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Free Test Prep CFA-Level-I Exam Questions (page: 39)

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Rollins Corporation is constructing its MCC (Marginal Cost of Capital) schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk- premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' component cost of debt?

  1. 8.6%
  2. 7.2%
  3. 10.0%
  4. 8.0%
  5. 9.1%

Answer(s): B

Explanation:

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent. The after-tax cost of debt equals = 12.0%(1 - 0.40) = 7.2%.



A firm needs to raise $123 million for a proposed capital expansion project. It's earnings breakpoint is $178 million and it is committed to maintaining a debt-to-equity ratio of 1.2. Its after-tax cost of debt is6.2% and the required rate of return on its equity is 13.2%. The firm's marginal cost of capital for the project equals ________.

  1. 7.12%
  2. 6.89%
  3. 9.38%
  4. 12.19%

Answer(s): C

Explanation:

Since the proposed capital requirement of $123 million is less than the earnings breakpoint, the firm's marginal cost of capital for the project equals its WACC. With D/E = 1.2, E/(D+E) = 1/(1+1.2) = 0.455. The WACC then equals 0.455*13.2% + 0.545*6.2% = 9.38%.



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, what is the MIRR of this project?

  1. This project will have multiple MIRR at any discount rate
  2. 7.038%
  3. The MIRR cannot be calculated due to the fact that no discount rate has been provided
  4. The MIRR cannot be calculated due to the fact that the project has uneven cash flows
  5. 2.639%

Answer(s): C

Explanation:

In order to calculate the Modified Internal Rate of Return, a explicit discount rate must be given. In this example, the MIRR cannot be calculated due to the fact that no discount rate has been provided. Remember that while the Internal Rate of Return is calculated without the use of an explicit discount rate, the Modified Internal Rate of Return requires some figure for the cost of capital.



Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

  1. Risk premium method.
  2. CAPM method.
  3. Accounting beta method.
  4. Pure play method.
  5. All of these answers are correct.

Answer(s): D

Explanation:

The pure play method is used for estimating the beta of a project in which a firm identifies several companies whose only business is the product in question, then calculates the beta for each firm, and finally, averages the betas to find an approximation to its own project's beta.



In his determination of a project's NPV and IRR, a financial analyst with Smith, Kleen, & Beetchnutty indexes the project's anticipated cash flows for the expected effects of inflation. However, the discount rate applied to these cash flows does not factor an adjustment for inflation. Assuming a positive inflation figure for the every period in the project's lifespan, which of the following correctly describes the effects of the omission on the NPV and IRR calculations?

  1. NPV and IRR will be biased upward
  2. NPV and IRR will be biased downward
  3. NPV will be biased downward, IRR will be biased upward
  4. NPV will be biased upward, IRR will be unaffected
  5. NPV will remain unaffected, IRR will be biased downward
  6. NPV will be biased downward, IRR will be unaffected

Answer(s): D

Explanation:

By failing to include an the effects of anticipated inflation in the discount rate applied to the project's cash inflows, this analyst is creating a situation in which the NPV calculations will be biased upward. This is due to the fact that the project's inflows have been adjusted for the anticipated effects of POSITIVE inflation, i.e. these cash flows have been indexed upward, while at the same time the rate at which these cash flows are being discounted has not increased. In effect, the cash inflows of the project are being overstated, and this will lead to an upward bias in the NPV calculation. Remember that the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows. The fact that this analyst has not incorporated the effects of inflation into the discount rate has no bearing on IRR, because the IRR equation does not call for a discount rate.



Brock Brothers wants to maintain its capital structure, which is 30 percent debt, and 70 percent equity. The company forecasts that its net income this year will be $1,000,000. The company follows a residual dividend policy, and anticipates a dividend payout ratio of 40 percent. What is the size of the company's capital budget?

  1. $857,143
  2. $1,428,571
  3. $1,000,000
  4. $600,000
  5. $2,000,000

Answer(s): A

Explanation:

Since the company expects to pay out 40% of net income or $400,000, it must expect to have $600,000 of retained earnings available for capital investment. Given that the firm will finance new investment with 70% equity and 30% debt, $600,000 must represent 70% of the firm's capital budget, that is, $600,000 = (0.7)CB or CB = $857,143.



Which of the following statements is most correct?

  1. Investors can interpret a stock repurchase by a firm as a signal that the firm's managers believe the stock is underpriced.
  2. None of these statements are correct.
  3. After a 3-for-1 stock split, a company's price per share will fall and it's number of shares outstanding will rise.
  4. Stock repurchases can be used by firms to defend against hostile takeovers since they increase the proportion of debt in a firm's capital structure.
  5. All of these statements are correct.

Answer(s): E

Explanation:

These are all correct.



Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure, which consists of 30 percent debt and 70 percent equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?

  1. 40%
  2. 45%
  3. 30%
  4. 25%
  5. 35%

Answer(s): A

Explanation:

Step 1 Find equity required to maintain capital budget:
Capital budget$3,000,000
% of budget financed with equityx 0.70
$2,100,000
Step 2 Calculate dividend:
Earnings$3,500,000
Less equity retained(2,100,000)
Dividend$1,400,000
Step 3 Find payout ratio:
Dividend/Earnings = $1,400,000/$3,500,000 = 0.4000 = 40%.



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