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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 61 )

Updated On: 26-Jan-2026
Page 61 of 793
PDF with 3960 Questions

Grant Grocers is considering the following investment projects:
Project Size of Project IRR of Project
V 1.0 million12.0%
W 1.2 million11.5%
X 1.2 million11.0%
Y 1.2 million10.5%
Z 1.0 million10.0%
The company has a target capital structure, which is 50 percent debt and 50 percent equity. The after- tax cost of debt is 8 percent. The cost of retained earnings is estimated to be 13.5 percent. The cost of equity is estimated to be 14.5 percent if the company issues new common stock. The company's net income is $2.5 million. If the company follows a residual dividend policy, what will be its payout ratio?

  1. 66%
  2. 12%
  3. 32%
  4. 54%
  5. 100%

Answer(s): C

Explanation:

The company's WACC (provided no new equity is issued) is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with the project IRRs reveals that the company will undertake projects V, W, and X. Total financing costs for these projects is $3,400,000. Of this amount, 0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus, $2,500,000 - $1,700,000 = $800,000 will be available for dividends. The payout ratio is then $800,000/$2,500,000 = 32%.



Rollins Corporation is constructing its MCC (Marginal Cost of Capital) schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk- premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' component cost of debt?

  1. 8.6%
  2. 7.2%
  3. 10.0%
  4. 8.0%
  5. 9.1%

Answer(s): B

Explanation:

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent. The after-tax cost of debt equals = 12.0%(1 - 0.40) = 7.2%.



A firm needs to raise $123 million for a proposed capital expansion project. It's earnings breakpoint is $178 million and it is committed to maintaining a debt-to-equity ratio of 1.2. Its after-tax cost of debt is6.2% and the required rate of return on its equity is 13.2%. The firm's marginal cost of capital for the project equals ________.

  1. 7.12%
  2. 6.89%
  3. 9.38%
  4. 12.19%

Answer(s): C

Explanation:

Since the proposed capital requirement of $123 million is less than the earnings breakpoint, the firm's marginal cost of capital for the project equals its WACC. With D/E = 1.2, E/(D+E) = 1/(1+1.2) = 0.455. The WACC then equals 0.455*13.2% + 0.545*6.2% = 9.38%.



Clay Industries, a diversified industrial firm, is considering investing into a new manufacturing facility which would allow the Company to expand its operations into a promising new market for industrial motors, specifically the High Temperature Superconducting, or HTS motors. This project is one of many currently under consideration for Clay Industries, and the amount of R&D expense allocated toward researching this new manufacturing facility is residual in nature. The following information applies to this new project.
R&D expense for the quarter $15,000
Initial cash outlay $45,000
t1: ($40,000)
t2: ($10,000)
t3: $40,000
t4: $40,000
t5: $16,000
t6: $25,000
Assuming no taxes and a $0.00 salvage value at t6, what is the MIRR of this project?

  1. This project will have multiple MIRR at any discount rate
  2. 7.038%
  3. The MIRR cannot be calculated due to the fact that no discount rate has been provided
  4. The MIRR cannot be calculated due to the fact that the project has uneven cash flows
  5. 2.639%

Answer(s): C

Explanation:

In order to calculate the Modified Internal Rate of Return, a explicit discount rate must be given. In this example, the MIRR cannot be calculated due to the fact that no discount rate has been provided. Remember that while the Internal Rate of Return is calculated without the use of an explicit discount rate, the Modified Internal Rate of Return requires some figure for the cost of capital.



Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

  1. Risk premium method.
  2. CAPM method.
  3. Accounting beta method.
  4. Pure play method.
  5. All of these answers are correct.

Answer(s): D

Explanation:

The pure play method is used for estimating the beta of a project in which a firm identifies several companies whose only business is the product in question, then calculates the beta for each firm, and finally, averages the betas to find an approximation to its own project's beta.



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