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Free Test Prep CFA-Level-I Exam Questions (page: 32)

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A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision-maker should

  1. Increase the NPV of the asset to reflect the greater risk.
  2. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.
  3. Reject the asset, since its acceptance would increase the risk of the firm.
  4. Increase the IRR of the asset to reflect the greater risk.
  5. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

Answer(s): E

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.



Lascheid Enterprises is an all-equity firm with 175,000 shares outstanding. The company's stock price is currently $80 a share. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earning each year--so its earnings per share equals its dividends per share. The firm's tax rate is 30 percent. The company is considering issuing $800,000 worth of bonds and using the proceeds for a stock repurchase. If issued the bonds would have an estimated yield to maturity of 8 percent. The risk-free rate is 5 percent and the market risk premium is also 5 percent. The company's beta is currently 1.0, but its investment banker's estimate that the company's beta would rise to 1.2 if they proceeded with the recapitalization. What would be the company's stock price following the repurchase transaction.

  1. $102.63
  2. $106.67
  3. $77.14
  4. $74.67
  5. $70.40

Answer(s): D

Explanation:

The bonds used in the repurchase will create a new interest expense for the company. This will change net income. Dividends per share will change because net income changes and the number of shares outstanding changes.
New interest expense: $800,000 x 8% = $64,000.
New net income: ($2,000,000 - $64,000)(1 - 0.3) = $1,355,200.
Shares repurchased: $800,000/80 = 10,000 shares.
New shares outstanding: 175,000 - 10,000 = 165,000 shares.
New dividends per share: $1,355,200/165,000 = $8.21.
We must also calculate a new cost of equity: 5% + (5%)1.2 = 11%.
New stock price: $8.21/11% = $74.67.



Driver Corporation faces an IOS schedule calling for a capital budget of $60 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) were $98 million for the year. The firm has $200 million in assets, pays an average of 10 percent on all its debt, and faces a marginal tax rate of 35 percent. If the firm maintains a residual dividend policy and will keep its optimal capital structure intact, what will be the amount of the dividends it pays out after financing its capital budget?

  1. $30.0 million
  2. $59.4 million
  3. $22.5 million
  4. $60.0 million
  5. $0

Answer(s): C

Explanation:

Calculate interest cost:
Total assets = $200M; 40% debt x $200M = $80 million in debt.
Interest cost = $80M x 0.10 = $8.0 million.
Calculate net income (in millions):
EBIT$98.0
less: Interest- 8.0
EBT$90.0
less: Taxes (35%) 31.5
Net income$58.5
Calculate portion of projects financed with retained earnings:
IOS contains $60 million in positive NPV projects.
Retained earnings portion:$60M x 0.60 = $36.0 million
Debt portion:$60M x 0.40 = $24.0 million
Calculate residual available for dividends:
$58.5M - $36.0M = $22.5 million in dividends.



Texas Products Inc. has a division, which makes burlap bags for the citrus industry. The unit has fixed costs of

$10,000 per month, and it expects to sell 42,000 bags per month. If the variable cost per bag is $2.00, what price must the division charge in order to break even?

  1. $2.47
  2. $3.15
  3. $2.24
  4. $2.00
  5. $2.82

Answer(s): C

Explanation:

Total costs = $10,000 + $2(42,000) = $94,000.
Price = $94,000/42,000 = $2.24.



Normal projects C and D are mutually exclusive. Project C has a higher net present value if the WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC exceeds 12 percent. Which of the following statements is most correct?

  1. None of the answers are correct.
  2. Project C probably has a faster payback.
  3. Project D is probably larger in scale than Project
  4. Project D has a higher internal rate of return.
  5. All of the statements are correct.

Answer(s): D

Explanation:

In this situation, D has a flatter NPV profile and a higher IRR. Project acceptance depends on what is the correct discount rate. If the discount rate is less than 12%, accept C. If it is greater than 12%, accept D.
Projects that return their cash flows early (faster payback) and have lower initial investments tend to have higher IRRs.



In applying the CAPM (Capital Asset Pricing Model) to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

  1. Expected rate of return on the market.
  2. All of these answers are subject to dispute.
  3. The stock's beta coefficient.
  4. Market risk premium.
  5. Risk-free rate.

Answer(s): B

Explanation:

Under the CAPM approach, it is difficult at best, to obtain correct estimates of the inputs required to make it operational:
1. there is controversy about whether to use long-term or short-term Treasury yields for the risk-free rate.
2. it is difficult to estimate the beta that investors expect to firm to have in the future, and it is difficult to estimate the market risk premium.



Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?

  1. 0%
  2. 40%
  3. 60%
  4. 100%
  5. 20%

Answer(s): E

Explanation:

EBIT$2,000,000
- I500,000 ($5,000,000 debt x 10% coupon)
EBT1,500,000
- Taxes600,000 ($1,500,000 EBT x 40% tax rate)
NI900,000
Project funding $1,200,000 project funded:
Residual earnings 0.60 equity = $720,000
0.40 debt = $480,000
Payable as dividends: 900,000 - 720,000 = $180,000
Dividend payout ratio = $180,000/$900,000 = 20%.



Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

  1. investors require that the dividend yield and capital gains yield equal a constant.
  2. investors are indifferent between dividends and capital gains.
  3. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.
  4. investors view dividends as being less risky than potential future capital gains.
  5. capital gains are taxed at a higher rate than dividends.

Answer(s): D

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.



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