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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 46 )

Updated On: 26-Jan-2026
Page 46 of 793
PDF with 3960 Questions

Returns on the market and Company Y's stock during the last 3 years are shown below:
Year Market Company Y
1995 -24% -22%
1996 10 13

1997 22 36
The risk-free rate is 5 percent, and the required return on the market is 11 percent. You are considering a low- risk project whose market beta is 0.5 less than the company's overall corporate beta. You finance only with equity, all of which comes from retained earnings. The project has a cost of $500 million, and it is expected to provide cash flows of $100 million per year at the end of Years 1 through 5 and then $50 million per year at the end of Years 6 through 10. What is the project's NPV (in millions of dollars)?

  1. $7.10
  2. $12.10
  3. $9.26
  4. $15.75
  5. $10.42

Answer(s): E

Explanation:

Step 1 Run a regression to find the corporate beta. Market returns are the X-input values, while Y's returns are the Y-input values. Beta is 1.2102.
Step 2 Find the project's estimated beta by subtracting 0.5 from the corporate beta. The project beta is thus 1.2102 - 0.5 = 0.7102.
Step 3 Find the company's cost of equity, which is its WACC because it uses no debt: k(s) = WACC = 5% + (11% - 5%)0.7102 = 9.26%.
Step 4 Now find the project's NPV (inputs are in millions):
CF(0) = -500
CF(1-5) = 100
CF(6-10) = 50
I = 9.26%
Solve for NPV = $10.42 million.



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 = 7.5%
Combined state/federal tax rate = 35%
Expected return on the market = 14.5%
Annual risk-free rate of return = 5.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.15 Annual preferred dividend = $1.35
Preferred stock net offering price = $17.70
Expected annual common dividend = $0.45
Common stock price = $30.90
Expected growth rate = 11.75%
Subjective risk premium = 3.3%
Given this information, and using the Bond-Yield-plus-Risk-Premium approach to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. 15.03%
  2. 9.97%
  3. 8.762%
  4. 7.70%
  5. 7.30%
  6. The WACC for Clay Industries cannot be calculated from the information.

Answer(s): D

Explanation:

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 Dividend-Yield-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 Bond-Yield-plus-Risk-Premium approach. To calculate the cost of equity using this approach, take the yield to maturity on the firm's outstanding debt (7.5%) and add a subjective risk premium (3.3%), which gives a cost of common equity of 10.8%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (7.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 4.875%. 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 7.627%. Incorporating these figures into the WACC equation gives the answer of 7.679%.



Which of the following statements is most correct?

  1. All of these statements are false.
  2. A break point is based on the dollar value used of a specific type of capital, and occurs at the point where the cost of that capital type increases. Thus, if a firm has $100,000 in earnings, and stockholders want $50,000 of those earnings paid as dividends, then retained earnings will have two break points.
  3. A firm facing a steep demand curve (that is, high flotation costs) for new equity would likely also face, at some point, a steeply upward sloping WACC curve.
  4. All of these statements are correct.
  5. One purpose of calculating the WACC (Weighted Average Cost of Capital) is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects, including those of greater than and lesser than average risks.

Answer(s): C

Explanation:

Because of high flotation costs, dollars raised by selling new stock must work harder than dollars raised by retaining earnings. Steep demand would result in a steeply upward sloping WACC curve. Note, however, that for most firms, new equity issues are rare.



Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.)

  1. $1,500
  2. $3,321
  3. $5,019
  4. $1,993
  5. $4,983

Answer(s): B

Explanation:

X = after-tax cash flow.
Y = before-tax cash flow.
X = Y(1 - T).
$10,000 = X(PVIFA(15%,10))
$10,000 = X(5.0188)
X = $1,992.51.
$1,992.51 = Y(1 - 0.40)
Y = $3,320.85 = $3,321.



Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

  1. possibly have a bias, but it could be upward or downward.
  2. more information is needed; otherwise, we can make no reasonable statement.
  3. be biased upward.
  4. be biased downward.
  5. be correct.

Answer(s): D

Explanation:

Given the fact that there is inflation, a cost of capital stated in nominal terms would understate the calculated NPV. If inflation is expected, but this expectation is not built into the forecasted cash flows, then the calculated NPV will be downward biased.



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