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

• Question 891:

  Strategic Systems Inc. expects to have net income of $800,000 during the next year. Its target, and current, capital structure is 40 percent debt and 60 percent common equity. The Director of Capital Budgeting has determined that the optimal capital budget for next year is $1.2 million. If Strategic uses the residual dividend model to determine next year's dividend payout, what is the expected dividend payout ratio?

  A. 0%

  B. 56%

  C. 28%

  D. 42%

  E. 10%

  Correct Answer: E

  Equity requirement = 0.6($1,200,000) = $720,000. Expected NI$800,000 Equity requirement720,000 Available for dividends$80,000 Payout ratio = $80,000/$800,000 = 0.10 = 10%.

• Question 892:

  Firm A has a higher operating leverage than firm B. All else equal, firm A has a _______ business risk and a ________ variability of ROE.

  A. lower, higher

  B. higher, lower

  C. higher, higher

  D. lower, lower

  Correct Answer: C

  "Operating leverage" refers to the extent to which changes in sales revenues affect operating profits. The greater the leverage, the higher the business risk and the variability of ROE.

• Question 893:

  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 45% debt, 50% common equity, and 5% preferred stock. Credit Rating BB

  +

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

  A. 7.21%

  B. 9.21%

  C. 9.0%

  D. 8.0%

  E. 2.5%

  F. 28.00%

  Correct Answer: B

  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 = .45(6%) + .5(12%) + .05(10.25%) = 9.21%

• Question 894:

  Which of the following choices correctly describes an investment in which the cash flows from an existing project must be considered along with the expected cash flows of a proposed project?

  A. Expansion project

  B. Retrenchment project

  C. Replacement project

  D. Non-normal project

  E. Marginal project

  Correct Answer: C

  In an analysis of a replacement project, the cash flows associated with the existing project must be examined along with the expected cash flows from a new project. Expansion project is defined as one for which the firm in question does not have an existing proxy, or a project which will expand the operations of the Company into a new market or functional niche. Expansion projects are for the expansion of revenues. "Marginal project" and "retrenchment project," are fictitious terms.

• Question 895:

  Which of the following equations correctly illustrates the calculation of the cost of perpetual preferred equity?

  A. None of these examples

  B. Net offering price/(required rate of return) + expected growth

  C. Offering price/(expected rate of return- required rate of return) + expected growth

  D. Annual dividend/(offering price + flotation costs)

  E. (Annual dividend/current preferred stock price) + expected growth rate

  F. Annual dividend/(offering price - flotation costs)

  Correct Answer: F

  The cost of perpetual preferred equity can be found by dividing the annual dividend by the net offering price, or gross offering price less flotation costs. Of the six answers listed, only #2 represents a recognized financial equation; the rest are largely fictitious.

• Question 896:

  Assume that all the assumptions of Modigliani and Miller hold. In particular, there are no taxes and transaction costs. A firm has a policy of paying out 8% of the stock price as dividends. However, an investor would like to receive only a 4% dividend. For this, he should:

  A. none of these answers.

  B. liquidate 8% of his stock holding after receiving the dividend.

  C. liquidate 4% of his stock holding after receiving the dividend.

  D. use half of the dividend amount to buy stock after receiving the dividend.

  Correct Answer: D

  Suppose the investor is holding stocks worth $100. The company then pays $8 as dividends. To reduce

  his dividend income to $4, the investor must buy stocks worth $4.

• Question 897:

  Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky. Assume now that GEC needs to raise $300 million in new capital. What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?

  A. 12.66%

  B. 6.00%

  C. 9.50%

  D. 13.77%

  E. 9.00%

  Correct Answer: C

  k(d) (interest rate on the firm's new debt) = 10%;

  k(d)(1 - T) (after-tax component cost of debt) = 10%(0.6) = 6%.

  D/A = 55%

  D(0) = $2.20

  g = 6%

  P(0) = $35

  P(N) = $35

  T (The firm's marginal tax rate) = 40%

  Retained earnings = $100M; BP(RE) = $100M/ .45 = $222.22M

  k(s) (component cost of retained earnings) = $2.33/$35 + 6% = 12.66%

  k(e) (component cost of external equity) = $2.33/$30 + 6% = 13.77%.

  WACC (Weighted Average Cost of Capital) (1) = 0.55(6%) + 0.45(12.66%) = 9.0% WACC(2) = 0.55(6%) +

  0.45(13.77%) = 9.5%

• Question 898:

  Your firm's EPS last year was $1.00. You expect sales to increase by 15 percent during the coming year. If your firm has a degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS?

  A. $1.6563

  B. $2.5843

  C. $2.2427

  D. $1.3481

  E. $1.9813

  Correct Answer: A

  EPS(0) = $1.00. DOL = 1.25. EPS(1) = ?

  %Change S = 15%. DFL = 3.50.

  DTL = DOL(DFL) = 1.25(3.50) = 4.375.

  EPS(1) = EPS(0)[1.0 + (DTL)(%Change Sales)] = $1.00[1.0 + (4.375)(0.15)] = $1.00[1.6563] = $1.6563.

• Question 899:

  A sudden and unexpected decrease in the tax rate would be expected to have the most significant impact on the carrying cost of which of the following components of a firm's capital structure?

  A. Retained earnings

  B. Common stock

  C. None of these answers

  D. Preferred stock

  E. Debt

  Correct Answer: E

  After a sudden and unexpected decrease in the tax rate, corporations will find themselves in an environment where the tax-shelter benefits of debt financing have become compromised. Currently, firms can deduct coupon payments on their debt securities from their annual income, and this taxdeductibility feature is an important consideration in any capital budgeting decision. A decrease in the tax rate will increase the cost of debt, and therefore will decrease the attractiveness of debt securities as an alternative to other methods of financing.

• Question 900:

  Smith Company has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?

  A. An increase in the flotation costs associated with issuing preferred stock.

  B. An increase in the flotation costs associated with issuing common equity.

  C. A reduction in the market risk premium.

  D. An increase in the company's beta.

  E. An increase in expected inflation.

  Correct Answer: C

  If the risk premium decreases, the required return on common equity will be reduced. All of the other answers will increase the firm's WACC.