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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 27 )

Updated On: 26-Jan-2026
Page 27 of 793
PDF with 3960 Questions

Photon Corporation has a target capital structure of 60 percent equity and 40 percent debt. The firm can raise an unlimited amount of debt at a before-tax cost of 9 percent. The company expects to retain earnings of $300,000 in the coming year and to face a tax rate of 35 percent. The last dividend was $2 per share and the growth rate of the company is constant at 6 percent. If the company needs to issue new equity, then the flotation cost will be $5 per share. The current stock price is $30. Photon has the following investment opportunities:
Project Cost IRR
1 $100,000 10.5%
2 $200,000 13.0
3 $100,000 12.0
4 $150,000 14.0
5 $75,000 9.0

  1. $150,000
  2. $450,000
  3. $350,000
  4. $550,000
  5. $625,000

Answer(s): B

Explanation:

Calculate the retained earnings break point (BPRE) as $300,000/0.6 = $500,000. Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% = 13.07%. Calculate ke as D1/(P0 - F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%. Find WACC below BPRE as: WACC = 0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed at 10.18%. Find WACC above BPRE as: WACC = 0.6(14.48%) + 0.4 (9%) (1 - 0.35) = 11.03%. Thus, financing in excess of $500,000 costs 11.03%. Projects 2, 3, and 4 all have IRRs exceeding either WACC and should be accepted. These projects require $450,000 in financing. Project 1 is the next most profitable project.
Given its cost of $100,000, half or $50,000 can be financed at 10.18% and the other half must be financed at 11.03%. The relevant cost of capital for Project 1 is then 0.5(10.18%) + 0.5(11.03%) = 10.61%. Since Project 1's IRR is less than the cost of capital, it should not be accepted. The firm's optimal capital budget is $450,000.



A stock has an expected dividend growth rate of 4.9%. The firm has just paid a dividend of $2.5 per share. With a required rate of return of 10%, the stock is trading at $42.8. The stock is:

  1. overpriced.
  2. insufficient information.
  3. fairly priced.
  4. under-priced.

Answer(s): D

Explanation:

The fair price of the stock with a required rate of return, r and a dividend growth rate, g, is given by P = D1/(r-g), where D1 = Do*(1-g) = dividend to be paid next year. In this case, the fair price of the stock equals 2.5*1.049/ (10% - 4.9%) = $51.42. Thus, the stock is under-priced by $(51.42 - 42.8) = $8.62.



Which of the following is not considered a capital component?

  1. All of these are considered capital components
  2. Preferred stock
  3. Common stock
  4. Long-term debt
  5. Retained earnings

Answer(s): A

Explanation:

The four major capital components are debt, preferred stock, retained earnings, and new issues of common stock.



Sun State Mining Inc., an all-equity firm, is considering the formation of a new division, which will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

  1. 2.0
  2. 1.0
  3. 2.2
  4. 1.6
  5. 1.8

Answer(s): B

Explanation:

Old assets = 1.0.New assets = 0.5.Total assets = 1.5.
Old required rate:New required rate:
18% = 7% + (5%)b16% = 7% + (5%)b
beta = 2.2.beta = 1.8.
New b must not be greater than 1.8, therefore
0.3333(b) = 0.3333
b = 1.0.
Therefore, beta of the new division cannot exceed 1.0.



Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?

  1. The cost of a product analysis completed in the previous tax year and specific to the new product.
  2. All of these are relevant.
  3. The use of factory floor space which is currently unused but available for production of any product.
  4. Shipping and installation costs associated with preparing the machine to be used to produce the new product.
  5. Revenues from the existing product that would be lost as a result of some customers switching to the new product.

Answer(s): A

Explanation:

The product analysis cost is considered a sunk cost and is not relevant.



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