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Free Test Prep CFA-Level-I Exam Questions (page: 16)

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The trade-off theory of capital structure implies that:

  1. firms issue debt up to the level where the total value added by the debt tax shield is offset by expected bankruptcy costs.
  2. firms will use debt up to the level where the flotation cost of new debt equals that of issuing more equity, thus minimizing the costs of raising capital.
  3. managers are uncomfortable with either too much debt or too much equity and hence, tend to choose debt ratios around 0.40 to 0.60.
  4. none of these answers.

Answer(s): D

Explanation:

According to the trade-off theory of capital structure, firms issue debt up to the level where the additional value added by the debt tax shield for another dollar of capital raised is offset by expected bankruptcy costs. This ensures that with only these two effects, the firm's stock price is maximized. Clearly, at this point, the total value added by the debt tax shield exceeds the expected bankruptcy costs.



PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10 percent. Sales for the year totaled $3,500,000 and variable costs were 60 percent of sales. Net income was equal to $600,000 and the company's tax rate was 40 percent. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?

  1. 1.15
  2. 1.22
  3. 2.68
  4. 1.12
  5. 1.00

Answer(s): B

Explanation:

First, calculate PQR's DFL as EBIT/(EBIT - I). Interest expense (I) on the debt is $1,500,000(10%) = $150,000.
We can work backwards from NI to find EBIT as follows: EBT = NI/(1 - T) or $600,000/0.6 = $1,000,000. EBIT = EBT + I or $1,000,000 + $150,000 = $1,150,000. DFL is thus $1,150,000/($1,150,000- $150,000) = 1.15.
Recognizing DTL = DFL x DOL, we can solve 1.40 = 1.15 x DOL for DOL = 1.22.



Which of the following statements is most correct?

  1. None of these answers.
  2. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.
  3. All of these answers.
  4. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.
  5. If a company's tax rate increases, but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital will fall.

Answer(s): E

Explanation:

The debt cost used to calculate a firm's WACC is k(d)(1 - T).
If k(d) remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, k (d)(1 - T), decreases.
k(d)(1 - T) = after-tax component cost of debt, where T is the firm's marginal tax rate.



Which of the following projects is likely to produce multiple Internal Rates of Return.
Project A
Initial investment outlay: ($1,000,000)
t1: $0.00
t2: $0.00
t3: $0.00
t4: $0.00
t5: $0.00
t6: $10,000,000
Project B
Initial investment outlay: ($1,000,000)
t1: $500,000
t2: $500,000
t3: $500,000
t4: $0.01
Project C
Initial investment outlay: ($1,000,000)
t1: $800,000
t2: ($100,000)
t3: $550,000
Project D
Initial investment outlay: ($500,000)
t1: $400,000
t2: ($1,000)
t3: $230,000
t4: ($50,000)

  1. Project D
  2. Project A, C and D
  3. Project A
  4. Project B
  5. Project C and D
  6. Project C

Answer(s): F

Explanation:

In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs calculation which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects C and D involve cash outflows superimposed within their cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as this, it is advisable to use either the NPV or MIRR methods, which are not subject to the problem of multiple IRRs associated with the traditional IRR method. From observation alone, we can determine that project C and D are non-normal projects, and are thus likely to result in multiple IRRs.
While project A is somewhat unusual in the fact that the first five periods produce no cash flows at all, there is only one sign change present in its cash flows, and thus is characterized as a "normal" project.



While evaluating a project using net income figures, you must:

  1. subtract all non-cash net expenses.
  2. none of these answers.
  3. add back all non-cash net expenses.
  4. add back depreciation.

Answer(s): C

Explanation:

In capital budgeting, annual cash flows, not accounting income, are used to evaluate a project. Hence, you must add back all non-cash net expenses, defined as total non-cash expenses - total non-cash revenues. You must also ignore financing costs.



Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18 percent. What is the Weighted Average Cost of Capital (WACC) at that point?

  1. 16.4%
  2. 14.2%
  3. 10.8%
  4. 13.6%
  5. 18.0%

Answer(s): B

Explanation:

MCC (Marginal Cost of Capital) = 0.4(0.14)(1 - 0.4) + 0.6(0.18) = 0.142 = 14.2%.



Consider the following information for a company.
Common Stock Price $53.25
Preferred Stock Par Price $100
Preferred Dividend $10
Debt Rating BB+
Owners Equity 25%
Preferred Stock Flotation Cost 2.5%
The Preferred Stock is issued at Par
Calculate the component cost of this newly issued preferred stock.

  1. 10%
  2. 2.5%
  3. 18.78%
  4. 12.5%
  5. 10.26%

Answer(s): E

Explanation:

The component cost of preferred stock is the dividend divided by issue price minus floatation cost. In this case the component cost of preferred stock = $10 / (100 - 2.5) = 10.26%.



Industries which are cyclical and heavily oriented toward research tend to have high levels of ________. Industries which are subject to high levels of lawsuits tend to high levels of ________.

  1. debt; equity
  2. equity; equity
  3. equity; debt
  4. debt; debt

Answer(s): B

Explanation:

Cyclical business conditions, high dependence on research and development and higher expected liabilities are all indicative of high business risks. This makes firms more risk-averse to debt.



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