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Free Test Prep CFA-Level-I Exam Questions (page: 36)

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If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is most correct?

  1. The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt.
  2. The percentage change in EBIT will equal the percentage change in net income.
  3. The percentage change in net operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income (NI).
  4. Since debt is used, the degree of operating leverage must be greater than 1.
  5. The percentage change in net operating income will be less than the percentage change in net income.

Answer(s): E

Explanation:

The greater the use of fixed assets, the more sensitive EBIT will be to changes in sales. Interest charges on debt are included in net income and not operating income, as the use of debt financing will have an impact on net income when sales change.



Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, with the yield to maturity on the firm's outstanding senior long-term debt at 13%. The company's combined federal/state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be 13.5%. Shares of Intelligent Semiconductor have a historical beta of

1.6, and in the past, the firm has assumed a 265 basis point risk premium when calculating the cost of equity. The firm's next dividend is expected to be $0.50 per share, and the dividend has been growing at a 12% annual rate. Finally, the firm's common stock is priced at $24.78. What is the cost of equity for this firm using the Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF) approach?

  1. 18.24%
  2. The cost of equity using the DCF approach cannot be calculated from the information provided.
  3. 16.15%
  4. 14.02%
  5. 15.65%
  6. 11.20%

Answer(s): D

Explanation:

The cost of issuing common stock can be calculated using several methods, including the Bond-Yield- Plus- Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. In this example, you have been asked to calculate the cost of equity using the Discounted Cash Flow method, which is commonly referred to as the Dividend-Yield-plus-Growth-Rate approach. In calculating the cost of equity using this approach, the following components are necessary: next expected annual dividend, growth rate of dividends, and the current stock price. Everything else provided in this example is largely irrelevant. The calculation of the cost of equity using the DCF approach is as follows: {[next annual dividend $0.50 / common stock $24.78] + expected dividend growth rate 12%} = 14.018%.



Clay Industries, a diversified industrial firm, is considering investing into a new manufacturing facility which would allow the Company to expand its operations into a promising new market for industrial motors, specifically the High Temperature Superconducting, or HTS motors. This project is one of many currently under consideration for Clay Industries, and the amount of R&D expense allocated toward researching this new manufacturing facility is residual in nature. The following information applies to this new project.
R&D expense for the quarter $15,000
Initial cash outlay ($45,000)
t1: ($40,000)
t2: ($10,000)
t3: $40,000
t4: $40,000
t5: $16,000
t6: $25,000
Assuming no taxes and a $0.00 salvage value at t6, which of the following best represent the IRR for his project?

  1. 7.039%
  2. This project will have multiple IRR at any discount rate
  3. The IRR cannot be calculated due to the fact that no discount rate has been provided
  4. The IRR cannot be calculated due to the fact that the project has uneven cash flows
  5. 2.639%

Answer(s): A

Explanation:

Remember that the quarterly R&D expense is a sunk cost, and one which cannot be directly attributable to this project. Because this quarterly R&D expense is not incremental in nature, it should be omitted from the IRR calculation. Additionally, the fact that this project has uneven cash flows is irrelevant for our calculation of IRR.
To determine the IRR for this project, the following information is necessary: the initial investment outlay, the amount of each period's cash inflow, and the number of periods. In calculating IRR, no discount rate is necessary, so the last answer is incorrect. The calculation of the IRR is found as follows: incorporate the initial investment outlay of ($45,000) as Cfo, for CO1=($40,000), CO2=($10,000), CO3=$40,000, CO4=$40,000, CO5=$16,000, CO6=$25,000, CPT IRR. This yields an IRR of 7.039%.



Ace Consulting, a multinational corporate finance consulting firm, is examining the sales potential for a new line of industrial motors developed by Clay Industries, a large industrial firm. In their analysis, Ace Consulting meets with the management of Clay Industries, and asks these individuals to specify the worst "reasonable" set of circumstances, along with the best "reasonable set." These figures are measured against the predetermined "base case" situation. Which of the following choices best describes this technique for measuring stand-alone risk?

  1. Case study analysis
  2. Sensitivity analysis
  3. Monte Carlo simulation
  4. Relational analysis
  5. Scenario analysis
  6. Regression analysis

Answer(s): E

Explanation:

Scenario analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of key variable values. In a scenario analysis, a financial analyst asks operating or other managers to identify the best and worst "reasonable" situations, and these situations are examined against the predetermined "base case."



Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings. The current market price of the firm's stock is $28; its last dividend was $2.20, and its expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15 percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital?

  1. 13.9%
  2. 14.3%
  3. 9.7%
  4. 15.8%
  5. 7.9%

Answer(s): D

Explanation:

Calculate the retained earnings break point:
Given:
Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.
Break point(RE) = $600(1 - 0.6)/0.6 = $400.
Allison will need new equity capital; capital budget exceeds Break point(RE).
Use the dividend growth model to calculate k(s):
k(s) = D1/Po + g = 2.2(1.06)/28(1-.15) + .06 = 0.0979 + 0.06 = 0.1579 = 15.8%.
k(s) = component cost of retained earnings or internal equity.



