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Free Test Prep CFA-Level-I Exam Questions (page: 20)

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Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average interest rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual dividend policy and maintains the same capital structure, what will its dividend payout ratio be?

  1. 35%
  2. 30%
  3. 15%
  4. 20%
  5. 25%

Answer(s): E

Explanation:

Capital budget = $20 million.
Optimal capital structure: 60% equity, 40% debt.
EBIT = $34.667 million.
Assets = $200 million.
k(d) = 10%; T = 40%. Dividend Payout = ?
Debt = 0.40($200 million) = $80 million.
Interest = 0.10($80 million) = $8 million.
EBIT$34.667
-INT8.000
EBT$26.667
Taxes (40%)10.667
NI$16.000
Equity needed = 0.60($20 million) = $12 million.
Net Income$16
-Equity needed12
Amount left for dividend$4
Dividend Payout = $4/$16 = 25%.



Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests on the contention that

  1. most investors will reinvest rather than spend dividends, so it would save investors money (taxes) if corporations simply reinvested earnings rather than paid them out as dividends.
  2. k(s) = D1/P0 + g is constant for any dividend policy.
  3. none of the answers are correct.
  4. investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of dividends.
  5. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

Answer(s): E

Explanation:

The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.



Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky. What is GEC's cost of equity from newly issued stock?

  1. 13.77%
  2. 13.33%
  3. 10.00%
  4. 12.66%
  5. 12.29%

Answer(s): A

Explanation:

k(d) (interest rate on the firm's new debt) = 10%
k(d)(1 - T) (after-tax-component cost of the debt) = 10%(0.6) = 6%.
D/A = 55%; D0 = $2.20; g = 6%; P0 = $35; PN = $35; T = 40%.
Retained earnings = $100M; BP(RE) = $100M/ .45 = $222.22M.
k(s) (component cost of retained earnings) = $2.33/$35 + 6% = 12.66%.
k(e) (component cost of external equity) = $2.33/$30 + 6% = 13.77%.



Suppose changes in corporate law make it more difficult for debt holders to force companies into bankruptcies.
This will cause firms to:

  1. raise more equity capital through retained earnings.
  2. either increase or decrease their debt levels.
  3. increase their debt-to-equity ratios.
  4. decrease their debt-to-equity ratios.

Answer(s): B

Explanation:

It is tempting to assume that lower probability of bankruptcy will entice firms into borrowing more. However, remember that debt holders are not entirely stupid! They will factor in this change in the law and demand a higher yield and stricter covenants on corporate debt to compensate for the lower recourse they have against the firms. Depending on whether they actually underestimate or overestimate the effect and also depending on whether the firms perceive that the debt holders have under- or overestimated the effect, companies could increase or decrease their debt levels.



As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR?

  1. 17 - 18%
  2. 15 - 16%
  3. 18 - 19%
  4. 14 - 15%
  5. 16 - 17%

Answer(s): C

Explanation:

Time line: (In millions)
012345 Years
-511222
Financial calculator solution: (In millions)
Inputs: CF(0) = -5; CF(1) = 1.0; CF(2) = 1.5; CF(3) = 2.0; N(j) = 3.
Output: IRR% = 18.37%.



A project that is intended to increase income is known as ________.

  1. Externality
  2. Replacement Project
  3. Cannibalization
  4. Opportunity Cost
  5. Expansion Project
  6. Low Cost Provider

Answer(s): E

Explanation:

An expansion project is defined as a project that is intended to increase income.



A mutual fund manager is examining the financial and operating condition of a Questron Media Corporation, and has discovered the following information.
Sales: $3,000,000
Fixed costs: $1,000,000
Variable costs: $300,000
Interest expense: $150,000
Tax rate: 35%
Weighted Average Cost of Capital: 14.75%
Beta coefficient: 1.66
Common shares outstanding: 1,321,000
Using this information, what are the earnings per share (EPS) for Questron Media?

  1. $1.26
  2. $1.47
  3. $0.66
  4. $0.76
  5. $0.78
  6. $0.89

Answer(s): D

Explanation:

The EPS figure is perhaps the single most popular term in the field of conventional equity investments. Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited. While quite popular and useful, many investors and business professionals do not truly understand the mechanics behind the EPS calculation, and an investigation into the components of EPS figure is a valuable learning experience. The EPS calculation is found by the following equation: {EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]} Additionally, the EPS figure can be found by:
{EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]} Incorporating the given information into the first EPS equation will yield the following: {EPS = [($3,000,000 - $1,000,000 - $300,000 - $150,000)(1 - 0.35)] / 1,321,000} = $0.7627



Monte Carlo simulation

  1. All of the answers are correct.
  2. Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable.
  3. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
  4. None of the answers are correct.
  5. Can be useful for estimating a project's stand-alone risk.

Answer(s): A

Explanation:

These are all true.



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