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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 55 )

Updated On: 26-Jan-2026
Page 55 of 793
PDF with 3960 Questions

All else equal, which of the following is/are true?

  1. Firms with higher business risk tend to have lower debt ratios.
    II. The higher the tax rate imposed on a firm, the lower its optimal debt ratio.
    III. The lower a firm's future capital requirements, the lower its current debt ratio.
  2. II & III
  3. III only
  4. I only
  5. II only
  6. I, II & III
  7. I & II

Answer(s): C

Explanation:

The higher the business risk and the future capital requirement, the stronger the balance sheet must be. This is accomplished through a lower reliance on debt. The higher the tax rate, the higher is the attractiveness of the tax-deductibility of the interest payments on debt. This lowers the after-tax cost of debt, raising the optimal debt ratio.



A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below:
Years0123
S-1,1001,00035050
L-1,10003001,500
The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the company should choose if it wants to maximize its stock price?

  1. 12.00%
  2. 18.62%
  3. 20.46%
  4. 19.08%
  5. 15.53%

Answer(s): D

Explanation:

Because the two projects are mutually exclusive, the project with the higher positive NPV is the "better" project.
S-1,1001,00035050
NPV(S) = $107.46
IRR(S) = 20.46%
L-1,10003001,500
NPV(L) = $206.83
IRR(L) = 19.08%
Project L is the "better" project: its IRR = 19.08%.



Incremental cash flows are

  1. cash flows that can be attributed to specific tax deductions like depreciation and interest expense.
  2. cash flows from a project that occur after the initial capital expense.
  3. cash flows that occur only if a project under consideration is accepted.
  4. the additional cash flows from a project for a given increase in capital invested.

Answer(s): C

Explanation:

Incremental cash flows of a project are the cash flows that occur if and only if the project is undertaken.



The management of Intelligent Semiconductor have adhered to the following capital structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt = 8.25%
Combined state/federal tax rate = 33%
Expected return on the market = 16.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Intelligent Semiconductor's Common Stock = 1.34 Annual preferred dividend = $1.05
Preferred stock net offering price = $18.90
Expected annual common dividend = $0.20
Common stock price = $100.90
Expected growth rate = 9.75%
Subjective risk premium = 5.3%
Given this information, and using the Capital Asset Pricing Model (CAPM) to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. The WACC for Clay Industries cannot be calculated from the information.
  2. 12.94%
  3. 13.55%
  4. 12.03%
  5. 15.60%
  6. 11.92%

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 Capital Asset Pricing Model. To calculate the cost of equity using this approach, use the following equation: {risk-free rate + beta(expected return on the market - risk-free rate). Incorporating the given information into this equation gives a cost of equity of 19.989% The after- tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (8.25%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 5.50%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend ($1.05) by the net offering price ($18.90). Using this method, the cost of preferred stock is found as 5.556%.
Incorporating these figures into the WACC equation gives the answer of 12.027%.



Woodson Inc. has two possible projects, Project A and Project B with the following cash flows:
Year Project AProject B
0-150,000-100,000
1100,00045,000
2105,00065,000
340,00080,000
At what cost of capital do the two projects have the same net present value (NPV)?

  1. 34.8%
  2. 10.3%
  3. 13.5%
  4. 15.8%
  5. 21.7%

Answer(s): E

Explanation:

To determine the crossover rate, find the differential cash flows between the 2 projects and then calculate the IRR of those differential cash flows.
tProject change, A - B
0-50,000
155,000
240,000
3-40,000
IRR = 21.7%.



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