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

• Question 1241:

  J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. What is the firm's cost of retained earnings?

  A. 15.5%

  B. 12.5%

  C. 10.0%

  D. 18.0%

  E. 16.5%

  Correct Answer: A

  k(s) = $2.20/$40 + 0.10 = 15.5%.

• Question 1242:

  Consider the following information:

  Borrowing Rate 10%

  Marginal Tax Rate 40%

  Preferred Stock Par Price $100

  Preferred Dividend $10

  Preferred Stock floatation cost 2.5%

  Cost of common equity 12.0%

  Preferred Stock issued at Par

  The Optimal Capital Structure is 40% debt, 50% common equity, and 10% preferred stock. Credit Rating

  BB+ What is the firm's Weighted Average Cost of Capital (WACC)?

  A. 12.62%

  B. 7.42%

  C. 9.0%

  D. 8.0%

  E. 2.5%

  F. 9.42%

  Correct Answer: F

  The firm's Weighted Average Cost of Capital (WACC) is a weighted average of the component cost of capital. In this case 10%(borrowing rate) x (1-.4)Tax savings = 6% is the component cost of debt. $10 (preferred dividend) / 97.5(Par minus floatation cost) = 10.25% is the component cost of preferred stock. Thus the WACC = .4(6%) + .5(12%) + .1(10.25%) = 9.42%

• Question 1243:

  An entrepreneur has invested $2.2 million in project A with an NPV of $245,000 and an estimated beta of

  0.59.

  She has invested another $3.7 million in project B with an NPV of $320,000 and an estimated beta of

  1.23.

  The firm's estimated beta equals ________.

  A. 1.11

  B. 0.72

  C. 1.23

  D. 0.99

  Correct Answer: D

  The market value of project A equals $2.2 million + $245,000 = $2.445 million.

  The market value of project B equals $3.7 million + $320,000 = $4.02 million. The firm can be considered a portfolio of 2 projects. The beta of a portfolio equals the weighted average of the betas of the individual components. The weight of a component equals the fraction of the market value it comprises. Therefore, the firm's market value equals 2.445 + 4.02 = $6.465 million and its beta equals 2.445/6.465*0.59 + 4.02/6.465*1.23 = 0.99.

• Question 1244:

  Which of the following factors affect(s) a firm's optimal pay-out ratio?

  I. The availability and cost of external capital.

  II. The investment opportunities available.

  III. The firm's target debt-to-equity ratio.

  IV.

  Investors' preference for dividends versus capital gains.

  A.

  II only

  B.

  I only

  C.

  I, II, III and IV

  D.

  IV only

  E.

  I, II and III

  F.

  I and III

  G.

  III only

  H.

  III and IV

  Correct Answer: C

  A firm must consider all of these factors while determining what fraction of the earnings it should pay out. It should be noted that another factor that must be considered is the capability of keeping the dividends stable over time.

• Question 1245:

  A company is considering a project with the following cash flows: TimeCash flow 0-$100,000 150,000 250,000 350,000 4-10,000 The project's cost of capital is estimated to be 10 percent. What is the modified internal rate of return (MIRR)?

  A. 11.25%

  B. 20.34%

  C. 14.25%

  D. 11.56%

  E. 13.28%

  Correct Answer: C

  First, calculate the present value of costs:

  N = 4, I/YR = 10, PMT = 0, FV = -10,000, and solve for PV = -$6,830.13.

  Add -$100,000 + -6,830.13 = -$106,830.13.

  Then, find the terminal value of inflows:

  Shift to BEGIN MODE, N = 3, I/YR = 10, PV = 0, PMT = -50,000, and solve for FV = $182,050.

  Finally, shift back to END mode, and solve for MIRR, where N = 4, PV = $-106,830, PMT = 0, FV =

  182,050, and solve for I/YR = 14.25%.

• Question 1246:

  Which of the following types of risk measures the variability of an asset's expected returns, assuming that the asset is not the only asset of the company in question while at the same time not taking into consideration the effects of shareholder diversification? Choose the best answer

  A. Beta coefficient

  B. Unsystematic risk

  C. Market risk

  D. More than one of these answers is correct

  E. Corporate risk

  F. Alpha risk

  Correct Answer: E

  Corporate risk is defined as the variability of an assets expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset not only without taking into consideration the effect of shareholder diversification, but of Company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only assets in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.

• Question 1247:

  The corporate finance division of Intelligent Semiconductor is examining the firm's recent sales in an attempt to forecast future operating performance. In their investigation, the management of the firm's corporate finance division have identified the following sales and EBIT information for the previous two years: Sales in year 1 $1,200,000 Sales in year 2 $1,500,000 EBIT in year 1 $400,000 EBIT in year 2 $550,000 Given this information, what is the degree of operating leverage for Intelligent Semiconductor for this period?

  A. .350

  B. 1.25

  C. .3667

  D. .3333

  E. 1.50

  Correct Answer: E

  To calculate the degree of operating leverage (DOL), use the following equation: {% change in EBIT/% change in sales}. Incorporating the given information into this equation yields the following: {[(year 2 EBIT $550,000 - year 1 EBIT $400,000)/year 1 EBIT $400,000]/[(year 2 sales $1,500,000- year 1 sales $1,200,000)/year 1 sales $1,200,000] = 1.50

• Question 1248:

  Which of the following is/are true?

  I. Discounted payback period and simple payback period can produce conflicting project rankings.

  II. Independent projects are mutually exclusive.

  III.

  The payback period rule ignores cash flows beyond the payback period.

  A.

  I, II and III

  B.

  II only

  C.

  I and III

  D.

  I and II

  E.

  I only

  F.

  II and III

  G.

  III only

  Correct Answer: C

  Independent projects are ones whose cash flows are not dependent on each other while mutually exclusive projects are those which cannot be undertaken simultaneously. It is not necessary for independent projects to be mutually exclusive or vice versa.

• Question 1249:

  The management of Olively.com, an online research network, are considering becoming a public company. At a lengthy meeting with the board of directors, the CEO of Olively.com details his idea as to methods in which the firm should raise capital. In his discussion, the CEO states that "45% of new capital should come from debt, leaving 55% to come from the issuance of common equity. We will disregard issuing preferred stock at this point." In the simplistic sense, the CEO of Olively.com is detailing which of the following?

  A. Optimal capital structure

  B. Target capital structure

  C. Target asset base

  D. Capital asset base

  E. Optimal asset base

  Correct Answer: B

  In this example, the CEO of Olively.com is detailing his idea of the company's target capital structure. The target capital structure can best be thought of as the proportion of debt, common stock, and preferred stock that the firm plans to issue in its effort to raise capital. The "optimal capital structure" is defined as the capital structure that balances risk and return, thereby maximizing the firm's stock price.

• Question 1250:

  Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?

  A. All else equal, a project's IRR increases as the cost of capital declines.

  B. All else equal, a project's NPV decreases as the cost of capital declines.

  C. All else equal, a project's NPV increases as the cost of capital declines.

  D. All else equal, a project's MIRR is unaffected by changes in the cost of capital.

  E. None of the answers are correct.

  Correct Answer: C

  Since the cost of capital is in the denominator of the NPV formula, the lower the cost of capital the higher the NPV. The more positive the NPV, the more cash the project is generating to service its debt and to provide the required return to shareholders.