Gibson Inc. is considering the following five independent projects:
Project RequiredAmount of CapitalIRR
A$20 0,000 20%
B600,000 15
C400,000 12
D400,000 11
E400,000 10
The company has a target capital structure, which is 40 percent debt and 60 percent equity. The company can issue bonds with a yield to maturity of 11 percent. The company has $600,000 in retained earnings, and the current stock price is $42 per share. The flotation costs associated with issuing new equity are $2 per share. Gibson's earnings are expected to continue to grow at 6 percent per year. Next year's dividend is forecasted to be $4.00. The firm faces a 40 percent tax rate. What is the size of Gibson's capital budget?

  1. $200,000
  2. $1,200,000
  3. $800,000
  4. $1,600,000
  5. $2,000,000

Answer(s): C

Explanation:

The size of Gibson's capital budget will be determined by the number of projects it can profitably undertake, i.e., those projects for which IRR > applicable WACC. First, find the costs of each type of financing: cost of retained earnings = k(s) = $4/$42 + 0.06 = 15.52% and cost of debt = k(d) = 11%. To calculate the cost of new equity, we solve for k(e) = $4/($42-$2) + 0.06 = 0.16 = 16%. Given the firm's target capital structure and its retained earnings balance of $600,000, the firm can raise $1,000,000 with debt and retained earnings before it must use outside equity. Therefore, the WACC for 0 - $1,000,000 of financing = 0.4(0.11)(1 - 0.4) + 0.6(0.1552) = 11.95% . Above $1,000,000, the firm must issue some new equity, so the WACC = 0.4(0.11)(1 - 0.4) + 0.6(0.16) = 12.24%. Obviously, Projects A and B will be undertaken. You must then determine whether Project C will be profitable. Since in taking A and B we will need financing of $800,000, the $400,000 needed for Project C would involve financing $200,000 with debt and retained earnings and $200,000 with debt and new equity. Thus, the WACC for Project C is ($200,000/$400,000) x 0.1195 + ($200,000/$400,000) x 0.1224 = 12.095% which is greater than Project C's IRR. Clearly, only Projects A and B should be accepted, and the firm's capital budget is $800,000.



Which of the following equations correctly illustrates the calculation of the cost of equity using the Dividend- Yield-plus-Growth-Rate approach?

  1. Annual dividend/current stock price * (1-tax rate)
  2. (Next annual dividend/current stock price) + expected growth rate
  3. (Retention rate)*(ROE)
  4. Risk-free rate of return + beta(expected return on the market - risk-free rate of return)
  5. Payout ratio * (ROE/[expected return-required rate of return]) F. (Last annual dividend/[expected return - required return]) * expected growth rate

Answer(s): C

Explanation:

The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The first choice illustrates the Capital Asset Pricing Model, while the second represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.



Ludicrous Telecom, an international telecommunications company, has recently announced its plans to issue additional common stock. The company has been publicly traded for over 25 years, and currently has a capital structure consisting of 35% debt, 55% equity, and 10% preferred stock. This is the first time since its initial public offering that the company has announced its intention to issue common stock. According to the Signaling Theory, this announcement should be viewed as which of the following? Choose the best answer.

  1. Bullish, because the company will be provided with additional capital from the share offering.
  2. Bullish, because it indicates superior investment prospects for the firm.
  3. Bullish, because it indicates a shift toward a more conservative capital structure.
  4. Bearish, because it indicates poor investment prospects for the firm.
  5. Bearish, because it indicates an shift toward a more radical capital structure.
  6. The signaling theory would not apply to this announcement.

Answer(s): D

Explanation:

According to the Signaling Theory, the management of companies send implicit signals to investors by their capital budgeting decisions. Believers of this theory feel that corporate managers have access to superior information, and are allowed to exploit this information asymmetry through their capital budgeting decisions.
According to the signaling theory, when investment prospects are good, companies will prefer to raise capital first by using internally generated funds, i.e. retained earnings and marketable securities investments. If this source of capital is unavailable, then companies will prefer to issue debt rather than common or preferred equity. The reasoning behind this is the fact that by raising debt, the company will not dilute the ROE figure, which is expected to be high due to favorable investment prospects. In contrast, when investment prospects are poor, the Signaling Theory states that companies will prefer to raise funds first by issuing common equity.
The reasoning behind this is the fact that by issuing additional equity when investment prospects are poor, companies will be able to "spread the losses" amongst a greater pool of investors, thereby lessening the overall negative effect. In this example, the management of Ludicrous Telecom have announced their intention on issuing additional common equity, and the Signaling Theory would state that this is sending a bearish signal as to the investment prospects of the firm.



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