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

• Question 1371:

  Consider the following information for Company ABC:

  Current Price of Stock $40.25

  Expected dividend in 1 Year $1.10

  Growth rate 9.2%

  Beta 1.2

  Risk Free Rate 4.5%

  Expected Market Return 10%

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

  A. 13.70%

  B. 11.93%

  C. 12.0%

  D. 9.20%

  E. 13.30%

  F. 11.04%

  Correct Answer: B

  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 = (1.1 / 40.25) + 9.2% = 2.73 + 9.2 = 11.93%

• Question 1372:

  The modified IRR (MIRR) is normally ________.

  A. all of these answers are correct

  B. none of these answers are correct

  C. greater than the regular IRR if IRR > k

  D. equal to the regular IRR if IRR < k

  E. less than the regular IRR if IRR > k

  Correct Answer: E

  MIRR assumes that cash flows from all projects are reinvested at the cost of capital, while the regular IRR assumes that the cash flows from each project are reinvested at the project's own IRR. Therefore the IRR will be greater than the MIRR if the IRR is greater than the cost of capital.

• Question 1373:

  An increase in the dividend payout ratio ________ the retained earnings break-point.

  A. decreases

  B. increases or decreases, depending on the tax rate

  C. increases

  D. does not affect

  Correct Answer: A

  As the dividend payout ratio is increased, the amount of earnings retained decreases, decreasing the amount of new debt that can be issued without changing the capital structure. Hence, the retained earnings breakpoint will decrease.

• Question 1374:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 35%

  common equity, and 15% preferred equity. The following information applies to the firm:

  Before-tax cost of debt = 9.5%

  Combined state/federal tax rate = 35%

  Expected return on the market = 14.5%

  Annual risk-free rate of return = 6.25%

  Historical Beta coefficient of Clay Industries Common Stock = 1.24

  Annual preferred dividend = $1.55

  Preferred stock net offering price = $24.50

  Expected annual common dividend = $0.80

  Common stock price = $30.90

  Expected growth rate = 9.75%

  Subjective risk premium = 3.3%

  Given this information, and using the Bond-Yield-plus-Risk-Premium approach to calculate the component

  cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 9.79%

  B. 8.36%

  C. 9.82%

  D. 6.93%

  E. 8.52%

  F. The WACC for Clay Industries cannot be calculated from the information.

  Correct Answer: E

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity of outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the DividendYield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Bond-Yieldplus-Risk-Premium approach. To calculate the cost of equity using this approach, take the yield to maturity on the firm's outstanding debt (9.5%) and add a subjective risk premium (3.3%), which gives a cost of common equity of 12.8%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long- term debt (9.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 6.175%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.516%.

• Question 1375:

  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. Where will a break in the MCC schedule occur?

  A. $20,000

  B. $10,000

  C. $42,000

  D. $30,000

  E. There will be no breaks in the MCC schedule.

  Correct Answer: D

  Break point(RE) = $15,000/.50 = $30,000.

• Question 1376:

  A financial analyst with Mally, Feasance and Company is examining shares of Intelligent Semiconductor.

  Assume the following information:

  Retention rate: 80%

  EPS: $3.98

  Discount rate: 12.35%

  Tax rate: 35%

  Beta coefficient: 1.5

  Expected return on the market: 12.5%

  Using this information, what is the expected growth rate of Intelligent Semiconductor? Choose the best

  answer.

  A. 65.00%

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

  C. 61.75%

  D. None of these answers is correct.

  E. 43.33%

  F. 9.88%

  Correct Answer: B

  In order to determine the dividend growth rate of Intelligent Semiconductor, the following equation should

  be used:

  {g = ROE(1 - Dividend Payout Ratio)}

  While the Retention Rate of Dividends (which equals one minus the Dividend Payout Ratio) is provided,

  the ROE figure is not. Further, the ROE figure cannot be determined from this information provided.

  Therefore, the growth figure cannot be calculated. Remember that in determining dividend growth using

  the formula outlined above, neither the tax rate nor the discount rate is incorporated into the equation.

  Furthermore, the Beta Coefficient and the expected return on the market are largely irrelevant in this

  example.

• Question 1377:

  Which of the following statements is most correct?

  A. All of the answers above are correct.

  B. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.

  C. A reduction in the corporate tax rate is likely to increase the debt ratio of the average corporation.

  D. None of these answers are correct.

  E. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

  Correct Answer: D

  A major reason for using debt is that interest is deductible, which lowers the effective cost of debt. Lowering the corporate tax rate reduces the tax advantages of debt leading firms to use less debt financing. If the personal tax rate were to increase, individuals would now find interest received on corporate debt less attractive, causing firms to utilize less debt financing. An increase in the costs of bankruptcy might lead firms to use less debt in order to reduce the probability of having to incur these higher costs.

• Question 1378:

  A stock has an expected dividend growth rate of 4.4%. The firm has just announced a dividend of $1.9 per share, with an ex dividend date 3 days from now. Investors expect a rate of return of 9% from the stock and the stock is trading at $31.84. Ignoring stock price uncertainty between now and the ex dividend date and expecting the same growth, the stock is:

  A. fairly priced.

  B. under-priced.

  C. insufficient information.

  D. overpriced.

  Correct Answer: B

  Ignoring stock price uncertainty between now and the ex dividend date, the stock would have a fair price of Po on the ex dividend date, given by Po = D1/(r-g) = 1.9*1.044/(9% - 4.4%) = $43.12. Therefore,the current fair price of the stock is $43.12 + $1.9 = $45.02, which is much greater than the actual trading price of $31.84. Thus, the stock is under-priced. Note that the operative phrase in this example is "ignoring all uncertainty between now and the ex dividend date and expecting the same growth." If the market is expecting some negative information about the firm to be released some time in the near future (not necessarily before ex dividend date) or does not believe that the firm will continue to grow at or more than 4.4%, the actual trading price could be a fair price. Hence, you should never blindly apply the DDM.

• Question 1379:

  From the information below, select the optimal capital structure for Minnow Entertainment Company.

  A. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.

  B. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.

  C. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

  D. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.

  E. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

  Correct Answer: B

  Since the optimal capital structure is the one that maximizes the price of the firm's stock, and minimizes the firm's WACC, this would be the optimal capital structure.

• Question 1380:

  Tapley Acquisition Inc. is considering the purchase of Target Company. The acquisition would require an initial investment of $190,000, but Tapley's after-tax net cash flows would increase by $30,000 per year and remain at this new level forever. Assume a cost of capital of 15 percent. Should Tapley buy Target?

  A. Yes, because the IRR < the cost of capital.

  B. Yes, because the NPV = $10,000.

  C. No, because NPV < 0.

  D. No, because k > IRR.

  E. Yes, because the NPV = $30,000.

  Correct Answer: B

  NPV = $30,000/0.15 - $190,000 = $200,000 - $190,000 = $10,000.