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Free Test Prep CFA-Level-I Exam Questions (page: 38)

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Which of the following are necessary conditions for the NPV and IRR methods to produce similar rankings? Choose the best possible answer.

  1. Projects must be mutually exclusive and of equal scale
  2. Projects must be independent and have normal cash flows
  3. Projects must be mutually exclusive and have normal cash flows
  4. Projects must have normal cash flows, and must be equal in scale and lifespan
  5. Projects must be of equal scale and have equal lifespans

Answer(s): D

Explanation:

When examining mutually exclusive projects with equal lifespans and of equal size, the IRR and NPV calculations will produce similar ranking results as long as the projects under examination have "normal" cash flows. It is when the projects under examination have "non-normal" cash flows that the IRR method can experience some difficulty. Non-normal cash flows are defined as cash flows in which negative cash inflows are juxtaposed within a series of positive cash inflows, creating a situation in which the sign will change more than once. When examining these "non-normal" projects, the Internal Rate of Return calculation will often produce multiple answers which leads to an incorrect accept/reject decision. In any examination in which the IRR and NPV produce conflicting rankings, the NPV calculation should be used.



Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. What is the maximum amount of new capital that can be raised at the lowest component cost of equity?

  1. $14,700
  2. $21,000
  3. $17,400
  4. $24,500
  5. $12,600

Answer(s): D

Explanation:

BP(RE) = $21,000 x .70/ .60 = $24,500.



Which of the following statements is most correct?

  1. If a firm repurchases its stock in the open market, the shareholders that tender are subject to capital gains taxes.
  2. All of the statements are correct.
  3. None of these statements are correct.
  4. If you own 100 shares in a company's stock, and the company does a 2 for 1 stock split, you will own 200 shares in the company following the split.
  5. Some dividend reinvestment plans increase the amount of equity capital available to the firm.

Answer(s): B

Explanation:

Tendering (selling) shares in the open market is a taxable event. With the stock split, you will own twice the shares but the stock price will be halved. Dividend reinvestment plans permit stockholders to automatically reinvest their dividends in the stock of the paying firm. The new stock type of DRIPs invests the dividends in newly issued stock, hence these plans raise new capital for the firm.



Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, and 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. What is the cost of equity for this proposed common stock issue using the Capital Asset Pricing Model?

  1. 18.24%
  2. 4.09%
  3. 12.64%
  4. 7.04%
  5. 5.56%

Answer(s): A

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. The latter is illustrated in this example. To calculate the cost of common equity using the CAPM, use the following formula: {cost of common equity = [risk free rate of return + beta(expected return on the market - risk free rate of return)}. Incorporating the appropriate figures into this example will yield a cost of common equity at 18.24%.



Given the following information, what is the required cash outflow associated with the acquisition of a new machine; that is, in a project analysis, what is the cash outflow at t = 0? Purchase price of new machine $8,000
Installation charge 2,000
Market value of old machine 2,000
Book value of old machine 1,000
Inventory decrease if new machine
is installed 1,000
Accounts payable increase if new
machine is installed 500
Tax rate 35%
Cost of capital 15%

  1. -$6,460
  2. -$8,980
  3. -$12,020
  4. -$5,200
  5. -$6,850

Answer(s): E

Explanation:

Cost plus installation($10,000)
Sale of old machine+2,000
Tax effect of sale ($1,000 x 0.34)(350)
Decrease in working capital1,500
Total investment at t = 0($6,850)



Los Angeles Lumber Company (LALC) is considering a project with a cost of $1,000 at time = 0 and inflows of $300 at the end of Years 1 - 5. LALC's cost of capital is 10 percent. What is the project's modified IRR (MIRR)?

  1. 15.2%
  2. 12.9%
  3. 20.7%
  4. 10.0%
  5. 18.3%

Answer(s): B

Explanation:

Tabular/Numerical solution:
TV = $300(FVIFA(10%,5)) = $300(6.1051) = $1,831.53.
$1,000 = TV/(1 + MIRR)^5
$1,000 = $1,831.53/(1 + MIRR)^5
(1 + MIRR)^5 = 1.83153
MIRR = 12.866%.



The degree of financial leverage is defined as:

  1. the change in EPS for a unit change in EBIT.
  2. the percentage change in EBIT for a 1% change in EPS.
  3. none of these answers.
  4. the percentage change in EBIT for a 1% change in the quantity sold.

Answer(s): C

Explanation:

The degree of financial leverage is defined as the percentage change in EPS for a 1% change in EBIT.



Grant Grocers is considering the following investment projects:
Project Size of Project IRR of Project
V 1.0 million12.0%
W 1.2 million11.5%
X 1.2 million11.0%
Y 1.2 million10.5%
Z 1.0 million10.0%
The company has a target capital structure, which is 50 percent debt and 50 percent equity. The after- tax cost of debt is 8 percent. The cost of retained earnings is estimated to be 13.5 percent. The cost of equity is estimated to be 14.5 percent if the company issues new common stock. The company's net income is $2.5 million. If the company follows a residual dividend policy, what will be its payout ratio?

  1. 66%
  2. 12%
  3. 32%
  4. 54%
  5. 100%

Answer(s): C

Explanation:

The company's WACC (provided no new equity is issued) is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with the project IRRs reveals that the company will undertake projects V, W, and X. Total financing costs for these projects is $3,400,000. Of this amount, 0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus, $2,500,000 - $1,700,000 = $800,000 will be available for dividends. The payout ratio is then $800,000/$2,500,000 = 32%.



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