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

• Question 1271:

  Consider the following information for a company.

  Common Stock Price $53.25

  Preferred Stock Par Price $100

  Preferred Dividend $10

  Debt Rating BB+

  Owners Equity 25%

  Preferred Stock Flotation Cost 2.5%

  The Preferred Stock is issued at Par

  Calculate the component cost of this newly issued preferred stock.

  A. 10%

  B. 2.5%

  C. 18.78%

  D. 12.5%

  E. 10.26%

  Correct Answer: E

  The component cost of preferred stock is the dividend divided by issue price minus floatation cost. In this case the component cost of preferred stock = $10 / (100 - 2.5) = 10.26%.

• Question 1272:

  Industries which are cyclical and heavily oriented toward research tend to have high levels of ________. Industries which are subject to high levels of lawsuits tend to high levels of ________.

  A. debt; equity

  B. equity; equity

  C. equity; debt

  D. debt; debt

  Correct Answer: B

  Cyclical business conditions, high dependence on research and development and higher expected liabilities are all indicative of high business risks. This makes firms more risk-averse to debt.

• Question 1273:

  The WACC of a firm equals 10.67%. The pre-tax cost of debt equals 8.4%, the firm pays 38% taxes and the firm's equity holders expect a rate of return of 17%. The firm's debt-to-equity ratio equals ________.

  A. 1.41

  B. 0.72

  C. 1.16

  D. 0.86

  Correct Answer: C

  Let E/(D+E) =

  A. Then,

  WACC = (1-A)*(1-t)*RD + A*RE, where t is the tax rate. Therefore,

  10.67% = (1-A)*(1-38%)*8.4% + A*17%. Hence, A = E/(D+E) = 0.463 and (D+E)/E = 1/0.463 = 2.16.

  This gives D/E = 1.16.

• Question 1274:

  Which of the following are methods of estimating a company's Cost of Retained Earnings?

  I. CAPM

  II. CANSLIM

  III. DCF Method

  IV.

  Bond-Yield-plus-Risk-Premium

  V.

  Least Cost Debt vs. Equity

  A.

  I, III, IV, and V

  B.

  I, II, III, IV, and V

  C.

  I, III and IV

  D.

  II only

  E.

  I only

  F.

  I and III

  Correct Answer: C

  The Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF method), and Bond-Yield-plusRisk-Premium methods may all be used to estimate a firm's Cost of Retained Earnings.

• Question 1275:

  While evaluating a project using net income figures, you must:

  A. subtract all non-cash net expenses.

  B. none of these answers.

  C. add back all non-cash net expenses.

  D. add back depreciation.

  Correct Answer: C

  In capital budgeting, annual cash flows, not accounting income, are used to evaluate a project. Hence, you must add back all non-cash net expenses, defined as total non-cash expenses - total non-cash revenues. You must also ignore financing costs.

• Question 1276:

  Which of the following projects is likely to produce multiple Internal Rates of Return. Project A Initial investment outlay: ($1,000,000) t1: $0.00 t2: $0.00 t3: $0.00 t4: $0.00 t5: $0.00 t6: $10,000,000 Project B Initial investment outlay: ($1,000,000) t1: $500,000 t2: $500,000 t3: $500,000 t4: $0.01 Project C Initial investment outlay: ($1,000,000) t1: $800,000 t2: ($100,000) t3: $550,000 Project D Initial investment outlay: ($500,000) t1: $400,000 t2: ($1,000) t3: $230,000 t4: ($50,000)

  A. Project D

  B. Project A, C and D

  C. Project A

  D. Project B

  E. Project C and D

  F. Project C

  Correct Answer: F

  In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs calculation which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects C and D involve cash outflows superimposed within their cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as this, it is advisable to use either the NPV or MIRR methods, which are not subject to the problem of multiple IRRs associated with the traditional IRR method. From observation alone, we can determine that project C and D are non-normal projects, and are thus likely to result in multiple IRRs. While project A is somewhat unusual in the fact that the first five periods produce no cash flows at all, there is only one sign change present in its cash flows, and thus is characterized as a "normal" project.

• Question 1277:

  Which of the following statements is most correct?

  A. None of these answers.

  B. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.

  C. All of these answers.

  D. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.

  E. If a company's tax rate increases, but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital will fall.

  Correct Answer: E

  The debt cost used to calculate a firm's WACC is k(d)(1 - T).

  If k(d) remains constant but T increases, then the term (1 - T) decreases and the value of the entire

  equation, k(d)(1 - T), decreases.

  k(d)(1 - T) = after-tax component cost of debt, where T is the firm's marginal tax rate.

• Question 1278:

  The trade-off theory of capital structure implies that:

  A. firms issue debt up to the level where the total value added by the debt tax shield is offset by expected bankruptcy costs.

  B. firms will use debt up to the level where the flotation cost of new debt equals that of issuing more equity, thus minimizing the costs of raising capital.

  C. managers are uncomfortable with either too much debt or too much equity and hence, tend to choose debt ratios around 0.40 to 0.60.

  D. none of these answers.

  Correct Answer: D

  According to the trade-off theory of capital structure, firms issue debt up to the level where the additional value added by the debt tax shield for another dollar of capital raised is offset by expected bankruptcy costs. This ensures that with only these two effects, the firm's stock price is maximized. Clearly, at this point, the total value added by the debt tax shield exceeds the expected bankruptcy costs.

• Question 1279:

  PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10 percent. Sales for the year totaled $3,500,000 and variable costs were 60 percent of sales. Net income was equal to $600,000 and the company's tax rate was 40 percent. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?

  A. 1.15

  B. 1.22

  C. 2.68

  D. 1.12

  E. 1.00

  Correct Answer: B

  First, calculate PQR's DFL as EBIT/(EBIT - I). Interest expense (I) on the debt is $1,500,000(10%) = $150,000. We can work backwards from NI to find EBIT as follows: EBT = NI/(1 - T) or $600,000/0.6 = $1,000,000. EBIT = EBT + I or $1,000,000 + $150,000 = $1,150,000. DFL is thus $1,150,000/($1,150,000$150,000) = 1.15. Recognizing DTL = DFL x DOL, we can solve 1.40 = 1.15 x DOL for DOL = 1.22.

• Question 1280:

  Which of the following figures is not explicitly incorporated into the earnings per share (EPS) calculation?

  A. Interest Expense

  B. Sales

  C. Fixed Costs

  D. Tax Rate

  E. Weighted Average Cost of Capital

  F. Variable Costs

  Correct Answer: E

  The WACC is not incorporated into the EPS calculation. The EPS calculation is found by the following

  equation:

  {EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares

  Outstanding]}

  Additionally, the EPS figure can be found by:

  {EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]}.