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Free Test Prep CFA-Level-I Exam Questions (page: 35)

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Scenario analysis ignores:

  1. the range of likely values that key variables can take.
  2. changes in some of the key variables.
  3. effect on the NPV of changes in project variables.
  4. none of these answers.

Answer(s): D

Explanation:

It is the Sensitivity Analysis that ignores the range of likely values that key variables can take. This is rectified using Scenario Analysis.



All else equal, which of the following is/are true?

  1. Firms with higher business risk tend to have lower debt ratios.
    II. The higher the tax rate imposed on a firm, the lower its optimal debt ratio.
    III. The lower a firm's future capital requirements, the lower its current debt ratio.
  2. II & III
  3. III only
  4. I only
  5. II only
  6. I, II & III
  7. I & II

Answer(s): C

Explanation:

The higher the business risk and the future capital requirement, the stronger the balance sheet must be. This is accomplished through a lower reliance on debt. The higher the tax rate, the higher is the attractiveness of the tax-deductibility of the interest payments on debt. This lowers the after-tax cost of debt, raising the optimal debt ratio.



A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below:
Years0123
S-1,1001,00035050
L-1,10003001,500
The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the company should choose if it wants to maximize its stock price?

  1. 12.00%
  2. 18.62%
  3. 20.46%
  4. 19.08%
  5. 15.53%

Answer(s): D

Explanation:

Because the two projects are mutually exclusive, the project with the higher positive NPV is the "better" project.
S-1,1001,00035050
NPV(S) = $107.46
IRR(S) = 20.46%
L-1,10003001,500
NPV(L) = $206.83
IRR(L) = 19.08%
Project L is the "better" project: its IRR = 19.08%.



Incremental cash flows are

  1. cash flows that can be attributed to specific tax deductions like depreciation and interest expense.
  2. cash flows from a project that occur after the initial capital expense.
  3. cash flows that occur only if a project under consideration is accepted.
  4. the additional cash flows from a project for a given increase in capital invested.

Answer(s): C

Explanation:

Incremental cash flows of a project are the cash flows that occur if and only if the project is undertaken.



The management of Intelligent Semiconductor have adhered to the following capital structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt = 8.25%
Combined state/federal tax rate = 33%
Expected return on the market = 16.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Intelligent Semiconductor's Common Stock = 1.34 Annual preferred dividend = $1.05
Preferred stock net offering price = $18.90
Expected annual common dividend = $0.20
Common stock price = $100.90
Expected growth rate = 9.75%
Subjective risk premium = 5.3%
Given this information, and using the Capital Asset Pricing Model (CAPM) to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. The WACC for Clay Industries cannot be calculated from the information.
  2. 12.94%
  3. 13.55%
  4. 12.03%
  5. 15.60%
  6. 11.92%

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 Capital Asset Pricing Model. To calculate the cost of equity using this approach, use the following equation: {risk-free rate + beta(expected return on the market - risk-free rate). Incorporating the given information into this equation gives a cost of equity of 19.989% The after- tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (8.25%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 5.50%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend ($1.05) by the net offering price ($18.90). Using this method, the cost of preferred stock is found as 5.556%.
Incorporating these figures into the WACC equation gives the answer of 12.027%.



Woodson Inc. has two possible projects, Project A and Project B with the following cash flows:
Year Project AProject B
0-150,000-100,000
1100,00045,000
2105,00065,000
340,00080,000
At what cost of capital do the two projects have the same net present value (NPV)?

  1. 34.8%
  2. 10.3%
  3. 13.5%
  4. 15.8%
  5. 21.7%

Answer(s): E

Explanation:

To determine the crossover rate, find the differential cash flows between the 2 projects and then calculate the IRR of those differential cash flows.
tProject change, A - B
0-50,000
155,000
240,000
3-40,000
IRR = 21.7%.



A project requires an initial outlay of $600. Over the next 5 years, it expects to have cash outflows of $200, $300, $175, $350 and $150. The revenues over the same period equal $100, $400, $700, $550 and $800. Assume that these cash flows occur at year-end. The project's payback period equals ________.

  1. 2.91 years
  2. 3.38 years
  3. 4.11 years
  4. 3.82 years

Answer(s): B

Explanation:

The payback period is defined as the expected number of years that would be required to recover the original investment. In particular, Payback period = Years before full recovery + (unrecovered cost at the start of payback year)/(net cash flow in the payback year) To calculate the payback period, you must have the stream of net cash flows = Revenues - out flows. The net cash flows over the next 5 years are $(100-200), $(400-300), $(700-175), $(550-350) and $(800-150) i.e. the net cash flows are: -$100, $100, $525, $200 and $650. The complete recovery of the total outlay of $600 + $100 (year 1 net outflow) occurs in the 4th year. At the beginning of the 4th year, the outstanding balance equals 600+100-100-525 = $75. Therefore, payback period = 3 + 75/200 = 3.375 years.



Hensley Corporation uses breakeven analysis to study the effects of expansion projects it considers. Currently, the firm's plastic bag business segment has fixed costs of $120,000, while its unit price per carton is $1.20 and its variable unit cost is $0.60. The firm is considering a new bag machine and an automatic carton folder as modifications to its existing production lines. With the expansion, fixed costs would rise to $240,000, but variable cost would drop to $0.41 per unit. One key benefit is that Hensley can lower its wholesale price to its distributors to $1.05 per carton (i.e., its selling price), and this would likely more than double its market share, as it will become the lowest cost producer. What is the change in the breakeven volume with the proposed project?

  1. 100,000 units
  2. 75,000 units
  3. 0 units
  4. 175,000 units
  5. 200,000 units

Answer(s): D

Explanation:

Calculate the old and new breakeven volumes using the old data and new projections: Old Q(BE) = $120,000/ ($1.20 - $0.60) = $120,000/$0.60 = 200,000 units.
New Q(BE) = $240,000/($1.05 - $0.41) = $240,000/$0.64 = 375,000 units.
Change in breakeven volume = 375,000 - 200,000 = 175,000 units.



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