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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 52 )

Updated On: 26-Jan-2026
Page 52 of 793
PDF with 3960 Questions

Longstreet Corporation has a target capital structure of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has an optimal capital budget of $1,500,000. Longstreet will retain $500,000 of after-tax earnings this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, then the flotation costs are 10 percent for the first $500,000. If the company issues more than $500,000 in new equity the flotation cost increases to 15 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?

  1. 12.18%
  2. 18.15%
  3. 12.34%
  4. 11.94%
  5. 12.58%

Answer(s): C

Explanation:

First, calculate the after-tax component cost of debt as 7%(1 - 0.3) = 4.9%. Next, calculate the retained earnings breakpoint as $500,000/0.5 = $1,000,000. Thus, to finance its optimal capital budget, Longstreet must issue some new equity. Note, Longstreet needs $500,000 in financing beyond that which can be supported by retained earnings alone. However, of this additional $500,000, 50% will be new equity and the remaining 50% will represent preferred stock and debt. Thus, Longstreet will issue $250,000 in new equity and flotation costs of 10% will be incurred. The cost of new equity is then[$5(1.10%)/$75(1 - 0.1)] + 10% = 8.15% + 10% = 18.15%.
Finally, the WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.



Seasons, Inc. has just decided to issue 1 million shares of new equity. The firm has had a steady dividend growth of 3% and is expected to continue along this path, having just paid a $3.23 per share dividend. The flotation costs for the new equity amount to 2.2% of the total capital raised and the firm receives $31.4 million before flotation costs, calculate the cost of external equity.

  1. 13.52%
  2. 14.19%
  3. 13.23%
  4. 13.83%

Answer(s): D

Explanation:

IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then Ke = D1/[P (1-F)] + g, where Ke is the cost of external equity. Here, g = 3%, D1 = 3.23*(1+3%) = $3.32, P = $31.4 and F = 2.2%. Therefore, Ke = 3.32/(31.4*(1-0.022)) + 3% = 13.83%.



A 5-year project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. If the project's cost of capital is 7.5%, the project's MIRR equals ________.

  1. 21%
  2. 17%
  3. 14%
  4. 7.5%

Answer(s): A

Explanation:

The MIRR is defined as that rate which discounts the terminal value of the cash inflows to equate to the present value of a project's costs (using the project's cost of capital). This can be better understood using actual numbers. The present value of the costs = 650 + 700/1.075 + 900/1.075^2 = 2,080. The terminal value (future value at the end of year 5) of the project equals 1,200*1.075^2 + 1,600*1.075 + 2,300 = 5406.75. Note that both these are calculated using the project's cost of capital. Then, MIRR satisfies 2,080 = 5406.75/(1+MIrr)^5.
Solving gives MIRR = 21%.



Which of the following statements is most correct?

  1. When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment.
  2. None of the answers are correct.
  3. In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital.
  4. Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same.
  5. All of the answers are correct.

Answer(s): C

Explanation:

Interest payments should not be included in the estimated cash flows because the effects of debt financing are reflected in the cost of capital used to discount the cash flows. If interest was subtracted from the cash flows, and then the remaining cash flows were discounted, the cost of debt would be double-counted.



Which of the following affects a firm's business risk?

  1. The degree of operating leverage.
  2. The risk of adjusting sales prices.
  3. The level of uncertainty about future sales.
  4. All of these answers are correct.

Answer(s): D

Explanation:

Business risk depends on: (1) unit sales variability, (2) sales price variability, (3) input price variability, (4) ability to adjust output prices for changes in input prices and, (5) the extent to which costs are fixed (operating leverage).



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