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Free Test Prep CFA-Level-I Exam Questions (page: 17)

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Which of the following are methods of estimating a company's Cost of Retained Earnings?

  1. CAPM
    II. CANSLIM
    III. DCF Method
    IV. Bond-Yield-plus-Risk-Premium
  2. Least Cost Debt vs. Equity
  3. I, III, IV, & V
  4. I, II, III, IV, & V
  5. I, III & IV
  6. II only
  7. I only
  8. I & III

Answer(s): C

Explanation:

The Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF method), and Bond-Yield-plus- Risk- Premium methods may all be used to estimate a firm's Cost of Retained Earnings.



A project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. The project's cost of capital is 10%. The project's NPV equals ________.

  1. $2,043
  2. $1,938
  3. $1,428
  4. $1,393

Answer(s): D

Explanation:

The discounted cash flow at the end of year N is obtained by dividing that year's cash flow by 1.1N, since the project's cost of capital is 10%. Using this, the discounted cash flows are:
-636, -744, +902, +1,093, +1,428.
The Present value of the cash flows is = -636 - 744 + 902 + 1,093 + 1,428 = $2,043. The net present value of the project = $(2,043 - 650) = $1,393.



The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of expected life remaining and a current book value of $30,000 versus a current market value of $24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value, what is the initial after tax outlay for the new printing machine?

  1. -$22,180
  2. -$36,000
  3. -$30,000
  4. -$33,600
  5. -$40,000

Answer(s): D

Explanation:

Initial outlay
Cost of new machine-$60,000
Salvage value (old)+ 24,000
Tax effect of sale = $6,000(0.4) = + 2,400
After-tax outlay =-$33,600



The date on which a firm's directors issue a statement declaring a dividend is known as ________.

  1. Ex-Dividend Date
  2. Declaration Date
  3. Payment Date
  4. Dividend Date
  5. Holder-of-Record Date

Answer(s): B

Explanation:

The date on which a statement is issued by a firm's directors declaring a dividend is known as the "Declaration Date."



Proponents of which of the following theories would claim that companies seek to balance the tax shelter benefits of debt financing with the increased interest rates and risk of bankruptcy that come with increased debt levels?

  1. Modigliani & Miller's "with-taxes" Theory of Capital Structure
  2. Bird-in-the-Hand Theory
  3. Modigliani & Miller's Theory of Capital Structure
  4. Tax Preference Theory
  5. Signaling Theory
  6. Trade-off Theory of Leverage

Answer(s): F

Explanation:

Trade-off Theory of Leverage
The Trade-off Theory of Leverage claims that firms will seek to balance the tax-shelter benefits of debt financing with the increased interest costs and risk of bankruptcy that come with increased debt levels. The Trade-off Theory of Leverage came about largely from criticisms raised against the Modigliani andMiller Theory of Capital Structure under the "with-taxes" assumption. M&M claimed that, under a restrictive set of assumptions, the value of firms would be maximized only when their capital structure is comprised of 100% debt. The Trade-off Theory of Leverage proposed a more realistic and moderate answer to the Capital Structure debate, and remains an important milestone in the field of Pure Finance.



Photon Corporation has a target capital structure of 60 percent equity and 40 percent debt. The firm can raise an unlimited amount of debt at a before-tax cost of 9 percent. The company expects to retain earnings of $300,000 in the coming year and to face a tax rate of 35 percent. The last dividend was $2 per share and the growth rate of the company is constant at 6 percent. If the company needs to issue new equity, then the flotation cost will be $5 per share. The current stock price is $30. Photon has the following investment opportunities:
Project Cost IRR
1 $100,000 10.5%
2 $200,000 13.0
3 $100,000 12.0
4 $150,000 14.0
5 $75,000 9.0

  1. $150,000
  2. $450,000
  3. $350,000
  4. $550,000
  5. $625,000

Answer(s): B

Explanation:

Calculate the retained earnings break point (BPRE) as $300,000/0.6 = $500,000. Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% = 13.07%. Calculate ke as D1/(P0 - F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%. Find WACC below BPRE as: WACC = 0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed at 10.18%. Find WACC above BPRE as: WACC = 0.6(14.48%) + 0.4 (9%) (1 - 0.35) = 11.03%. Thus, financing in excess of $500,000 costs 11.03%. Projects 2, 3, and 4 all have IRRs exceeding either WACC and should be accepted. These projects require $450,000 in financing. Project 1 is the next most profitable project.
Given its cost of $100,000, half or $50,000 can be financed at 10.18% and the other half must be financed at 11.03%. The relevant cost of capital for Project 1 is then 0.5(10.18%) + 0.5(11.03%) = 10.61%. Since Project 1's IRR is less than the cost of capital, it should not be accepted. The firm's optimal capital budget is $450,000.



A stock has an expected dividend growth rate of 4.9%. The firm has just paid a dividend of $2.5 per share. With a required rate of return of 10%, the stock is trading at $42.8. The stock is:

  1. overpriced.
  2. insufficient information.
  3. fairly priced.
  4. under-priced.

Answer(s): D

Explanation:

The fair price of the stock with a required rate of return, r and a dividend growth rate, g, is given by P = D1/(r-g), where D1 = Do*(1-g) = dividend to be paid next year. In this case, the fair price of the stock equals 2.5*1.049/ (10% - 4.9%) = $51.42. Thus, the stock is under-priced by $(51.42 - 42.8) = $8.62.



Which of the following is not considered a capital component?

  1. All of these are considered capital components
  2. Preferred stock
  3. Common stock
  4. Long-term debt
  5. Retained earnings

Answer(s): A

Explanation:

The four major capital components are debt, preferred stock, retained earnings, and new issues of common stock.



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