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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 24 )

Updated On: 26-Jan-2026
Page 24 of 793
PDF with 3960 Questions

Which of the following methods of evaluating capital projects incorporate an explicit discount rate into the equation?

  1. Net Present Value, Payback Period
  2. Internal Rate of Return, Modified Internal Rate of Return
  3. Discounted Payback Period, Net Present Value, Payback Period
  4. Discounted Payback Period, Net Present Value, Modified Internal Rate of Return
  5. Discounted Payback Period, Net Present Value, Internal Rate of Return

Answer(s): D

Explanation:

Of the methods for evaluating capital projects, the Net Present Value, Modified Internal Rate of Return, and Discounted Payback Period Methods incorporate an explicit discount rate into their equations. This discount rate is often referred to as the "cost of capital" for the project being examined. Remember that the Internal Rate of Return equation does not involve the incorporation of an explicit discount rate,rather solves to find that rate which equates the present value of a project's cash inflows with that of its cash outflows. Additionally, the "Payback Period" method does not involve an explicit discount rate, rather fails to incorporate any form of discounting into its calculation. The Payback Period is an overtly simplistic method, and as such, the figures produced by this method should be viewed with a degree of caution.



Which of the following figures is not explicitly incorporated into the earnings per share (EPS) calculation?

  1. Interest Expense
  2. Sales
  3. Fixed Costs
  4. Tax Rate
  5. Weighted Average Cost of Capital
  6. Variable Costs

Answer(s): E

Explanation:

The WACC is not incorporated into the EPS calculation. The EPS calculation is found by the following equation:
{EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]}
Additionally, the EPS figure can be found by:
{EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]}.



The trade-off theory of capital structure implies that:

  1. firms issue debt up to the level where the total value added by the debt tax shield is offset by expected bankruptcy costs.
  2. firms will use debt up to the level where the flotation cost of new debt equals that of issuing more equity, thus minimizing the costs of raising capital.
  3. managers are uncomfortable with either too much debt or too much equity and hence, tend to choose debt ratios around 0.40 to 0.60.
  4. none of these answers.

Answer(s): D

Explanation:

According to the trade-off theory of capital structure, firms issue debt up to the level where the additional value added by the debt tax shield for another dollar of capital raised is offset by expected bankruptcy costs. This ensures that with only these two effects, the firm's stock price is maximized. Clearly, at this point, the total value added by the debt tax shield exceeds the expected bankruptcy costs.



PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10 percent. Sales for the year totaled $3,500,000 and variable costs were 60 percent of sales. Net income was equal to $600,000 and the company's tax rate was 40 percent. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?

  1. 1.15
  2. 1.22
  3. 2.68
  4. 1.12
  5. 1.00

Answer(s): B

Explanation:

First, calculate PQR's DFL as EBIT/(EBIT - I). Interest expense (I) on the debt is $1,500,000(10%) = $150,000.
We can work backwards from NI to find EBIT as follows: EBT = NI/(1 - T) or $600,000/0.6 = $1,000,000. EBIT = EBT + I or $1,000,000 + $150,000 = $1,150,000. DFL is thus $1,150,000/($1,150,000- $150,000) = 1.15.
Recognizing DTL = DFL x DOL, we can solve 1.40 = 1.15 x DOL for DOL = 1.22.



Which of the following statements is most correct?

  1. None of these answers.
  2. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.
  3. All of these answers.
  4. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.
  5. If a company's tax rate increases, but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital will fall.

Answer(s): E

Explanation:

The debt cost used to calculate a firm's WACC is k(d)(1 - T).
If k(d) remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, k (d)(1 - T), decreases.
k(d)(1 - T) = after-tax component cost of debt, where T is the firm's marginal tax rate.



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