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

• Question 901:

  According to the "Tax Preference Theory," which factor(s) would lead investors to desire a lower payout of dividends over a relatively higher payout of dividends?

  I. Capital gains may be taxed at a lower marginal rate than ordinary income

  II. The cost of retained earning equity capital is usually lower than debt capital

  III. Capital gains are not taxed until the stock is sold and the gain is realized

  IV.

  If the stock is held until the owner dies, the beneficiary may use the stock price at the time of inheritance as the basis, thus any capital gains up until that point are not taxed

  V.

  Investors prefer a stable dividend policy

  A.

  None of these answers

  B.

  I only

  C.

  I, III and IV

  D.

  I, II, III, IV and V

  E.

  II and III

  Correct Answer: C

  The "Tax Preference Theory" states that there may be three reasons that investors would prefer lower dividend payments along with higher capital gains as opposed to high dividend payments. Long term capital gains may be taxed at a lower marginal rate than ordinary income (dividends). Also, investors have more control over when the taxable event occurs with capital gains. They are not taxed until the stock is sold and the gain is realized. Finally, if the stock is held until death, the beneficiary may claim the value at that time as the basis, thus avoiding taxes on any gains that previously accrued.

• Question 902:

  Capitol City Transfer Company is considering building a new terminal in Salt Lake City. If the company goes ahead with the project, it must spend $1 million immediately (at t = 0) and another $1 million at the end of Year 1 (t = 1). It will then receive net cash flows of $0.5 million at the end of Years 2 - 5, and it expects to sell the property and net $1 million at the end of Year 6. All cash inflows and outflows are after taxes. The company's cost of capital is 12 percent, and it uses the modified IRR criterion for capital budgeting decisions. What is the project's modified IRR?

  A. 11.5%

  B. 11.9%

  C. 11.4%

  D. 12.0%

  E. 11.7%

  Correct Answer: E

  Time line: (In millions)

  k = 12%

  MIRR = ?

  0123456 Yrs

  -1-1.5.5.5.51.0

  Tabular/Numerical solution:

  PV(Outflows) = -$1,000,000 - ($1,000,000/1.12) = $1,892,857.

  TV(Inflows) = $500,000(FVIFA(12%,4))(FVIF(12%,1)) + $1,000,000

  = $500,000(4.7793)(1.12) + $1,000,000 = $3,676.408.

  $1,892,857 = $3,676,408/(PVIF(MIrr,6)0

  PVIF(MIrr,6) = 1.94225 (Take 6th root of both sides)

  1 + MIRR = 1.11699

  MIRR = 11.699%.

• Question 903:

  Consider the following information for Company XYZ:

  30 day T-Bill rate (Risk free rate) 5.2%

  Common Stock Beta 1.1

  Expected Rate of return for the market 12.0%

  Debt Credit Rating BBB

  Calculate this firm's cost of retained earnings using the CAPM approach.

  A. 5.72%

  B. 17.2%

  C. 10.2%

  D. 12.0%

  E. 12.68%

  F. 5.2%

  Correct Answer: E

  To calculate the cost of retained earnings for a firm using CAPM, one may use the following formula: Cost of retained earnings = risk free rate + ((expected rate of return on the market - risk free rate) x Beta). In this case the cost of retained earnings = 5.2% + ((12.0% - 5.2%) x 1.1 = 12.68%.

• Question 904:

  Project A has an IRR of 12% and project B has an IRR of 9%. The crossover rate for these projects is 6.9%. You use the NPV rule for making project selections. If both the projects have a cost of capital of 10.4% and the projects are independent with normal cash flows, you should:

  A. select neither A nor B.

  B. select project B.

  C. insufficient information.

  D. select project A.

  Correct Answer: D

  Note that the crossover rate is unimportant here since the projects are independent, not mutually exclusive. Hence, you should select all projects with positive NPV. In this case, since A has an IRR greater than the cost of capital and it has normal cash flows, it has a positive NPV. Project B's IRR exceeds the cost of capital and hence has negative NPV. Therefore, you should select A and reject B.

• Question 905:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 45%

  common equity, and 5% perpetual 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 Expected annual preferred dividend =

  $1.55

  Preferred stock net offering price = $24.50

  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 Discounted Cash Flow (DCF) approach, what is the Weighted

  Average Cost of Capital for Clay Industries?

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

  B. 8.96%

  C. 13.05%

  D. 12.34%

  E. 7.70%

  F. 9.97%

  Correct Answer: B

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on 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 Discounted Cash Flow, or Dividend-Yield-plus-Growth-Rate approach. To calculate the cost of equityusing this approach, take the expected annual dividend on common equity ($0.80) divided by the market price of common stock ($30.90), and add the expected growth rate (9.75%) to this figure. Using this method, the cost of common equity is found to be 12.34%. 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 8.957%.

• Question 906:

  Which of the following would not have an influence on the optimal dividend policy?

