000 The company's cost of capital is 10 percent (WACC = 10%). What is the net present value (NPV) of the project with the highest internal rate of return (IRR)?

  A. $7,090

  B. $12,510

  C. $8,360

  D. $11,450

  E. $15,200

  Correct Answer: E

  NPV(A) = $15,200; IRR(A) = 21.3811%.

  NPV(B) = $7,092; IRR(B) = 19.2783%.

  Project A has the highest IRR, so the answer is $15,200.

• Question 1142:

  The opportunity costs of a project refer to:

  A. the costs already incurred in developing the project.

  B. none of these answers.

  C. the costs that would be incurred in one or more of mutually exclusive projects that are rejected in favor of the project selected.

  D. the costs incurred due to the effects of the project on the firm's other projects at hand.

  Correct Answer: B

  The cash flows that could be earned if the assets were not used for the project but elsewhere are known as "opportunity costs." None of the given choices fits this definition. Note that the costs already incurred in developing the project are called "sunk costs," the costs incurred due to the effects of the project on the firm's other projects at hand are "externality" or "spill-over" costs. "The costs that would be incurred in one or more of mutually exclusive projects that are rejected in favor of the project selected" looks tempting but is not an opportunity cost.

• Question 1143:

  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' cost of retained earnings using the bond-yield-plus-risk-premium approach?

  A. 16.6%

  B. 16.0%

  C. 16.9%

  D. 14.1%

  E. 13.6%

  Correct Answer: B

  Cost of retained earnings (Bond yield plus risk premium approach): k(s) = 12.0% + 4.0% = 16.0%.

• Question 1144:

  Davis Corporation is faced with two independent investment opportunities. The Corporation has an investment policy, which requires acceptable projects to recover all costs within 3 years. The Corporation uses the discounted payback method to assess potential projects and utilizes a discount rate of 10 percent. The cash flows for the two projects are: Time Project A Project B 0-100,000-$80,000 140,000 50,000 240,000 20,000 340,000 30,000 430,000 0 Which investment project(s) does the company invest in?

  A. Project B only.

  B. Project A only.

  C. Neither Project A or Project B.

  D. Project A and Project B.

  Correct Answer: A

  The sum of the PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project A is $99,474.08. Thus, the discounted payback period of Project A exceeds 3 years and Project A is not acceptable. The PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project B are $45,454.55, $16,528.93, and $22,539.44, respectively. These PVs sum to $84,522.92, which is greater than the cost of the project, indicating that the discounted payback period is less than 3 years. Thus, Project B will be undertaken.

• Question 1145:

  O'Donnell Inc. has a cost of capital of 11.5 percent. The company has a project with the following cash

  flows:

  Year Cash flow

  0-$200

  1 235

  3 300

  What is the project's modified internal rate of return (MIRR)?

  A. 28.15%

  B. 39.87%

  C. 40.15%

  D. 32.90%

  E. 36.27%

  Correct Answer: D

  Step 1 Find the PV of the outflows: CF(0) = -200 CF(1) = 0 CF(2) = -65 I = 11.5 Solve for NPV = -$252.28. Step 2 Find the TV of the inflows by first finding their NPV and then finding the FV of the NPV: CF(0) = 0 N = 3 CF(1) = 235 I = 11.5 CF(2) = 0 PV = -427.18 CF(3) = 300 PMT = 0 I = 11.5 Solve for FV = $592.16. Solve for NPV = $427.18. Step 3 Calculate the MIRR by equating the PV of the outflows with the TV of the inflows: N = 3 PV = -252.28 PMT = 0 FV = 592.16 Solve for I = 32.90%.

• Question 1146:

  A financial analyst is examining shares of Floweration.com, a sprawling Internet "dot com" company, in an attempt to evaluate the firm for possible investment. In her analysis, the financial analyst has determined the following information for the most recent fiscal year: Sales $2,250,000 Total fixed cost $1,300,000 Total variable cost $305,000 Interest expense $5,750 EBIT $645,000 Amortization expense $4,550 Given this information, what is the Degree of Total Leverage for Floweration.com?

  A. 2.843

  B. 3.064

  C. 1.731

  D. 3.488

  E. 3.043

  Correct Answer: E

  The Degree of Total Leverage (DTL) demonstrates how a given change in sales will impact a firm's EPS. The equation used for calculating the DTL is as follows: {[Sales - variable costs] / [sales - variable costs fixed costs - interest expense]}. Incorporating the given values for these components into the DTL equation yields the following: {[Sales $2,250,000 - variable costs $305,000] / [sales $2,250,000 - variable costs $305,000 - fixed costs $1,300,000 - interest expense $5,750]}=3.043. While somewhat intuitively appealing, "EBIT" and "amortization expense" are not explicitly incorporated into the DTL equation.

• Question 1147:

  A project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. The project's cost of capital is 10%. The discounted payback period equals ________.

  A. 2.26 years

  B. 4.02 years

  C. 3.19 years

  D. 3.46 years

  Correct Answer: B

  The cash flows of the project starting at the end of year 1 are: -700, -900, +1,200, +1,600, +2,300 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. The discounted cash flow at the end of year N

  is obtained by dividing that year's cash flow by 1.1N, since the project's cost of capital is 10%. Using this,

  the discounted cash flows are:

  -636, -744, +902, +1,093, +1,428.

  Recovery occurs in the 5th year. At the beginning of the 5th year, the outstanding balance equals 650 +

  636 + 744 - 902 - 1093 = 35. Therefore, the discounted payback period = 4 + 35/1428 = 4.02 years.

• Question 1148:

  The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is the break point due to retained earnings being used up?

  A. $17,000

  B. $24,000

  C. $10,000

  D. $30,000

  E. $56,000

  Correct Answer: B

  Calculate net income and retained earnings EBT$40,000 Less: Taxes$16,000 NI$24,000 RE = 0.70($24,000) = $16,800. Break point retained earnings: BP(RE) = $16,800/0.70 = $24,000.

• Question 1149:

  A firm's capital structure consists of 25% debt with a pre-tax cost of 7% and an after-tax cost of 4.9%. Common equity makes up 45% of the structure and the rest is made up of preferred equity. Thepreferred stock has a coupon of 8% and is currently trading at 84% of its par value. The required rate of return on the common stock is 16.2%. The firm's WACC is ________.

  A. 11.5%

  B. 10.92%

  C. 11.37%

  D. 11.90%

  Correct Answer: C

  To get the WACC in this case, you need to have information on the cost of preferred stock. This is not necessarily equal to the coupon rate on the preferred equity. Rather, it is the discount rate, R, that equates the present value of the perpetual payments on the preferred equity to its current price. The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. In this problem, since the preferred stock is at 84% and pays 8% coupon, we have 84% = 8%/ R, giving R = 9.52%. Now, the interest payments on debt are tax-deductible but those on preferred equity are not. Hence, no tax adjustment is necessary for preferred stock but you must use after-tax cost of debt in WACC calculations. With this in mind, WACC = 0.25*4.9% + 0.45*16.2% + 0.3*9.52% = 11.37%.

• Question 1150:

  The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is Global's cost of retained earnings?

  A. 10.33%

  B. 9.66%

  C. 12.22%

  D. 17.22%

  E. 16.00%

  Correct Answer: E

  k(s) (component cost of retained earnings) = $.945/$8.59 + 0.05 = 0.1600 = 16.00%.