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

• Question 881:

  Consider the following characteristics of a firm:

  Stock price $60

  Annual dividend $1

  Debt rate 12%

  Equity floatation cost 5%

  Tax rate 40%

  Preferred Stock Par value $100

  What is the firm's after tax cost of debt?

  A. 1.8%

  B. 5%

  C. 7.2%

  D. 12%

  E. 1.7%

  F. 60%

  Correct Answer: C

  A firm's after tax cost of debt may be calculated using the following formula: After Tax Cost of Debt = Cost of Debt x (1 - Tax Rate). In this case the After Tax Cost of Debt = 12% x (1 - 40%) = 12% x 60% = 7.2%.

• Question 882:

  A consulting firm is currently under contract with a Busy Bus and Van Lines, Inc., and has agreed to formulate various financial reports and trend projections for the Company. During the most recent month, the consulting firm has been able to determine the following; Busy Bus and Van Lines currently pays out 30% of its net income as dividends, and this rate is expected to remain stable. Additionally, Busy has maintained a steady ROE of 15% for the last ten years, and this is also expected to remain stable. The risk-free rate of return is 5.35%, and the firm is in a 35% combined state/federal income tax rate. Finally, Busy Bus and Van Lines has informed the consulting firm that its shareholders require a 12.5% or greater rate of return, and the firm's common stock is priced at $9.65. Using the Retention Growth Rate method, which of the following most closely resembles the growth rate of Busy Bus and Van Lines, Inc.?

  A. 12.5%

  B. 184%

  C. 19.5%

  D. The growth rate of this firm cannot be determined from the information provided.

  E. 15.85%

  F. 10.5%

  Correct Answer: F

  When security analysts estimate growth rates, the Retention Growth Rate method is often the method employed. In estimating growth using this model, the retention rate (defined as the percentage of net income that is retained within the firm and not distributed as dividends), is multiplied by the figure for ROE. The calculation of the answer in this example is as follows: {[1 - payout ratio 30%]

  * ROE 15%}= 10.5%. This method is most useful when the growth rate or the components of the equation are expected to remain stable.

• Question 883:

  A firm's reliance on debt ________ as bankruptcy costs increase. The debt ratio _______ as the probability of default increases.

  A. increases; decreases.

  B. decreases; decreases.

  C. increases; increases.

  D. decreases; increases.

  Correct Answer: B

  Expected bankruptcy costs are a deterrent to high debt levels. These costs increase if the probability of default increases or the costs associated with the bankruptcy increase. In either of these cases, a firm will reduce its reliance on debt.

• Question 884:

  Ecodevelopment Company has two mutually exclusive construction projects to evaluate. Each type of project can be duplicated repeatedly in different geographic locations around the country, but each requires a very different set of assets to construct. Thus, Ecodevelopment uses the equivalent annual annuity method to evaluate such projects. Project type A costs $6 million initially and generates expected end-of-year cash flows of $3 million, $5 million, and then $10 million when it is sold after 3 years. Project type B costs $9 million initially and has projected end-of-year cash flows of $3, $3, $6, and $6 million in Year 1 through Year 4, and then $10 million in Year 5. The project types are equally risky and the firm's cost of capital is 12 percent. What is the EAA of the higher valued project type?

  A. $2.726 million

  B. $4.389 million

  C. $3.240 million

  D. $6.000 million

  E. $5.600 million

  Correct Answer: C

  Calculate each project's original life NPV:

  NPV(A) = $3.0(PVIF(12%,1)) + $5.0(PVIF(12%,2)) + $10.0(PVIF(12%,3)) - $6.0

  = $3.0(0.8929) + $5.0(0.7972) + $10.0(0.7118) - $6.0

  = $2.6787 + $3.9860 + $7.1180 - $6.0

  = $7.7827 million = $7,782,700.

  NPV(B) = $3.0(PVIFA(12%,2)) + $6.0(PVIFA(12%,2))(PVIF(12%,2))

  + $10.0(PVIF(12%,5)) - $9.0

  = $3.0(1.6901) + $6.0(1.6901)(0.7972) + $10.0(0.5674) - $9.0 =

  $5.0703 + $8.0841 + $5.6740 - $9.0

  = $9.8284 million = $9,828,400.

