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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 63 )

Updated On: 26-Jan-2026
Page 63 of 793
PDF with 3960 Questions

Which of the following statements is correct?

  1. The rent referred to in the other statement is a sunk cost, and as such it should be ignored.
  2. The preceding statement would be true if "upward" were replaced with "downward."
  3. The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities.
  4. If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration.
  5. In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV.

Answer(s): D

Explanation:

The foregone rent is an "opportunity cost" which should be charged to the project under consideration. The cash flows should not take account of interest, because financial costs are dealt with by discounting at the WACC. If interest were deducted to find cash flows, then this cost would be "double counted," and the NPV would be downward biased. Ignoring interest when determining cash flows produces no bias in the NPV whatever. Note also that externalities can be either positive or negative--they tend to be negative if the new project is a substitute for existing products, but positive if the new project is complementary to the firm's other products.



Which of the following statement completions is most correct? If investors prefer dividends to capital gains, then

  1. dividend policy as determined by the residual dividend policy is the only dividend policy which will maximize the price per share of common stock.
  2. k(s) will increase as dividends are reduced.
  3. k(s) will decrease as dividends are reduced.
  4. the equilibrium return, k(s), will not be affected by a change in dividend policy because tax effects will offset these preferences.
  5. k(s) will decrease as the retention rate increases.

Answer(s): B

Explanation:

The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.



In examining the beta for its machine tools division, the management of Clay Industries has regressed the division's ROA against that of the S&P 500. Which of the following best characterize this method of calculating project beta?

  1. None of these answers
  2. Project Beta Method
  3. Monte Carlo Regression
  4. Pure Play Method
  5. Regression of the Poisson Distribution
  6. Accounting Beta Method

Answer(s): F

Explanation:

In this example, the management of Clay Industries has determined the Beta coefficient for its machine tools division using the Accounting Beta Method. In using the Accounting Beta Method, the monthly (or quarterly) ROE or ROA of a specific division/project is compared to that of a large group of firms. This "large group of firms" is frequently characterized by a major market index, such as the S&P 500 or the Wilshire 5000. The Accounting Beta Method is used more frequently than the Pure Play Method, primarily because it is often difficult to find "pure-play" firms.



As the director of capital budgeting for Raleigh/Durham Company, you are evaluating two mutually exclusive projects with the following net cash flows:
Year Project XProject Z
0-$100-$100
150 10
240 30
330 40
410 60
Is there a crossover point in the relevant part of the NPV profile graph (the northeast, or upper right, quadrant)?

  1. Yes, at k = 13%
  2. Yes, at k = 9%
  3. No
  4. Yes, at k = 7%
  5. Yes, at k = 11%

Answer(s): D

Explanation:

Financial calculator solution:
Project X
Inputs: CF(0) = -100; CF(1) = 50; CF(2) = 40; CF(3) = 30; CF(4) = 10.
Output: IRR = 14.489%.
Project Y
Inputs: CF(0) = -100; CF(1) = 10; CF(2) = 30; CF(3) = 40; CF(4) = 60.
Output: IRR = 11.79%.
Calculate the NPVs of the projects at k = 0 discount rate.
NPV(X,k = 0%) = -100 + 50+ 40 + 30 + 10 = 30.
NPV(Y,k = 0%0 = -100 + 10 + 30 + 40 + 60 = 40.
Calculate the IRR of the differential project, i.e., Project(X - Y) IRR(X - Y)Inputs: CF(0) = 0; CF(1) = 40; CF(2) = 10; CF(3) = -10; CF(4) = -50.
Output: IRR = 7.167%.
Solely using the calculator we can determine that there is a crossover point in the relevant part of an NPV profile graph. Project X has the higher IRR. Project Y has the higher NPV at k = 0. The crossover rate is 7.17% and occurs in the upper right quadrant.



The management of Clay Industries have adhered to the following capital structure: 50% debt, 35% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt = 9.5%
Combined state/federal tax rate = 35%
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 = $1.55
Preferred stock net offering price = $24.50
Expected annual common dividend = $0.80
Common stock price = $30.90
Expected growth rate = 9.75%

Given this information, and using the Dividend-Yield-plus-Growth-Rate approach to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. 9.82%
  2. 6.93%
  3. 8.36%
  4. 10.02%
  5. The WACC for Clay Industries cannot be calculated from the information provided.
  6. 9.79%

Answer(s): C

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 Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow, approach. To calculate the cost of common equity using this approach, divide the expected annual dividend by the selling price of the outstanding common stock, and add the expected growth rate. Using the DCF method, the cost of common equity can be found as follows: {[$0.80/$30.90] + 9.75%} = 12.34%. The after-tax cost of debt can be found by multiplying the yield to maturity of the firm's outstanding long-term debt (9.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 6.175%. 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 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.355%.



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