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Free Test Prep CFA-Level-I Exam Questions (page: 41)

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Santorum Co. has a capital structure which consists of 50 percent debt, 30 percent common stock, and 20 percent preferred stock. The company's net income was just reported to be $1,000,000. The company pays out 40 percent of its net income as dividends. How large of a capital budget can the company have, without having to issue additional common stock or change its capital structure?

  1. $600,000
  2. $2,000,000
  3. $1,200,000
  4. $200,000
  5. $180,000

Answer(s): B

Explanation:

The retained earnings break point indicates the size of the capital budget when not issuing additional common stock. BP(RE) = ($1,000,000(1 - 0.4))/0.30 = $2,000,000.
BP = break point; RE = retained earnings



The management of Intelligent Semiconductor is considering two mutually exclusive projects, which are detailed below:
Project A
Electron looping apparatus
Initial investment outlay ($6,000,000)
t1: $2,750,000
t2: $1,250,000
t3: $1,250,000
t4: $2,750,000
Cost of capital of 10.55%
Project B
Optical switching apparatus
Initial investment outlay ($5,040,000)
t1: $1,000,000
t2: $1,000,000
t3: $1,500,000
t4: $1,500,000
t5: $1,500,000
t6: $750,000
t7: $300,000
t8: $50,000
Cost of capital of 10.55%
Assuming no taxes, a $0.00 salvage value at the end of the each project's life, as well as the ability to replicate each project identically at the end of its lifespan, which is the superior investment according to the Common Life approach? Additionally, what are the NPV and IRR of the superior project over the common life?

  1. Project B, NPV $305,221; IRR 13.65%
  2. None of these answers
  3. Project B, NPV $287,725.32; IRR 12.38%
  4. Project A, NPV $465,515; IRR 12.78%
  5. Project A, NPV $462,038; IRR 12.72%

Answer(s): E

Explanation:

The Replacement Chain, or "Common Life" approach, is a useful method which allows two or more projects with unequal lives to be examined. In the Replacement Chain approach, the lifespans of each project being examined are multiplied in such a way that the resulting projects share a "common life." In this example, the Optical Switching apparatus has a lifespan of eight periods, while the electron looping apparatus has a four- period lifespan. The common multiple of both projects is 8, and by replicating the cash flows of the electron looping project through period 4, i.e. by carrying out the project for an additional cycle, we can arrive at a "common life" for both projects. Carrying out the electron-looping project through eight periods will yield the following series of cash flows:
Electron looping apparatus
t0: ($6,000,000)
t1: $2,750,000
t2: $1,250,000
t3: $1,250,000
t4: [$2,750,000 + ($6,000,000)]=($3,250,000)
t5: $2,750,000
t6: $1,250,000
t7: $1,250,000
t8: $2,750,000
By incorporating these cash flows into your calculator, you will find a NPV of $462,038 for this project, as well as an IRR of 12.72%. The Optical Switching apparatus has a NPV of $287,725 and an IRR of 12.38%.



Which of the following statements is most correct?

  1. Sunk costs should be ignored in capital budgeting.
  2. None of these answers are correct.
  3. Externalities should be ignored in capital budgeting.
  4. All of these answers are correct.
  5. Opportunity costs should be ignored in capital budgeting.

Answer(s): A

Explanation:

Sunk costs should be ignored. The other statements are false.



The management of Intelligent Semiconductor is considering the creation of a new manufacturing facility. The following information applies to the new facility:
Initial investment outlay: ($50,200,000)
t1: ($3,000,000)
t2: ($1,500,000)
t3: $12,000,000
t4: $20,000,000
t5: $25,000,000
t6: $25,000,000
t7: $20,000,000
t8: ($1,500,000)
t9: ($3,000,000)
t10: $500,000
Assuming a 15% discount rate, along with a $0.00 salvage value at the end of year 10, what is the Modified Internal Rate of Return for this project?

  1. 13.19%
  2. 9.88%
  3. 12.66%
  4. 14.61%
  5. 13.90%
  6. Because this is a non-normal project, the Modified Internal Rate of Return cannot be calculated.

