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Free Test Prep CFA-Level-I Exam Questions (page: 27)

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A Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate.

The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock.

The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.
Where will a break in the MCC schedule occur?

  1. $20,000
  2. $10,000
  3. $42,000
  4. There will be no breaks in the MCC schedule.
  5. $30,000

Answer(s): E

Explanation:

Break point(RE) = $15,000/.50 = $30,000.



A financial analyst with Mally, Feasance & Company is examining shares of Intelligent Semiconductor. Assume the following information:
Retention rate: 80%
EPS: $3.98
Discount rate: 12.35%
Tax rate: 35%
Beta coefficient: 1.5
Expected return on the market: 12.5%
Using this information, what is the expected growth rate of Intelligent Semiconductor? Choose the best answer.

  1. 65.00%
  2. The answer cannot be determined from the information provided.
  3. 61.75%
  4. None of these answers is correct.
  5. 43.33%
  6. 9.88%

Answer(s): B

Explanation:

In order to determine the dividend growth rate of Intelligent Semiconductor, the following equation should be used:
{g = ROE(1 - Dividend Payout Ratio)}
While the Retention Rate of Dividends (which equals one minus the Dividend Payout Ratio) is provided, the ROE figure is not. Further, the ROE figure cannot be determined from this information provided. Therefore, the growth figure cannot be calculated. Remember that in determining dividend growth using the formula outlined above, neither the tax rate nor the discount rate is incorporated into the equation. Furthermore, the Beta Coefficient and the expected return on the market are largely irrelevant in this example.



The modified IRR (MIRR) is normally ________.

  1. all of these answers are correct
  2. none of these answers are correct
  3. greater than the regular IRR if IRR > k
  4. equal to the regular IRR if IRR < k
  5. less than the regular IRR if IRR > k

Answer(s): E

Explanation:

MIRR assumes that cash flows from all projects are reinvested at the cost of capital, while the regular IRR assumes that the cash flows from each project are reinvested at the project's own IRR. Therefore the IRR will be greater than the MIRR if the IRR is greater than the cost of capital.



An increase in the dividend payout ratio ________ the retained earnings break-point.

  1. decreases
  2. increases or decreases, depending on the tax rate
  3. increases
  4. does not affect

Answer(s): A

Explanation:

As the dividend payout ratio is increased, the amount of earnings retained decreases, decreasing the amount of new debt that can be issued without changing the capital structure. Hence, the retained earnings breakpoint will decrease.



The management of Clay Industries have adhered to the following capital structure: 50% debt, 35% common equity, and 15% preferred equity. The following information applies to the firm:
Before-tax cost of debt = 9.5%
Combined state/federal tax rate = 35%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.24 Annual preferred dividend = $1.55
Preferred stock net offering price = $24.50
Expected annual common dividend = $0.80
Common stock price = $30.90
Expected growth rate = 9.75%
Subjective risk premium = 3.3%
Given this information, and using the Bond-Yield-plus-Risk-Premium approach to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. 9.79%
  2. 8.36%
  3. 9.82%
  4. 6.93%
  5. 8.52%
  6. The WACC for Clay Industries cannot be calculated from the information.

Answer(s): E

Explanation:

The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity of outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Bond-Yield-plus-Risk-Premium approach. To calculate the cost of equity using this approach, take the yield to maturity on the firm's outstanding debt (9.5%) and add a subjective risk premium (3.3%), which gives a cost of common equity of 12.8%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (9.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 6.175%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price.
Using this method, the cost of preferred stock is found as 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.516%.



Consider the following information for Company ABC:
Current Price of Stock $40.25
Expected dividend in 1 Year $1.10
Growth rate 9.2%
Beta 1.2
Risk Free Rate 4.5%
Expected Market Return 10%
Calculate this company's cost of retained earnings using the Discounted Cash Flow (DCF) method.

  1. 13.70%
  2. 11.93%
  3. 12.0%
  4. 9.20%
  5. 13.30%
  6. 11.04%

Answer(s): B

Explanation:

The DCF method for estimating the cost of retained earnings states: Cost of Retained Earnings = (Dividend for period 1 / Current Price) + Growth Rate. In this case the estimated Cost of Retained Earnings = (1.1 / 40.25) + 9.2% = 2.73 + 9.2 = 11.93%



Project A has a higher IRR than project B. Both projects have normal cash flows. If the projects have the same cost of capital which is greater than the crossover rate,

  1. Project A has a higher NPV.
  2. Both projects have the same NPV.
  3. Project B has a higher NPV.
  4. Insufficient information.

Answer(s): A

Explanation:

The crossover rate is the discount rate at which the graphs of NPV versus discount rate for the two projects cross. Since the projects have normal cash flows, they will have a single crossover rate. Further, the project with the higher IRR has a "flatter" NPV profile. Therefore, if the cost of capital is larger than the crossover rate, the project with the flatter profile will have a larger NPV.



Steadybeta currently operates 3 projects, resulting in a beta of 1.27. It is considering a risky expansion project whose cash flow analysis indicates a beta of 2.3. The project requires a capital commitment of $4.8 million and has an NPV of $2 million. The current risk-free rate is 5.6% and the market risk premium is 8.9%. Steadybeta's current market capitalization is $17.2 million. If Steadybeta undertook the project, the required rate of return expected by its shareholders will be:

  1. 14.8%
  2. 13.9%
  3. 19.5%
  4. 16.2%

Answer(s): C

Explanation:

19.5% The firm can be considered a portfolio of 4 projects. The beta of a portfolio equals the weighted average of the betas of the individual components. The weight of a component equals the fraction of the market value it comprises. Since the project has an NPV of $2 million, its market value equals $6.8 million and the market value after the project is undertaken will be $(17.2+6.8) = $24 million. Therefore, the beta of the firm after it undertakes the project equals 17.2/24*1.27 + 6.8/24*2.3 = 1.56. The required rate of return then equals 5.6% + 1.56*8.9% = 19.5%.



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