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

• Question 1231:

  Using the Security Market Line concept in capital budgeting, which of the following is correct?

  A. If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted.

  B. If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted.

  C. If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.

  D. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.

  Correct Answer: D

  If the expected rate of return on a given capital project lies above the SML, the expected rate of return on the project is more than enough to compensate for its risk, and the project should be accepted. Conversely, if the project's rate of return lies below the SML, it should be rejected.

• Question 1232:

  Bouchard Company's stock sells for $20 per share, its last dividend was $1.00. Its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the amount of common equity in the capital structure is 60 percent. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

  A. 12.15%

  B. 11.80%

  C. 11.30%

  D. 11.45%

  E. 12.63%

  Correct Answer: E

  BP(RE) = RE/Equity fraction = $1,000,000/0.6 = $1,666,667.

  Since the capital budget will be $2 million, and since all equity in the WACC (Weighted Average Cost of

  Capital) beyond $1,666,667 will be external equity, the WACC of the last dollar raised will include equity at

  a cost of k(e) (component cost of external equity obtained by issuing new common stock as opposed to

  retaining earnings):

  k(e) = $1(1.06)/$20(1 - 0.2) + 0.06 = 0.0663 + 0.06 = 0.1263 = 12.63%.

• Question 1233:

  A financial analyst with Smith, Kleen, and Beetchnutty is examining shares of Clay Industries for possible

  investment. Assume the following information:

  EPS: $4.19

  ROE: 11.25%

  Growth rate of dividends: 6.75%

  Discount rate: 11.50%

  Tax Rate 35%

  Using this information, what is the dividend payout ratio for Clay Industries? Further, what is the annual

  dividend?

  A. 35.87%, $1.50

  B. 60.00%, $2.51

  C. 60.00%, $1.68

  D. The answer cannot be determined from the information provided.

  E. 40.00%, $1.68

  F. 40.00%, $2.51

  Correct Answer: E

  To determine the dividend payout ratio, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows: {g = ROE (1 - Dividend Payout Ratio)} In order to determine the Dividend Payout Ratio, the equation must be rearranged to the following: {(1 Dividend Payout Ratio) = Growth Rate of Dividends / ROE}. Imputing the given information into this equation will yield: {(1 - Dividend Payout Ratio) = 0.0675/0.1125)} = 0.60 Finally, subtracting this answer from 1 will yield the answer of 40%. We must subtract the first answer from one because the first answer represents the retention rate, i.e. the percentage of earnings that is retained and reinvested at the firm's ROE, and not the Dividend Payout Ratio. The retention rate and the payout ratio will always combine to equal positive one. In order to determine the annual dividend, take the Dividend Payout Ratio, which was found to be 40%, and multiply this figure by the Earnings Per Share calculation, which is given as $4.19. This will yield an annual dividend of $1.676. As you can see, neither the discount rate nor the tax rate is factored into the equation

• Question 1234:

  Which of the following statements is correct?

  A. Due to the way the MCC (Marginal Cost of Capital) is constructed, the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.

  B. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.

  C. The lower a company's tax rate, the greater the advantage of using debt in terms of lowering its WACC.

  D. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC (Weighted Average Cost of Capital) on a before-tax basis.

  E. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero. It is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.

  Correct Answer: E

  Because corporations can exclude dividends for tax purposes, preferred stock often has a market return that is less than the issuing company's cost of debt. Then, if the issuer's tax rate is zero, its component cost of preferred would be less than its cost of debt.

• Question 1235:

  A portfolio manager with Mally, Feasance, and Company is examining shares of Allcycles.com. Assume the following information: Annual Dividend: $0.45

  EPS: $2.15

  Tax Rate: 35%

  Discount Rate: 12.25%

  ROE: 18%

  Using this information, and assuming that ROE is expected to remain stable, what is the dividend growth

  rate for Clay Industries?

  A. 14.64%

  B. 15.51%

  C. 3.77%

  D. 12.67%

  E. The answer cannot be determined from the information provided.

  F. 14.23%

  Correct Answer: F

  To calculate the growth rate, use the following equation: {g = ROE(1 - Dividend Payout Ratio)}.

