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

• Question 981:

  Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent. What is the firm's cost of retained earnings?

  A. 15.0%

  B. 15.5%

  C. 16.5%

  D. 16.0%

  E. 17.0%

  Correct Answer: E

  EBIT$1,000,000 Interest400,000 EBT$600,000 Taxes (40%)240,000 Net income$360,000 EPS(1) = $360,000/100,000 = $3.60. D(1) = $3.60(0.5)= $1.80. k(s) = ($1.80/$40.00) + 0.125 = 17.0%.

• Question 982:

  Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital budgeting?

  A. All of the statements are correct.

  B. Only incremental cash flows are relevant to the accept/reject decision.

  C. The return on invested capital is the only relevant cash flow.

  D. None of the statements are correct.

  E. Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.

  Correct Answer: B

  Incremental cash flows are the net cash flows attributable to an investment project and are the only cash flows relevant in capital budgeting.

• Question 983:

  The management of Allcycles.com, a motorcycle supply chain, is examining several capital projects. The firm is financed according to the following schedule based on market values: 60% debt 35% common stock 5% perpetual preferred stock Additionally, consider the following information: Yield on outstanding debt: 10.12% Tax rate: 35% Annual preferred dividend: $0.64

  Preferred stock price: $7.36

  Return on equity: 18%

  Dividend payout ratio: 25%

  Cost of common stock: 16.33%

  Using this information, what is the Weighted Average Cost of Capital for Allcycles.com?

  A. 10.55%

  B. The answer cannot be completely calculated from the given information.

  C. 9.98%

  D. 10.04%

  E. None of these answers.

  F. 10.10%

  Correct Answer: F

  In order to calculate the WACC, it is necessary to first calculate the component after-tax cost of debt,

  common equity, and preferred equity. Once the cost of these components is determined, they are imputed

  into the WACC equation, which is as follows:

  {WACC = [(% weight of debt securities * cost of debt) + (% weight of common stock * cost of common

  stock) + (% weight of preferred stock * cost of preferred stock)]} To calculate the component after-tax cost

  of debt, use the following equation:

  {Cost of debt = [yield on outstanding debt securities * (1 - tax rate)}

  Factoring in the given information into this equation would yield the following:

  {After-tax cost of debt = [10.12% * (1 - 0.35%)]} = 6.578%

  To calculate the component cost of outstanding preferred stock, the following equation must be used:

  {Cost of preferred stock = [annual dividend / preferred stock price]}

  {Cost of preferred stock - = [$0.64 / $7.36]} = 8.70%.

  The final component of the WACC calculation, the cost of common equity, has been provided as 16.33%.

  Now that the after-tax cost of debt, preferred stock, and common stock have been determined, the WACC

  calculation can be found. The calculation of the WACC is as follows:

  {[0.60 * 0.06578] + [0.35 * 0.1633] + [0.05 * 0.0870]} = 10.10%.

• Question 984:

  Which of the following is/are true about dividend policies?

  I. Under the Bird-in-the-Hand theory, stocks with lower pay-out ratios have higher required rates of return.

  II. Under the Tax Preference theory, stocks with lower pay-out ratios have lower required rates of return.

  III.

  Under the Modigliani-Miller theory, the price of a stock does not change with a change in the dividend policy.

  A.

  II only

  B.

  I and II

  C.

  I, II and III

  D.

  I and III

  E.

  I only

  F.

  III only

  G.

  II and III

  Correct Answer: D

  (II) is not necessarily true when the capital gains tax is higher than realized income tax.

• Question 985:

  Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. What is the component cost of the equity raised by selling new common stock?

  A. 12.0%

  B. 16.4%

  C. 14.6%

  D. 15.0%

  E. 17.0%

  Correct Answer: E

  k(e) (component cost of external equity) = ($2.10/$21.88(1-.20)) + 0.05 = 17%.

• Question 986:

  Which of the following statements is most correct?

  A. The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method assumes reinvestment at the IRR.

  B. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate.

  C. The NPV method does not consider the inflation premium.

  D. The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period.

  E. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR.

  Correct Answer: E

  The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR.