  Calculate the equivalent annual annuity:

  NPV(A) = $7,782,700 = EAA(A)(PVIFA(12%,3))

  EAA(A) = $7,782,700/2.4018 = $3,240,361.40.

  NPV(B) = $9,828,400 = EAA(B)(PVIFA(12%,5))

  EAA(B) = $9,828,400/3.6048 = $2,726,475.81.

• Question 885:

  Holding all else equal, an decrease in which of the following will cause an increase in the theoretical growth rate of common stock dividends according to the Growth Rate of Dividends Model?

  I. ROE

  II. Payout ratio

  III.

  Tax rate IV Preferred stock price

  V.

  Discount rate

  VI.

  Retention rate

  A.

  II, V

  B.

  None of these answers

  C.

  II, IV

  D.

  III, II

  E.

  I, III, IV

  F.

  V, VI

  Correct Answer: B

  The equation used to determine the theoretical growth rate of common stock dividends is as follows:

  {Annual growth rate = [ROE * (1 - dividend payout ratio)]}

  As you can see, of the choices listed, only a decrease in the dividend payout ratio will cause an increase in

  the theoretical growth rate of common stock dividends.

• Question 886:

  Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a part of) business risk?

  A. The ability to change prices as costs change.

  B. Changes in required returns due to financing decisions.

  C. The extent to which operating costs are fixed.

  D. Demand variability.

  E. Sales price variability.

  Correct Answer: B

  Business risk depends on:

  (1)

  unit sales variability,

  (2)

  sales price variability,

  (3)

  input price variability,

  (4)

  ability to adjust output prices for changes in input prices and,

  (5)

  the extent to which costs are fixed (operating leverage).

• Question 887:

  The Residual Dividend Policy leads to:

  A. the firm paying out a constant fraction of earnings as dividends.

  B. the firm maintaining a constant absolute amount of dividends.

  C. the firm maintaining a steady growth of dividends.

  D. a highly unstable dividend policy.

  Correct Answer: D

  Under the Residual Dividend Policy, a firm first determines the amount of capital it requires for sufficiently profitable projects. It then uses retained earnings to supply equity capital and raises debt in the proper amount to maintain the target capital structure. If any earnings are left over after this, they are paid out as dividends. If not, the firm will not only not pay any dividends but also issues new equity for financing. Thus, the amount of dividends paid out can swing wildly from one year to the next, based on the current business conditions and future growth prospects.

• Question 888:

  Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

  A. Composite method.

  B. Bond-yield-plus-risk-premium method.

  C. CAPM and Bond-yield-plus-risk-premium methods.

  D. DCF (Discounted Cash Flow) method and CAPM (Capital Asset Pricing Model) methods.

  E. CAPM method.

  Correct Answer: C

  In the CAPM approach, the stock's beta coefficient must be estimated, which is used as an index of the stock's risk. In the bond-yield-plus-risk-premium method the risk premium is judgmentally added to the interest rate on the firm's own long- term debt.

• Question 889:

  In the absence of bankruptcy and agency costs and signaling actions, tax deductibility of interest payments implies that the optimal debt ratio should be:

  A. none of these answers

  B. 50%

  C. 100%

  D. zero

  Correct Answer: C

  If there are no costs to increased debt, such as bankruptcy costs, and no signaling effects in a firm's decisions about the capital structure, then a firm would try to maximize the benefits of the debt shield i.e. the deductibility of interest payments. This implies a debt ratio of 100%.

• Question 890:

  If a company uses the same discount rate for evaluating all projects, which of the following results is likely?

  A. Accepting no projects.

  B. Accepting poor, high-risk projects.

  C. Accepting only poor, high-risk projects.

  D. Accepting only good, low risk projects.

  E. Accepting all projects.

  Correct Answer: B

  Under the risk-adjusted discount rate, differential project risk is dealt with by changing the discount rate. High-risk projects are discounted at a higher cost of capital; lower-risk projects are discounted at a rate below the firm's average cost of capital, etc. This approach incorporates project risk into capital budgeting.