Answer(s): E

Explanation:

Remember that the Modified Internal Rate of Return escapes many of the pitfalls associated with the traditional Internal Rate of Return calculation. One such pitfall is the fact that the traditional IRR cannot produce reliable calculations for "non-normal" projects, such as the project illustrated in this example. The Modified Internal Rate of Return, however, escapes this basic flaw and can be used to evaluate virtually any project. The calculation of the answer in this example is as follows:
Step 1: Determine the Future Value of the cash inflows by compounding each positive inflow by the cost of capital. This value is often referred to as the "Terminal Value." Remember that in this example, the positive cash inflows begin at period 3.
Step 2: Determine the Present Value of the cash outflows by discounting each negative inflow by the cost of capital. The cash inflows to be discounted occur in periods 1, 2, 8, and 9.
Step 3: Determine the rate that equates the PV of the cash outflows to the FV of the cash inflows. The calculation of the FV of the cash inflows is shown as follows:
FV of the cash inflows = {[$12,000,000 * 2.660] + [$20,000,000 * 2.313] + [$25,000,000 * 2.011] + [$25,000,000
* 1.749] + [$20,000,000 * 1.521] + [$500,000 * 1]} = $203,100,000.
This is the terminal value.
The calculation of the PV of the cash outflows is calculated as follows:
PV of the cash outflows = {$50,200,000 + [$3,000,000 / 1.15] + [$1,500,000 /1.323] + [$1,500,000 / 3.059] + [$3,000,000 / 3.518]} = $55,285,596.07
Now that the present and future (terminal) values of the cash flows have been determined, the Modified Internal Rate of Return can take place. The following values are imputed into the Present Value worksheet on your calculator:
PV =($55,285,596), FV = $203,100,000, N = 10, PMT = $0.00, Compute I. Imputing these values will yield an answer of 13.896% for the Modified Internal Rate of Return.



A firm has issued a perpetuity with a total face value of 100 million dollars and a coupon rate of 5.8%. If the risk free rate equals 5.8% and investors require a rate of return of 10.6% from the perpetuity, what's the amount the firm raised through the issue?

  1. $55.28 million
  2. none of these answers
  3. $100 million
  4. $54.72 million

Answer(s): D

Explanation:

The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. Hence, the price of the perpetuity issue = $(100*5.8%/10.6% ) million = $54.72 million.



Merryweather, a manufacturer of summer casual wear, has a return on equity of about 10.6%. It typically pays out about 27% of its earnings as dividends. The firm's stock has a beta of +0.23. The market has an expected return of 16.2% and the prevailing risk-free rate is 6.9%. Merryweather recently announced that last year's EPS was $4.3 per share. Given these data, Merryweather's share price should be:

  1. $91.19
  2. $84.84
  3. $96.07
  4. $78.29

Answer(s): C

Explanation:

The dividend growth rate, g = ROE*(1-payout ratio) = 0.106*(1-0.27) = 7.738%.
The dividend this year was 4.3*0.27 = $1.16. Therefore, expected dividend next year = D1 = (1+g)*Do = 1.07738*1.16 = $1.25.
The required rate of return on the stock can be found using CAPM, which gives Rstock = Rf + beta*(Rm - Rf) = 6.9% + 0.23*(16.2% - 6.9%) = 9.039%.
Therefore, Po = D1/(k-g) = 1.25/(9.039% - 7.738%) = $96.07.



Which of the following statements is correct?

  1. It is unrealistic to expect that increases in net working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project.
  2. Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value.
  3. All of these statements are false.
  4. An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project.
  5. Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions.

Answer(s): B

Explanation:

A gain on the sale occurs when equipment is sold for more than its book value. This increases profit and cash flow.



Which of the following is/are true about the DOL?

  1. The DOL measures the change in EBIT for a given change in the quantity sold.
    II. The DOL is zero at the break-even level.
    III. The DOL decreases as the level of sales increases.
  2. I only
  3. II & III
  4. I, II & III
  5. III only
  6. II only

Answer(s): D

Explanation:

The DOL measures the percentage change in EBIT for a given percentage change in the quantity sold. At a sales level of Q units, DOL = Q(P-V)/[Q(P-V) - FC] Hence, at the break-even level, the DOL is infinite but decreases as the sales increase.



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