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

• Question 1261:

  Consider the following information for Company XYZ:

  Current Price of Stock $35.00

  Expected dividend in 1 Year $1.20

  Growth rate 7.2%

  Beta 1.6

  Risk Free Rate 4.5%

  Expected Market Return 15%

  Marginal Corporate Tax rate 34%

  Bond Yield 12.34%

  Calculate this company's cost of retained earnings using the Discounted Cash Flow (DCF) method.

  A. 10.63%

  B. 11.52%

  C. 13.30%

  D. 9.20%

  E. 12.0%

  F. 21.30%

  Correct Answer: A

  The DCF method for estimating the cost of retained earnings states: Cost of Retained Earnings = (Dividend for period 1 / Current Price) + Growth Rate. In this case the estimated Cost of Retained Earnings = (1.2 / 35.00) + 7.2% = 3.43 + 7.2 = 10.63%

• Question 1262:

  Sensitivity Analysis ignores:

  A. the range of likely values that key variables can take.

  B. changes in some of the key variables.

  C. none of these answers.

  D. effect on the IRR of changes in project variables.

  Correct Answer: A

  One of the drawbacks of Sensitivity Analysis is that it ignores the range of likely values that key variables can take. This is rectified using Scenario Analysis.

• Question 1263:

  Your company is choosing between the following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How much value will your firm sacrifice if it selects the project with the higher IRR? Project S: -1,000500500500 Project L: 012345 -2,000668.76668.76668.76668.76668.76

  A. $481.15

  B. $291.70

  C. $332.50

  D. $243.43

  E. $535.13

  Correct Answer: B

  NPV(S) = $243.43; IRR(S) = 23.38%.

  NPV(L) = $535.13; IRR(L) = 20.00%.

  Value sacrificed: $535.13 - $243.43 = $291.70.

• Question 1264:

  Simmons Shoes is considering a project with the following cash flows:

  TimeProject Cash Flows ($)

  0-700

  2-200

  Simmons' WACC is 10 percent. What is the project's modified internal rate of return (MIRR)?

  A. 28.93%

  B. 17.10%

  C. 18.26%

  D. 29.52%

  E. 25.28%

  Correct Answer: C

  There are three steps to getting an MIRR:

  1.

  Find PV of outflows:

  -$700 + -$200/(1.1)^2 = -$865.2893.

  2.

  Find FV of inflows:

  $400 (1.1)^3 + $600(1.1) + $500 = $1,692.40.

  3.

  Find MIRR:

  N = 4

  PV = -865.2893

  PMT = 0

  FV = 1,692.40

  Solve for I = MIRR = 18.2593%.

• Question 1265:

  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 will be the WACC above the break point?

  A. 11.9%

  B. 8.3%

  C. 12.5%

  D. 14.1%

  E. 10.6%

  Correct Answer: A

  Preferred stock return: 10/80 = 12.5% WACC = 6%(0.40) + 12.5%(0.10) + 16.5%(0.50) = 11.90%.

• Question 1266:

  Polk Products is considering an investment project with the following cash flows: tCash Flow 0-100,000 140,000 290,000 330,000 460,000 The company has a 10 percent cost of capital. What is the project's discounted payback?

  A. 2.67 years

  B. 1.86 years

  C. 2.49 years

  D. 1.67 years

  E. 2.11 years

  Correct Answer: B

  The PV of t = 1 CF is found as follows: N = 1, I = 10, PMT = 0, FV = 40,000, and, thus PV = - $36,363.64.

  Similarly, find the PV of t = 2 CF which is $74,380.17. Since the sum of these PVs is greater than the t = 0 CF of $100,000, we know the discounted payback is less than two years. We can now solve for the discounted payback period as follows: DP = 1 + ($100,000 - $36,363.64)/$74,380.17 = 1.86.

• Question 1267:

  The Present Value of a project's cash flows when its cost of capital equals its internal rate of return :

  A. equals zero.

  B. is positive.

  C. is negative.

  D. could be all of these answers.

  Correct Answer: B

  The IRR is by definition the discount rate at which the NPV = 0. Therefore, at this point, the PV is greater than zero, since the initial outlay is always non-zero and NPV = PV - cash outlay.

• Question 1268:

  Suppose capital gains are taxed at 28% and realized income is taxed at 40%. The tax preference theory implies that as the dividend pay-out ratio is increased, the stock price:

  A. increases or decreases.

  B. decreases.

  C. increases.

  D. remains unaffected.

  Correct Answer: B

  Since the capital gains tax rate is lower than the realized income tax rate, investors would prefer to defer the realization of this income through the capital gains component. Hence, increasing the payout ratio will make the stock less attractive and depress the price.

• Question 1269:

  Ameriscam, Inc. is considering the issuance of some junior subordinated debt. The Company's combined state/federal corporate tax rate is 30%, and the coupon on its outstanding senior debt is 7.55%. The proposed debt would pay an annual coupon. Very recently, Ameriscam has met with a corporate finance firm, who advised the Company that the pre-tax cost of a debt issuance would be 7.70%; Ameriscam's finance division mirrored these findings. A month earlier, a study in a popular financial magazine found that shareholder's require a 7.95% rate of return on similar investments. Which of the following represents the best answer for Ameriscam's estimated after-tax cost of debt for this proposed debt issuance?

  A. 5.425%

  B. The after-tax cost of debt cannot be determined from the information provided.

  C. 5.565%

  D. 5.39%

  E. 5.285%

  Correct Answer: D

  Remember that in calculating the after-tax cost of debt for new debt issues, the MARGINAL cost of issuing new debt is the most relevant measure. In this example, the marginal cost of debt is given as 7.70%, and the after-tax cost of debt capital is found by multiplying (1 - corporate tax rate) by this figure. Specifically, the calculation of the after-tax cost of debt for Ameriscam is as follows: {pre-tax cost of issuing new debt 7.70%

  * [1-combined state/federal tax rate 30%]} = 5.39%. While the coupon rate on the firm's outstanding senior debt is often used as a proxy, this number is significantly inferior to the use of marginal figures. What is relevant in this example is the cost of new debt, and this can best be approximated by using the marginal cost of a new debt issue. Often, in capital budgeting and related corporate finance decisions, the only available figures are related to the cost and yield of outstanding debt, and in these instances, using the cost of outstanding debt is very appropriate. However, in this example, using the cost of existing debt does not yield the best possible answer.

• Question 1270:

  Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18 percent. What is the Weighted Average Cost of Capital (WACC) at that point?

  A. 16.4%

  B. 14.2%

  C. 10.8%

  D. 13.6%

  E. 18.0%

  Correct Answer: B

  MCC (Marginal Cost of Capital) = 0.4(0.14)(1 - 0.4) + 0.6(0.18) = 0.142 = 14.2%.