• Question 987:

  Delphinium Inc.'s target capital structure has a debt ratio of 60 percent. The firm can raise up to $100,000 in new debt at a before-tax cost of 8.5 percent. If more than $100,000 of debt is required, the cost will be 9 percent. Net income last year was $100,000, and it is expected to continue to grow each year at a rate of 10 percent indefinitely. The firm expects to maintain its dividend payout ratio of 40 percent on the 10,000 shares of common stock outstanding. If it must sell new common stock, it would encounter a 15 percent flotation cost on the first $400,000, and a 20 percent cost if more than $400,000 of new outside equity is required. Delphinium's tax rate is 30 percent, and its current stock price is $88 per share. The firm has an unlimited number of projects, which will earn a 10.25 percent return. What is this year's capital budget if the firm invests to the point where the Marginal Cost of Capital (MCC) intersects the Investment Opportunity Schedule (IOS)?

  A. The company has an infinite capital budget.

  B. $1,000,000

  C. $1,165,000

  D. $400,000

  E. $1,150,000

  Correct Answer: C

  Step 1 Find the break points for the problem. There will be three break points: one for retained earnings,

  one for debt, and one for the change in flotation costs of new stock.

  Step 2 Calculate the component costs of capital:

  We know NI = $100,000 and there are 10,000 shares, therefore E(0) = $100,000/10,000 = $10. Also, the

  payout ratio is 40% so D(0) is $4. D(1) = D(0)(1 + g) = $4(1.1) = $4.40.

  k(s) = D1/P0 + g = $4.40/$88 + 10% = 15%.

  ke(1) = D1/P0(1 - F1) + g = $4.40/$88(1 - 0.15) + 10% = 15.88%.

  ke(2) = D1/P0(1 - F2) + g = $4.40/$88(1 - 0.20) + 10% = 16.25%.

  kd(1) = 8.5%(1 - T) = 8.5%(0.7) = 5.95%.

  kd(2) = 9%(1 - T) = 9%(0.7) = 6.30%.

  Step 3 Calculate the marginal costs of capital:

  MCC(1) = w(ce)k(s) + w(d)k(d1) = 0.4(15.00%) + 0.6(5.95%) = 9.57%.

  MCC(2) = w(ce)k(e1) + w(d)k(d1) = 0.4(15.88%) + 0.6(5.95%) = 9.92%.

  MCC(3) = w(ce)k(e1) + w(d)k(d2) = 0.4(15.88%) + 0.6(6.30%) = 10.13%.

  MCC(4) = w(ce)k(e2) + w(d)k(d2) = 0.4(16.25%) + 0.6(6.30%) = 10.28%.

  MCC Applicable Range

  1$0 through $165,000

  2$165,000 - $166,667

  3$166,667 - $1,165,000

  4over $1,165,000

  Since the IRR of all projects is given as 10.25% the point where the MCC intersects the IOS is $1,165,000,

  where the MCC jumps from 10.13% to 10.28%.

• Question 988:

  Which of the following statements is most correct?

  A. All of these answers are correct.

  B. Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity financing.

  C. The optimal capital structure maximizes EPS.

  D. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.

  E. The optimal capital structure minimizes the cost of equity.

  Correct Answer: B

  Increases in the debt ratio increase the cost of both debt and equity. Bondholders recognize that firms with higher debt levels are more likely to experience financial problems, which will explain why increases in the debt ratio raise the cost of debt. Concerning the cost of equity, the business risk premium, in the required rate of return equation, does not depend on the debt level. It will remain constant at all debt levels. However, the financial risk premium does vary depending on the debt level; the higher the debt level, the greater the risk premium, and therefore the higher the cost of equity.

• Question 989:

  Which of the following statements is most correct?

  A. All these statements are false.

  B. The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).

  C. Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage.

  D. All these statements are true.

  E. The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.

  Correct Answer: E

  DOL is the % change in EBIT that results from a given % change in sales, while DFL is the % change in EPS that results from a given % change in EBIT. If no debt were used, the DFL would be 1.0.

• Question 990:

  Consider the following information for a company. Common Stock Price $75.50 Preferred Stock Par Price $100 Preferred Dividend $4.0

  Debt Rating BB+

  Owners Equity 12.27%

  Preferred Stock Flotation Cost 2.0%

  The Preferred Stock is issued at Par

  Calculate the component cost of this newly issued preferred stock.

  A. 6.57%

  B. 4.0%

  C. 7.0%

  D. 3.92%

  E. 18.78%

  F. 4.08%

  G. 12.27%

  Correct Answer: F

  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 = $4.00 / (100 - 2) = 4.08%.