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Free Test Prep CFA-Level-I Exam Questions (page: 9)

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A stock has a beta of 0.44 and the market risk premium is 7.9%. Its dividend growth rate is 4.25% and its P/E ratio is 8.7. If the firm has a dividend payout ratio of 70%, the risk-free rate equals ________.

  1. 6.81%
  2. 7.12%
  3. 8.82%
  4. 4.56%

Answer(s): C

Explanation:

Po/E1 = dividend payout/(k - g) Therefore, 8.7 = 0.7/(k - 0.0425), giving expected return = k = 12.3%.
Now, the CAPM expected return on the stock is given by k = Rf + beta*(Rm - Rf). Therefore, 12.3% = Rf + 0.44*7.9%, giving risk-free rate = 8.82%.



Which of the following may be used as mechanisms to motivate managers to act in the best interest of the stockholders?

  1. Managerial compensation
    II. Direct stockholder intervention
    III. Threat of firing
    IV. Threat of takeover
  2. IV only
  3. I only
  4. I, II, III & IV
  5. III only
  6. I, II & III
  7. II only

Answer(s): C

Explanation:

Managerial compensation may be designed to not only attract and retain the best managerial talent for a firm, but also to align the management's action with the interest of the shareholders. Direct intervention is another mechanism that may be used to motivate management into acting in the owner's best interest. This in practice is executed with a wide degree of success. The threat of firing may also be used as well as the threat of hostile takeovers. The threat of a hostile takeover is strongest when a company is under performing and/or its stock is undervalued.



Given the following net cash flows, determine the IRR of the project:
TimeNet cash flow
0$1,520
1-1,000
2-1,500
3-500

  1. 36%
  2. 28%
  3. 32%
  4. 24%
  5. 20%

Answer(s): D

Explanation:

Time line:
0123 Periods
1,520-1,000-1,500500
Financial calculator solution: Using cash flows,
Inputs: CF(0) = 1,520; CF(1) = -1,000; CF(2) = -1,500; CF(3) = 500.
Output: IRR% = 23.98%.



International Transport Company is considering building a new facility in Seattle. If the company goes ahead with the project, it will spend $2 million immediately (at t = 0) and another $2 million at the end of Year 1 (t = 1). It will then receive net cash flows of $1 million at the end of Years 2 - 5, and it expects to sell the property for $2 million at the end of Year 6. The company's cost of capital is 12 percent, and it uses the modified IRR criterion for capital budgeting decisions. Which of the following statements is most correct?

  1. The regular IRR is less than the cost of capital. Under this condition, the modified IRR will also be less than the regular IRR.
  2. The project should be accepted because the modified IRR is greater than the cost of capital.
  3. If the regular IRR is less than the cost of capital, then the modified IRR will be greater than the regular IRR.
    That situation applies in this case.
  4. The project should be rejected because the modified IRR is less than the regular IRR.
  5. Given the data in the problem, the modified IRR criterion indicates that the project should be accepted.
    However, the NPV is negative. This demonstrates that the modified IRR criterion is not always a valid decision method for projects such as this one.

Answer(s): C

Explanation:

PV(Outflows) = -$2,000,000 - $2,000,000/1.12 = -$3,785,714.
TV(Inflows) = $1,000,000(FVIFA(12%,4))(1.12) + $2,000,000
= $1,000,000(4.7793)(1.12) + $2,000,000 = $7,352,816.
1 + MIRR = [7,352,816/3,785,714]^1/6; MIRR = 11.7%.
Since the MIRR is less than the cost of capital, the IRR is less than the MIRR.



An investment of $1,000 will return $60 annually forever. What is its internal rate of return?

  1. 6.00%
  2. 60.00%
  3. 16.67%
  4. cannot be determined
  5. 0.60%

Answer(s): A

Explanation:

$1,000 = $60/Irr; IRR = 0.06 = 6%.



Which of the following statements is most correct?

  1. We ideally would like to use historical measures of the component costs from prior financing in estimating the appropriate weighted average cost of capital.
  2. The cost of a new equity issuance could possibly be lower than the cost of retained earnings if the market risk premium and risk-free rate decline by a substantial amount.
  3. None of these statements.
  4. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70% of dividend income.
  5. All of these statements.

Answer(s): C

Explanation:

Unlike interest expense on debt, preferred dividends are not deductible, hence there are no tax savings associated with the use of preferred stock. The component costs of WACC should reflect the costs of new financing not historical measures. The cost of issuing new equity is always greater than the cost of retained earnings because of the existence of flotation costs.



The Present Value of a project's cash flows when its cost of capital equals its internal rate of return :

  1. equals zero.
  2. is positive.
  3. is negative.
  4. could be all of these answers.

Answer(s): B

Explanation:

The IRR is by definition the discount rate at which the NPV = 0. Therefore, at this point, the PV is greater than zero, since the initial outlay is always non-zero and NPV = PV - cash outlay.



A Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity.
The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock.

Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock.

The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.

What will be the WACC above the break point?

  1. 11.9%
  2. 8.3%
  3. 12.5%
  4. 14.1%
  5. 10.6%

Answer(s): A

Explanation:

Preferred stock return: 10/80 = 12.5% WACC = 6%(0.40) + 12.5%(0.10) + 16.5%(0.50) = 11.90%.



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