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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 71 )

Updated On: 26-Jan-2026
Page 71 of 793
PDF with 3960 Questions

A firm's capital structure has a debt-to-equity ratio of 0.8. The pretax cost of debt is 7%. The beta of the stock is 1.3 in an environment with risk-free rate of 5.5% and an expected market return of 16%. The firm is in the 45% tax bracket. The weighted average cost of capital of the firm equals ________.

  1. 12.35%
  2. 9.43%
  3. 6.91%
  4. 13.81%

Answer(s): A

Explanation:

Using CAPM, the cost of equity equals 5.5% + 1.3*(16% - 5.5%) = 19.15%. Since the debt interest is tax deductible, the after-tax cost of debt equals 7%*(1-0.45) = 3.85%. Now, the D/E ratio = 0.8. Hence, (D+E)/E = 1.8, giving E/(D+E) = 0.556. Thus, equity forms 55.6% of the capital while debt forms 44.4%. The WACC is then equal to 0.556*19.15% + 0.444*3.85% = 12.35%.



A project has the following cash flows over the next 5 years: $800, $300, $400, $900 and $1,200. Assume all cash flows occur at the end of a year. The project requires an initial cash outlay of $1,750. The firm faces a marginal borrowing rate of 8%. The payback period for the project equals ________.

  1. 3.86 year
  2. 4.19 years
  3. 4 years
  4. 3.28 years

Answer(s): D

Explanation:

The payback period is defined as the expected number of years that would be required to recover the original investment. In particular,
Payback period = Years before full recovery +
(unrecovered cost at the start of payback year)/(net cash flow in the payback year) In this case, the recovery occurs in the 4th year. At the beginning of the 4th year, the unrecovered cost equals 1,750 - 800 - 300 - 400 = 250. Total cash flow in the 4th year equals 900. Therefore, payback period = 3 + 250/900 = 3.28 years. Note that the discount rate does not figure in the calculation of payback period.



While calculating the weights of various components of the capital structure, one must use:

  1. minimum of book or market values.
  2. book values.
  3. liquidation values.
  4. market values.

Answer(s): D

Explanation:

WACC calculations are based on current market values, not historical cost.



Assume the following information about two individual projects.
Project A
Initial cash outflow: $175,000
Expected cash inflows
t1: $75,000
t2: $65,000
t3: $35,000
t4: $35,000
t5: $15,000
Project B
Initial cash outflow: $100,000
Expected cash inflows
t1: $15,000
t2: $15,000
t3: $18,000
t4: $45,000
t5: $45,000
Assuming these projects are not mutually exclusive, and the cost of capital is 10%, which of the two should be undertaken according to NPV? Additionally, which of the two projects has the steeper NPV profile?

  1. Project B should be accepted, project A has a steeper NPV profile
  2. Project A should be accepted, project A has a steeper NPV profile
  3. Project B should be accepted, project B has a steeper NPV profile
  4. Both projects should be accepted, project A has a steeper NPV profile
  5. Project A should be accepted, project B has a steeper NPV profile
  6. Neither project should be accepted, project B has a steeper NPV profile

Answer(s): E

Explanation:

The NPV of project B is found to be ($1,766.21), and thus should not be accepted. However, project A has a positive NPV of $6,416.14, and should be accepted. Project B is characterized as having the majority of its cash inflows occurring in later time periods, and thus is more sensitive to changes in the cost of capital. This is exemplified by a steeper NPV profile for project B.



Which of the following equations correctly illustrates the calculation of the cost of equity using the Discounted Cash Flow approach?

  1. (Retention rate)*(ROE)
  2. Last annual dividend/(1 + required rate of return)
  3. Next annual dividend/current stock price
  4. (1-tax rate)
  5. (Next annual dividend/current stock price) + expected growth rate
  6. (Last annual dividend/[expected return - required return])
  7. expected growth rate
  8. Risk-free rate of return + beta(expected return on the market - risk-free rate of return)

Answer(s): E

Explanation:

The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The fourth choice illustrates the Capital Asset Pricing Model, while the fifth represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.



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