  While the ROE figure has been provided, the Dividend Payout Ratio must be calculated manually. To find

  the Dividend Payout Ratio, divide the annual dividend by the EPS figure, giving the following:

  {Dividend Payout Ratio = ($0.45/$2.15)}

  From this equation, we determine that the Dividend Payout Ratio for this firm is 20.93%. Inputting this

  figure into the growth rate equation will yield a dividend growth rate of 14.23% for this firm.

  As you can see, tax rates and discount rates are not factored into the calculation.

• Question 1236:

  Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company retains 30 percent of its earnings to fund future growth. ZPC's expected EPS and k(s) for various capital structures are given below. What is the optimal capital structure for ZPC? Debt/AssetsExpected EPS ($)k(s) 20%2.5015.0% 303.0015.5 403.2516.0 503.7517.0 704.0018.0

  A. Debt/Total Assets = 20%

  B. Debt/Total Assets = 30%

  C. Debt/Total Assets = 70%

  D. Debt/Total Assets = 40%

  E. Debt/Total Assets = 50%

  Correct Answer: E

  The optimal capital structure maximizes the firm's stock price. When the debt ratio is 20%, expected EPS is $2.50. Given the firm's policy of retaining 30% of earnings, the expected dividend per share D1 is $2.50 x 0.70 = $1.75. The stock price Po is $1.75/(15% - 7%) or $21.88. When the debt ratio is 30%, expected EPS is $3.00 and expected D1 is $3.00 x 0.70 = $2.10. The stock price Po is $2.10/(15.5% - 7%) =$24.71. Similarly, when the debt ratio is 40%, D1 = $2.275 and Po = $25.28. When the debt ratio is 50%, D1 = $2.625 and Po = $26.25. When the debt ratio is 70%, D1 = $2.80 and Po = $25.45. The stock price is highest when the debt ratio is 50%.

• Question 1237:

  In applying the CAPM (Capital Asset Pricing Model) to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

  A. Expected rate of return on the market.

  B. All of these answers are subject to dispute.

  C. The stock's beta coefficient.

  D. Market risk premium.

  E. Risk-free rate.

  Correct Answer: B

  Under the CAPM approach, it is difficult at best, to obtain correct estimates of the inputs required to make it operational:

  1.

  there is controversy about whether to use long-term or short-term Treasury yields for the risk-free rate.

  2.

  it is difficult to estimate the beta that investors expect to firm to have in the future, and it is difficult to estimate the market risk premium.

• Question 1238:

  Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?

  A. 0%

  B. 40%

  C. 60%

  D. 100%

  E. 20%

  Correct Answer: E

  EBIT$2,000,000

  -I500,000 ($5,000,000 debt x 10% coupon) EBT1,500,000

  -Taxes600,000 ($1,500,000 EBT x 40% tax rate) NI900,000 Project funding $1,200,000 project funded: Residual earnings 0.60 equity = $720,000

  0.40 debt = $480,000 Payable as dividends: 900,000 - 720,000 = $180,000 Dividend payout ratio = $180,000/$900,000 = 20%.

• Question 1239:

  Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

  A. investors require that the dividend yield and capital gains yield equal a constant.

  B. investors are indifferent between dividends and capital gains.

  C. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.

  D. investors view dividends as being less risky than potential future capital gains.

  E. capital gains are taxed at a higher rate than dividends.

  Correct Answer: D

  The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g.

• Question 1240:

  Which of the following statements is most correct?

  A. None of these statements are correct.

  B. If a firm finds that the cost of debt financing is currently less than the cost of equity financing, an increase in its debt ratio will always reduce its cost of capital.

  C. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, the cost of retained earnings is generally lower than the after-tax cost of debt financing.

  D. The capital structure which minimizes the firm's cost of capital is also the capital structure which maximizes the firm's stock price.

  E. The capital structure which minimizes the firm's cost of capital is also the capital structure which maximizes the firm's earnings per share.

  Correct Answer: D

  The optimal capital structure is the one that maximizes the price of the firm's stock, and this generally calls for a debt ratio which is lower than the one that maximized expected EPS.