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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 59 )

Updated On: 26-Jan-2026
Page 59 of 793
PDF with 3960 Questions

The management of Clay Industries have adhered to the following capital structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Yield to maturity of outstanding long-term debt = 9.5%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.24 Annual preferred dividend = $1.75 Preferred stock net offering price = $28.50
Combined state/federal corporate tax rate = 35%
Given this information, and using the Capital Asset Pricing Model 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 determined from the information provided.
  2. 14.45%
  3. 10.00%
  4. 12.14%
  5. 8.54%
  6. 10.81%

Answer(s): F

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 required to calculate the cost of equity using the Capital Asset Pricing Model (CAPM), which is illustrated as follows: {risk-free rate + beta(expected return on the market - risk-free rate)}. Using this model, the cost of common equity can be found as 16.48%. The cost of perpetual preferred stock can be found by dividing the annual dividend by the net offering price, which is illustrated in this case as follows: {$1.75/28.50) = 6.14%. The after-tax cost of debt can be found by taking the yield to maturity on the firm's outstanding long- term debt (9.5%), and multiplying this figure by (1 - annual tax rate 35%) = 6.175%. Incorporating all of these figures into the WACC equation gives a Weighted Average Cost of Capital of 10.807%



Which of the following statements is correct?

  1. If you are choosing between two projects which have the same cost, and if their NPV profiles cross, then the project with the higher IRR probably has more of its cash flows coming in the later years.
  2. The NPV and IRR methods both assume that cash flows are reinvested at the cost of capital. However, the MIRR method assumes reinvestment at the MIRR itself.
  3. There can never be a conflict between NPV and IRR decisions if the decision is related to a normal, independent project, i.e., NPV will never indicate acceptance if IRR indicates rejection.
  4. A change in the cost of capital would normally change both a project's NPV and its IRR.
  5. To find the MIRR, we first compound CFs at the regular IRR to find the TV, and then we discount the TV at the cost of capital to find the PV.

Answer(s): C

Explanation:

To see this, sketch out a NPV profile for a normal, independent project, which means that only one NPV profile will appear on the graph. If WACC < IRR, then IRR says accept. But in that case, NPV > 0, so NPV will also say accept.



Ace Consulting, a corporate finance consulting firm, is examining the operations of Intelligent Semiconductor and has determined the following information:
Sales $1,000,000
Total variable costs $270,000
Total fixed costs $400,000
Interest expense $75,000
EBIT $325,000
Given this information, what is the degree of total leverage for Intelligent Semiconductor?

  1. 1.342
  2. 2.863
  3. 1.4925
  4. 3.077
  5. 2.292

Answer(s): B

Explanation:

The Degree of Total Leverage (DTL) demonstrates how a given change in sales will impact a firm's EPS. The equation used for calculating the DTL is as follows: {[Sales - variable costs] / [sales - variable costs - fixed costs
- interest expense]}. Incorporating the given values for these components into the DTL equation yields the following: {[Sales $1,000,000 - variable costs $270,000] / [sales $1,000,000 - variable costs $270,000 - fixed costs $400,000 - interest expense $75,000]}=2.863. The EBIT figure is not explicitly incorporated into the DTL equation.



Which of the following are necessary conditions for the NPV and IRR methods to produce similar rankings? Choose the best possible answer.

  1. Projects must be mutually exclusive and of equal scale
  2. Projects must be independent and have normal cash flows
  3. Projects must be mutually exclusive and have normal cash flows
  4. Projects must have normal cash flows, and must be equal in scale and lifespan
  5. Projects must be of equal scale and have equal lifespans

Answer(s): D

Explanation:

When examining mutually exclusive projects with equal lifespans and of equal size, the IRR and NPV calculations will produce similar ranking results as long as the projects under examination have "normal" cash flows. It is when the projects under examination have "non-normal" cash flows that the IRR method can experience some difficulty. Non-normal cash flows are defined as cash flows in which negative cash inflows are juxtaposed within a series of positive cash inflows, creating a situation in which the sign will change more than once. When examining these "non-normal" projects, the Internal Rate of Return calculation will often produce multiple answers which leads to an incorrect accept/reject decision. In any examination in which the IRR and NPV produce conflicting rankings, the NPV calculation should be used.



Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. What is the maximum amount of new capital that can be raised at the lowest component cost of equity?

  1. $14,700
  2. $21,000
  3. $17,400
  4. $24,500
  5. $12,600

Answer(s): D

Explanation:

BP(RE) = $21,000 x .70/ .60 = $24,500.



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