  A. The costs associated with selling new common stock.

  B. All of these statements can have an effect on dividend policy.

  C. Bond indenture constraints.

  D. A strong shareholders' preference for current income versus capital gains.

  E. The possibility of accelerating or delaying investment projects.

  Correct Answer: B

  The optimal payout ratio is a function of 4 factors:

  1.

  Investors' preferences for dividends versus capital gains.

  2.

  The firm's investment opportunities.

  3.

  The firm's target capital structure.

  4.

  The availability and cost of external capital.

• Question 907:

  Assume the following information for Bearstone Concrete and Manufacturing, Inc.

  EPS: $6.25

  ROE: 10.16%

  Growth rate of dividends: 5.25%

  Discount rate: 12.80%

  Tax Rate 35%

  Common shares outstanding 2,000,000

  Using this information, what is the retention rate for this firm? Further, what is the annual dividend?

  A. 48.33%, $3.02

  B. 51.67%, $3.23

  C. 45.81%, $2.86

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

  E. 48.33%, $3.23

  F. 51.67%, $3.02

  Correct Answer: F

  To determine the retention rate of dividends, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows: {g = ROE (1 - Dividend Payout Ratio)} In order to determine the retention rate, the equation must be rearranged to the following: {(1 Dividend Payout Ratio) = Growth Rate of Dividends / ROE}. Imputing the given information into this equation will yield as follows: {(1 - Dividend Payout Ratio) = 0.0525/0.1016)} = 0.51673. Remember that the retention rate is equal to (1 - Dividend Payout Ratio). Therefore, no further calculation is necessary to determine the retention rate. In order to determine the annual dividend, take the Dividend Payout Ratio, which is found by (1 - Retention Rate), and multiply this figure by the Earnings Per Share calculation, which is given as $6.25. This will yield an annual dividend of $3.02. As you can see, neither the discount rate, tax rate, nor the number of common shares outstanding is factored into the equation.

• Question 908:

  A firm is considering undertaking a project requiring $7 million of new capital. The managers of the firm consider the prospects of the project having a 36% rate of return extremely likely, with a small probability that the project will not recover anything invested. The firm's current debt ratio is 70% and market analysts have estimated that the tax benefits from an increase in the debt level will be far smaller than the increase in bankruptcy costs. The Signaling Theory implies that the firm will try to raise _______ capital. The Trade-off Theory implies that the firm will try to raise _______ capital.

  A. equity; equity

  B. equity; debt

  C. debt; debt

  D. debt; equity

  Correct Answer: D

  Since additional debt does not create more benefits from tax shield than the losses anticipated due to increased bankruptcy costs, the Trade-off theory implies that the firm will try to raise equity capital for the project. On the other hand, since the prospects of the project are extremely favorable, Signaling Theory says that the firm would rather raise the capital through debt so that the profits from the project are shared on an equity basis only with the current shareholders.

• Question 909:

  Which of the following statements is most correct?

  A. An increase in the cost of equity capital when a company announces an increase in its dividend per share, would be consistent with the bird-in-the-hand theory.

  B. All of these statements are correct.

  C. The tax preference theory states that, all else equal, investors prefer stocks that pay low dividends because retained earnings can lead to capital gains that are taxed at a lower rate.

  D. A dividend policy that involves paying a consistent percentage of net income is the best policy if the "clientele effect" is correct.

  E. An increase in the stock price when a company decreases its dividend is consistent with the signaling theory.

  Correct Answer: C

  The reasons investors might prefer a low dividend payout to a high payout are:

  1.

  Long-term capital gains are taxed at a maximum 28% rate, whereas dividend income is taxed at rates up to 39.6%. Obviously, high tax-bracket investors might prefer to have firms plow back earnings into the firm, presumably leading to a higher stock price, and resulting in a lower-taxed capital gain.

  2.

  Capital gain taxes are not paid until the stock is sold and taxes paid in the future has a lower effective cost than taxes paid today.

  3.

  If stock is held until one dies, no capital gains tax is due because the cost basis of the stock of the beneficiaries who inherit the stock, is the stock's value on the death day, thus escaping any capital gains tax.

• Question 910:

  Copybold Corporation is a start-up firm considering two alternative capital structures--one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share. What is the coefficient of variation of expected EPS under the conservative capital structure plan?

  A. 0.58

  B. 0.15

  C. 0.23

  D. 0.39

  E. 1.00

  Correct Answer: A

  Calculate coefficient of variation

  Expected EPS conservative:

  E(EPS) = 0.6($1.00) + 0.4($0.20) = $0.68.

  Standard deviation

  SD(EPS-Conservative) = [0.6($1.00 - $0.68)^2 + 0.4($0.20 - $0.68)^2]^1/2 = [0.0614 + 0.0922]^1/2 =

  0.3919.

  CV(Conservative) = 0.3919/0.68 = 0.576.