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Free Test Prep CFA-Level-I Exam Questions (page: 33)

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Doering Computers is considering two mutually exclusive projects. Their cash flows are shown below:
tProj. A Cash FlowsProj. B Cash Flows
0-$500-$700

1200 250
2400 475
3100 125
4----225
The company's cost of capital (WACC) is 10 percent. Each of the projects can be repeated. What is the equivalent annual annuity (EAA) of the project, which adds the most to shareholder value?

  1. $61.64
  2. $52.82
  3. $63.45
  4. $35.20
  5. $25.41

Answer(s): B

Explanation:

Find NPV of each project.
NPV(A) = $87.5282.
NPV(B) = $167.4271.
Find EAA:
For Project A:
N = 3; I = 10; PV = -87.5282; FV = 0; solve for PMT = EAA = $35.1964.
For Project B:
N = 4; I = 10; PV = -167.4271; FV = 0; solve for PMT = EAA = $52.8184.



TCH Corporation is considering two alternative capital structures with the following characteristics.
AB
Debt/Assets ratio0.30.7
kd10%14%
The firm will have total assets of $500,000, a tax rate of 40 percent, and book value per share of $10, regardless of capital structure. EBIT is expected to be $200,000 for the coming year. What is the difference in earnings per share (EPS) between the two alternatives?

  1. $4.78
  2. $2.87
  3. $7.62
  4. $1.19
  5. $3.03

Answer(s): B

Explanation:

Capital structure A: The firm will have debt of $500,000(0.3) = $150,000 and equity of $350,000. We're told the shares have a book value of $10 so the number of shares outstanding is $350,000/$10 = 35,000. Interest expense will be $150,000(10%) = $15,000. We can compute EBT as EBIT - I or $200,000 - $15,000 = $185,000. Also, we can compute NI as EBT(1 - T) or $185,000(1 - 0.4) = $111,000. Finally, EPS = $111,000/35,000 = $3.17. Capital structure B: The firm will have debt of $500,000(0.7) = $350,000 and equity of $150,000. The number of shares outstanding is $150,000/$10 = 15,000. Interest expense will be $350,000 (14%) = $49,000. We can compute EBT as $200,000 - $49,000 = $151,000. Also, we can compute NI as $151,000 (1 - 0.4) = $90,600. Finally, EPS = $90,600/15,000 = $6.04. The difference in EPS between capital structure A and capital structure B is $6.04 - $3.17 = $2.87.



Longstreet Corporation has a target capital structure of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has an optimal capital budget of $1,500,000. Longstreet will retain $500,000 of after-tax earnings this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, then the flotation costs are 10 percent for the first $500,000. If the company issues more than $500,000 in new equity the flotation cost increases to 15 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?

  1. 12.18%
  2. 18.15%
  3. 12.34%
  4. 11.94%
  5. 12.58%

Answer(s): C

Explanation:

First, calculate the after-tax component cost of debt as 7%(1 - 0.3) = 4.9%. Next, calculate the retained earnings breakpoint as $500,000/0.5 = $1,000,000. Thus, to finance its optimal capital budget, Longstreet must issue some new equity. Note, Longstreet needs $500,000 in financing beyond that which can be supported by retained earnings alone. However, of this additional $500,000, 50% will be new equity and the remaining 50% will represent preferred stock and debt. Thus, Longstreet will issue $250,000 in new equity and flotation costs of 10% will be incurred. The cost of new equity is then[$5(1.10%)/$75(1 - 0.1)] + 10% = 8.15% + 10% = 18.15%.
Finally, the WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.



Seasons, Inc. has just decided to issue 1 million shares of new equity. The firm has had a steady dividend growth of 3% and is expected to continue along this path, having just paid a $3.23 per share dividend. The flotation costs for the new equity amount to 2.2% of the total capital raised and the firm receives $31.4 million before flotation costs, calculate the cost of external equity.

  1. 13.52%
  2. 14.19%
  3. 13.23%
  4. 13.83%

Answer(s): D

Explanation:

IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then Ke = D1/[P (1-F)] + g, where Ke is the cost of external equity. Here, g = 3%, D1 = 3.23*(1+3%) = $3.32, P = $31.4 and F = 2.2%. Therefore, Ke = 3.32/(31.4*(1-0.022)) + 3% = 13.83%.



A 5-year project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. If the project's cost of capital is 7.5%, the project's MIRR equals ________.

  1. 21%
  2. 17%
  3. 14%
  4. 7.5%

Answer(s): A

Explanation:

The MIRR is defined as that rate which discounts the terminal value of the cash inflows to equate to the present value of a project's costs (using the project's cost of capital). This can be better understood using actual numbers. The present value of the costs = 650 + 700/1.075 + 900/1.075^2 = 2,080. The terminal value (future value at the end of year 5) of the project equals 1,200*1.075^2 + 1,600*1.075 + 2,300 = 5406.75. Note that both these are calculated using the project's cost of capital. Then, MIRR satisfies 2,080 = 5406.75/(1+MIrr)^5.
Solving gives MIRR = 21%.



Which of the following statements is most correct?

  1. When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment.
  2. None of the answers are correct.
  3. In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital.
  4. Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same.
  5. All of the answers are correct.

Answer(s): C

Explanation:

Interest payments should not be included in the estimated cash flows because the effects of debt financing are reflected in the cost of capital used to discount the cash flows. If interest was subtracted from the cash flows, and then the remaining cash flows were discounted, the cost of debt would be double-counted.



Which of the following affects a firm's business risk?

  1. The degree of operating leverage.
  2. The risk of adjusting sales prices.
  3. The level of uncertainty about future sales.
  4. All of these answers are correct.

Answer(s): D

Explanation:

Business risk depends on: (1) unit sales variability, (2) sales price variability, (3) input price variability, (4) ability to adjust output prices for changes in input prices and, (5) the extent to which costs are fixed (operating leverage).



Which of the following statements is correct?

  1. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
  2. If corporate tax rates were decreased while other things were held constant, and if the Modigliani Miller tax- adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to increase their use of debt.
  3. The optimal capital structure is the one which simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.
  4. None of these statements are true.
  5. If corporate tax rates were decreased while other things were held constant, and if the Modigliani Miller tax- adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

Answer(s): E

Explanation:

If corporate tax rates were decreased while other things were held constant, and if the MM tax- adjusted tradeoff theory of capital structure were correct, corporations would decrease their use of debt because the tax shelter benefit would not be as great as when tax rates are high. Business risk is the riskiness of the firm's operations if it uses no debt. The optimal capital structure does not maximize EPS, and the degree of total leverage shows how a given change in sales will affect earnings per share.



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