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Free Test Prep CFA-Level-I Exam Questions (page: 13)

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Which of the following statements is most correct?

  1. None of these statements are correct.
  2. If a firm finds that the cost of debt financing is currently less than the cost of equity financing, an increase in its debt ratio will always reduce its cost of capital.
  3. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, the cost of retained earnings is generally lower than the after-tax cost of debt financing.
  4. The capital structure which minimizes the firm's cost of capital is also the capital structure which maximizes the firm's stock price.
  5. The capital structure which minimizes the firm's cost of capital is also the capital structure which maximizes the firm's earnings per share.

Answer(s): D

Explanation:

The optimal capital structure is the one that maximizes the price of the firm's stock, and this generally calls for a debt ratio which is lower than the one that maximized expected EPS.



Suppose capital gains are taxed at 28% and realized income is taxed at 40%. The tax preference theory implies that as the dividend pay-out ratio is increased, the stock price:

  1. increases or decreases.
  2. decreases.
  3. increases.
  4. remains unaffected.

Answer(s): B

Explanation:

Since the capital gains tax rate is lower than the realized income tax rate, investors would prefer to defer the realization of this income through the capital gains component. Hence, increasing the payout ratio will make the stock less attractive and depress the price.



A project's break-even point is 1,235 units when the average sale price per unit is $35 and the average variable cost equals $17.5 per unit. The fixed costs of the project are closest to ________.

  1. $613
  2. $21,612.5
  3. none of these answers
  4. $43,225

Answer(s): B

Explanation:

The break-even sales revenue equal 1,235*$35 = $43,225. The total variable costs equal $17.5*1,235 = $21,612.5. The fixed costs are therefore equal to $43,225 - $21,612.5 = $21,612.5.



Ameriscam, Inc. is considering the issuance of some junior subordinated debt. The Company's combined state/ federal corporate tax rate is 30%, and the coupon on its outstanding senior debt is 7.55%. The proposed debt would pay an annual coupon. Very recently, Ameriscam has met with a corporate finance firm, who advised the Company that the pre-tax cost of a debt issuance would be 7.70%; Ameriscam's finance division mirrored these findings. A month earlier, a study in a popular financial magazine found that shareholder's require a 7.95% rate of return on similar investments. Which of the following represents the best answer for Ameriscam's estimated after-tax cost of debt for this proposed debt issuance?

  1. 5.425%
  2. The after-tax cost of debt cannot be determined from the information provided.
  3. 5.565%
  4. 5.39%
  5. 5.285%

Answer(s): D

Explanation:

Remember that in calculating the after-tax cost of debt for new debt issues, the MARGINAL cost of issuing new debt is the most relevant measure. In this example, the marginal cost of debt is given as 7.70%, and the after- tax cost of debt capital is found by multiplying (1 - corporate tax rate) by this figure. Specifically, the calculation of the after-tax cost of debt for Ameriscam is as follows: {pre-tax cost of issuing new debt 7.70%
* [1-combined state/federal tax rate 30%]} = 5.39%. While the coupon rate on the firm's outstanding senior debt is often used as a proxy, this number is significantly inferior to the use of marginal figures. What is relevant in this example is the cost of new debt, and this can best be approximated by using the marginal cost of a new debt issue. Often, in capital budgeting and related corporate finance decisions, the only available figures are related to the cost and yield of outstanding debt, and in these instances, using the cost of outstanding debt is very appropriate. However, in this example, using the cost of existing debt does not yield the best possible answer.



The WACC of a firm equals 10.67%. The pre-tax cost of debt equals 8.4%, the firm pays 38% taxes and the firm's equity holders expect a rate of return of 17%. The firm's debt-to-equity ratio equals ________.

  1. 1.41
  2. 0.72
  3. 1.16
  4. 0.86

Answer(s): C

Explanation:

Let E/(D+E) =
E. Then,
WACC = (1-A)*(1-t)*RD + A*RE, where t is the tax rate. Therefore, 10.67% = (1-A)*(1-38%)*8.4% + A*17%. Hence, A = E/(D+E) = 0.463 and (D+E)/E = 1/0.463 = 2.16.
This gives D/E = 1.16.



Rapacity Consultants has just finished a project feasibility study for a cash-rich firm at a cost of $3 million. The consultants have concluded after much analysis that the project's cash flows have a net present value of $1.3 million and a payback period of 5.3 years. The firm should:

  1. reject the project since it has a long payback period.
  2. reject the project since it has a negative NPV.
  3. none of these answers.
  4. accept the project since it has a positive NPV.

Answer(s): D

Explanation:

The $3 million spent on consultants represent sunk costs and must be ignored while looking toward the future.
In that direction, the project has a positive NPV and should be accepted.



The firm's target capital structure is consistent with which of the following?

  1. Minimum cost of equity.
  2. Maximum earnings per share (EPS).
  3. Minimum cost of debt.
  4. Minimum risk.
  5. Minimum weighted average cost of capital (WACC).

Answer(s): E

Explanation:

The target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to raise capital.



Consider the following three projects:
Project A
Initial cash outflow: $1,000,000
Cash inflows as follows
t1: $500,000
t2: $450,000
t3: $150,000
t4: $150,000
t5: $150,000
Project B
Initial cash outflow: $1,000,000
Cash inflows as follows
t1: $150,000
t2: $150,000
t3: $150,000
t4: $450,000
t5: $500,000
Project C
Initial cash outflow $1,000,000
Cash inflows as follows
t1: $280,000
t2: $280,000
t3: $280,000
t4: $280,000
t5: $280,000
Assuming no taxes, an 8.5% cost of capital, along with a $0.00 salvage value at the end of the fifth year, what is the NPV of each project? Additionally, which of the three projects has the steepest NPV profile?

  1. Project A NPV: $276,837; Project B NPV: $40,334; Project C NPV: $103,380; Project A has a steepest NPV profile
  2. Project A NPV: $ 267,837; Project B NPV: $44,330, Project C NPV: $135,820; Project A has a steepest NPV profile
  3. Project A NPV: $168,513.54 Project B NPV: $40,334; Project C NPV: $103,380; Project B has a steepest NPV profile
  4. Project A NPV: $168,531.54; Project B NPV: $40,334; Project C NPV: $103,380; Project C has a steepest NPV profile
  5. Project A NPV: $168,513.54, Project B NPV: $14,550; Project C NPV: $103,380; Project B has the steepest NPV profile
  6. Project A NPV: $276,837; Project B NPV: $114,550; Project C NPV: $135,820; Project A has a steepest NPV profile

Answer(s): C

Explanation:

Due to the fact that project B is characterized by having the majority of its cash inflows occurring during later time periods, it is more sensitive to changes in the cost of capital. This fact is exemplified by a steeper NPV profile.



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