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Free Test Prep CFA-Level-I Exam Questions (page: 29)

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Market risk in a revenue-producing project can best be adjusted for by

  1. Ignoring it.
  2. Adjusting the discount rate downward for increasing risk.
  3. Picking a risk factor equal to the average discount rate.
  4. Adjusting the discount rate upward for increasing risk.
  5. Reducing the NPV by 10 percent for risky projects.

Answer(s): D

Explanation:

An increase in a project's beta will cause its stock price to decrease unless the increased beta were offset by a higher expected rate of return. Therefore, high-risk investments require higher rates of return, whereas low-risk investments require lower rates of return.



Which of the following figures is not expressly incorporated into the Degree of Operating Leverage, as based on the "unit sales" calculation.

  1. Average sales price
  2. Total variable operating costs per unit
  3. Price
  4. Common shares outstanding
  5. Total fixed operating costs
  6. Sales in units

Answer(s): D

Explanation:

The Degree of Operating Leverage (DOL) measures the percentage change in EBIT that results from a given change in sales. The DOL can be calculated using several methods, including one that is based on unit sales.
This version of the DOL equation is as follows: {DOL = [(Sales in units(average sales price - variable cost per unit) / (sales in units(average sales price - variable cost per unit) - total fixed operating costs]}. Of the choices listed, only the number of common shares outstanding is not incorporated into the DTL equation. In fact, the number of common shares outstanding is not factored into any of the equations used to calculate DOL.



The additional risk associated with a firm's earnings when it uses debt capital is known as

  1. business risk.
  2. systematic risk.
  3. capital market risk.
  4. financial risk.

Answer(s): D

Explanation:

Financial risk is the additional risk associated with a firm's earnings when it uses debt capital.



Which of the following statements is most incorrect?

  1. All of these answers are correct.
  2. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.
  3. The optimal capital structure minimizes the WAC
  4. None of these answers are correct.
  5. Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity financing.

Answer(s): B

Explanation:

This statement is not always true.



Returns on the market and Company Y's stock during the last 3 years are shown below:
Year Market Company Y
1995 -24% -22%
1996 10 13

1997 22 36
The risk-free rate is 5 percent, and the required return on the market is 11 percent. You are considering a low- risk project whose market beta is 0.5 less than the company's overall corporate beta. You finance only with equity, all of which comes from retained earnings. The project has a cost of $500 million, and it is expected to provide cash flows of $100 million per year at the end of Years 1 through 5 and then $50 million per year at the end of Years 6 through 10. What is the project's NPV (in millions of dollars)?

  1. $7.10
  2. $12.10
  3. $9.26
  4. $15.75
  5. $10.42

Answer(s): E

Explanation:

Step 1 Run a regression to find the corporate beta. Market returns are the X-input values, while Y's returns are the Y-input values. Beta is 1.2102.
Step 2 Find the project's estimated beta by subtracting 0.5 from the corporate beta. The project beta is thus 1.2102 - 0.5 = 0.7102.
Step 3 Find the company's cost of equity, which is its WACC because it uses no debt: k(s) = WACC = 5% + (11% - 5%)0.7102 = 9.26%.
Step 4 Now find the project's NPV (inputs are in millions):
CF(0) = -500
CF(1-5) = 100
CF(6-10) = 50
I = 9.26%
Solve for NPV = $10.42 million.



The management of Clay Industries have adhered to the following capital structure: 50% debt, 45% common equity, and 5% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt = 7.5%
Combined state/federal tax rate = 35%
Expected return on the market = 14.5%
Annual risk-free rate of return = 5.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.15 Annual preferred dividend = $1.35
Preferred stock net offering price = $17.70
Expected annual common dividend = $0.45
Common stock price = $30.90
Expected growth rate = 11.75%
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. 15.03%
  2. 9.97%
  3. 8.762%
  4. 7.70%
  5. 7.30%
  6. The WACC for Clay Industries cannot be calculated from the information.

Answer(s): D

Explanation:

The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on 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 (7.5%) and add a subjective risk premium (3.3%), which gives a cost of common equity of 10.8%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (7.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 4.875%. 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 7.627%. Incorporating these figures into the WACC equation gives the answer of 7.679%.



Which of the following statements is most correct?

  1. All of these statements are false.
  2. A break point is based on the dollar value used of a specific type of capital, and occurs at the point where the cost of that capital type increases. Thus, if a firm has $100,000 in earnings, and stockholders want $50,000 of those earnings paid as dividends, then retained earnings will have two break points.
  3. A firm facing a steep demand curve (that is, high flotation costs) for new equity would likely also face, at some point, a steeply upward sloping WACC curve.
  4. All of these statements are correct.
  5. One purpose of calculating the WACC (Weighted Average Cost of Capital) is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects, including those of greater than and lesser than average risks.

Answer(s): C

Explanation:

Because of high flotation costs, dollars raised by selling new stock must work harder than dollars raised by retaining earnings. Steep demand would result in a steeply upward sloping WACC curve. Note, however, that for most firms, new equity issues are rare.



Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.)

  1. $1,500
  2. $3,321
  3. $5,019
  4. $1,993
  5. $4,983

Answer(s): B

Explanation:

X = after-tax cash flow.
Y = before-tax cash flow.
X = Y(1 - T).
$10,000 = X(PVIFA(15%,10))
$10,000 = X(5.0188)
X = $1,992.51.
$1,992.51 = Y(1 - 0.40)
Y = $3,320.85 = $3,321.



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