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Free Test Prep CFA-Level-I Exam Questions (page: 25)

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Consider the following information:
30-day treasury rate (Risk Free rate) 7.2%
Company XYZ Bond yield 10.2%
Beta 0.8
Risk Premium 4.0%
Credit Rating B-
Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach.

  1. 15.2%
  2. 12.2%
  3. 11.36%
  4. 17.4%
  5. 5.2%
  6. 14.2%

Answer(s): F

Explanation:

To estimate a firm's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach, simply take the company's bond yield and add the risk premium. In this case the cost of retained earnings = 10.2% + 4.0% = 14.2%.



Clay Industries, a large industrial firm, is in the process of developing a coal refining system which greatly increases the efficiency of coal as an energy source. However, the new system has been criticized as leading to a tremendous increase in emissions of CFTA, a dangerous carbon-based pollutant believed to be linked to thyroid cancer.

While the firm is concerned about the possible risk to the public posed by the new system, the management of Clay Industries decides that the sales potential for the product outweighs both the risk to society and the liability exposure of the firm.

Which of the following choices best describes this situation faced by Clay Industries?

  1. Opportunity cost problem
  2. Diminishing returns problem
  3. Cannibalization problem
  4. Positive externality
  5. Negative externality
  6. Principal/agent problem

Answer(s): E

Explanation:

In this situation, a negative externality exists for Clay Industries and the development of the new coal refining system.
A negative externality is some detrimental effect which is to result on stakeholders from the acceptance of a project. While often difficult to quantify, externalities are an important consideration in the accept/reject decision in capital projects. Externalities can be both positive and negative.



Which of the following projects is likely to have multiple Modified Internal Rates of Return. Assume a 14.5% cost of capital.
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. More than one of these answers are correct
  3. None of these answers is correct
  4. Project A
  5. Project B
  6. Project C

Answer(s): C

Explanation:

Remember that the Modified Internal Rate of Return method will not produce multiple answers for nonnormal projects. The fact that MIRR will not produce multiple answers for non-normal projects is one of the reasons that this method should be considered as superior to the traditional Internal Rate of Return method.



Shelby Inc. is considering two projects which have the following cash flows:
Project 1Project 2
Time Cash Flows Cash Flows
0-$2,000-$1,900
1500 1,100
2700 900
3800 800
41,000 600
51,100 400
At what cost of capital would the two projects have the same net present value?

  1. 5.98%
  2. 5.85%
  3. 6.40%
  4. 6.70%
  5. 4.73%

Answer(s): B

Explanation:

Subtract Project 2 cash flows from Project 1 cash flows:
CF(0) = -100
CF(1) = -600
CF(2) = -200
CF(3) = 0
CF(4) = 400
CF(5) = 700
Put these in the cash flow register and solve for the IRR = 5.85%.



Which of the following factors directly influence capital structure decisions?

  1. Business risk
    II. Availability of various sources of capital under attractive terms III. Expropriation risk
    IV. The firm's tax position
  2. Management's subjective attitudes toward risk
    VI. Country risk
  3. II, III, IV, V
  4. I, II, III, IV, V, VI
  5. I, III, IV
  6. I, II, IV, V
  7. I, II, II, IV, VI

Answer(s): D

Explanation:

There are four primary factors which influence capital structure decisions: business risk, financial flexibility, the firm's tax position, and management's subjective attitudes toward risk. Business risk is defined as the riskiness of a firm if it uses no debt. Financial flexibility refers to the ability of a company to easily raise various sources of capital under favorable terms. "Expropriation risk," and "country risk," while legitimate forms of risk, are not directly applicable to the capital structure decision. Expropriation risk is defined as the risk that a firm's existing assets and facilities will be seized, or "expropriated" by a governmental, social, or military entity. This risk is frequently incorporated into discussions of international operations.



Which of the following statements is correct?

  1. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model.
  2. Although some methods of estimating the cost of capital encounter severe difficulties, the CAPM (Capital Asset Pricing Model) is a simple and reliable model that provides great accuracy and consistency in estimating the cost of capital.
  3. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms.
  4. The DCF (Discounted Cash Flow) model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained.

Answer(s): C

Explanation:

Since depreciation is a significant non-cash expense, it is added back to net income when calculating cash flow.



The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is the cost of common equity raised by selling new stock?

  1. 10.33%
  2. 12.22%
  3. 16.00%
  4. 17.22%
  5. 9.66%

Answer(s): D

Explanation:

k(e) (component cost of external equity) = $.945/$8.59 (1-.10) + 0.05 = 0.1722 = 17.22%.



Which of the following statements is most correct?

  1. If Congress cuts the capital gains rate, but leaves the personal tax rate unchanged, then this would provide an incentive for companies to increase their dividend payouts.
  2. If a firm follows a residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.
  3. None of these answers are correct.
  4. Despite its drawbacks, a residual dividend policy is an effective way to stabilize dividend payouts, which makes it easier for firms to attract a clientele which prefers high dividends.
  5. All of these answers are correct.

Answer(s): B

Explanation:

The residual dividend model is a model in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm's optimal capital budget. Ther esidual dividend policy minimizes the costs to the company of raising outside funds, but it does not provide a stable cash flow to the investors and most investors prefer stable dividends.



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